Govt debt and urbanization

The State Council, China's cabinet, has directed the National Audit Office to audit all local government debt accounts, reflecting the rising concern over debt levels amid the economic slowdown. Of late, disappointing trade figures, combined with lower than expected second quarter GDP figures, have increased the pressure on the central government to introduce some sort of financial stimulus package to boost the economy.

Many experts, however, are warning against any such stimulus for the urbanization drive. The problem is local governments' debts, which have been in the news ever since the central government announced a 4-trillion-yuan ($652-billion) stimulus package in 2008 to overcome the shocks of the global financial crisis. In fact, the experts say it's the stimulus that helped create this mountain of debt.

According to official data, local government debts today exceed 12 trillion yuan, although ratings agency Fitcsh suggests the figure could be as high as 13 trillion yuan, or a quarter of China's GDP.

Fears that fresh, and perhaps substantial, funds (or rather loans) from the central to the local governments will add to this mountain of debt are well founded. But local governments' reckless lending and profligate spending alone cannot be blamed for the problem.

Changes in the tax laws in 1994 forced local governments to depend on areas other than taxation as their main source of revenue. And they found land (or the transfer of land-use rights) a convenient and lucrative alternative. Since local governments cannot depend on income from taxation, one can understand their desperation to seize the opportunity offered by land.

But with local government debts threatening to turn into a national debt crisis, the central government has to either exercise tighter control or change its funding pattern. The central government has to take immediate measures to rein in excessive local government spending and enforce austere spending limits. For instance, it can impose severe financial penalties on local governments that cross their spending limit. In this regard, China could learn from the United Kingdom where local government finances are strictly managed.

To prevent the recurrence of such humungous local government debt in the long term, the central government should review the nature of urbanization and determine whether spending and debt are vital ingredients of urbanization.