Rein in speed of debt rise

At the end of last year, the National Audit Office released the results of its long-awaited updated survey of China's local government debt, which totalled 17.9 trillion yuan ($2.95 trillion) in June 2013, up from 10.7 trillion yuan at the end of 2010, when the previous tally by the NAO took place.

Included in the June 2013 total is around 7 trillion yuan of contingent liabilities that the NAO calls "debt that the governments may have". These contingent liabilities, largely resulting from explicit and implicit government guarantees by local governments to local government investment platforms, rose a full 75 percent from the end of 2010 to June 2013, as local government investment platform borrowing continued to take place on a very large scale, despite earlier intentions to rein it in.

The NAO's survey confirms that a large-scale rollover of local government debt is taking place, as the short-term maturity of most loans is inconsistent with their use in financing infrastructure, which tends to generate direct or indirect revenues only after a time lag. Indeed, the NAO found that 23 percent of the local government debt matured in the second half year of 2013. With another 22 percent maturing in 2014, rollover - either into new loans or bonds - will have to continue in 2014.

Once we include local government borrowing, fiscal policy has been more expansionary in recent years than the official fiscal data suggests. The inclusion of local government debt pushed up total government debt to around 57 percent of GDP at the end of last year. This is still a manageable level, especially when compared to the government debt in developed countries.

However, it is important to also look at the pace at which these debts have risen in recent years. Whereas the official fiscal data says China's government deficit was around 1.5 percent of GDP in recent years, RBS estimates, which take into account the NAO's data on local governments, suggest it was actually around 7 percent between 2011 to 2013, with the bulk contributed by local governments. The only reason why, despite such high deficits, the government debt-to-GDP ratio did not rise faster than it did in the past five years was that GDP growth remained fairly high.

At RBS we think that, from a macroeconomic perspective, China's overall debt of around 210 percent of GDP and the associated financial risks do not seem large enough to overwhelm the economy and financial system, when we look at macroeconomic indicators, the pattern of growth in the real economy and the robustness of the banking sector. Nonetheless, overall debt is rising too rapidly and the pace of increase needs to be reined in.

As to local government debt, the NAO's numbers show that the overall pace of build-up of local government debt has been too fast, from a sustainability perspective. In addition, specific problems and financial risks have resulted. In the case of some of the infrastructure that is being built, the revenues are unlikely to ever be sufficient to repay the loans, even after maturity extension. Thus, the associated local government investment platforms may need to default on their loans.

Going forward, in order to put local government finances on a sounder, more sustainable footing, the government will need to both recognize and address the problems with the existing stock of local debt and stem the flow of new local government borrowing and the associated risks.

China's leadership has started to take measures in this direction. Most of the measures proposed so far call on banks and local governments to take action and change behavior. While such measures are key, the central government will also need to acknowledge its role in the creation of the problems and become more actively involved in the resolution of legacy problems.

With regard to existing bad loans, resolution will often require the involvement of local governments, especially in the case of local governments in poorer parts of China, and higher levels of government. The losses will have to be absorbed by the banks, local governments and higher levels of government.

For a while already, the central government has tried to stem the flow of new lending by local government investment platforms, including by instructing banks to halt lending to those investment platforms with dubious financial prospects.

However, by itself such a stop could be disruptive and lead to the kind of stress that is not obviously in the interest of the bank, which is why it has in practice been difficult to enforce the rules.

At the Third Plenary Session of the 18th Central Committee of the Communist Party of China in November 2013, the leadership called for hardening local government budget constraints through increased transparency and stricter budget management as well as strengthening incentives among local government officials to contain debt, including by making debt a criterion in the performance evaluation system for senior local government officials.

Such measures are key but not enough. In part local government borrowing has resulted from a mismatch between their revenues and their expenditure responsibilities. Unlike almost all other countries, in China local governments are largely responsible for expenditure on healthcare, education and social security, in addition to most local infrastructure, and the current structure of intergovernmental fiscal relations often does not provide sufficient resources for them to carry out these mandates.

The central government has taken some steps to relieve the financial pressures on local governments by transferring some expenditure responsibilities to the central government and increasing the revenue base of local governments. However, the steps so far have been modest and piecemeal. China needs a complete overhaul of the intergovernmental fiscal relations in these directions. Together with the hardening of budget constraints, the rebalancing of incentives of local governments and orderly development of local government bond issuance this would go a long way in putting local government finances on a sound footing.

The author is chief China economist with The Royal Bank of Scotland.