Local anaesthesia

China's accidental austerity requires state action

Just when China's slowing economy needs a public spending push, surging local government debt is acting as a fiscal speed bump.

Recently released official statistics show sub-national government liabilities swelled to 24 trillion yuan ($3.8 trillion) by the end of last year, up a staggering 34 per cent over the previous 18 months. Out of this, about 15.4 trillion yuan is direct borrowing by local authorities; the rest is owed by related financial vehicles.

The jump in reported debt is partly due to more accurate stocktaking. Nevertheless, it shows the scale of the problems piling up in Chinese local authorities, which have borrowed heavily to fund spending on infrastructure and property development.

The government is attempting to ease the burden by swapping local government debt into long-term municipal bonds with a lower rate of interest. But even though the scheme was recently expanded to 3.2 trillion yuan, it is still too small to make a significant difference.

Besides, even if the cost of servicing their existing debts falls, local governments still face pressure to spend less. That's because they have relied on sales of land to pump up their budgets: this source of income accounts for a third of their income. But the property market slowdown means revenue from land sales is down 38 per cent so far this year.

The central government will offset some of this untimely austerity by running a bigger deficit. Nevertheless, the overall drag on spending might still knock 0.8 percentage points off China's gross domestic product (GDP) growth, estimates Fitch Ratings.

How to ease the short-term pain? Aggressive monetary easing is one option, but that would risk sinking the yuan and hastening capital outflows. A better way to square the circle may be for the central government to take on some of the local debt by issuing long-term sovereign bonds.

Though China's total debt has grown rapidly in recent years, the central government's liabilities are currently less than 17 per cent of GDP - significantly lower than the 38 per cent of GDP owed by local governments. It's true that Beijing needs to preserve some of that strength in order to recapitalise China's state-owned banks. Even so, it could use some of its spare firepower for deficit spending. Otherwise, the economy's jerky ride could get bumpier.