Chapter 6. Local Government Finances and Fiscal Risks
Author:
Mr. Waikei R Lam
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Print Publication Date:
14 Jan 2017
Keywords:
BOOK; government; China; pension; rate; local government; bond financing; debt-swap program; bond obligation; vehicle activity; Fiscal law; Securities markets; Sovereign bonds; Fiscal risks; Global
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Abstract

Local governments play a critical role in executing fiscal policies in China. Aside from providing basic public services, they undertook sizable public investment that has contributed to remarkable growth. Much of the large-scale fiscal stimulus since the global financial crisis was carried out through local governments. Along with public infrastructure investment, local governments have also contributed to the real estate boom through land development. In addition, research has attributed competition among prefectural local governments as a significant factor in China’s growth success (Song, Storesletten, and Zilibotti 2011).

Local governments play a critical role in executing fiscal policies in China. Aside from providing basic public services, they undertook sizable public investment that has contributed to remarkable growth. Much of the large-scale fiscal stimulus since the global financial crisis was carried out through local governments. Along with public infrastructure investment, local governments have also contributed to the real estate boom through land development. In addition, research has attributed competition among prefectural local governments as a significant factor in China’s growth success (Song, Storesletten, and Zilibotti 2011).

Yet although local governments have played a key role in growth, their revenue base is small relative to their spending obligations. Local government tax revenue accounted for nearly half of total government revenue, while spending obligations were roughly two-thirds of the total (Wang and Herd 2013). Even accounting for transfers from central government, they still faced a structural shortfall. Until the revised budget law was effective, local governments, with the exception of a few pilot programs, were formally prohibited from borrowing. They therefore had strong incentives to circumvent financing constraints by obtaining revenue from land sales and setting up financing vehicles to borrow from banks and capital markets and to undertake build-and-transfer arrangements.

Recognizing the buildup of risk in local government finance, the authorities revised the budget law with effect from the beginning of 2015. Reform measures in the budget law focused on containing risk from local government finance, developing the bond market for local governments, and addressing intergovernmental relations. The government also introduced a debt-swap program to facilitate the transition by converting financing-vehicle debt to local government bonds.

While the budget law and related directives could strengthen local government finances, key hurdles remain, and success will rest on decisive implementation. For example, circumvention to borrow in ways prohibited in the budget law continues, as the Ministry of Finance notes. Local government bond markets remain underdeveloped despite growing in size. As a result, policy priorities will be to further strengthen local government finances by reining in possible circumvention, developing greater liquidity and credit discipline in the bond market, formulating a resolution framework for potential financial distress of local government, monitoring emerging risks from public-private partnerships, and aligning intergovernmental revenue and spending.

This chapter reviews the structural features of local government finances, noting the misalignment of revenue that is falling short of spending obligations at local levels. An outline of the current reform measures, including the revision to the budget law, to strengthen local government finances follows. Although the budget law and related directives will contribute to sounder finances for local governments, key hurdles remain in implementation and in fully resolving structural misalignment. Policy options to strengthen local government finances given existing reform initiatives are discussed, followed by conclusions.

Structural Features of Local Government Finances

Local governments in China play a critical role in executing fiscal policies. Four broad subnational government levels exist (provincial, prefectural, county, township), with an informal village government below the township level. Each government level reports to the level above it, similar to the arrangement of the People’s Congress at each subnational level. Provincial government consists of 36 provinces, autonomous regions, and provincial-level municipalities. Over 3,000 prefectural and county-level governments undertake most public services and investment. Prefectures and counties are often densely populated, ranging from 150,000 to 2 million residents.

Local governments receive transfers from an upper level, while providing for those at lower levels. County governments typically have the highest spending obligations (in relative terms) and are therefore the most dependent on transfers.

Local government financial positions vary significantly across regions. In general, metropolitan areas have stronger fiscal positions than inner regions (Figure 6.1 and Brys and others 2013), with indirect taxes comprising more of their revenue (Annex 6.1 and Annex Tables 6.1.1 and 6.1.2). Tax revenue accounts for 18 percent of GDP in large provincial-level municipalities on average, compared with about 12 percent of GDP in other provinces. On a consolidated basis, including lower-level government, provinces are generally in deficits.

