Chapter

8 Medium-Term Fiscal Issues

Author(s):
Wanda Tseng, and Markus Rodlauer
Published Date:
February 2003
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Author(s)
James Daniel,, Thomas Richardson,, Raju Singh, and George Tsibouris 

At first glance, fiscal policy does not seem a pressing medium-term policy challenge for China. The measured debt stock is low, and the reported budget deficit is modest and easily financed. However, fiscal activity in China extends well beyond the state budget, and public finances will face a number of difficult challenges in the next few years. There is a sizable amount of quasi-fiscal debt in the form of nonrecoverable loans in the banking system, the legacy of central planning. Further, although efforts are being made to limit the flow of new nonperforming loans, through state-owned enterprise (SOE) and financial sector reforms, the possibility that part of ongoing bank funding will become nonperforming cannot be ruled out. The budget also faces heavy future expenditure demands for health and education, pension reform, and the government’s ambitious infrastructure program.

As a result, a broader measure of China’s public debt stock is larger than reported stock, and could grow further if corrective measures are not taken. Alternatively, if the budget deficit is reduced gradually over the next few years and the creation of new nonrecoverable loans is successfully contained, the debt stock should stabilize and then fall over the medium term.

The potential fiscal burden from the pension system is also large. Without reform, the existing, largely pay-as-you-go system cannot deal with either the long-term problem of a rapidly aging population or the short-term problem of providing pensions to the employees of SOEs. The World Bank’s recommendations to address these problems include consolidating and unifying pension administration, fully funding individual accounts, and implementing parametric reforms such as raising the retirement age.

Meanwhile China’s system of fiscal federalism needs to ensure greater equalization in public service delivery across provinces. The current transfer system relies heavily on regressive “revenue returned” transfers and not enough on progressive “subsidy” transfers and specific-purpose grants.

The Current State of Public Finances

Although China’s official fiscal statistics show only a modest deficit and debt stock, on a broader definition both are larger. The official budget data should be adjusted for unrecorded budgetary spending, extra-budgetary account balances, and quasi-fiscal spending. The official debt data should be adjusted for unrecorded explicit debt and quasi-fiscal (contingent) liabilities.

According to the official data, the budget deficit has hovered at relatively modest levels over the last 20 years, with a major decline in both revenue and expenditure (Figure 8.1). Revenue collection fell from about 31 percent of GDP in 1979 to about 13 percent in 1995, before recovering to about 16 percent in 2000. The revenue decline after 1979 was in large part due to the separation of the financial accounts of the SOEs from the budgetary accounts, a move undertaken to improve the managerial and financial autonomy of the SOEs. A concomitant reduction in the financing of SOE investments out of the state budget resulted in a corresponding decline in expenditure. Since the mid-1990s, however, both revenue and expenditure have rebounded, and the budget deficit widened in response to the Asian crisis.

Figure 8.1.State Budget

(In percent of GDP)

Sources: Ministry of Finance; and IMF staff estimates.

The official definition of the state budget has historically excluded three important items that should normally be included: central government on-lending to local governments of certain bond issues since 1998, external official borrowing by government agencies (such as loans from the World Bank), and interest payments (included since 2000). Also, subsidies to enterprises are recorded as negative revenue rather than expenditure. When these adjustments are made for 2001, the state budget is estimated to have had revenue of 17.2 percent of GDP, expenditure of 20.4 percent of GDP, and an overall deficit of 3.2 percent of GDP (Table 8.1). The primary deficit was 2.3 percent of GDP.

Table 8.1.Official and IMF Measures of the Fiscal Deficit and the Debt Stock, 2001
MeasurePercent of GDP
Fiscal deficit
State budget, official measure2.6
State budget, IMF measure3.2
Plus funds’ balance2.6
Plus funds’ balance and policy bank net lending3.6
Debt stock
Explicit, official measure15.6
Explicit, IMF measure24.4
Sources: Ministry of Finance; and IMF staff estimates.
Sources: Ministry of Finance; and IMF staff estimates.

