The road to public finance reform

When local governments cannot close the financing gap by transfers from the central government, they have often turned to off-budget resources, accumulating debt. Local government debt has increased by 67 percent since 2010.

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While the amount of total local government debt is still manageable at 30 percent of GDP, its rapid expansion is worrisome. Moreover, approximately 40 percent of it has been incurred by non-transparent local government financing vehicles, which emerged to circumvent the Budget Law's prohibition on local government borrowing. Such financing vehicles have proliferated since 2008 as two-thirds of the financing responsibility of the 4-trillion-yuan ($643 billion) stimulus package rested on local governments.

To address problems arising from local government financing vehicles, China should set in place appropriate monitoring and regulatory frameworks. It is also crucial to ensure sufficient revenues for local governments.

In order to provide more resources to the local governments to meet their needs, strengthening of local government-specific taxes would be a priority. In this regard, international experience suggests that taxes on natural resources and property are an appropriate choice.

Regarding the provision of social services such as education, health and pensions, in addition to possible expansion of the central government's role in the expenditure side, larger transfers from the central government to local governments could be considered.

Local governments need to be provided with more flexibility to borrow by introducing municipal bonds, a practice the government is already piloting in six cities. However, at the same time, there should be effective debt management and monitoring mechanisms to avoid inadvertent over borrowing by local governments.

In public finance reform, public-private partnerships (PPPs) could play a significant role.

The PPP model could help the local governments in China make the transition to becoming buyers of services on a competitive basis rather than suppliers. I would like to however cautioned against using PPP as a tool to transfer expenditure to less-transparent off budget spending. PPPs are not a panacea and they do bring risks and contingent fiscal costs on local governments. While PPP has the potential to enhance public service provision, there are numerous examples of failures in both advanced and developing economies. PPPs need to be designed and implemented carefully.

Reforming State-owned enterprises is critical to allow the market a greater role in the economy but it is also deeply related to the reform of public finance. In many developing countries, inefficient SOEs are the reasons for the loose fiscal expenditure to subsidize them and for the loss of potential revenue to the government. In this context, I note that the Third Plenum's decision to transferring an increased share of SOE's dividends to public spending such as education and health, and to the social security fund.

China needs to embark on implementing reforms earlier than later based on the clearly defined agenda. As the great ancient Chinese philosopher Lao Tzu said, it is important for China to do the difficult things while they are easy, and do the great things while they are small. Indeed, China's challenges will become even more difficult, if not addressed now.

The author is president of Asian Development Bank. The article is an excerpt from his speech at the China Development Forum 2014 in Beijing on March 23.