Figure 6.1.
Figure 6.1.
Figure 6.1.
Figure 6.1.

Local Government Revenue and Tax Sharing System

Local governments face structural challenges in their finances. First, their spending obligations often far outstrip their revenues.1 Although the central government provides transfers amounting to more than two-thirds of local government revenue, the transfers do not fully cover the misalignment. Second, each level of local government was required to maintain a balanced budget and was prohibited from borrowing (except in a few pilot cases) prior to the adoption of the revised budget law in 2015 (see below). As a result of these two constraints, local governments have relied on other means of financing, such as land-sale revenue, and have circumvented those constraints by establishing quasi-fiscal local government financing vehicles (LGFVs) to borrow from banks (against their land collateral) or to undertake other financing for infrastructure projects.

Local government financing vehicles (LGFVs) are distinct entities owned by local governments, typically established for public infrastructure. In fact, the increase in infrastructure spending after the global financial crisis was mostly financed off budget through borrowing by LGFVs. They are legally registered as corporations and have public sector objectives, in contrast with state-owned enterprises, which tend to run on a mostly commercial basis (Appendix III of IMF 2014). In many cases, local governments shared the LGFVs’ responsibilities to service debt and provide guarantees on their debt.

Financing through LGFVs has contributed to growing fiscal risks. Along with the reliance on land-sale revenue, off-budget LGFV borrowing has grown substantially in recent years. Expanding the definition of government to include LGFV activities, the “augmented” fiscal deficit of general government was about 10 percent of GDP in recent years (Annex 6.2 and Figure 6.2). The flip side of the rapid increase in off-budget spending has been the rise of “augmented” local government debt to RMB28 trillion, or 41.7 percent of GDP as of end-2015, of which more than two-thirds was explicit government debt (IMF 2016; Lam and Wingender 2015). Based on these augmented balances, fiscal space has been considerably more limited than headline data suggest. The large augmented fiscal deficits raise questions about local governments’ ability to continue financing the current level of spending and service their debts (Barnett and Zhang 2014), including the following:

  • Aggregate debt has masked wide disparities across regions. Debt ratios in some provinces have reached over 100 percent of annual fiscal revenue and over 60 percent of provincial GDP. The debt burden is often higher for provinces that rely more on off-budget LGFV financing (Figure 6.2).

  • Vulnerabilities are closely linked with the financial sector and real estate markets because of the reliance on land-sale revenue and large bank exposures (about RMB4 trillion or 5 percent of GDP between 2010 and 2014).2

Figure 6.2.
Figure 6.2.
Figure 6.2.

Local Government Finances

Recent Measures to Strengthen Local Government Finances

The government recognized the growing risks emanating from local government finances and the web of vulnerabilities linked to other sectors. It has committed to reforms to address structural misalignment of local government finances and took multiple measures in recent years, including the following:

  • National audit. A comprehensive national audit in 2013 sought to identify local government borrowing across provinces. The audit found that most debt was through bank loans and build-and-transfer arrangements via financing vehicles. The audit provided a strong basis for subsequent policy design to resolve fiscal risks.

  • Pilot program on bond issuance. The Ministry of Finance initiated a pilot program in 2010, which allowed the central government to issue debt on behalf of local governments. The pilot program later also authorized selected provinces to sell bonds directly subject to a quota during 2011–14.3 Prior to the revised budget law in 2015, the local government bond market remained small, with an outstanding balance of 6.2 percent of GDP in 2014. The local government bond market has expanded as bond financing is the only option permitted under the revised budget law for local governments.

  • Revisions to the budget law. The revised budget law, effective from 2015, aimed to strengthen the transparency and accountability of the budget framework and local government finances (Annex 6.3).

    • The budget law, along with the State Council’s directive (2015 No. 43), aimed to replace unregulated LGFV borrowing with regulated public-private partnerships (PPPs) and provincial bond financing nationwide (known as the strategy of “opening the front door while closing the back door”). All other forms of local government borrowing or guarantees are prohibited.

