BY EDOARDO CAMPANELLA
Huge infrastructure projects are not always symbols of power and affluence. They often hide a sense of fear and insecurity. More than 2,000 years ago, for example, during the Qing dynasty, nomadic incursions from Inner Asia led to the construction of the Great Wall. Now, concerns about a slowing economy have pushed Beijing to undertake a massive economic stimulus program, worth more than $160 billion, with a special focus on investment in subways, roads, and railways.However, just as the Great Wall did not stop the barbarians from raiding China’s countryside, so these infrastructural projects will do little to propel the Chinese economy. Instead, they will likely exacerbate tensions between Beijing, which is imposing their construction, and the cash-strapped local governments that have to pay for them. China risks swapping negligible short-term growth for future financial instability.
The economic relationship between the different levels of Chinese government is complicated and uneasy. As a result of a convoluted fiscal system by which money is transferred from the central government to the provinces, local governments usually lack the funds needed to cover the expenses related to Beijing’s ambitious growth targets. In fact, provinces, towns, and counties receive roughly half of total tax revenues but are responsible for two-thirds of total government spending. And they have few ways to make up the money; until 2014, they could not even borrow money without the central government’s permission.
For Beijing, this system ensures that local officials are dependent on (and compliant with) the capital. Communist Party leaders fear that, if not properly controlled, regional and subregional governments might drift from the center, undermining the country’s unity. Beijing is right to be worried. China consists of 23 provinces, 334 prefectures, and thousands of counties with diverse geographies, distinct cultural traditions, and disparate economic needs. The risk of political fragmentation is already high without granting financial autonomy to each administrative unit.
China boasts the world’s highest bridge and its longest bridge. But projects like these pile up debt and breed corruption while producing little benefit for locals.
However, over-centralization comes at a cost. Central planners aren’t well placed to identify the most profitable (or useful) infrastructure projects. China boasts the world’s highest bridge and its longest bridge. But projects like these pile up debt and breed corruption while producing little benefit for the locals whose true needs are hardly understood by a technical committee gathering in Beijing.
The coastal province of Jiangsu is emblematic of the dysfunctional relationship between the different levels of government. The province boasts a GDP larger than Turkey’s and a population larger than Germany’s. It also holds the record as one of the most indebted provinces in the country—its local debt is over 80 percent of its fiscal revenues, making Jiangsu a systemic risk to the Chinese economy. As of the end of 2017, Zhenjiang, one of the province’s port cities, had accumulated interest-bearing liabilities of almost $60 billion, nearly 14 times the city’s general fiscal revenue that year. Most of this debt has to do with the construction of roads, harbors, and railways mandated by Beijing.
This intricate intergovernmental transfer system creates a dangerous cycle. Local governments overspend to assuage Beijing, and they end up running huge deficits and piling up a mountainous debt. Then, the central government complains about the lavishness of local governments when it must step in and foot the bill. Zhenjiang, for instance, was recently offered the opportunity to receive a special long-term loan to pay back its debt in exchange for a commitment to control its spending—spending that is necessary for it to meet the growth targets set for t by Beijing. So far, the city has failed to do so, arousing the ire of the Ministry of Finance.
Because Beijing never sends enough money to pay for the infrastructure projects it imposes, local governments usually resort to off-budget borrowing. They may use state-owned land and shares in local state firms as collateral to raise money from banks, the bond market, and consumers rather than from the central government by creating ad hoc state-owned enterprises (technically known as Local Government Financing Vehicles).
But Beijing still remains the guarantor of such debt—a liability that isn’t even counted in China’s national debt figures. According to the IMF, in 2018, although China’s official debt was listed at around 40 percent of GDP, the augmented debt (which takes into account local obligations) was about 75 percent. Infrastructure spending accounts for roughly two-thirds of the gap between the two measures. S&P Global Ratings likens it to “an iceberg with titanic credit risks.”
China’s stimulus program will only compound its debt problem, sending a signal of growing weakness to the rest of the world.Perhaps understanding as much, Beijing has instructed local governments to issue so-called special-purpose bonds with proceeds earmarked for infrastructure projects. Special-purpose bonds differ from traditional local government bonds in that they are repaid by the returns on the projects, not by the government. In other words, with this type of borrowing, Beijing gets out of acting as the guarantor of last resort of its own projects.
But special-purpose bonds will compound the local governments’ problems. Local infrastructure projects often take years to generate investment returns (if they ever do), which raises the risk of default. Not surprisingly, in 2018, special-purpose bonds coveredless than 15 percent of local governments’ funding needs to pay for physical infrastructure. Localities with highly fragile finances simply struggled too much to issue bonds that were not guaranteed by Beijing.
If the bonds aren’t taken up, Beijing will be forced to reluctantly take on the liabilities itself— either directly as in the past or indirectly by forcing banks (which are de facto controlled by the government) to purchase the special-purpose bonds. In turn, paying off an outsized public debt will end up draining resources from more productive uses and might hinder China’s geopolitical ambitions. Alternatively, Beijing might decide not to intervene and let localities default on their debt, but this would trigger a panic in financial markets that would eventually feed through the economy, compromising growth.
Instead of trying to juice the economy by boosting investment and accumulating more debt, Beijing should focus on other policies. Reforming state-owned enterprises, taming the shadow banking sector, promoting environmental regulation, and supporting young entrepreneurs would lay down the foundations for a more balanced economic model. Otherwise, China will only temporarily (and rather fictitiously) counter its slowdown while alienating local governments and falling into a hidden debt trap.