To tackle local government debt, first understand it

By ZHANG WENJUN / 10-24-2019 / (Chinese Social Sciences Today)
An employee counts yuan banknotes at a bank in Beijing. Photo: XINHUA

For a long time, the formation process of local government debt has been analyzed in the framework of economics. Therefore, the research on local government debt is often seen as a purely technical process, focusing on how to build a debt risk warning system and how to formulate scientific fiscal and monetary policies. Such a tradition has arisen because local government debt has built up in the fiscal system and manifested itself in financial risks, both of which fall under the purview of macroeconomics, so it is natural to study local government debt from the perspective of economics.
In fact, the deep-rooted solution to the problem of local government debt needs to be found in the field of public administration. Public administration activities revolve around the allocation of financial resources. All political organizations and interest groups want the government to formulate policies to maximize its own interests in the allocation of financial resources. However, the scarcity of financial resources leads to the needs of most political organizations and interest groups going unmet.
The buildup of local government debt shows that borrowing loans is the best choice for local government. From the perspective of public administration, it is helpful for us to understand the formation mechanism of local government debt more comprehensively to explain the decisions of local governments.
Three-fold principal-agent relationship
Local government officials in developed countries such as the United States and the United Kingdom are elected, so they choose debt strategies to maximize the current welfare of voters. 
Due to China’s different administrative system, some people think that the reason why local Chinese government officials choose to take on debts is different from those of the United States and the United Kingdom who prioritize the maximization of the welfare of residents within their jurisdiction. They think that local Chinese government officials only need to answer to upper administrative bodies, rather than the people. This is actually a misunderstanding of the current three-fold “people—central government—local government” principal-agent relationship in China.
In China’s administrative system, the “central government—local government” principal-agent relationship motivates local government officials to compete against each other in terms of GDP, fiscal revenue, attracting investment and other aspects. 
In this context, local government officials will choose to expand investment scale and assume a large amount of debt to maximize their own interests after taking office. This can be interpreted as the “upward” responsibility of local government officials. 
However, it is inadequate to explain why local government officials choose to raise debt instead of levying taxes to boost the budget. In fact, most local government officials in China adopted this strategy in the 1990s, which led to the occurrence of various apportion issues and arbitrary collection of fees.
At this time, we need to introduce the current three-fold “people—central government—local government” principal-agent relationship to understand why local government officials choose to be in debt. The central government is entrusted by the people and delegates the functions of economic development and social management to local governments, which is the current administrative system of our country’s three-fold entrustment relationship. 
Though this administrative system is quite different from the hierarchical “people—local government—central government” principal-agent relationship in Western countries, the following two mechanisms are designed in China to effectively reduce the agency costs of local governments.
First, the central government directly participates in local affairs through vertical management agencies, inspection groups and other forms. Second, the central government supervises local affairs through public opinion feedback such as via the internet, the office of letters, and visits at various levels. 
In balancing the pros and cons of improving the welfare of the people in the jurisdiction and prohibiting the levying of fees arbitrarily, the local government should not only answer to upper administrative bodies but to the general public, so local governments in China in the end typically conclude taking out loans to be the best choice.
Unitary state administration system
It is not enough to understand why local governments are willing to borrow loans. We must also understand why they are able to do so. In this regard, some scholars believe that the reason for the formation of local government debt is that China is a country that is going through economic transition and its market economic system is still imperfect. 
Indeed, the imperfect market economic system is a major cause of the formation of local government debt in China, but it would not be the root cause. Otherwise, we could not explain the local debt phenomenon of some Western developed countries. For example, German local governments set up some budget-independent public institutions who then take loans from the bank, but they do not have the ability to pay back the loans, so the local governments in fact shoulder the responsibility  and thus increase their implicit debt. Similarly, Danish local governments finance fixed assets such as schools and government office buildings through sale-and-leasebacks. 
In these Western developed countries with perfect market economic systems, the local governments’ borrowing behavior is similar to the implicit debt formation process in China.
Therefore, the present situation of the market economy transformation is not enough to explain why local governments can borrow money. Similar to the above-mentioned administrative systems in Germany and Denmark, China is also a country with a unitary administrative system. 
In contrast to the federal state system, where there is a natural firewall between the local debt and the federal debt, the central government of the unitary state bears unlimited joint liability for the local government debt risk. It is this fundamental difference in the administrative system that has led to the central government becoming the lender of last resort for local government debt. It can be argued that the unitary administrative system is the fundamental reason why local governments in China can borrow money.
In reality, since the reform and opening up, China’s market economy system has been greatly improved, and the power boundary of local governments has been clarified, but local government debt has always appeared in different forms. 
Similar to the current collaboration between local government debt and financing platform companies, in the 1980s and 1990s, China’s local government debt was tightly bound to state-owned enterprises. Under the fiscal system at that time, local governments performed many social functions such as housing, employment, medical care, education and elderly care through state-owned enterprises. To keep state-owned enterprises in business, local governments not only provided regular subsidies to them, but also coordinated loans from financial institutions. 
At that stage, it was the local government credit behind those state-owned enterprises that assured the financial institutions, because they knew that the central government was the lender of last resort.
Policy advice
Therefore, analyzing the formation mechanism of local government debt in China from the perspective of public administration is conducive to facilitating more targeted measures for the effective governance of local government debt.
Going forward, we need to better take advantage of the principal-agent relationship between the central and local governments, to encourage friendly competition centering on assessment indicators and adjust the assessment system in a timely manner. 
From the perspective of management, a single assessment index is convenient for central government supervision and the daily operations of local governments, which could effectively reduce management cost. However, the single assessment index system will in turn increase the agency cost of local governments, which is reflected in the fact that they will sacrifice other indicators in order to achieve the performance of the single indicator. 
For example, some may strive to meet the target GDP growth at the expense of local environmental and fiscal sustainability. In this regard, in the evaluation of local governments, we should continue to include other auxiliary indicators such as the scale of local government debt on the premise of focusing on the GDP indicator, so as to form a perfect assessment system. 
At the same time, it is necessary to make full use of the unitary administrative system and strengthen the administrative constraints on various stakeholders formed by local debts. Though it is easy for local governments to borrow money because they have the central government as the lender of last resort, the absolute authority of the central government can effectively deter various stakeholders from illegal borrowing through efficient administrative orders. At present, the main task is to make implicit debt explicit, so that local government officials have no other “flexible” means to borrow debt.
Meanwhile, the illusion that the central government will be the parachute in the case of local government debt default should be fundamentally eliminated, so as to preemptively supervise financial institutions’ lending interactions with local governments. With these two measures, we should be able to build an effective way to manage local government debt.
Zhang Wenjun is an associate professor from the Jiangxi Academy of Governance. 
​edited by YANG XUE