    • In terms of debt monitoring, the central government has set aggregate limits on bond issuance and used a set of indicators, such as debt to GDP and debt service to fiscal revenue, to monitor fiscal risk in an early warning system. Local government bond issuance also required credit ratings and disclosures of local budgets, as well as legislative approval at the provincial level or of the National People’s Congress.

    • The law also envisaged greater use of general transfers to better align local government revenue and spending.

Interim steps were taken to smooth the implementation of the new budget law. First, ongoing local government infrastructure projects were allowed to borrow in the original ways in 2015. Second, the government promoted greater use of PPPs to leverage private participation in infrastructure projects. Third, the debt-swap program was introduced to replace maturing local government debt (identified in the national audit) with bonds, beginning in 2015, over a horizon of three to five years (Figure 6.3).

Figure 6.3.
Figure 6.3.
Figure 6.3.

Local Government Bond Markets

The debt-swap program has also contributed to the expansion of the local government bond market, which has steadily increased to about 8.7 percent of GDP by June 2016. At the same time, the debt-swap program has restructured local government debt by extending the maturity from one to three years to an average of five to seven years and reducing the interest burden for local government by about 400 basis points.4 Spreads over sovereign bonds were tight at about 30–50 basis points for public auctions and 40–70 basis points for targeted placements, which did not fully reflect underlying credit risks. As banks were the key investors in these bonds, they faced a lower interest margin and extended the maturity of claims, thereby widening balance sheet mismatch. In return, banks gained the certainty that local government would honor such obligations, instead of an implicit guarantee on claims against LGFVs. Banks’ capital buffers would improve because the risk weight of capital would drop from 100 percent on LGFV loans to 20 percent on local government bonds. The net impact varies across banks and depends on their exposure to local governments.

However, key hurdles remain in the implementation of the budget law, including the following:

  • Possible circumvention. The budget law does not fully resolve the problems of moral hazard in local government financing. As the authorities maintain an ambitious growth target, local governments will have an incentive to support growth through alternative financing. They may seek to circumvent the rules, for example, to obtain financing through service contracts, or continue to provide guarantees in ways that are prohibited.5 In that context, LGFV bond issuance began to pick up again in April 2015 after the temporary decline in 2014. Monitoring of local government debt against regulatory limits and financial benchmarks is challenging given the availability and frequency of data release.

  • Impediments in the local government bond market. The bond market remains illiquid despite growing rapidly. Quotas for bond issuance across provinces are not rule based, nor are they aligned with multiyear planning. At the moment, the regulations on bond markets are fragmented: the overall ceiling of issuance is set by the Ministry of Finance and the National People’s Congress, while the securities regulator regulates bonds in open exchanges, and the banking regulator monitors banks’ bond holdings.

  • Lack of a resolution framework in debt management. The budget law specifies an early warning system in monitoring local government debt, but does not account for resolution in case local government faces distress or repayment difficulties. This creates uncertainty and possibly reduces investors’ willingness to hold those bonds.

  • Emerging risks from PPPs. The execution rate of PPPs remains low, at about 20 percent of total commitments, partly because of high administrative costs and limited private capital participation. More important, misuse of PPPs may become more prevalent as a source of contingent liabilities unless they are subject to adequate governance and transparency.

  • Structural misalignment remains. Although the budget law envisages greater use of fiscal transfers, it does not fully resolve the structural misalignment of greater spending obligations than revenue at local levels.

Policies to Strengthen Sustainable Local Government Finances

Decisive implementation of the budget law, along with further reforms, would need to address remaining hurdles outlined above, including:

  • Enhancing financial oversight and disclosures to limit circumvention. To avoid possible circumvention, timely and credible disclosure and audits of local government finances are necessary to assess debt-related financial and fiscal risks.6 The disclosure and audit could also strengthen market discipline by investors and rating agencies and be combined with multiyear budget planning (see Chapter 4). Moreover, the Ministry of Finance can also develop financial disclosure guidelines to ensure consistency across local governments while transitioning to the accrual-based accounting system. A formal rule-based approach to borrow would simplify and make transparent the credit allocation process, and improve predictability of financial flows to local government. Over the medium term, when a sound, rule-based framework is established for regulating local government borrowing, lower-level governments, such as prefectures and cities, could be allowed to borrow independently.

