Local Government Borrowing

160 Baoyun Qiao and Anwar Shah

departments that report to the State Council offer specific-purpose transfers from their own budgets.However,there is no clear procedure in the decision-making process to allocate the resources to provincial and subprovincial governments,and the arbitrary nature ofcentral grant allocations has led to extensive negotiations by local authorities and encourages rent-seeking.

Local Government Borrowing

Local governments are forbidden to borrow from commercial banks or from the capital market,except with special approval from the central government,according to China’s 1994 budget law and related regulations. In addition,local governments are prohibited from direct borrowing.In other words,only the central government can issue bonds or borrow on behalfoflocal governments from either domestic or foreign banks.The central government issued about US$75 billion in domestic bonds and US$1.5 billion in foreign bonds in 2003.About 10 percent ofthese bonds were for local governments.

However,local governments frequently succeed in circumventing these restrictions by borrowing “offthe books”through special projects and enterprise accounts.Meanwhile,locally owned enterprises can and do borrow from banks and on the capital market—despite their dependence on government subsidies ofvarious kinds,which often makes them de facto government agencies.Given the still limited direct and indirect transfers from the center to provinces,such borrowing from local commercial banks by enterprises (under the jurisdiction oflocal governments) actually finances local capital investment and spending.In addition,most local governments provide implicit loan guarantees for SOEs,as the budget law prohibits explicit guarantees.Local governments also provide loan guarantees to the central bank for local financial institutions so that they can avoid financial risk.

Debts to government employees—largely teachers ofelementary and secondary school and to vendors providing products or services to governments—are also a main channel oflocal borrowing.Local governments,particularly county and lower-level governments,are responsible for salaries of teachers in elementary and secondary schools.Because ofserious fiscal difficulties,governments at these levels in poor jurisdictions usually are not able to pay the full salaries.The unpaid part becomes the local debt.Local governments in poor jurisdictions may also not be able to pay farmers for their agricultural products.In such cases,farmers who sell their products

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to governments and may get only informal documents showing the government borrowing.

Domestic loans are an important approach to financing capital investment for local governments.Currently,domestic loans are more open to the state-owned units.It is common practice for local governments to freely establish companies that then borrow from the banks to initiate capital investment projects.

Local governments may also borrow through “collective financing,”in which they select various groups,such as government employees and employees oflocal SOEs,to borrow from.The borrowing can be voluntary, but most ofthe time it is forced by the local government.Most ofthese borrowings have been used to start local enterprises.However,a significant number ofthese enterprises have not been successful.The bankruptcy of such enterprises in the middle and western regions,owing to lack ofmanagement skills and experience,has left serious debts for local governments, especially county and lower-level ones.

Because local borrowing is prohibited,local governments are reluctant to admit debt.Consequently,it is difficult to know the volume oflocal borrowing.It is estimated that total local borrowing was more than US$120 billion by the end of2004 (Wei 2004).The deficits oflocal governments have also accumulated into significant debt,because local deficits are financed by borrowing in general.Currently,debt is a very heavy burden on local governments.According to the audit report to the National People’s Congress in June 2002,the total debt for 49 counties (and cities) audited was about US$8 billion—2.1 times the yearly disposable fiscal resources.For the county and lower-level governments,it is estimated that total debts were about US$40 billion by the end of2001,while the debts for townships were more than US$20 billion.The total debts would be much higher ifthe implicit debts,such as the unpaid civil servants’salaries and farmers’services,were included.

Local borrowing plays an important role in local economic development and in the alleviation oflocal fiscal pressures in China.The significant improvement oflocal infrastructure in almost all jurisdictions in the past decade is attributed partly to local borrowing.This contribution was more significant for richer jurisdictions such as Shanghai and Beijing.Local borrowing also temporarily alleviated local fiscal pressures in poor jurisdictions to finance current needs,because intergovernmental transfers are not well designed to meet fiscal gaps.

However,the negative side ofinformal local borrowing is very serious. Such borrowing creates contingent liabilities for local governments and is