Revenue and expenditure related to extrabudgetary funds are sizable but probably broadly balanced. The off-budget funds and operations comprise three broad types of funds:1 social funds, authorized extrabudgetary funds, and unauthorized extrabudgetary funds. Although no data are readily available from before 1994, aggregate revenue and expenditure of the social funds have hovered around 2–3 percent of GDP since then. Aggregate revenue of the extrabudgetary funds in 2000 was 7.8 percent of GDP, which exceeded aggregate expenditure by 0.6 percent of GDP. Unauthorized extrabudgetary funds are illegal; they probably do not enjoy significant access to bank borrowing and therefore would not be able to run substantial deficits.

In the past the government used the banking system extensively to finance SOEs. This mechanism served as a way of compensating for the decline in resources coming from the state budget and has been used particularly for investment projects and agricultural procurement. Lending to SOEs was done in the context of the annual credit plan, which until 1997 established gross lending targets for specific institutions and projects, and was provided by the state commercial banks and, more recently, by the policy banks created in 1994. According to the Government Finance Statistics Manual, lending for policy purposes should be incorporated into the fiscal accounts. There are several approaches to measuring the quasi-fiscal component of lending for public policy purposes:

  • Develop an overall estimate of net lending, which refers to the outstanding stock of lending by banks at the end of each period in which government direction is involved.

  • Attempt to isolate the grant component. The value of loans could be decomposed into two components: a pure loan component, which would represent the loan had it been undertaken on an exclusively commercial basis, and a grant component, which would represent the government’s role as a promoter of public policy.

  • Estimate the eventual impact of lending by banks on the government’s net worth. This would correspond to policy lending and other lending by banks that is not being repaid by SOEs and would end up being reflected in the resulting cost of recapitalizing the banking system. This impact on government net worth would be particularly relevant for debt sustainability calculations.

Given data limitations, the first approach is the most practical, although the third is better suited for medium-term sustainability analysis. The second approach is not feasible for data reasons. The third approach is practical for estimating the existing debt stock, but estimating the flow deficit is more difficult, because it requires an assumption about the extent to which new loans are likely to become nonrecoverable. The first approach (directed lending) is also difficult to apply fully, because many loans made by state commercial banks to SOEs may be used either for commercial purposes or for purposes of public policy. However, a narrower definition can be used, namely, new lending by policy banks.2 By definition, such lending is done for purposes of public policy and should be incorporated into the fiscal accounts. In 2001 the policy banks increased their stock of loans to the economy by 1.0 percent of GDP (and by 1.5 percent of GDP in 2000).

Including estimates of quasi-fiscal activity of the banking sector increases the broader fiscal deficit substantially. When only lending by policy banks is included (the first approach), the broader fiscal deficit was about 3.6 percent of GDP in 2001. If one includes an estimate of the potential cost to the government of all lending by the banking system in 2001 (the third approach), the broader fiscal deficit was probably still larger.

Explicit public debt is low by international standards. Central government debt is estimated to have reached 24.4 percent of GDP in 2001.3 Of this, 20.1 percentage points was domestic debt and the rest public and publicly guaranteed external debt. This debt includes Y 270 billion (3.4 percent of 1998 GDP) in tradable treasury bonds issued to recapitalize the four state-owned commercial banks in 1998, although these bonds are excluded from official debt statistics.

Including contingent liabilities associated with bank loans, the total public debt stock at the end of 2001 was higher. Loan losses of the state-owned banks are not legally a liability of the government, but these are losses that the government may have to cover at some point in the future. Estimates of the stock of nonrecoverable loans are very difficult given data limitations, but it is likely that these loans will pose substantial demands on the public finances in the future.4

The Medium-Term Fiscal Outlook

China’s public debt stock will grow further if corrective measures are not taken. As noted above, although China’s explicit debt stock is relatively modest, its implicit debt, which includes nonrecoverable bank loans (but not pension liabilities; see below), is substantial. Similarly, the broadly defined fiscal deficit is also large, taking into account new nonrecoverable loan growth and the cost of interest on the implicit debt stock.

The medium-term fiscal outlook is burdened by two main factors: further accumulation of nonperforming loans and greater budgetary expenditure pressures. Accelerated efforts are needed in banking reform to stem the flow of new nonperforming loans. Budgetary spending is likely to increase significantly to meet social and infrastructure policy objectives. Budgetary outlays on education and public health will need to be increased to raise expenditure per student, increase enrollment rates, and bolster public health programs (see World Bank, 1997). Large infrastructure programs are planned and are being executed in the areas of roads and communications, energy, agricultural improvements, and the environment. For example, the authorities’ highway construction program is estimated to cost about $150 billion (12 percent of 2001 GDP) over the next 15 years, of which approximately 20 percent is expected to be funded by the state budget.