  • Developing a sound bond market with greater liquidity and credit discipline. Promoting the sound development of the bond market is critical as it will increasingly be an important source of financing. Several measures could facilitate the development of the bond market. Specifically:

    • Broaden the investor base. A wider investor base, particularly long-term investors such as insurance companies and pension funds, would help accommodate the increasing size of bond issuance. Opening the bond market to foreign qualified investors can also enrich price discovery, expand liquidity, and strengthen the financial reporting to be more in line with international best practices.

    • Better differentiate credit risks. Differentiation of credit risks through market discipline will require stronger rating standards. For example, the rating agency should disclose the methodology, including the weights assigned to various factors. The cap on bond coupons—spreads over sovereign bond yields—should be gradually phased out.

    • Strengthen regulation and supervision. An efficient bond market has the salient feature of offering fair and equitable treatment between investors and issuers. Ensuring policy coordination and information sharing among regulators are key aspects for the adequate supervision of local government bond markets.

  • Formulating a resolution framework. The government has recently announced contingency measures to resolve potential financial distress of local governments. Overall, the framework contains elements to (1) define the role and responsibilities of various stakeholders, (2) specify the threshold that would trigger enhanced oversight, and (3) identify steps to resolve financial risk. Decisive enforcement can place local government finance on a sounder footing.

In case of restructuring local government debt, international experience suggests a transparent and impartial administrative or judicial mechanism (World Bank 2013a, 2013b). Enhanced oversight could involve progressive loss of local budget autonomy if a local government is unable to address financial risks (Wei 2014). Typically it involves a sequence of establishing restructuring plans depending on the corrective actions and the specified time frame (van Eden and others 2015).7 For example, Norway and North Carolina in the United States have a framework to resolve fiscal distress (Table 6.1).

Table 6.1.

International Examples of Enhanced Oversight Mechanisms

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Source: IMF staff.

For China, the framework can contain measures to raise intergovernmental transfers and/or to prohibit further bond issuance and allocate losses to creditors, while ensuring minimum moral hazard and disruptions to public services. The framework would apply to subprovincial-level governments. The provinces would execute monitoring and oversight. Local governments that experience repayment difficulties but do not pose systemic risks could be subject to conditionality during the debt restructuring. The revised budget law prohibits any bail-out of the provinces.

  • Monitoring emerging PPP risks. Close monitoring can prevent the misuse of PPPs, build-to-transfer arrangements, and other innovative financing vehicle activity. Any use of PPPs as “side doors” for off-budget financing should be prohibited. Stronger guidelines in specifying the distinct role of public and private capital may help reduce barriers and uncertainty, which in turn will attract private participation. Any contingent liabilities for local governments arising from PPPs should be fully assessed against fiscal risks.

  • Aligning structural mismatch of intergovernmental revenue and spending. Anchoring local government finances on a sound footing calls for better alignment of fiscal relations between central and local governments. While international experience does not point to a uniform blueprint, theoretically the shortfall can be narrowed by increasing transfers or taking on a greater share of spending from the central government and/or granting more tax authority to local governments (Annex 6.4). In a majority of countries, misalignment has been resolved in part by raising the local government tax base. Reforms to strengthen the portability of pension, health care, and education benefits, as well as tax reforms to improve local government revenue, will take time to mature and correct for the misalignment.

  • Complementary policies to avoid sharp fiscal tightening. Advancing reforms to strengthen local government finances might bring unintended fiscal tightening. As a result, the adjustment would likely require a comprehensive multi-year plan and consistent macroeconomic policies. An orderly and gradual tightening of off-budget spending will put local government finance on a sounder footing (IMF 2014), while the on-budget spending on proconsumption measures can help mitigate the growth slowdown. Monetary conditions might also need to stay accommodative to facilitate restructuring of local government bonds.

Conclusions

Local governments have been a key driver of investment-led growth, but have faced a structural shortfall of revenue relative to their large spending obligations. This has created incentives to obtain financing through land sales and to set up financing vehicles to borrow from banks and capital markets. Limited oversight has given rise to the rapid buildup of vulnerabilities in local government finances.

