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A man casts his fishing rod into the Jialing River in Chongqing. (Reuters)

In recent years, the Chinese central government has been viewed as an example of fiscal health. As of the end of 2012, the total worth of the issued national bonds was 8.27 trillion RMB, which was equal to 15.9 percent of the country's annual GDP. In 2013, the budgeted deficit of the central government is 850 billion RMB, 14.2 percent of budgeted revenue. Yet those numbers tell only one side of the story. Despite the good standing of the central government's budget, the expanding scale of local government debts has been a source of concern in the media and academia.

On June 10, the National Audit Office released the audit report on local government debts. It selected 36 administrative entities -- 15 provinces, their capital cities, three municipal cities and one district from each municipal city -- and audited their debts over the course of four months. The report offers a glimpse into the fiscal dilemma that many of China's local authorities are facing.

What do the numbers say?

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In the end of 2012, all debts borrowed by the 36 local governments totaled 3.85 trillion RMB, including the debts that governments are directly responsible for repaying, those in which the governments act as the guarantor, and other debts of an unspecified nature (see Figure 1). In 2011 and 2012, those authorities managed to repay 39.1 percent of all left-over debts, while borrowing more heavily than before (see Figure 2). Thus, the overall scale of local government debt grew until 2012 exceeds that of 2010 by 12.9 percent.

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Of the 36 political entities audited, sixteen have a debt ratio (the ratio of total debts to its fiscal capability) of over 100 percent, the most indebted having a ratio of 219.6 percent. Moreover, the pressure from this is urgent. In 2012, the debt-service ratios (the ratio of total debt due in 2012 to an entity's fiscal revenue in 2012) of twenty administrative units were higher than 20 percent, the highest being 67.7 percent, suggesting that a considerable portion of the year's fiscal income was used to repay debts.

This audit report only sampled provincial and high-level township governments, most of which are located in the economically stronger eastern part of China. Thus, most of the audited governments are more financially sound and have lighter burdens of expenditure than the average local government in China, which means the debt problem may be even more severe than the report reveals.

Until 2008, most local governments used to borrow under their own name. However, this practice has several drawbacks for local authorities. First, bank loans borrowed are subject to supervision by upper level authorities, which demand high levels of transparency. More importantly, this method of borrowing may prevent local governments from issuing local bonds. From 1995 to 2009, the Budget Law prohibited local governments from issuing bonds. In 2009, the central government legalized local bonds, but the bonds issued by any local authority needed to be approved and controlled by the National Treasury Ministry.

Due to the inconveniences mentioned above, nowadays, most local governments prefer an alternative way of financing - namely, through "local financing platforms." Those "platforms" are state-owned companies founded by local governments, who transfer fiscal revenues and land reserves to those companies as their initial assets. When their registered assets exceed a certain amount, the financing companies enjoy substantial freedoms in borrowing from banks or issuing corporate bonds. Those loans and bonds are usually guaranteed by future fiscal revenues or income from land-selling. In these days, almost all local governments utilize financing platforms, instead of borrowing directly, as their primary way of introducing capital (see Figure 3). The 36 local authorities audited in the aforementioned report have 223 affiliated financing companies.

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Although financing companies are expected to become financially self-sustainable by investing in infrastructure projects and running them for profit, a large proportion of them have fallen into a financial black hole. According to the audit report, among the 223 financing companies, 68 have a debt ratio over 70 percent. 53.7 percent of the total debt that was repaid by the 223 companies in 2012 was actually repaid with fiscal revenue or new loans.

Undoubtedly, bank loans and bonds are the two major types of government debt (see Figure 4).Governments also seek new financial resources through trust loans, financial leasing, sale-leasebacks, build-transfers and other informal bonds, which are all illegal. These debts made up 15.8 percent of new debt from money borrowed by 36 local authorities in 2011 and 2012. Compared to bank loans and bonds, these practices are less transparent and harder to supervise.

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The traditional explanation for the over-borrowing of local governments traces the phenomenon to the 1994 tax reform, which redefined the central-local fiscal balance. In the 1980's and early 1990's, tax collection was relegated to the local level, which kept most of the revenue. In 1994, the central government built a top-down system of its own to collect taxes directly, and appropriated most of the revenue. While local governments lost their major source of income, they remained responsible for paying for most major welfare programs. Thus, projected welfare expenditures exceeded potential revenue, driving local governments to borrow heavily.

Yet this explanation is neither sufficient nor accurate. Although most state revenues are channeled to the central government, the central government transferred a huge amount of money to local authorities to cover their expenses (this practice is called "transfer payments"). In 2013, money reallocated from the central to provincial authorities will account for 70.2 percent of total budgeted spending of the central government. With the transferred payments, the local governments should have been able to keep their deficits at a very low level.

For local governments, the real deficit booster has been infrastructure investment. In 2011, a research paper by scholars at Beijing Normal University and Peking University argued that county-level governments had a "productive expenditure bias" -- that is, authorities are much more willing to spend on programs that directly stimulate economic production, especially infrastructure, than on welfare and public service programs. Nowadays, economic performance is still used as a major criterion for the evaluation and promotion of local bureaucrats, while fiscal health is paid no attention during the process. This has incentivized officials to borrow as much as possible, and to invest what they borrow in programs that boost the GDP.

The factor that adds a final layer of pessimism to the local debt problem is the declining ability of local governments to generate revenue through "land financing," which is the local governments' largest income source that is free monitoring or intervention by higher-level authorities. The term "land financing" refers to local governments' practice of appropriating land-use rights from farmers with low compensation and selling those rights at high prices to real estate developers. In 2010, land financing interests made up about 35 percent of total public revenue for local governments. Because of the significant role that land financing plays in local governments' fiscal muscle, it has a deciding impact on whether authorities are able to repay their debts.

Unfortunately, as the urbanization process peters off and the State Council has issued a series of measures to cool down real estate markets, land financing is no longer as profitable as it once was. As the audit report suggests, the debts that four provincial and 17 township governments promised to repay with their future land finance income amounted to 54.6 percent of their total debts, yet their land financing income in 2012 declined by 8.8 percent compared to 2010. The weakening of land financing means that local debt is increasingly risky.

Unlike in the United States, where the federal and local governments have a closed fiscal system, fiscal responsibilities in China are transferable among different administrative levels. When a local government is trapped in financial deadlock, the central government can come to its aid, instead of letting it go bankrupt. This soft budget constraint not only makes fiscal risks permeable, but also eliminates the last obstacle that would prevent local governments from borrowing beyond their ability to repay. Unless this soft budget constraint is hardened, the risks of local debt will continue to trouble China.

This post also appears at Tea Leaf Nation, an Atlantic partner site.

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