China’s Reforms: A New Important Step Towards Fiscal Stability

China’s National People's Congress has passed State Council plans to allow local (provincial) governments to raise debt officially, via the bond market, as part of a set of amendments to the budget law.

We discuss the implications of the changes in the context of the broader, long-term fiscal reform process. We conclude that while much of the broader agenda remains outstanding, these are important and promising steps.

The amendments to local government borrowing show that, under this administration, it is possible to make breakthroughs on difficult issues

The amendments

The National People's Congress, China’s parliament, on 31 August passed a set of amendments to the budget law. In a break with the country’s history, local (provincial) governments will be allowed – under certain conditions – to raise debt officially, via the bond market.

The move follows earlier pilot programs since 2011 involving several cities (Shanghai, Shenzhen, Beijing and Qingdao) and provinces (Zhejiang, Guangdong, Shandong, Jiangsu, Jiangxi, as well as the Ningxia region).

The other important amendments aim to make fiscal management more medium-term oriented and the budgeting system more comprehensive and transparent. They are meant to improve the consolidation of government finances as well.

The context

Traditionally, local governments in China are officially not allowed to run deficits and borrow. However, that ban has not been consistent with the reality of local government finances.

Under the current system of inter-governmental fiscal relations, local governments are responsible for expenditures on education, health and social security. On top of that, they have been keen to engage in large infrastructure development projects.

Local governments circumvented the constraints by setting up local government investment vehicles (LGIVs) for specific purposes. These are typically infrastructure-related and could borrow from banks, or, increasingly in recent years, from the shadow banking system.

Such borrowings became truly sizeable recently, especially since the 2008-10 stimulus package (see chart below).

Local governments’ large-scale borrowing

The unofficial and segmented nature of these borrowings means that oversight and transparency are very poor. Also, the maturity of loans (up to three years) does not sit well with the long-term nature of infrastructure projects.

The current changes are part of a broader, long-term fiscal reform process that aims to better match local governments’ revenues and expenditures.

They are also meant to harden local government budget constraints, increase transparency and oversight, and move to a more medium-term perspective on fiscal policy while strengthening budgetary procedures.

The impact

The opening up to bond financing should lead to lower financing costs for local governments. Local government financing via the bond market should typically result in lower borrowing costs than what their financing vehicles pay to banks or trust companies.

Also, on the bond market, it is easier to obtain financing via longer maturities, which obviously is a better fit for infrastructure projects and which reduces roll-over risks.

The changes should also raise the transparency of local government borrowing and local government finances generally.

The regulatory framework

The amendments are not meant to give free rein to local governments.

Although the central government sees a role for credit ratings in helping to discipline local governments’ financial behavior, local government borrowings in China will remain supervised and regulated by the central government.

This approach differs from the US, where the bond market and credit ratings are supposed to play a disciplining role. 

Local bond issuance will be subject to a quota set by the State Council. Moreover, the new law stipulates several restrictions:

  • Borrowing from banks and shadow banking institutions is to stop
  • State Council approval is required for bond issuance
  • The borrowing can only be used for investment projects, not for recurrent spending
  • Debt guarantees are not allowed

However, depending on implementation and further government decisions, it may be hard and/or sub-optimal to strictly enforce these restrictions.

Given the large amounts of maturing loans by local government investment vehicles in the coming quarters, it may not be realistic to ban roll-overs in the short to medium term, especially if the State Council is conservative on the bond issuance quota caps.

As money is fungible, it is hard to judge whether, on the margin, financing is used for the designated types of projects or for other kinds of spending.

Not allowing debt guarantees by (higher levels of) government, while good for hardening budget constraints and avoiding moral hazard, would raise interest rates for a large share of the public sector borrowing.

What’s still outstanding

With regard to the overall fiscal reform agenda, there is still a lot to be done to better match the expenditure responsibilities of local governments with available revenues.

In our view, this remains a key structural reform towards rebalancing the pattern of growth towards a larger role for services and consumption. Dealing with the mismatch is needed to give local governments the money and incentives to provide public services to migrants, which is key to the government’s “new urbanization” objective.

One way to achieve this is a larger local tax base, preferably designed so that local governments benefit from those economic activities that the central government wants to promote. These include consumption, service sector activity, and full migration (of whole families). Enlarging the local tax base can be done, for instance, via a substantial property tax.

Another way is to recentralize expenditure responsibilities, either by more rules-based transfers from the central government or moving the responsibility for more spending items to the central government. This was done a few years ago for the nine years of public education.

Recentralizing expenditure responsibilities would help lower the very large gaps in access to public services that currently exist between the rich and poor areas.

Transfers have already increased in recent years. However, it is key to make transfers rules-based, so that local governments can base their future plans and policies on them.

The recent amendments contain important reforms to the transfer payment system aimed at moving from specific to general transfers and reducing the need for matching funds.


Fiscal reform has traditionally been difficult to agree on and implement, and it will take time. It is difficult, politically, to push through reforms that face resistance from vested interests.

In this case, local governments, especially those from richer areas, stand to lose out in a move to a fairer, more reasonable fiscal system.

However, the amendments to local government borrowing show that, under this administration, it is possible to make breakthroughs on difficult issues.

About the Author

This article is excerpted from “Alert: China,” a report by Royal Bank of Scotland and affiliated companies that was published on 02 September 2014. It has been re-edited for conciseness and clarity.

©Copyright 2014 The Royal Bank of Scotland plc and affiliated companies (RBS). All rights reserved.

Photo credit: Shutterstock


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