Debt is not the purpose, the risk is the fundamental goal

• News
• 2024-09-07

In order to guard against and resolve local debt risks, the Ministry of Finance has recently indicated its intention to increase the debt limit by a large amount to replace the existing implicit local government debt. This is also the most significant measure to support debt resolution in recent years, which has attracted market attention.

Since this policy requires an increase in the debt limit, it must be approved by the Standing Committee of the National People's Congress (NPC). Therefore, the specific details of the debt resolution are still to be revealed in subsequent NPC meetings. What is the background for the central government to introduce the most significant debt resolution in recent years at this time?

Luo Zhiheng, Chief Economist at Guangdong Kai Securities, believes that under the current backdrop of guarding against and resolving local debt risks, local governments are facing many severe challenges. The real estate industry is in a period of adjustment and transformation, and sources of revenue such as real estate-related taxes and land transfer income are significantly affected. The fiscal revenue and expenditure gap of local governments has widened, and the difficulty of repaying principal and interest on local debt has increased.

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"Debt resolution is not the goal, risk resolution is the fundamental objective. We must not stop development to resolve debt," Luo Zhiheng said.

Data from the Ministry of Finance shows that in the first eight months of this year, local general public budget revenue was 8.2415 trillion yuan, a year-on-year increase of 0.4%; local government fund budget revenue was 2.3904 trillion yuan, a year-on-year decrease of 23.5%.

Luo Zhiheng stated that under the debt resolution policy requirements, local governments mainly focus on reducing the debt scale, which affects their ability and enthusiasm for economic development. The result is that the contraction of the debt scale on the numerator leads to a more significant decline in economic growth on the denominator, and the debt risk actually increases passively, resulting in a certain degree of contraction effect.

"Local debt resolution should shift from 'developing while resolving debt' to 'resolving debt while developing'. Debt resolution is not the goal, risk resolution is the fundamental objective, and development must not be halted for debt resolution," said Luo Zhiheng.

In March of this year, the State Council's executive meeting proposed to coordinate debt resolution and development, and to promote debt risk resolution in high-quality development. It is necessary to use debt resolution as an opportunity to force a transformation of development methods, to take bigger steps in reform and innovation, and to find new development paths in resolving debt risks.

Luo Zhiheng believes that the Ministry of Finance's introduction of the most significant debt resolution measure in recent years indicates that a new round of large-scale implicit debt replacement is about to begin. In terms of specific forms, it can continue the current special refinancing bonds and special new special bonds, or it can restart the issuance of replacement bonds, which are more standardized and more in line with the actual use of bonds.

The balance of government debt must be controlled within the limit approved by the NPC, and the current local debt balance limit is about more than 1.76 trillion yuan, while the national debt balance limit is about more than 800 billion yuan. Therefore, the available debt resolution quota is limited and must be approved by the NPC to increase the debt limit in order to have more debt resolution quota.In Luo Zhiheng's view, the new round of large-scale debt replacement holds significant importance.

He stated that for local governments, issuing local government bonds to replace implicit debt is conducive to making implicit debt explicit, optimizing local debt structures, and alleviating interest payment pressures. More importantly, the fiscal space released through debt replacement allows local governments to allocate resources more flexibly, supporting the development of key areas and weak links, such as education, healthcare, and environmental protection, thereby enhancing the internal momentum of local economies and social welfare. For urban investment companies, debt replacement helps these companies shed historical debt burdens, enabling them to move forward lightly and providing a solid foundation for their transformation and development.

In fact, China has carried out multiple rounds of debt replacement, with the core being the explicitness of implicit debt.

Through audit and identification, China has made the local government debt that was not included in budget management by the end of 2014 explicit, locking in the local government debt balance of 15.4 trillion yuan at the end of that year. The vast majority of this was local debt in non-government bond forms, with relatively short terms and high interest rates. To address this, China launched a plan in 2015 to use about three years to issue government bonds to replace over 14 trillion yuan of local government existing debt in non-government bond forms.

Ultimately, from 2015 to 2018, China issued a total of 12.2 trillion yuan in local government bonds to replace local existing debt in non-government bond forms. After the replacement, the average interest rate of local government debt at the end of 2018 was about 6.5 percentage points lower than at the end of 2014, saving approximately 1.7 trillion yuan in interest. This was the first round of large-scale debt replacement.

