Luo Zhiheng 罗志恒 is the Chief Economist and President of the Research Institute at Yuekai Securities and one of China’s leading scholars on macroeconomics and fiscal policies. He sat at Li Qiang, Chinese Premier’s roundtable on Jul. 6. Although what he said was not disclosed, the following article, published on Jul. 7, may contain clues to his opinions.

“The intensification of budgetary imbalances and the prevention and resolution of hidden local government debts remain a top priority.”

“There are three levels of risks: fiscal operation risks, fiscalization of economic and social Risks, contributing factors in institutions and mechanisms.”

Since the 18th National Congress of the Communist Party of China, the Party Central Committee has adhered to problem-oriented and bottom-line thinking, enhanced risk awareness, improved prevention and control capabilities, and focused on preventing and resolving major risks. The 19th National Congress of the Party identified the prevention and resolution of major risks as one of the three critical battles. The 20th National Congress of the Party emphasized the need to enhance risk awareness and uphold bottom-line thinking in light of the complexity of domestic and international situations.

Fiscal policy serves as the foundation and important pillar of national governance. In recent years, fiscal policies have played a significant role in preventing and resolving major risks by mitigating fiscal risks and cooperating with the overall situation to address a series of economic and social risks. The Central Economic Work Conference at the end of 2022 proposed to ensure fiscal sustainability and controllable local government debt risks while effectively supporting high-quality development, emphasizing on the need to prevent and resolve local government debt risks, resolutely curbing the increase in debt and resolving existing risks. The National Conference on Fiscal Work put forward the key deployment of proactively and prudently guarding against and mitigate risks and hazards, firmly uphold the bottom line of preventing systemic risks, and specifically addressing the resolution of hidden debts of local governments, the governance of local government financing platforms, and coordination in preventing risks in other areas.

In recent years, the international situation has become increasingly turbulent, with a growing trend of de-globalization. The operating logic of the global economy has shifted from efficiency to security, and there has been a significant increase in shocks to the global industrial supply chain. China is facing rising risks of supply chain disruptions and bottlenecks. Domestically, under the impact of the pandemic and the transition of economic growth rates, the prominent difficulty in the current economic operation is insufficient total demand, leading to an increase in economic and social risks caused by the downward trend in economic growth. Considering the domestic and international situations, the Party Central Committee has placed fending off and defusing major risks at a higher priority and proposed the need to better coordinate development and security, achieving a safer form of development.

Fiscal policies actively serve to safeguard the governance of the Party Central Committee and manage the country's finances. In the face of a continuous macroeconomic downturn and significant challenges for microeconomic entities, large-scale tax reductions and fee cuts and tax and fee deferral measures were implemented to stabilize market entities, preventing a sharp decline in economic growth, and significant rise in unemployment rates.

Fiscal instruments such as special bonds were utilized to expand government investment and stimulate social investment. Measures such as research and development expense deduction and government-guided funds were implemented to promote high-quality economic development. Regarding local government debt risks, especially hidden debt risks, efforts have been made to curb the increase in debt, resolve the existing debt, strengthen supervision, and hold those who are responsible accountable.

A normalized cross-departmental collaborative regulatory mechanism has been established to control and mitigate the risks of hidden local government debt, preventing the spread of fiscal risks to financial risks. In response to the sudden impact of the pandemic, fiscal policies have been proactive, expanding the fiscal deficit, while avoiding excessive flooding. The overall leverage ratio of government departments remains lower than that of major international economies, which enhances fiscal sustainability and the ability to prevent and resolve risks.

In 2023, China's economic and social development is facing new circumstances, and the fiscal situation and risks faced by the fiscal sector are also undergoing new changes. Overall, there are three levels of risks:

First, there are risks related to the fiscal operation itself. The tight fiscal balance will continue, and preventing and resolving hidden local government debt will continue to be of utmost importance.

Second, there are fiscal-related economic and social risks. Fiscal efforts will be needed to mitigate risks in areas such as real estate and finance, which will further elevate fiscal risks.

Third, there are institutional factors contributing to fiscal risks, particularly in the area of debt. These factors include an overly broad scope of government functions and expenditure responsibilities, as well as the continued emphasis on government performance and regional competition as driving forces, which have not been fundamentally addressed. Along with the uncertainty of domestic and international situations, the need to guard against "black swan" incidents and other risks will continue to increase.

