Leaders in Beijing acknowledge that fiscal reform is critical, and that it has a long way to go in China. In particular, reform plans promise to close the gap between what the central government commands local governments to spend and the resources available to them. That fiscal gap contributes to resource misallocation, suffocating debt, inefficiency, underinvestment in public services, industrial overcapacity, local resistance to reforms, and deteriorating growth potential. In 2014, leaders approved fiscal reforms and a 2016 deadline for “basically” finishing major tasks. Those deadlines slipped.

To gauge fiscal reform progress, we watch the gap between local government expenditures and the resources available to pay for them, including central government transfers. Our primary indicator shows the official trend in dark blue and an “augmented” calculation of the gap including off-balance sheet, or “extra-budgetary,” expenses and revenues in light blue – thus covering the range of estimates. The higher the expenditure-to-revenue ratio, the more concerning the side effects, including debt burdens. Our supplemental fiscal indicators include local financing sources, the national official and augmented fiscal position, the move from indirect to direct taxes, and the share of expenditures on public goods.

Quarterly Assessment and Outlook

Center-local fiscal reform conditions did not see fundamental improvement in 2Q2017, and the local government fiscal gap continues to rise both by official and augmented measures. This cannot persist without elevating the risk of destabilizing debt levels, as the National Financial Work Conference held in July and chaired by President Xi Jinping made clear. There are no magic solutions to this conundrum: either local expenditure contributions to growth must fall or stability risks must rise; asset sales, mostly land, are already as high as possible. The exception is selling off state enterprise assets, which could both raise revenue and reduce liabilities on the government’s balance sheet, but that is not likely to happen in a fiscally meaningful way in the near-term. See State-Owned Enterprise Reform section for more on this topic.

Considering these fiscal pressures and mixed policy signals, a near-term alteration in fiscal priorities to manage the conflicting goals of growth and deleveraging is needed if China is to get on track to its self-stated fiscal reform objectives and reduce risks while sustaining growth into the longer term. The Party Congress held in October checked all the major boxes without offering a clear priority list. And even a good fiscal policy redirection will take time. Therefore, we expect fiscal imbalances to stay at the current level, if not further increase, in the near term, leaving interpretation of fiscal policy declarations (such as they are) murky until tangible results materialize.

Policymakers remain torn between fiscal sustainability and the desire for stable GDP growth.

This Quarter’s Numbers

Our primary fiscal indicator reflects increasing local government expenditures, both on-budget and off-budget, and decreasing bond issuance over the past four quarters up to 2Q2017 to pay for them. The current on-budget expenditure-to-revenue ratio is 112.1% and the extra-budgetary ratio is 145.4%, which means that in the most conservative scenario, required local expenses are 12.1% higher than normal sources of revenue (retained taxes and fees plus transfers from the central government). Once we include extra-budgetary items such as local governments’ extra spending on infrastructure, that deficit widens to 45.4%, a five-year high.

Central authorities are working to limit local bond issuance as a financing channel to avoid future indebtedness burdens. China’s central bank (People’s Bank Of China, PBOC) has been tightening bond financing since August 2016; at a July 2017 National Financial Work Conference, President Xi pledged to curtail local government debt growth. On a four-quarter moving average (4qma) basis, new bond issuance fell 48.1% in 2Q2017 over the previous year, leaving less fiscal wiggle room.

But local governments’ expenditures grew rapidly in the first half of 2017 to support stable reported GDP growth. General budget expenditures grew 25.6% and 13.5% year-on-year in 1Q and 2Q. On the positive side, general budget revenue in 1Q and 2Q bounced back from negative growth last year but remained near the bottom of the five-year trajectory (5.4% and 4.3% year-on-year, respectively). Off-budget infrastructure spending, meanwhile, grew by 19.6% and 16.4% year-on-year in the past two quarters, gaining steam after growth temporarily moderated in 4Q2016. The bottom line is that fiscal deficits played a critical role in China’s surprisingly strong 6.9% GDP growth over the most recent two quarters despite central bank deleveraging.

Supplemental indicators provide additional perspective. The fiscal buffer provided by the legalization of local bond issuance in 2016 is unsustainable, and Beijing is torn between tolerating it to support growth and curtailing it to reduce future risks. But as seen in Sources of Local Government Financing, by mid-year debt issuance was back up, adding nearly RMB 1 trillion in additional liabilities. This was necessary to finance expenditures, as central transfers, locally retained tax revenues, and revenue from land sales were insufficient. While Beijing has pledged to reduce local dependence on land sales, which are a cause of real estate and industrial overcapacity, authorities still rely on land for about RMB 1 trillion in revenue a quarter. Official and Unofficial National Fiscal Deficit is a reminder of the limits to national fiscal capacity overall: while officially deficits are manageable (4.3% of GDP on a 4qma basis), the augmented deficit count, adjusted for land acquisition and infrastructure spending, stands at 16.7% of GDP – back to its 2016 peak.

The mix of taxation sources also matters. To improve fiscal management Beijing intends to move from indirect to direct taxation (see Moving from Indirect to Direct Taxes). The direct tax share has risen to 30.2% as of 2Q2017, growing steadily though far short of the OECD average. A shift from a business tax to a value-added tax (VAT) system (both indirect taxes) was only completed in May 2016. New moves toward direct taxation, especially the introduction of property taxes, are not likely to materialize soon. On the expenditure side, in addition to the increasing spending mandates on infrastructure, Government Social Expenditures as Percentage of Total Expenditure shows social spending, which is essential to future productivity, growing at a moderate speed. Today’s government expenditures on education, social security, health and family planning, and environmental protection amount to 37.2% of total fiscal expenditure, compared with 33.7% five years ago.

Policy Analysis: 2Q2017

Policymakers remain torn between fiscal sustainability and the desire for stable GDP growth. This was especially true in this quarter as officials set the table for the October 2017 National Party Congress. That supportive instinct is increasingly in conflict with China‘s stated concerns about rising debt levels and systemic financial risk. Against this backdrop, policy developments in the quarter centered on prohibiting unregulated local government financing activities while encouraging regulated borrowing and on implementing business tax cuts to avoid defaults and failures.

In a June 2 notice, the Ministry of Finance (MOF) prohibited local governments from issuing debt to cover the purchase of recurrent services. This was one in a series of steps to close loopholes in off-books local government financing. Yet on the same day, MOF started a local government pilot program to issue special bonds backed by revenue-generating items such as land reserves and local toll roads. On June 26, MOF together with the Ministry of Transport (MOT) allocated RMB 73 billion in new quotas for toll road–backed bond issuance. This is just an example of the contrary directions in current fiscal policy.

Beijing continues to use fiscal policy to support growth at the national level as well. In late June, the National Development and Reform Commission (NDRC) outlined a cost-relief plan for business. This involves lowering pension and insurance contributions by businesses, consolidating VAT brackets, expanding tax exemptions for small and low-profit businesses, and cutting various administrative fees.

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