Due to subsequent violations of debt issuance by localities, a large scale of government implicit debt was formed. To prevent risks, starting from 2019, government bonds were issued again to replace implicit debt, with an increasing trend in the replacement intensity.

After several rounds of debt reduction, Luo Zhiheng believes that preventing and resolving debt risks does not simply mean reducing the scale of debt itself, but rather resolving risks. Risks can be reduced by optimizing debt structures, lowering financing costs, and extending debt terms. While maintaining the necessary scale of financing, local governments must strengthen the management of debt liquidity risks to avoid the occurrence of debt crises.

"At present, there is no need to overly fear the scale of local debt. From the perspective of local governments, the debt scale is large and the risks are significant, but from a national perspective, due to the low leverage ratio of the central government and the large space for central borrowing, China's government debt ratio is lower than that of major international economies. Moreover, China's debt is mainly domestic debt, which is low risk," said Luo Zhiheng.

How to fundamentally solve the local debt problem?

According to the Ministry of Finance data, by the end of 2023, the national government's statutory debt balance was 70.77 trillion yuan. Among them, the national debt balance was 30.03 trillion yuan, and the local government's statutory debt balance was 40.74 trillion yuan. The national government's statutory debt ratio (the ratio of government debt balance to GDP) was 56.1%. This debt ratio is significantly lower than that of some developed countries such as Japan and the United States.Luo Zhiheng suggests that debt replacement should be managed differently based on regional debt risks, tailored to local conditions. During the debt replacement process, it is essential to fully consider the economic and fiscal strength of different regions as well as their debt risk situations, implementing differentiated replacement strategies. For regions with higher debt risks, more policy support and financial inclination should be provided to ensure the smooth progress of debt replacement; for regions with lower debt risks, more new debt quotas can be granted to invest in project construction and support regional economic development.

He stated that extending the maturity of debt and reducing debt costs through debt replacement is only a temporary solution, aimed at alleviating liquidity risks and creating time and space for development; however, the key is to make full use of the strategic time and space created, focusing on improving the efficiency of debt use and optimizing the structure of debt expenditure, while simultaneously establishing the necessary safeguards for debt management and accountability systems. Otherwise, the time and space created by debt replacement will be wasted again, and it will be difficult to establish financial discipline.

Luo Zhiheng recommends that in terms of debt management, it is necessary to clarify the authority and procedures for borrowing, strengthen the supervision of debt limits and investment directions, and establish risk warning and emergency response mechanisms to ensure the standardization and effectiveness of debt management. In terms of accountability systems, ineffective investments and the expansion of debt risks caused by distorted performance views and decision-making errors must be held accountable. If they are caused by macroeconomic environment, fiscal system, and accidental factors, it is necessary to implement the "three distinctions" and the due diligence exemption system, further refining the scope of due diligence exemption.

Luo Zhiheng believes that in the long term, to fundamentally solve the local debt problem, it is necessary to suppress the generation of local hidden debt from three dimensions: fiscal system, debt budget management, and urban investment transformation:

- In terms of the fiscal system, it is necessary to stabilize the macro tax burden, clarify the boundaries between the government and the market, centralize central government powers and expenditure responsibilities, and merge institutions in counties with population outflow.

- In terms of debt budget system, strengthen the management of local government debt, and establish debt and capital budgets. It is necessary to establish and improve debt risk warning and prevention mechanisms, strictly control the scale of new debt, and ensure that the debt scale is adapted to the level of economic development. At the same time, it is necessary to strengthen fiscal discipline and regulatory efforts to prevent local governments from illegal borrowing and disguised borrowing.

"At present, China's debt management is only a balance and limit management, and there is no more detailed debt budget that covers scale, structure, principal and interest payment plans, investment directions, etc. The debt constraint is insufficient, and it is necessary to establish debt budgets and capital budgets. The capital budget is a budget prepared for fiscal expenditure activities that can form public fixed assets, such as government fixed asset investment; the debt budget is a budget that plans the scale, structure, principal and interest payment plans of government debt in detail, and is an upgraded version of the current debt limit management." said Luo Zhiheng.

- Accelerate the transformation of urban investment. In the future, it is necessary to accelerate the market-oriented transformation of urban investment companies, and promote their development towards marketization, specialization, and standardization. By introducing social capital, optimizing corporate governance structures, and improving operational efficiency, the self-sustaining ability and market competitiveness of urban investment companies can be enhanced, thereby reducing their dependence on local governments.