Reform to ease debt risks

The greatest risk in the present-day global economy is the continuous exacerbation of sovereign debt risks, which are haunting both developed and developing countries. China is no exception. Its government debts have recently caught the attention of the world, with experts and scholars coming forward one after another to argue that China's debts have reached a dangerous level and will soon spiral out of control and therefore China is heading for a debt crisis.

However, no one can accurately assess China's current debt situation, unless their judgment is based on a scrutiny of the country's sovereign balance sheet and an examination of the transmission mechanism behind it. All developed countries now deeply mired in the sovereign debt crisis have been following the path of low growth, big deficits and high liabilities, and have negative net assets. China, however, has opted for the development model of high growth, small deficits and low liabilities. Moreover, China won't fall into a debt crisis because it has enough sovereign assets to pay for its sovereign debts. China has also not come near to the international line in terms of financial deficits or debt ratio.

But China has remained exposed to the risk of growing sovereign debts. The big financial stimulus package and the lenient credit it has handed out since the outbreak of the global financial crisis has raised the debt leverage of the Chinese government and, in particular, local governments. By the end of 2011, the outstanding debts of the provincial, prefecture and county levels hit 10.7 trillion yuan ($1.73 trillion), with the outstanding government debts of the institutions running financing platforms at 4.97 trillion yuan, or 46.38 per cent of the local governments' total debts. Of the 2,856 county-level governments, only 54 were debt-free. Given the 7.2 trillion yuan of the central bond balance at the end of 2011, the total government debt stood at 18 trillion yuan, about 38 percent of the country's 2011 GDP. Nevertheless, the figure remains in control and was much smaller than those in most developed economies. It is not the size of China's government debts that is worrying, it is the structural risks lurking behind them.

From a medium and long-term point of view, covert debts pose the biggest risks for China. A complete covert guarantee system has taken shape, with the central government standing at the center and local governments making up the main links. All local treasuries keep considerable power over financing, and do not subject themselves to budget constraints, and, deviating from the requirement in the Budget Law that they balance their financial revenues and expenditures, most of them choose to raise a lot of debt. As a result, they have fallen deep into covert debts consisting of arrearages, credits and guarantees. Due to the lack of any definite division of their debt repayment responsibilities, however, the local governments will pass on their responsibilities to those at a higher level once their debts grow beyond their financial capacities, endangering central financial security.

Local government debt risks have continued exacerbating along with the acceleration of the pace of urbanization. Since their incomes from land transfers and tax revenues are hardly enough for the launch of their urbanization undertakings, local governments create all forms of investment and financing platforms such as urban development companies, local commercial banks and urban investment companies to raise funds.

With weaker growth in their nominal GDP and a fast slowdown in their tax revenues and land-transferring fees, local governments are seeing their land-related incomes falling daily. The land-related net incomes earned by the local governments in 2012 made up just 20 percent of their financial revenues that year, 31.7 percent lower than the peak level attained in 2010. Although local government debt risks have not yet spiraled out of control, the slowdown of the growth of the national economy as a whole is driving local government debts to an even higher level. Since the Chinese government no longer boasts a financial surplus and a low debt ratio as it did before the outbreak of the global financial crisis, it does not hold a solid position against the risks arising from the rapid growth of government debts, especially as the economy is slowing. It can no longer grow its balance sheet based mainly on land finance any longer.

It is obvious, therefore, that the debt risks endangering both the central and the local governments are rooted in the country's financial system. As the situation stands, it is necessary to speed up reforms of both the central and the local financial systems and substantially increase the financial and debt transparency. Given the fact that repayment of local government debts has entered a peak period, a financial risk reserve should be created and increased year by year. This general reserve fund should be used exclusively for repayment of government debts. This is the most effective arrangement for preventing the spread and transfer of debt risks.

From a medium and long-term point of view, a race between reform and crisis will be inevitable. China must perfect its central and local financial systems, and create a framework for the control of financial debt as soon as possible. Greater efforts are needed to control local government debts by putting into place a budget-regulated debt financing mechanism, so that the debt level of local governments will be kept at a rational level. The slowdown of the growth of the Chinese economy and the contraction of land-related revenues will put an ever greater debt repayment pressure on the local governments. As the situation now stands, it is necessary to cope with the debt risks by preventing them and lightening them. This brooks no delay in establishing a rational division of financial powers and authority of office between the central and the local governments, and a reform of the country's financial and tax systems that centers on setting responsibilities over spending.