Opinion: It’s Fine for Local Governments to Repay Old Debts With New Ones
The Ministry of Finance recently said that “the upper limit of local government debt issued to pay back bonds maturing in 2018 will be decided according to either the number of bonds requested to be issued or the amount that is maturing, whichever figure is lower.”
This triggered some debate as to whether the ministry had, for the first time, said clearly that local governments are allowed to issue new debt to pay back old. The debate, whatever its conclusion, reflects the widespread anxiety in society over China’s local government debt.
Since 2008’s 4 trillion yuan ($623 billion) stimulus package, China’s local government debt has grown bigger and bigger, becoming an economic issue watched the world over. The 2015 Budget Law clarified that bonds were the only legal form of local government debt, allowing local governments to swap other forms of debt previously accrued, mostly via local government financing vehicles, into bonds. Since then, China’s local government debt management system has become gradually more refined, practical and orderly.
But one question remained unanswered: With local government debt growing larger and larger, how can they pay it all back? Local officials that I have contacted often ask when the central government will take on local government debt. They perhaps think that if local governments are unable to pay back their own debts, sooner or later, the central government will step up instead. Several academics hold this view. Yet the Ministry of Finance has repeatedly emphasized that “whoever’s child it is should hold it themselves;” in other words, local governments should be responsible for their own debt repayment. But with these children growing ever larger, the ministry has not given any guidance on how local governments are supposed to keep on holding them.
The Budget Law proposed managing local government debt quotas, and emphasized that “debt taken on should have a repayment plan and a stable source of repayment funds; it must be used only for capital expenditure for public welfare, not for day-to-day expenses.” But it did not clarify how to deal with the debt local governments have already accumulated, now the peak period of infrastructure spending is over. In the long run, where are these “stable sources of repayment funds”? The Budget Law’s stipulations on the future direction of local government debt are vague, but the subtext is that if there is no need to fund construction in the future, then local governments should be able to pay back all their debts.
This has meant the market and international public opinion are greatly concerned about whether local governments are in fact able to pay back all their debts. Here, government debt is often compared with corporate debt, with the belief that as long as the debt is used to make high-quality assets, then local governments will be able to repay it. Some research teams’ estimates of China’s government balance sheets have attracted much public attention. According to the Budget Law, local government debt can only be used for “capital expenditure for public welfare.” However, assets formed in this way are unlikely to generate the market value required to repay the debt. If they are supposed to be able to, then government debt has already created great risks.
These understandings of the future of local government debt do not reflect the substance of the problem. As I understand it, local government debt is an appropriate method by which local governments use their creditworthiness to raise money, and government creditworthiness is not the same as that of corporations. The ideal direction for local government debt to take is toward “not defaulting and also not repaying everything.” Not defaulting means local governments can pay maturing debt on time and avoid liquidity crises; not repaying everything means that total debt can rise with no need to pay it all back within a certain time frame. Borrowing to pay back old debts is actually a systematic long-term solution to settle debt repayments, not an ad hoc measure. But the market has to be able to trust local governments’ creditworthiness, and local governments must be able to effectively manage their debt and avoid liquidity crises.
The evolution of local government debt in the U.S., Germany and Japan demonstrates the necessity of “not defaulting and also not repaying everything.” Historically, local government debt played an important role in supporting infrastructure construction in these countries. Even though the peak infrastructure-building phase of these countries is long gone, their local government debt balance as a proportion of gross domestic product is still going up, and is higher than China’s at present. This shows that in the long run, these countries have never repaid their total debt. A few places, such as the U.S. city of Detroit, have had to default on their debt though, showing the difficulty of managing local government creditworthiness well.
Looking at local government debt from this perspective creates high requirements for China’s local government debt management system. First, there should be clear legal support for localities borrowing to pay back old debts, in order to stabilize market expectations. Second, local governments should be able to effectively manage their creditworthiness to avoid financial risks. Controlling and reducing all kinds of illegal hidden debt is therefore a key problem. Finally, local governments must properly maintain their creditworthiness, which involves efficiently allocating their debt quota and improving the performance of their spending on public interest projects.
Wang Dehua is a research fellow with the National Academy of Economics Strategy under the Chinese Academy of Social Sciences
Jun 26 18:38
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