China: Beyond the Miracle
Part 8 – Can China manage its fiscal risks?
• China’s fiscal system is sound if looked at on the basis of the government’s balanced budget and relatively low public debt burden. However, the fiscal outlook is more challenging if all contingent liabilities are taken into account.
• The current decentralised fiscal system, which was established in 1994, faces a significant mismatch between revenues and expenditures at the local level. Local governments often have to resort to fee collections, land sales and direct borrowing to meet their spending needs.
• Local governments also lack an accountable fiscal system with hard budget constraints. Standing at an estimated 25% of GDP, we think local governments’ liabilities, if left unchecked, could grow rapidly, posing significant fiscal and financial risks in the medium term.
• In the long run, we think the pension system poses the greatest threat to fiscal sustainability in China. There is already a large funding gap, estimated to be as large as 35% of 2011 GDP, and the population will age rapidly in the coming years.
• China’s government liabilities are already very high. We estimate total liabilities at 62-97% of GDP, depending on assumptions of pension gaps. Moreover, some current favourable conditions for debt sustainability are likely to change as growth slows, capital account becomes more open and financing costs rise.
• Although we think the probability of a debt crisis in China is low, the risk is real, especially if the contingent liabilities of local governments and the financial system, as well as the pension gap, continue to grow.
• The key to averting the risk of a debt crisis is further economic reforms, including financial reform, state-owned enterprise (SOE) reform, fiscal and pension reform. Contingent liabilities need to be effectively controlled and managed. Local government soft budget constraints and the ensuing overspend and overborrow need to be addressed.
• Policies addressing these risks imply more social welfare spending and less fixed asset investment. These are also likely to lead to slower growth. At the same time, we think such reforms, combined with rising wages and improving income distribution, would further promote consumption.
• Such policies could also lead to higher funding costs and increased income redistribution from the corporate to the household sector. This would squeeze profits further, increase financial risks and promote consolidation in heavy and highly leveraged industries.