Before 1978, China had a highly centralized fiscal system, which mainly reflected the country’s planned economic system. The central government collected all revenues and allocated all the spending of the administration and public institutions. In parallel with the reforms implemented in the country for Deng Xiaoping, the government started to decentralize the fiscal system.
In 1994, the government launched a bold fiscal reform in order to struggle against a rapid decline in the tax/GDP ratio, which dampened the government’s ability to conduct macroeconomic and redistribution policies. The flagship of the reform was a new taxation system and the adoption of a tax-sharing scheme, where the most lucrative sources of tax revenues, such as the Value-Added Tax and the Enterprise Income Tax, were administrated by the central government.
The result of this reform was a steady increase in revenues, which jumped from 10.8% of GDP in 1994 to 22.7% of GDP in 2013. While expenditures followed suit and increased at a double-digit rate in the same period, the fiscal deficit was kept in check. In the 1994-2013 period, the government’s fiscal deficit averaged 1.4% of GDP.
The new system, however, left local government with just few sources of revenue and they had to rely on land sales and indirect borrowing (mostly so-called “shadow banking”) to finance their activity. In addition, local governments put in place off-budget local government financing vehicles to raise funds and finance investment projects. According to data released by the National Audit Office in December 2013, the total amount of debt held by local governments was CNY 17.9 trillion (USD 3.0 trillion) or 33.0% of GDP, which was well above the CNY 10.7 trillion reported in the 2010 audit.
Although debt is still at manageable levels, the government should be wary of both the increase in reliance on shadow banking and the rapid pace of debt accumulation. Moreover, the government should increase the revenue sources for local governments. In this regard, in August 2014, the National People’s Congress passed amendments to the budget law, allowing provincial government to issue bonds directly and increase transparency. This move paves the way for local governments to raise debt in the bond market.
China’s government debt is almost entirely denominated in local currency and owned by domestic institutions. In addition, the government has cash savings equivalent to 6% of GDP in the People’s Bank of China. This situation shields the economy against government debt crises.
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