Recognizing these issues, authorities have embarked on measures to strengthen local government finances, including the implementation of a revised budget law and other related directives. The goals are to (1) contain excessive risks emanating from local government borrowing, (2) develop the local government bond markets for sustainable financing, and (3) overcome misalignment in intergovernmental finances. However, key hurdles remain in the implementation. This includes possible circumvention by local governments to continue off-budget borrowing and an underdeveloped bond market. At the same time, structural misalignment of local government revenue and spending remains.

The success of reforms is by no means guaranteed and rests on implementation. Further steps are needed to fully establish a sustainable regulatory framework, including enhancing oversight and disclosure, developing the bond market with greater credit discipline and liquidity, establishing a resolution framework for potential financial distress on local government debt, and closer monitoring of emerging risks from PPPs. Putting local government finances on a sound footing also calls for the alignment of intergovernmental fiscal relations.

Annex 6.1. Tax Sharing and Distribution of Fiscal Revenue

Annex Table 6.1.1.

Tax Sharing Arrangement between Central and Subnational Governments

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Sources: CEIC; and IMF staff estimates.

Following the completion of value-added tax reform, the tax sharing arrangement is temporarily split equally between the central and local governments.

Value-added tax (VAT) sharing is temporarily changed to 50:50 after the full extension of VAT to all services in May 2016.

Estimates based on social security contributions ratio to GDP.

The sharing of tax revenues, if excluding social security contributions, will be about 50.4 percent and 49.6 percent, respectively, for the central government and local governments.

Annex Table 6.1.2.

Distribution of Fiscal Revenues in Subnational Governments1

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Sources: CEIC; and Wang and Herd 2013.

Distribution across subnational governments based on local fiscal statistical yearbook for 2009.

For local governments, the receipts consist of compensation from “newly constructed land use” fund; compensation from the “transfer of usage rights for government-owned land” fund; revenues from government-owned land fund and cultivation fund of agricultural land.

The distribution across subcentral governments is based on the relative share in 2009.

Annex 6.2. Augmented Debt and Deficits with a Broader Definition of Government

A significant amount of activity that is fiscal in nature, such as a majority of local government infrastructure spending, is not included in China’s general government data. Since the financial crisis in 2008–09, such off-budget infrastructure spending has become an important countercyclical tool. To better assess the contribution of fiscal policy to stabilizing output and the concomitant rise in indebtedness, the augmented fiscal data are constructed by expanding the perimeter of government to include off-budget infrastructure spending. The broader concept includes government-guaranteed debt and debt for which the government has rescue responsibility if borrowing entities cannot repay.

Under the broader concept, the augmented fiscal debt rose to 56 percent of GDP in 2015, because the augmented fiscal deficit (about 10 percent of GDP per year) has been much higher than the headline fiscal deficit (Table 6.2.1).

Annex Table 6.2.1.

China: General Government Fiscal Data

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Sources: CEIC; China Ministry of Finance; National Audit Office; and IMF staff estimates and projections. Note: SOE = state-owned enterprise.

Includes central and local governments’ withdrawal from budget stabilization funds.

Includes adjustments for local government balance carried forward, redemption of local government bonds, and government bonds issued under government-managed funds.

GDP in this table refers to expenditure-side nominal GDP.

Net land sale proceeds refer to the portion used to finance current and infrastructure spending, which is estimated by subtracting the acquisition cost, compensation to farmers, and land development from the gross land sale proceeds.

The overall net lending/borrowing includes net land sale proceeds as a decrease in nonfinancial assets recorded above the line.

Includes local government bonds and other market financing through the use of local government financing vehicles (LGFVs).

IMF staff estimates are based on the explicit debt and fractions (less than 19 percent according to the National Audit Office estimate) of the government-guaranteed debt and liabilities that the government may incur.

Estimates of debt levels before 2015 include central government debt and explicit local government debt (identified by the Ministry of Finance and National People’s Council in September 2015). The large increase in general government debt in 2014 reflects the authorities’ recognition of the off-budget local government debt borrowed previously. The estimation of debt levels after 2015 assumes zero off-budget borrowing from 2015 to 2021.

