Solution to potential crisis lies in deepening reform of the tax distribution system and expanding revenue sources

The total amount of local government debt in China has been a sensitive and contentious issue for a long time, and the true figure is still not clear.

But what is even more important than the numbers is the fact that risks do exist. It is high time that China accelerated the comprehensive management of local governments' debts, in order to avoid these debts being transformed into a debt crisis or bank crisis, which has happened in some developed countries.

China's local government debt problem has been around for years. Since the reform of the tax system in 1994, the majority of national tax revenues have flowed into the State coffers and local governments have faced difficulties financing their governance.

What's more, the Budget Law prohibits local governments from borrowing. To get around this restriction, local governments set up companies to borrow money, many without considering their ability to repay the loans, which are usually supported by government promises of some form. Not enough attention had been paid to these obligations until recently.

The local government debt problem was exacerbated by the 4-trillion-yuan ($618-billion) stimulus package introduced to cope with the effects of the global financial crisis. Of the package, the central government provided 1.2 trillion yuan, while the rest came from local governments. To do this, credit policies were loosened, creating an opportunity for local governments to get loans on an unprecedented scale. Local financing platforms increased from only 2,000 in 2008 to around 10,000, with local government debt increasing dramatically over the same period.

In the first half of 2008, the total amount of local government debt was just 1.7 trillion yuan. At the end of 2010, the figure was up to 10.7 trillion yuan, which was equivalent to 27 percent of China's GDP in 2010, according to the National Audit Office.

The 10.7 trillion yuan is not a small number, and 80 percent of it comes from bank loans. More than half of these debts have to be paid off between 2011 and 2013. Indeed local governments will have to race against time, as about 25 percent of their loans have to be paid off before the end of this year, and 17 percent next year.

The credit rating companies, like Moody's and Standard and Poor's, warn of the increasing risks of bad loans and short sell China's bank industry. Local government debt is one of the most serious risks threatening China's economic safety.

The main risk of local debt is the low efficiency of real estate investment combined with land financing leading to property bubbles and the deterioration of loan quality. Moreover, hidden risks exist in those loans that have no specific borrowers, or borrowers that have difficulty in paying back the money, or misappropriate the loans for other purposes.

A debt repayment mechanism must be quickly established to cope with the local debt problem.

But fundamentally, the key to solving the problem is to further deepen reform of the tax system. The central government should take the tariffs, social security tax and personal income tax, while the local governments should expand the channels for local revenues and establish a new taxation framework.

First of all, local governments should expand the scope and variety of taxes on resources and include part of these taxes in local revenues.

Then, during the 12th Five Year Plan period (2011-2015), we should consider reforming the environment tax. Since local governments are held accountable for the well-being of their local ecologies, the revenues from the environment tax should mostly go to local governments.

Finally, we should further expand the range of real estate taxes and fully apply a property tax. The property tax collected by developed countries has already become an important part of public finance at both the state and local levels.

The author is a researcher with the State Information Center.

China Forum