To ensure sustainable debt dynamics over the medium term, it will be necessary both to reduce the explicit budget deficit and to contain the flow of new nonrecoverable loans. The envisaged budgetary adjustment should come mostly from higher revenue, although it will also be necessary to reallocate expenditure further toward priority areas. Tax policy measures could include a reduction of tax preferences, unification of the corporate tax regime for domestic and foreign enterprises, extending the value-added tax to services,5 and including the self-employed in the income tax net. Tax administration efforts should consolidate the reforms currently under way to enhance taxpayer compliance, increase the focus on arrears collection, and improve audit programs.

Strong growth alone will not solve China’s public debt problem. Even with average real annual growth of 7–8 percent of GDP, timely reforms are needed to ensure fiscal sustainability. On the other hand, the analysis also shows that the public debt-to-GDP ratio can be controlled with a modest, sustained fiscal adjustment effort and continued SOE and financial sector reforms.

Other Issues

In addition to facing the medium-term outlook described above, the government needs to reform its pension system and how it shares resources across provinces. Failure to address these problems will hamper the reform process and could have significant fiscal costs.

Pension System

China’s pension system faces large contingent liabilities and hampers the SOE reform process.6 Because of the aging of the population, the current pay-as-you-go system is heavily underfunded on an actuarial basis.7 Because SOEs are still responsible for a substantial part of pension provision, the current system also makes it more difficult to tackle the problem of unprofitable firms and to increase labor mobility. The government has decided in principle to move toward a three-tier system as recommended by the World Bank, but it has yet to decide on a number of critical issues. These decisions, when made, should allow the reform to proceed, leading to greater unification of pension administration, funded individual accounts, and lower pension benefits.

The World Bank estimates the government’s implicit pension debt at about 90 percent of GDP, with a financing gap of about 70 percent of GDP (Dorfman and Sin, 2001).8 Although China’s implicit debt is lower than in most OECD countries, this reflects mainly the fact that China’s pension system only covers about 20 percent of the workforce, whereas pension systems in OECD countries cover about 90 percent.

The above estimates are highly sensitive to parameter changes, and reforms of the system could significantly reduce the financing gap. For example, Dorfman and Sin (2001) estimate that if the retirement age were gradually increased to 65 or if the individual account benefit followed a life annuity payout, the financing gap of the system would be reduced substantially. The gap could be narrowed to less than 10 percent of GDP through comprehensive reforms, including gradually increasing the retirement age to 65; paying out individual accounts using annuities calculated based on life expectancy at retirement; and indexing base and individual account pensions to consumer prices instead of wages.

Reforms in the pension system and the SOE sector are closely linked. The current system, which is mainly administered and paid by individual SOEs, impedes labor mobility, does not provide a level playing field for enterprises, and complicates SOE restructuring by failing to delink pension provision from enterprise management. Without a clear statement of an enterprise’s legal obligations, it is difficult to value the enterprise, legally segregate the social and financial liabilities, and decide the hierarchy of claimants in bankruptcy proceedings.

In 1997 the government adopted a nationwide three-tier pension system, like that recommended by the World Bank. This system will comprise a public pension, mandatory individual pension accounts, and supplementary voluntary individual accounts.9 So far the individual accounts are largely notional and are not funded; instead current contributions are being used to meet current pension payment needs. A pilot reform project for provincial pensions was initiated in 2001 in the northern province of Liaoning, which has a large concentration of SOEs. In June 2001 the government announced that, when joint-stock limited companies with state shares launch initial public offerings or issue additional shares, they must sell state shares up to 10 percent of the total funds to be raised, with the proceeds to be transferred to the national social security fund. The program was suspended in late 2001 following a sharp decline in share prices, which was partly attributed to the increased supply of SOE shares coming to the market under the program.

However, the problem of the implicit pension debt has not been fully addressed, nor has administration been unified. Although the envisaged sale of state shares will provide some funding, it will probably not be sufficient. Either the implicit pension debt will have to be reduced through parametric reforms,10 or the debt will need to be financed by the government. Although the cash flow needs of the current system are not likely to be very large in the medium term, any transition to a funded system will likely require government financing. However, World Bank simulations suggest that the amount of government financing needed to fund the individual accounts would be modest if accompanied by the recommended parametric reforms.