Because of data gaps, the augmented fiscal data estimates rely partly on assumptions, and thus need to be read with caution and can serve only as a complement, not a substitute, to the standard fiscal definitions. Estimating the augmented fiscal data involves numerous assumptions, and the uncertainty around the estimates suggests some caution in interpreting the results.

Nonetheless, it is clear that China has considerably less fiscal space than indicated by conventional general government data. Additional sources of vulnerability include possible contingent liabilities related to the financial sector, state-owned enterprises, and actuarial shortfalls in the pension system. However, a comprehensive assessment would also need to account for the government’s holding of financial and nonfinancial assets, such as the China Investment Corporation, national pension fund, and the equity stake in state-owned enterprises.

Annex 6.3. Key Features of the Revised Budget Law

The revised budget law has been a significant step and provided a legal basis for fiscal reforms. The implementation since 2015 was a step toward modernizing the fiscal framework by 2020. The amendments aimed to strengthen the oversight of local government finance and enhance the effectiveness of fiscal management (Table 6.3.1).

Annex Table 6.3.1.

The 2015 Fiscal Budget under the New Budget Law

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Source: Ministry of Finance.

Full Coverage to Achieve a Consolidated Budget

The budget law required the adoption of a multiyear budget framework, which specifies the conditions on how to manage annual deficits and surpluses. The multi-year budgeting would allow the government to better manage fiscal policy across economic cycles. Any deficits in local governments would be subject to approval from the National People’s Congress. The government would also take a consolidated approach incorporating all existing government funds into the budget. Fiscal budget and outturn would be published within 20 days of approval by the People’s Congress.

Local Government Financing

The government adopted the strategy to “open the front door and close the back door” in local government financing. The budget law allowed local governments to issue bonds and reflect this on the budget, but the amount, usage, and issuance would require prior approval by the National People’s Congress through the State Council. Under the law, other means of local government financing were prohibited, including guarantees. A transitional period was granted for 2015 to avoid unintended tightening of fiscal positions. Moreover, the law envisaged an early warning system and risk assessment of local government debt.

Fiscal Transfers

The budget law tightened the use of earmarked transfers, which were common but created rent-seeking activity by local governments. The law would move toward a general fiscal transfer that covered basic public services, with periodic evaluations.

Annex 6.4. International Experience8

Intergovernmental Relations

Anchoring local government finances on a sound footing calls for better alignment of fiscal relations between central and local governments. Across Organisation for Economic Co-operation and Development economies, tax autonomy of local governments varies significantly (Annex Figure 6.4.1). On one hand, in countries like Australia and Mexico, for example, local governments have full authority to set the tax rate or introduce tax cuts without consulting upper-level governments. On the other, upper-level government, such as in China and France, retains almost complete authority in setting tax rates and has a tax sharing arrangement with lower-level governments.

Annex Figure 6.4.1.
Annex Figure 6.4.1.

Tax Revenue on Income, Profit, and Capital Gains across Countries

(Percent of tax revenues by tax autonomy indicators)

Sources: Organisation for Economic Co-operation and Development; and IMF staff estimates.

Other countries usually have explicit fiscal rules, clear tax authority, or sharing arrangements across different levels of government. Local governments are often allowed to borrow if backed by the central government, while others rely more on market discipline. Sole reliance on market discipline is rare, except for a few cases, such as the United States. Aligning the intergovernmental relationship is difficult in any country and takes a long time (Annex Figure 6.4.2).

Annex Figure 6.4.2.
Annex Figure 6.4.2.

Institutional Arrangements for Local Governments

Source: IMF staff.

