Chinese Local Gov’t Incentives Hinder Central Gov’t Reform Agenda

Misaligned incentives between China's central and regional and local governments (RLGs) are an obstacle to economic reform and rebalancing, a credit negative, says Moody's Investors Service.

In particular, Moody's notes that wide disparities in the economic and fiscal conditions of RLGs-- which implement the bulk of China's central government policies -- are creating local incentives that in turn can hinder the central government agenda.

This situation could weigh on the pace, and even thoroughness, of reform and slow China's economic rebalancing. This, in turn, could make it more challenging for China's state-owned enterprises (SOEs) and RLGs to deleverage, a process that is central to the reduction of contingent liabilities for the Chinese sovereign and risk mitigation for banks.

Moody's points out that local economic, corporate and fiscal conditions shape RLGs' incentives to implement central government directives.

Specifically, RLGs are likely to protect local economic and social stability, even when these interests complicate a speedy implementation of the central government's reform agenda, says Moody's.

RLGs in China are responsible for most of the country's social spending, but sometimes have weak accountability for social responsibilities, such as education and health care, in the absence of extra support from the central government.

In addition, a lack of efficient supporting systems can weaken administrative coordination across the different tiers of government and further diminish centralized authority, thereby increasing the complexity of managing policy implementation, says Moody's.

Moreover, RLGs have a degree of autonomy for embracing reforms in ways that can differ from the central government's intent.

The central government has taken measures to address these misaligned incentives, including the transfer of payments, intra-governmental fiscal reforms and a new system for assessing public officials. It also has strengthened its campaign to root out corruption among RLG officials, an initiative to enhance central government oversight of the activities of RLGs.

These measures could realign the incentives of governments, which would support credit quality. However, it is too early to conclude whether they will fundamentally change the relationship between the central government and RLGs in a way that will raise the prospects of effective reforms.