Usman W. Chohan (楚浩云) is an MBA candidate at Desautels with a Concentration in Strategy and Leadership. He is currently on an MBA exchange in Beijing, at a joint program between Tsinghua School of Economics (SEM) and MIT. He has previously served as the Special Situations Analyst in the Global Equities Team at Natcan Investment Management, the Investment Arm of the National Bank of Canada. The following piece is based on his work on Fiscal Decentralization in China.
The perennial question of how to distribute economic power between the center and the federating units has stymied many a federal structure, and an important dilemma embedded within this overarching question is whether the smaller federating units can raise their own revenues, including levying their own taxes and, equally importantly, issuing their own debt. According to the Pendulum Theory of Federalism, a state periodically sways between episodes of centralization and decentralization, where the latter accords greater discretion to the federating units. In China, the pendulum of federalism has definitively swayed towards decentralization, and as a general trend in Chinese policy, Fiscal Decentralization has been a major source of empowerment for provinces, autonomous regions, and municipalities relative to the central government.
As part of this decentralization movement, subnational entities can have their own revenue streams and are responsible for much of the public expenditure under their jurisdiction in areas such as education, welfare, healthcare, and so on. Provinces can also pass their own laws and regulations, as long as these do not conflict with national laws. Furthermore, the central government gives the provinces a great deal of latitude in adopting policies to boost economic growth, and it encourages provinces to engage in “approved policy experiments” (for an example of an urbanization experiment, please see my article on Erdos City).
However, one major feature of financial empowerment that had previously not been granted to subnational entities was the ability to issue debt. This has been very recently amended by the central government, which announced on May 21st, 2014 that local governments will be able to issue bonds for the first time. Ten local governments, including several fiscally stable provinces and Tier-1 cities such as Beijing and Shanghai, have been selected for a pilot scheme whereby they will be able to directly sell fixed income instruments. Previously, the only mechanism for provinces and municipal governments to raise debt was through the intermediation of the central government, which would issue debt instruments and take responsibility for the repayment of these instruments on behalf of the subnational entities, who were prohibited from conducting the issuances themselves. The local governments bypassed this prohibition through a Special-Purpose Vehicle (“SPV”, 特殊目的的载体)known as the Local Government Finance Vehicle (“LGFV”, 地方政府融资载体), which allowed them to assume debts without showing them on their balance sheets. The amounts borrowed collectively by LGFVs have been of a colossal magnitude, with a government audit ascribing a value to the 10,000 LGFVs in China of RMB17.9 Trillion ($3.1 Trillion CAD).
Special-Purpose Vehicles have drawn fierce criticism in recent years for their role in masking the true debt position of vulnerable borrowing entities by misleading investors and analysts about the susceptibility of these entities to insolvency and to crisis events. This is because their true exposure to debt is surreptitiously concealed through the transfer of their debts onto the balance sheets of the seemingly independent Special-Purpose Vehicles. In the case of LGFVs, since the debt held by these vehicles is ultimately backed by the local governments, a series of defaults by these LGFVs would potentially destabilize the structure of public finances and therefore carry a sizeable risk for the overall financial system. The central government, cognizant of the damage that LGFVs might cause, had tried in past few years to prevent these LGFVs from issuing bonds and from borrowing from banks. This, however, created the adverse incentive for local governments to borrow from what is termed the shadow banking system (影子银行), a collection of non-bank financial institutions that operate in comparative clandestineness and that lend at high-interest rates for short-term maturities. This is an undesirable scenario from the financial transparency standpoint, and the central government would rather have the local governments bring the debts onto their formal balance sheets.
Therefore, in order to reduce the reliance on the LGFVs, which pose a latent default risk and misrepresent debt levels, and to reduce reliance on the shadow banking system, which is based on clandestine lending and usurious interest rates, the government has now authorized select local governments to issue fixed income instruments. This is a highly positive development for local governments because they are receiving more comprehensive autonomy as part of fiscal decentralization, and they are now potentially better able to manage their own finances. In addition to possessing revenue streams, they can also now issue debt to fund important projects such as infrastructure development and healthcare. Provincial bonds will also add a diversification element to investor fixed income portfolios, and have the potential to grow into a meaningful asset sub-class in future years. In Canada, for example, actively traded provincial bonds account for about 20% of the total bond market, while active municipal issuance represents about 2% of the market, and market size in both sectors has grown consistently over the last ten years. However, the freedom to raise debt entails certain inherent risks, foremost among which is the risk of misusing the debt for projects that do not yield adequate financial or social returns, such as urban vanity projects which do not attract residents. Insofar as this initiative empowers local governments towards astute management of their balance sheets, and helps them to evade the pernicious influence of the shadow banking system and the clandestineness of LGFVs, the ability to issue local government debt is a welcome initiative. Ultimately, the ability to issue subnational debt is a logical step in the federation’s pendulum swing towards fiscal decentralization.