China local governments' fiscal stress may roll over to 2023, think tank warns

(By Caixin journalists Zhang Yukun and Cheng Siwei)

China's local governments struggled to balance revenue and spending last year, as massive tax relief, "zero-Covid" outlays, and a property market meltdown drained their coffers. One state-backed think tank warns that the fiscal strain could continue to plague localities in 2023.

The Chinese Academy of Fiscal Sciences (CAFS) on 27 February published a report based on surveys with 521 city- and county-level finance departments, detailing how local governments have relied heavily on transfer payments - funds distributed by upper-level governments to lower-level ones - and accumulated huge debt piles to finance their day-to-day operations and underpin local economies.

In 2022, local governments' fiscal self-sufficiency rate, which refers to the ratio of revenue to spending in the general public budget, dropped 4.3 percentage points from the previous year to 48.4%, according to the report. That was partly due to a spike in tax relief to support businesses hurt by the pandemic - China's tax revenue shrank 3.5% last year.

Last year, revenue in the local general public budget, which excludes transfer payments from the central government, dropped 2.1% to 10.9 trillion RMB (US$1.6 trillion), according to data from the Ministry of Finance.

Cutting taxes and fees is important for stabilising the economy, but when such policies continue for too long, governments will ultimately face insurmountable financial challenges, CAFS said in the report.

China's fiscal situation is expected to improve in 2023 with an anticipated rebound in the economy and reduced tax refunds, the think tank said. Since local governments already handed out trillions of RMB in refundable value-added tax (VAT) to businesses last year, the impact of the VAT refund policy on local tax revenue should be smaller in 2023.

To cope with fiscal strains last year, local governments resorted to nontax revenue to fill their coffers, but some of the revenue sources, such as offloading state-owned assets, can only provide temporary and one-time relief. Nontax revenue in the national general public budget surged 24.4% last year, according to finance ministry data.

Income from land sales - a key revenue source for local governments - plummeted 23.3% last year, according to the ministry.

CAFS' surveys found that some of the land plots were sold not to property developers, but local government financing vehicles (LGFVs), state-owned entities used to fund infrastructure and other public projects. More than half of residential land by value was sold to LGFVs last year, the report said, noting that much of the land remained undeveloped.

It's noteworthy that some resource-rich regions in central and western China saw their revenue grow last year, riding the wave of rising bulk commodity prices due to geopolitical tensions, but CAFS said that the growth and its contribution to the whole country's local finances were both limited.

Finance Minister Liu Kun said in a press conference Wednesday that local finances are expected to recover this year. He reiterated that fiscal policy for 2023 will be more proactive, and that transfer payments to local governments will be further expanded.

However, there are still uncertainties related to the restoration of market confidence, so fiscal resources at different levels of government may still come under pressure this year, CAFS said.

Last year, expenditure in the local general public budget, which includes transfer payments from the central government, grew 6.4% to 22.5 trillion RMB, finance ministry data show.

The growth in spending was partly due to ballooning public health costs as well as other spending to help people affected by Covid-19 outbreaks.

Fiscal spending on health grew 17.8% nationwide, while social welfare and employment spending increased 8.1%, as localities dealt with waves of Covid-19 outbreaks with stringent containment measures. Health spending soared in provincial-level regions with large-scale Covid-19 outbreaks in 2022, including Shanghai, where this category of expenditure more than doubled compared with the previous year.

Besides health, some provincial-level regions, such as Zhejiang and Anhui, also hiked expenditure for science and technology development in response to foreign countries' restrictions on China's access to certain technologies and products, the CAFS report said.

Local fiscal strains have been further exacerbated by mounting debts. Last year, local governments paid 1.1 trillion RMB in interest on bonds, up 20.8% from 2021, the report said. The share of interest payments on local government bonds in comprehensive local fiscal resources hit 4% last year, up from 2.6% in 2019.

The snowballing debts have considerable impact on local finances, the report said. A city in western China used more than a quarter of its revenue in the general public budget to pay interest on its general bonds in the first 10 months last year.

Around 86% of local government bonds by value maturing last year were refinanced, meaning the issuers borrowed additional funds to repay the principal, CAFS said. That's similar to the average level of 87% from 2019 to 2021.

This article was first published by Caixin Global as "China Local Governments' Fiscal Stress May Roll Over to 2023, Think Tank Warns". Caixin Global is one of the most respected sources for macroeconomic, financial and business news and information about China.

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