Managing Local Government Debt

Ex Ante Measures

These include fiscal targets for aggregates such as the deficit, debt level, revenue, and spending. Balanced-budget rules for subnational governments, for example, have gained in popularity, especially in large federal countries. These measures can be an important tool for fiscal policy management, but setting targets at the proper level requires careful consideration. For example, there are important trade-offs when setting debt limits for local governments. If thresholds are set too low, the lack of borrowing can limit investment and affect growth prospects. On the other hand, when targets are set too high, excessive local government borrowing can lead to macroeconomic and financial instability. In addition to targets, some central governments also use direct controls to ensure that subnational governments’ fiscal management is in line with national principles. Examples include the centralization of all government borrowing with subsequent on-lending to subnational entities. Direct control measures can also take more benign forms such as having to request permission or having to justify borrowing from private markets. While direct control measures are not as widespread as fiscal targets, governments tend to rely on them more in times of fiscal strain.

Another set of ex ante tools consists of procedure-based systems that ensure transparency and consistency of local government policies and accountability of managers. Examples include guidelines for reporting and publishing of fiscal accounts and the use of multiyear budgeting to improve fiscal policy coordination and response to shocks and alternative scenarios. Independent auditing of subnational financial accounts is also an important component used in many countries. Several countries, such as Mexico, require subnational governments to subscribe to a credit rating system in order to access financial markets.

Ex Post Measures

In addition to ex ante measures, central governments also need ex post measures to deal with subnational government insolvency. Simply relying on market forces can be insufficient if the risks are not priced efficiently due to implicit guarantees. There are three key elements to a financial distress or insolvency framework for local governments: (1) definition of a trigger for the procedure, (2) provisions to resolve local government debts collectively and to negotiate debt restructuring, and (3) plans for fiscal adjustment to bring expenditure in line with revenue. Ex post measures must also ensure that insolvent subnational governments remain able to deliver essential public services during a debt restructuring procedure. They should also enable subnational governments to eventually regain some level of creditworthiness. An insolvency mechanism must also protect creditor rights to reduce borrowing costs and encourage financial market development.

Country Experience

Brazil. Despite having had fiscal targets on the total debt stock and new borrowing of subnational governments—expressed as percentages of revenue—Brazil experienced three subnational debt crises in the 1980s and 1990s. The last episode occurred in 1997, with a federal restructuring of states’ debt equivalent to 11.5 percent of GDP. Unlike previous attempts at reducing moral hazard and hardening budget constraints, the central government’s restructuring program this time was conditioned on states’ fiscal and structural reforms. The Fiscal Responsibility Law, which was adopted in 2000, now imposes constraints on the overall level of spending and on budget balances of all subnational governments. It also restrains systemically large categories of spending such as wage expenditure. The central government sets overall limits on the debt level of subnational governments—determined in percent of current revenue net of transfers—and is also in charge of monitoring compliance and enforcing sanctions for local officials and governments. The law also established harmonized rules for budget planning and reporting. Crucially, the reform was effective at increasing transparency and clarifying the costs associated with default, thereby improving the credibility of hard budget constraints on subnational governments.

India. In response to rising debt levels among states, India embarked on a fiscal reform program in the early 2000s. The goal was to control the growth of current expenditures (such as wages and pension) and reform the taxation system (such as moving from a turnover tax to a value-added tax. Importantly, central government on-lending to states was also replaced by market-based financing. Oversight of states’ fiscal policy now relies on a combination of imposed and coordinated fiscal rules as well as direct control measures by the central government. For example, the Indian constitution prohibits states from borrowing abroad. Other measures include the provision under which states with a debt-service ratio in excess of 20 percent are classified as having debt stress, triggering the central government’s close monitoring of additional borrowing by the state. Coordinated fiscal rules among states’ own legislation are now all based on the national Fiscal Responsibility Law, which recommends fiscal deficits below 3 percent of gross state domestic product. Most state laws also require governments to present a medium-term fiscal plan along with the annual budget. Several laws also have led to improvements in disclosure of fiscal risks such as contingent liabilities as well as reporting of any significant changes in accounting policies.