Fiscal Federalism

China has partially succeeded in reforming its system of fiscal federalism, but more needs to be done to ensure greater equalization in service delivery across provinces. The design of intergovernmental fiscal relations is an important ingredient of a successful economic transition, and China’s large and diverse population makes this issue especially important. Industrial location decisions under China’s planned economy bore little relation to market signals, with the result that the transition process involves sharply uneven adjustment costs in different regions. Heavy industries were often located far from their markets, and these enterprises became unviable once they faced international and domestic competition and had to pay for transportation services at realistic prices. Furthermore, certain coastal provinces have been allowed to experiment with market-oriented reforms since 1978. Thus the social costs of transition are greater inland, whereas the engines of growth, and therefore of income, are located in the coastal provinces.

Intergovernmental relations over the last 20 years have evolved in two broad phases: decentralization before 1994 and recentralization since then. The fiscal revenue sharing system established in 1980 gave incentives for local government to reduce revenue transfers to the center. As a consequence of these and other factors (including the decline of the SOE sector), the central government’s share of total revenue fell from 39 percent in 1985 to 22 percent in 1993. By the early 1990s the authorities considered central government revenue to be seriously inadequate, prompting the far-reaching fiscal system reform of 1994.

The 1994 reform significantly changed the revenue sharing rules and increased the importance of transfers. Under the new system, tax revenue assigned to the central government included 75 percent of the (newly introduced) value-added tax; excises and trade-related taxes (customs duties and excises and value-added taxes levied on imports); the enterprise income tax collected from central SOEs; turnover taxes on the railroads and the financial sector; and a securities stamp tax. At the same time, a national tax service was established to administer the new central and shared revenue system. Local governments were assigned the following revenue sources: 25 percent of the value-added tax; the business tax (apart from that collected from banks, railroads, and insurance companies); enterprise income taxes levied on local SOEs; the personal income tax; and a number of smaller taxes.11

The 1994 reform succeeded in increasing central government resources. Between 1995 and 2000 the state revenue-to-GDP ratio rose from 11.2 percent to 15.3 percent, and the central government’s share of total revenue rose from 22 percent to 52 percent. Central government expenditure (excluding transfers to local governments) increased from 3.8 percent of GDP in 1993 to 6.2 percent in 2000.

Although the 1994 reform established a rules-based transfer system, it has not yet provided each province with sufficient resources to deliver a minimum standard of public services. The new system of transfers from central to local governments comprised four main parts:

  • Revenue returned. This provides each province with 30 percent of the increase in value-added tax and excise tax collection in its province over the 1993 base. This is a regressive transfer (in the sense that richer provinces benefit most) but also the most important, accounting for 39 percent of total transfers in 2001 (2.3 percent of GDP). That share, however, has fallen from 72 percent in 1996.

  • Specific-purpose grants. Hundreds of different earmarked grants are allocated on an ad hoc basis. They represent a large and, in recent years, growing share of total transfers, reaching 35 percent in 2001 (2.0 percent of GDP), up from 18 percent in 1996. These transfers are probably progressive in that they are targeted to projects in poorer provinces.

  • Subsidy transfers. These are meant to ensure that each province has adequate resources. They are rules based and depend on variables such as provincial GDP and student-teacher ratios. These transfers have represented only a small but growing share of total transfers, rising from 6 percent in 1996 to 25 percent in 2001 (1.4 percent of GDP).

  • Fixed subsidies. These transfers were designed to ensure that every province would have total nominal revenue no lower than in 1993. Specifically, the transfer would equal the province’s 1993 base revenue minus the 25 percent share of value-added tax revenue and minus most other local revenue sources. As the 1993 level is fixed in nominal terms, this transfer is declining relative to other transfers and in 2001 amounted to 2 percent of total transfers (0.1 percent of GDP).

The focus of reforming the system of fiscal federalism should be on ensuring that each province has sufficient resources to deliver a minimum standard of public services. This means continuing to reduce the importance of revenue-returned transfers and greatly increasing the importance of subsidy and specific-purpose transfers to those provinces in need.