1. Fiscal Operation Risks: The intensification of budgetary imbalances and the prevention and resolution of hidden local government debts remain a top priority. In recent years, the overall trend of tight fiscal balance in China will continue due to factors such as economic downturn, tax reduction, and rigid expenditures. Meanwhile, as the long-term turning point of the real estate market shifts downward, the era of booming land transfer revenues have come to an end.

The peak of debt maturity is approaching, resulting in a faster decline in the macro tax burden and an exacerbation of budgetary imbalances. With the process of “ going back to normal” in economic and social operations, the economy will continue to recover on a low base but still face a series of challenges and uncertainties. The contribution of external demand to the economy will shift from positive to negative due to the global economic downturn, making the expansion of domestic demand a key policy focus.

However, achieving complete recovery and significant growth in consumption will take time, and there is a need to increase urban and rural residents' income through multiple channels and address the issue of insufficient consumer willingness. Risks in the real estate sector persist, and the downward trend in exports will lead to a decline in manufacturing investment, undermining the foundation of fiscal revenue recovery.

Fiscal expenditure should remain strong, especially in stabilizing investment, promoting infrastructure investment, resolving real estate risks, and driving real estate investment. From a vertical perspective of government levels, the lower the level, the more prominent the budgetary imbalances is, as well as the difficulties in ensuring the "three guarantees" (guarantee payment of salaries, normal operation of grassroots government, and the basic wellbeing of the people).

Dependence on central transfers to local governments and provincial-level transfers to lower-level governments is high, otherwise, liquidity and payment risks may arise. In the first five months of this year, general public budget revenue saw a significant increase compared to the first quarter, mainly due to the base effect, while land transfer revenue continued to decline after negative growth from last year. It is important to have a clear understanding of the fiscal situation. The basic trend of income for this year is expected to be low growth in the first quarter, high growth in the second quarter, and a decline in the third and fourth quarters.

The risks of local government debt, especially hidden debt, have been a top priority in governance in recent years. Some provinces also face issues such as concentrated maturities of interest-bearing debts of local government financing vehicles (LGFVs), declining operational efficiency, and difficulties in transformation. In this situation, the concentrated maturities of LGFV bonds and the further decline of some local government revenues from land transfers may trigger risk-averse behavior by financial institutions. At the same time, the scale of interest payments on explicit local government debt in China continues to rise, leading to a higher growth rate of debt servicing expenditures, which reduces fiscal coordination capacity and hampers fiscal sustainability.

2. Fiscalization of Economic and Social Risks: Risks in the real estate and financial sectors remain prominent. In recent years, the tendency of economic and social risks in China to transmit to fiscal risks has increased, and the fiscal sector has assumed the role of providing a safety net for these risks.

First, real estate companies face liquidity difficulties, and there is insufficient confidence among residents in purchasing homes. Risks such as unfinished real estate projects, bankruptcies of real estate companies, and rapid decline in real estate investment pose significant economic risks. The Party Central Committee has implemented a series of measures to alleviate the situation, promote the recovery of the real estate market, and boost market confidence. Some local governments have established relief funds and taken other measures to ensure the completion of housing projects. These measures increase the government's expenditure responsibilities.

Second, the possibility of financial risks becoming exposed during an economic downturn increases. To prevent systemic risks, in addition to the measures taken by financial regulatory authorities, the fiscal sector may need to provide upfront funding to ensure social stability.

Third, there is an interplay between urban investment risks and fiscal risks.

3. Issues in Institutions and Mechanism: The government-market relationship is not smooth, there is an excessive burden of government expenditure. Fundamentally, the major risks that fiscal policy needs to prevent and address are the insufficient coordination between the government and the market, the excessive responsibilities of government expenditures, and the issues arising from performance assessment mechanisms and competition among local governments, which lead to inflexible expenditure responsibilities. Without resolving issues in institutions and mechanisms, the contradictions between fiscal revenue and expenditure and the risks associated with local government debt will continue to persist in the long term.

Fiscal policies have already demonstrated some good practices in preventing and resolving major risks, which can be continued and further strengthened. In addition, there is a need to continue exploring new approaches to better and more efficiently prevent and resolve risks, curb the increase in risks, resolve existing risks, and safeguard against systemic risks.

1.Risk prevention should be based on promoting high-quality development and harnessing the synergistic role of fiscal policy with other policies.