France. Unlike Brazil and India, France is a unitary state with a long tradition of centralization. However, two recent waves of decentralization have given more powers to local governments, and, since 2003, local governments have increased financial autonomy. The management framework of subnational governments’ borrowing includes the use of fiscal targets such as a limit on annual debt service, including interest paid on guaranteed loans, of 50 percent of operating revenue. Direct control measures include a prohibition on borrowing for uses other than capital investment and the fact that debt payments are a compulsory expenditure item that must be fully budgeted. In addition, no single borrower may receive a guarantee in excess of 5 percent of operating revenue; and total guarantees cannot exceed 50 percent of the debt of the entity receiving the guarantee. The central government has retained a strong supervisory role of local government finances. Ex post measures include the stipulation that local governments cannot go bankrupt and public assets cannot be pledged as collateral. Moreover, if a subnational government becomes insolvent, the central government will enforce fiscal adjustment and facilitate debt negotiations with creditors. Importantly, the central government does not provide any guarantees for local government borrowing, though small exceptional assistance is available to ensure continued service delivery. Local governments can also be placed under central control if they fail to meet the mandated fiscal targets.

References

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We are thankful for comments from the Development Research Council of the State Council, experts from the Ministry of Finance, the People’s Bank of China and the Chinese Academy of Social Sciences, Philippe Wingender, CUI Lu (Ministry of Finance), TANG Tao (People’s Bank of China), ZHAO Weixin (Renmin University of China), and YI Cheran (University of Science and Technology Beijing). Sung Jung provided excellent research assistance.

1

Tax revenue broadly consists of three types: (1) central taxes exclusively to finance central government spending, which mostly include taxes related to foreign trade such as duties, trade-related value-added tax, luxury taxes, and export rebates; (2) local government taxes under the control of local governments, such as property-related taxes and business operation taxes; and (3) taxes shared between the central and local governments, including personal and corporate income taxes and the value-added tax (excluding the trade-related component).

2

The aggregate gross land sale revenue was sizable at about 7 percent of GDP (net land sale revenue was 2V2–3 percent of GDP after accounting for expenses related to city construction, land development, and compensation for relocation). In some provinces, as much as one-fifth of tax revenue (excluding land sales) comes from real estate.

3

Interest on local government bonds is exempt from taxes and can be traded in both interbank and securities exchange markets. The interbank market is the dominant platform (trading in the China Futures and Exchange Trading System) and accounts for over 90 percent of bond turnover. The exchange markets trade bonds through public auctions at the Shanghai and Shenzhen stock exchanges.

4

Bonds issued so far have been plain vanilla with bullet maturities of 3, 5, 7, and 10 years, at fixed rates, offering regular coupon payments, and in domestic currency.

5

People’s Daily, May 27, 2016, “Debt-Swap Program Will Not Crowd Out Private Capital,” republished on the Ministry of Finance website (in Chinese). www.mof.gov.scn/zhengwuxinxi/caizhengxinwen/201605/t20160527_2040795.htm.

6

The Ministry of Finance uses a debt-to-GDP ratio of 60 percent and debt-to-revenue ratio of 100 percent as thresholds for monitoring the risk. Additional indicators can include (1) debt-service-to-free-revenue ratios that capture free revenue not otherwise dedicated to specific uses or committed by contract for repayment; (2) debt service to current primary balance, which assesses the risks before interest payments; and (3) current-surplus (deficit)-to-revenue ratio, local-wage-to-current-expenditure ratio, and local-tax and fees-to-revenue ratios.

7

For instance, the adjustment of fiscal positions to meet debt services may take a few years. The plan could include annual benchmarks to measures progress.

8

Prepared by Philippe Wingender.

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Cover Modernizing China
Modernizing China
Investing in Soft Infrastructure
ISBN:
9781513539942
Publication Date:
14 Jan 2017
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781513539942.071
Pages:
388
Figure 6.1.

Local Government Revenue and Tax Sharing System
Figure 6.1.

Local Government Revenue and Tax Sharing System
Figure 6.1.

Local Government Revenue and Tax Sharing System
Figure 6.2.

Local Government Finances
Figure 6.2.

Local Government Finances
Figure 6.3.

Local Government Bond Markets
Figure 6.3.

Local Government Bond Markets
Annex Figure 6.4.1.

Tax Revenue on Income, Profit, and Capital Gains across Countries

(Percent of tax revenues by tax autonomy indicators)
Annex Figure 6.4.2.

Institutional Arrangements for Local Governments