China’s central government may issue debt to finance trillions of renminbi worth of spending on social welfare programmes as part of the country’s aggressive bid to close its gaping income rift. As part of the plan, economists predict local municipalities may be given greater leeway to directly issue bonds, which help achieve the government’s reform goals as well as give municipalities a much-needed financing avenue.
On February 5, the State Council released a strongly worded guideline on reforming China’s income distribution system, which tackles corruption, state-owned enterprise (SOE) regulation and emphasises social-welfare spending. In particular, the Council notes it will ramp up spending in areas such as education, employment, social security, healthcare, affordable housing and poverty alleviation.
China has one of the measures of income inequality in the world, with the top 10% of households accounting for approximately 85% of all family wealth in 2010, the latest year for such figures, according to the China 2025 report released by Jefferies on February 23.
As China shifts from an investment economy to a consumption one, eliminating wealth inequality is one of the top priorities for the upcoming administration led by Xi Jinping. To achieve this, the government will spend Rmb3.8 trillion (US$610.7 billion) annually on the key reform areas, according to professor Li Gan at the Southwestern University of Finance.
The crux of this will come from taxes, which will contribute Rmb1-2 trillion a year if tax revenue increases at a compounded annual growth rate (CAGR) of 15%-20% as expected, according to Li and Jefferies.
And as part of the State Council’s guidelines, SOEs will be required to contribute 10% of their profits to the government through dividend payments, up from 5% now. This contribution could amount to just Rmb200 billion.
While economists predict that the government will primarily readjust the spending composition to finance the reform, it will also consider expanding debt issuance. This would not only help obtain the necessary funding, but it would also help to grow and mature its debt programme.
“China is in a good position to finance this reform, even in the past few years as we’ve notably seen a slowdown the country’s nominal GDP growth,” said Junwei Sun, a China economist at HSBC. “But China still has the ability to raise more debt at this current stage; the overall debt to GDP [gross domestic product] ratio is estimated at around 54%, still manageable. Greater issuance more would be a helpful addition to the government’s spending for the social welfare, especially as some of this funding depends on SOE performance.”
Economists believe that bond issuance will initially come from the central government, which currently manages China’s sovereign issues, but may expand to local governments in the coming years.
To date, China’s Ministry of Finance (MoF) collects financing requests from municipalities across the country and issues bonds on their behalf. This system was put in place so local governments do not over-borrow.
Yet the system constrained municipalities’ financing capabilities. Instead, they turn to bank loans for capital, though struggle as banks have become more stringent in their lending. And to local government financing vehicles (LGFVs), which are backed by the government but are technically independent, to issue bonds on their behalf. Yet these LGFV bond yields are higher than what a local government could conceivably achieve, leading to higher costs.
“The issue of local governments and how to channel more financing to them is definitely an issue,” said Louis Kuijs, China economist at RBS. “There is a major agenda outstanding on how to change that fiscal system so local governments have more assistance to finance their mandates on things such as health education, social security and housing. They have difficulty doing that, and people envisage eventually they will be able to issue bonds.”
Their time may be approaching. To achieve its reform goals, the central government will turn its attention to local provinces to enact social change. This means municipalities may have more flexibility to issue debt to directly fund local welfare programmes.
“After the National People’s Congress in March we’ll see what the chances are that local governments will be allowed to issue bonds,” said Sun. “The government thinks local debt is a problem or a risk but we think the most feasible solution is to allow local governments themselves to issue bonds. This will resolve the short-term mismatch to raise funds for local construction, meanwhile in the longer-term, if the government wants to localise social reforms to decrease the income gap, local governments can get money into the hands of the communities in a more efficient way.”
However, the change won’t be immediate. Not only will the central government need to amend law to allow local governments to directly issue, but they must address municipalities’ ability to repay their debt.
Ivan Chung, senior credit analyst at Moody’s, says that the provinces with the poorest constituents – who are the targets of these reforms – are themselves the poorest. This means they may need to offer higher yields to attract investors, which is costlier than the MoF raising debt on their behalf.
“There would be some sort of disparity from Beijing, Shanghai and Guangdong who are wealthier and can afford it and the poorer provinces that have to borrow at a higher cost. It is most cost effective that the MoF raises the money and gives it to the poorer regions,” said Chung. “The system is highly centralised, so for now they’ll look at transfer payment between central and provincial government to pay for a lot of this.”