China is struggling to emerge from the economic crisis

This month, China’s new Finance Minister Lan Fuan told markets what they were waiting to hear: Beijing will boost budget spending to support the faltering post-pandemic recovery in the world’s second-largest economy.

Lan said China will deploy an arsenal of local and central government bonds, including new treasury facilities worth 1 trillion renminbi ($0.140 billion) – which will push Beijing’s budget deficit to a two-decade high of 3.8 percent this year, “to maintain… The intensity of fiscal spending is at an appropriate level.”

But while investors welcomed the message, many analysts question how much financial muscle Beijing actually has to boost flagging confidence and drive stronger economic momentum.

As economic growth slows and the previous investment-led development model loses momentum, tax revenues are under pressure, analysts said. Beijing is also reluctant to borrow more, given that it has huge pools of bad debt to resolve at the local government level.

“This is the longer-term story — that fiscal policy has been restrictive over the last three to four years,” said Logan Wright, director of China markets research at Rhodium Group. “(And) she became more and more restricted in terms of what she could actually do.”

This year, as the economy struggled to recover from the downturn caused by Covid-19 controls in 2022 and the real estate slowdown, the government responded with additional easing measures.

China is reluctant to leverage as much as it did after the financial crisis in 2008, when it unleashed a four-trillion-renminbi stimulus, then worth 13 percent of GDP.

Analysts say that this time, the central government did not take advantage of what appears to be a relatively clean balance sheet. Compared with local governments, which have debt worth about 76 percent of GDP, the central government had only about 21.3 percent last year, according to Wright.

“We believe Beijing has significant financial resources at its disposal,” said Fred Newman, chief Asia economist at HSBC. He said Beijing has room to add more debt worth between 20 and 30 percentage points of GDP, which will go a long way to solving local governments’ debt problems.

IMF analysts also said in research released in August that China’s net financial position, taking into account its assets such as stock holdings, was among the world’s 15 largest, at 7.25 percent of GDP, although This has been steadily declining and economic growth has diminished. Asset valuation was subject to uncertainty due to factors including liquidity.

However, most analysts believe that the central government’s real debt obligations are much larger than the numbers indicate. Beijing serves as the final arbitrator for the country’s total government debt, which Rhodium Wright estimated at 142 percent of GDP last year, including debt held by the central government, policy banks, local governments, and local government financing vehicles (LGFV) — which is out of balance. Paper entities that raise their own money.

“In China, the boundaries are a little blurry,” said Hui Shan, an economist at Goldman Sachs, on how to calculate total government debt obligations. “At what point the LGFV’s obligations end before it becomes a local government responsibility – that line is difficult to draw.”

Solving local government debt problems has become one of the most pressing issues for Beijing. The International Monetary Fund raised its forecast for China’s economic growth for this year to 5.4 percent from 5 percent, and said Beijing still needs to “implement coordinated fiscal framework reforms.”

Since September, Beijing has asked state banks to lower interest fees and extend the term of local government loans, Gavikal Dragonomics wrote. Beijing has also allowed provincial governments to issue bonds to pay off LGFV’s debts.

By early November, at least 27 provinces and one municipality had issued RMB1.2 trillion in bonds, using quotas of local government bond sales that had been allocated in previous years but had not been fully used.

By bailing out local governments with another round of bond swaps — the last of which was in 2015-18 — the central government was prioritizing “risk prevention,” Gavekal said. That meant stopping damaging defaults in the bond market, which could have a massive multiplier effect.

This comes at the expense of enhancing a sense of moral hazard among local government borrowers. But there are signs that Beijing is becoming less demanding of local governments about growth targets, which could reduce the need to borrow excessively in the future.

“The message to local government officials is that we’re not putting as much pressure on you as in the past to achieve exceptionally high growth rates, so you don’t need local government financing programs as much as you did in the past.” said Chris Beador, deputy director of China research at Gavekal.

But analysts say the underlying problem of insufficient government revenue generation will remain. Under the 1994 reforms, the central government controls tax revenues while local governments are responsible for more services. Lacking the cash to meet all of their obligations, many local governments often borrow excessively.

“The financial structure is the real reason we got into this mess. So there has to be a change in political incentives eventually, and perhaps a change in the financial structure, in order to get us out of the crisis,” Beddor said.

But another critical problem was that as China’s old debt-based investment model shifted toward a more consumption-based model, revenues from land sales and value-added taxes declined, especially with the collapse of the real estate market in recent years.

Overall tax collection to GDP fell from 18.5 percent in 2014 to 13.8 percent last year, Rhodium’s Wright said.

The Chinese Communist Party may increasingly face stark choices about how to balance social and development needs with some of President Xi Jinping’s strategic goals, such as developing high-tech industries or infrastructure projects abroad.

“There’s a bigger issue of how to keep the finances in the system,” Wright said. “The important point is that China faces very meaningful trade-offs between all these adjustments.”

Wright said China could increase its fiscal deficit further, but that deficit was already high at a total of 7 percent of GDP. “Yes, you can increase that to as high as 8-9 percent, but after that there is almost nowhere to go,” he said. “It’s really hard to keep expanding.”