Firstly, when preventing and resolving risks, it is essential to strike a balance between risk mitigation and economic development, ensuring that the measures taken do not generate greater risks. Since the beginning of this year, the economy has been returning to normal operations, with service consumption rebounding significantly, and the first-quarter economic recovery exceeding expectations. However, starting from April, the pace of economic recovery has slowed down. The manufacturing PMI remained in the contraction zone in June, while CPI and PPI continued to decline. Unemployment rates among young people have increased, and profits of industrial enterprises above a designated big size have declined while accounts receivable recovery period has lengthened. This economic situation indicates the need for continued fiscal efforts to expand total demand. Specific measures should be implemented to further reduce taxes and fees for manufacturing, small and medium-sized enterprises, and individual businesses. Special bond issuance progress should be accelerated, and funds should be directed toward projects.

Secondly, a firewall should be established between economic and social risks and fiscal risks. When economic and social risks such as real estate and financial risks occur, efforts should be made to resolve them within the respective sectors to prevent risk spillover.

Thirdly, there should be enhanced coordination between economic policies and non-economic policies, as well as fiscal and non-fiscal policies. Non-economic policies can play a significant role in boosting confidence and expectations, thereby creating a better external environment for the implementation of economic policies. From January to May this year, private investment decreased by -0.1% YoY, and investment in the manufacturing sector has declined, reflecting the insufficient confidence of market entities. Fiscal policy, along with other policies, should further focus on stimulating microeconomic vitality and boosting confidence and expectations.

2. Enhance fiscal resource coordination, optimize expenditure structure, and strengthen debt management. 

Firstly, coordinate fiscal resources and activate existing funds, further leveraging the advantages of the state-owned economy. 

Secondly, stabilize the macro tax burden, with expenditure policy as the main focus and revenue policy as a supplement. In recent years, the macro tax burden in China has rapidly decreased. In 2022, the proportion of general public budget revenue to GDP dropped to 16.8%, a decrease of 0.8 percentage points compared to 2021 and a decline of 5.3 percentage points from the peak in 2015. The rapid decline in the macro tax burden has led to a decrease in the government's fiscal capacity, which needs to be adjusted in a timely manner. In the current situation of weak expectations among microeconomic entities, it is challenging for income policies to promote economic growth as enterprises and people are not willing to invest or spend. Expenditure policies, on the other hand, can directly generate demand expansion, thereby stimulating economic cycles.

Thirdly, optimize the expenditure structure and improve expenditure efficiency. Maintain a balance between ensuring essential needs and controlling expenditures, allocating limited funds to areas that contribute to high-quality development, such as promoting technological innovation, improving people's well-being, and strengthening infrastructure investment. Reduce general expenditures and further improve performance management.

Fourthly, continue to increase fiscal transfers from the central government to local governments and from provincial governments to municipal and county-level governments, to alleviate the contradictions between revenue and expenditure and mitigate liquidity payment risks in fiscal operations.

Fifthly, strengthen debt management to gradually alleviate the risks of hidden local government debt. Enhance accountability, enforce budget constraints, and prevent the accumulation of new hidden debts. For existing debt, adopt measures such as risk-sharing with financial institutions, market-based negotiations to reduce costs and optimize maturity structure, and exchanging time for space to avoid disruptions in funding due to concentrated maturities. Guide urban investment platforms to transform into state-owned enterprises, establish standardized corporate governance structures, and explore new business models.

3. Reform institutional mechanisms and define the roles and scale of government functions and expenditures through market-oriented and rule-of-law approaches.

The complexity of internal and external environments and the stage of economic development determined that the risks faced by fiscal policy will continue to increase, and the difficulty of preventing and resolving risks will also increase. Therefore, more reform measures should be taken to mitigate risks. Specifically, regarding the issue of local government debt, especially hidden debts, it is necessary to further clarify the relationship between the government and the market, define the scale and responsibilities of the government, and prevent local governments, especially county-level governments, from falling into a state of nearly unlimited liability. At the same time, it is important to establish incentive mechanisms that are more accommodating and accountable for local governments.

For further insights, please refer to Luo’s latest article on Caixin last Wednesday, “Why balance-sheet recession theory doesn’t fit modern China”. For the Premier’s roundtable with economists which Luo Zhiping attended, please refer to a previous post by East is Read:

During the symposium, experts including Liu Shangxi, Luo Zhiheng, Tian Xuan, Huang Xianhai, Yuan Haixia, Qin Hailin, Lu Ming, and Zhao Wei spoke. The official readout didn’t elaborate on what they said at the meeting, but below are some of what they said recently about the Chinese economy before the meeting.