Conclusions

China’s current fiscal position is much weaker than official data suggest, mainly because of the quasi-fiscal operations of the banking system. The already large public debt stock (including quasi-fiscal liabilities) will grow further if corrective measures are not taken. Alternatively, it could be reduced gradually—to a sustainable level—if the budget is tightened modestly every year and the flow of new nonperforming loans is significantly (but gradually) curbed.

Other medium-term fiscal issues, such as pension reform and fiscal federalism, also need to be addressed. The pension system’s finances are unsustainable and its administration is fragmented. The system of intergovernmental transfers does not provide sufficient equalization in service delivery across provinces. Failure to address these issues not only will be costly but will also hamper economic reform.

The overall fiscal policy agenda is challenging. Revenue should be further increased. Expenditure, which will likely continue rising to meet pressing social needs, should be further prioritized. Quasi-fiscal spending through the banking system should be quickly reined in. Individual pension accounts should be fully funded, pension benefits should be made less generous, and pension administration should be further unified. The system of intergovernmental transfers should ensure greater equalization in public service delivery across provinces.

References

Social funds include the Pension Fund, the Unemployment Fund, the Medical Fund, the Injury Fund, and the Maternity Fund. Authorized extrabudgetary funds are financed by properly legislated fees and surcharges and operate at the central, regional, and local government levels. Unauthorized extrabudgetary funds are not sanctioned by the State Council and therefore operate in contravention to the law. They are financed by a variety of taxes, surcharges, and fees.

As part of a long-term plan to convert specialized banks to commercial banks, three policy banks were created in 1994. These banks were designed as nonprofitmaking financial institutions for the purpose of providing financing for policy-oriented projects identified in the state development plan or to promote industrial policies for specific sectors. However, most existing policy loans were not transferred, nor have policy banks taken over sole responsibility for all policy lending. In particular, the large state banks have continued to be the principal source of working capital for SOEs. The formal credit plan was abandoned in 1998. Although informal governmental credit guidance likely persists (for example, by encouraging state commercial banks to lend to the government’s priority projects), the state commercial banks are responsible for assessing the viability of projects and held accountable for their lending decisions.

The central government is the only level of government legally authorized to borrow domestically or abroad. However, enterprises established by local governments may borrow.

The authorities report that nonperforming loans of the state commercial banks amounted to 22 percent of GDP (31 percent of outstanding loans) at the end of 2001. In addition, Y 1.4 trillion (17 percent of 1999 GDP) of the nonperforming loans of the state commercial banks was transferred to asset management companies. Market estimates of nonperforming loans in China’s state commercial banks are substantially higher.

Integrating the business tax into the value-added tax is also recommended on general efficiency grounds (for example, to reduce tax cascading). Capital goods should also be removed from the value-added tax base.

This section draws heavily on World Bank research, mainly by Mark Dorfman.

The system currently has about 105 million contributors (about 12 percent of the working population) and 32 million beneficiaries. Although rates vary across localities, the average combined contribution rate is about 27 percent of wages, and the replacement rate is about 80 percent. The number of contributors is projected to increase modestly through 2010 and then decrease to 86 million by 2050. Conversely, the number of retirees is projected to increase markedly, to 95 million by 2050.

Implicit pension debt is a measure of the present value of accrued benefits under the pension system if the system were terminated at a particular date (including benefits to be paid to current pensioners and pension rights that current workers have earned up to the termination date, which is assumed to be in 1998). The financing gap is measured by summing the net present value of the current balance (revenue less expenditure) throughout the projection period (75 years in the case of Dorfman and Sin).

Contributions would amount to about 24 percent of the wage, with employee contributions reaching 8 percent of their wage and employers contributing the rest. Although the system is still being finalized, the new scheme is likely to provide a pension with a replacement rate of 50–60 percent, with about 20 percentage points coming from a public pension provided by the budget and the rest from funded individual accounts.

In addition to the institutional reform (the three-tier system), the World Bank has recommended unifying and raising the retirement age, indexing pension payments to inflation (instead of indexing them to wages or raising them on an ad hoc basis), and linking the individual account pension to life expectancy at retirement.

By law, local governments have very limited ability to set taxes. They can only modify the rates of a few minor taxes; all other decisions must be made by the central government. In practice, however, lower levels of government have used a variety of illegal taxes, fees, and surcharges.

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