The National People’s Congress concluded last month and among the many historic changes, it’s the minor changes that might end up being more impactful for investors. Despite significant airtime given to proposed efforts around financial de-risking, poverty alleviation and government restructuring, the overall outlook for structural reform still remains mixed.
While some analysts will point to greater centralization in Beijing as a key part of the plan to accelerate the pace of reform, others will highlight the fact that a centrally managed governing system might not be effective in implementing market-driven reforms.
While the overall reform outlook is unclear, we think fiscal reform is one area where progress is likely, and even small changes can help China rebalance towards less credit-intensive growth. Specifically, reforms that balance the relationship between central and local government finances.
The gap between what Beijing requires local governments to spend and the resources available to them contributes to many of China’s imbalances. Local governments in China are responsible for the bulk of infrastructure investment and social spending, but they have little ability to raise taxes and control their revenues. This large fiscal gap is one of the main reasons behind high debt levels, misallocation of resources, underinvestment in public services, and industrial overcapacity.
Local government spending as a share of GDP has risen substantially since the financial crisis and has remained over 20 percnt for the past five years. On the other hand, central government spending has continued to fall as a share of GDP. This has contributed to an official budget deficit of nearly 10 percent of GDP at the local level while the central government runs a sizable surplus. As a result, local government debt has increased substantially and often through shadow channels in order to pay for higher expenditures.
Furthermore, the spending is often wasteful, as local governments prioritize industrial activity rather than public amenities in an effort to boost local growth. Efforts to clarify local government responsibilities and improve their ability to raise transparent revenues, while also curbing wasteful spending, would go a long way in resolving some of China’s structural imbalances.
Despite paying lip service to fiscal reform during Xi Jinping’s first term, we see three reasons why fiscal reform might become a reality in his next term:
1) The official deficit target was lowered from 3 percent to 2.6 percent. While this partly reflects a recovery in revenues it also reflects a message to local government on the need for fiscal discipline.
2) Beijing has lately strengthened language on the monitoring of local government debt issues, but also outlined a number of steps to provide local governments with more resources. This includes expanding bonds that local governments can issue, reforming the transfer system between provinces and gradually taking steps towards introducing a property tax.
3) Perhaps most importantly, Xi’s choice for finance minister, Liu Kun, spent most of his career as a local government fiscal official where he piloted fiscal initiatives that now serve as the template for other provinces. Don’t be surprised if this is a big year for fiscal reform.
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