China’s debt divide is hurting its economy | Beijing’s refusal to surrender control to local government or take on more responsibility is key to the country’s challenges

> China’s central government debt has crept up to about 24 per cent of gross domestic product, which is minimal by global standards, and the leadership is deeply reluctant to let it climb higher. Yet in contrast, the debts of China’s local governments are vast — 93 per cent of GDP according to IMF figures, which are probably an underestimate — and rising. This division between central and local government, and the desire of one to have control but not responsibility with respect to the other, is fundamental to the economic challenges of China today.

> A basic fact about China’s fiscal system is that local governments do almost all of the spending, but rely on the centre for revenue to an extent that is rare elsewhere in the world. Localities bear most of the responsibility for education, health, social security and housing, in addition to obvious local duties such as roads, parks and rubbish collection, and spend about 85 per cent of the government total. They directly collect only around 55 per cent of government revenues. The system is balanced by transfers from the centre to the regions.

> In a country as large as China there are merits to devolving decisions closer to the people, but the mismatch between revenue and expenditure creates many problems. For example, the lower down the pyramid of governance, the more the system gets starved of resources, because each tier — province, prefecture, county — tends to hold back what it needs before passing cash onwards down the chain. The implementation of central government spending plans is haphazard. Meanwhile, local government officials, who must deliver growth to climb the bureaucratic ranks, do whatever they can to find money.

> China’s property boom was partly driven by the reliance of local governments on land sales for revenue. Off-the-books borrowing by so-called local government financing vehicles was a way to get around the revenue constraint and fund infrastructure. As land sales slump due to the housing slowdown, and the central government cracks down on local borrowing, there are many reports of municipalities resorting to fines and penalties, launching retrospective tax investigations or simply not paying staff on time as they struggle to balance their books. None of this is good for the struggling private sector.

> What the central government has not been willing to do, as is typical for Xi, is surrender control. It often specifies the services that local governments must provide, yet declines to hand over the revenue sources that fund them. It is reluctant to take big new spending responsibilities onto the central books. It has cracked down on local government debt, and yet true to Zhou’s preferences, it is unwilling to let central government debt rise instead. The result has been a de facto fiscal tightening during the past few years even as the economy has struggled to recover after Covid.

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