Wednesday, 5 March 2014

China Debt Dynamics: Part 1 - Government Debt

This is Part 1 of a two-part series. This piece was originally carried in the Shocks & Surprises Global Weekly Summary for week ending 3rd January 2014. 

Holiday seasons are generally a convenient time to slip out bad news, and so it happened that China published its latest and best effort to tally government debts on New Year's Eve 2013. A serious effort this was as well, with 54.4k auditors deployed to ferret out the liabilities of five levels of government – central, provincial, prefectural, county and township administrations are all counted. The total as of June 2013 came to 30.27tr yuan, equivalent to a not-so worrying 56% of GDP, but also to a distinctly worrying 248% of total govt revenues (tax and non-tax) for the 12m to June 2013.

Even the maximalist 30.27tr yuan tally comes to only 56% of GDP, which by itself is hardly an alarming proportion. Despite the headlines, this number is not directly comparable to the previously announced 10.7tr yuan estimate of local govt debt as of end-2010 – that tally accounted for only for provincial, prefectural and county govt debt. Even though the debt total is sharply higher than previously thought, this is still not debt-meltdown data. But it ought to alert us to the way this larger-than-expected debt total is likely to bear on policy-choices and policy-making.

The key weakness, and therefore potentially a key policy-constraint, is that the debt is large relative to China's ability to raise taxes: 30.27tr is equivalent to 248% of total central and local revenues, including both tax and non-tax revenues.  That means that every one percentage point rise in financing costs has the potential of attracting (over time) a rise in interest payments equivalent to 2.5% of total revenues.   Now, in the 12m to September 2013, China's fiscal deficit of 811mn yuan was equivalent to 6.5 percent of total revenues. In other words, whether China likes it or not, current fiscal policies are now significantly leveraged to financing costs.

The obvious conclusion from this is that PBOC probably faces more constraints on raising interest rates than previously thought.  And from that, we should also expect that 2013's experience of allowing a rising Rmb to exert increasing economic discipline is likely to be extended in 2014 and beyond. The strong Rmb may be painful for exporters, but their interests are unlikely to outweigh those of the government.

The second obvious conclusion is that China is going to need to raise its government revenues relative to GDP. In the 12m to September, revenues were equivalent to 22.6% of GDP. This proportion has been largely unchanged since 2011, and has interrupted the steady progress made in raising this ratio since 1998 at least (when it was just 11.7% of GDP).  Evidently, for the last few years, the tactical need to support the economy over-rode the strategic need to raise the tax-take.  At some point, that strategic issue will have to be addressed.

The renegotiation of tax raising powers and responsibilities between the Centre and the Provincial governments outlined in the 3rd Plenum were always going to be one of the tougher reforms to deliver. These numbers make those negotiations tougher – a lot tougher – as well as more urgent. Quite possibly this is the single biggest and toughest reform upon which the rest of the package will stand or fall. [So far this year (as of early March) it has not featured significantly as a topic of discussion.]

And there is a third thought: if the debt-total highlights the government's unexpected sensitivity to rising financing costs, then it also raises the classic Chinese question:  who pays?  In this case, it's not difficult to imagine that sections of the financial industry – banks in particular – will find themselves picking up some of the costs involved in keeping the apparent financing costs down, even if market rates rise.  The temptation to extend financial repression – ie, by keeping deposit rates negligible  - even in the face of liberalizing lending interest rates is likely to be strong.  Similarly, we can imagine that the Ministry of Finance is rather more attached to those 20% deposit reserve ratios than previously thought – commandeering deposits is, after all, the cheapest source of financing of all.

And there is this final thought: although it may seem that New Year’s Eve is a suspiciously quiet time to slip out such important data,  the fact that is was published at all is important. It is a message from China’s leadership of the seriousness of their intentions, and the limits of their room for manoeuvre.

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