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Fiscal Policy Decentralization and Monetary Policy Fiscalization - China’s Fiscal and Monetary Policy Systems: Flaws and Reforms

作者Author:Jianfeng Yin 2020-09-02 2020年09月02日
The Chinese government has recently announced a plan to raise the fiscal deficit for 2020 by one trillion yuan over the previous year and to issue special COVID-19 Treasury bonds worth one trillion yuan. These are necessary and exciting measures for coping with COVID-19’s economic impact. However, China’s fiscal and monetary policies still have fundamental defects. First, the implementation of China’s fiscal policy has become the responsibility of local governments. Second, China’s monetary policy is burdened with extraneous fiscal functions. These policy defects greatly increase systemic financial risks exposing the central bank to potential huge losses, which, if materialized, would prevent it from taming inflation with monetary policy and acting as a lender of last resort to maintain financial stability.

The Chinese government has recently announced a plan to raise the fiscal deficit for 2020 by one trillion yuan over the previous year and to issue special COVID-19 Treasury bonds worth one trillion yuan. These are necessary and exciting measures for coping with COVID-19’s economic impact. However, China’s fiscal and monetary policies still have fundamental defects. First, the implementation of China’s fiscal policy has become the responsibility of local governments. Second, China’s monetary policy is burdened with extraneous fiscal functions. These policy defects greatly increase systemic financial risks exposing the central bank to potential huge losses, which, if materialized, would prevent it from taming inflation with monetary policy and acting as a lender of last resort to maintain financial stability.

1. Fiscal Policy Decentralization: Causes and Consequences

China has adopted a growth-oriented fiscal system. Unlike mature market economies, economic affairs, rather than public goods, account for a large share of government spending in China. According to an IMF study (2018),[1] social assistance, government health expenditure and government education expenditure made up 0.7%, 3% and 3.7%, respectively, of China’s GDP, which are eclipsed by the average levels of emerging economies (1.4%, 3.9% and 4.2%, respectively) and OECD countries (2%, 6.6% and 5%, respectively). Despite an aging population and excess fixed capital relative to the workforce, China’s fiscal resources are heavily invested in infrastructure projects that yield increasingly poor returns.

In 1994, China centralized fiscal power and decentralized administrative functions. Since then, fiscal decentralization has turned fiscal policy implementation into a local government responsibility. Fiscal policy serves three functions, resource allocation (via the offering of public goods), income distribution (via taxation) and macroeconomic stability. While central and local governments share responsibilities for offering public goods (resource allocation) and collecting taxes (income distribution), the central government should be almost solely responsible for maintaining economic stability. The problem is that China’s local governments are overburdened with fiscal responsibilities, including funding public goods (such as pension system, unemployment insurance and public spending on education and healthcare) and since the global financial crisis of 2007-2009, maintaining economic stability.

The decentralization of fiscal policy has resulted in unequal access to public goods across regions and, more importantly, to government debt imbalance. Despite China’s seemingly modest government leverage ratio above 50% in 2018 in contrast to 250% for Japan and 100% for the US, China’s local government debt made up 70% of the total government debt, far higher than Japan (10%), as a unitary state, and the US (30%), as a federal state. In China, regional imbalance is another aspect of debt imbalance. In a recent study[2], we found that China’s local governments in less developed regions faced heavier debt burdens than those in more developed regions. Based on government debt stock, average maturity and issuance cost in 2019, we expect the debt service burdens of a large number of provinces and cities to peak in 2021, by which time the cost of debt service would amount to 42% of locally retained fiscal revenues in less developed regions. That is to say, some local governments would have to assume new debt to repay existing debts and thus avoid debt default.

Yet the burden of debt service may come earlier than expected as COVID-19 takes its toll on local government solvency in 2020. In Q1, almost all provincial and municipal governments posted negative fiscal revenue growth. Seven provinces, including Hubei, reported fiscal revenue growth of -20% to -31%. Despite these sharp declines in fiscal revenue, local governments still have to boost spending to fight COVID-19. As a result, local governments have quickened their bond issuance in Q1 2020 and extended bond maturity to mostly ten years. In the future five years, local governments will have to shoulder hefty burdens to service their debt, giving rise to the risk of extreme events.

Fiscal risks from fiscal policy decentralization are likely to breed financial risks. In 2015, the Ministry of Finance started to curb local government financing vehicles and shadow banks, nudging local governments to raise funds via the more transparent bond market. By Q1 2020, local government debt worth 37 trillion yuan included 22.6 trillion yuan in local government bonds, 9.5 trillion yuan in city investment bonds, and less than six trillion yuan in local government financing vehicles and shadow bank funds. This shift to more transparent and less costly access to financing is consistent with policy intention. Yet it means that a regional debt default would ripple through global markets in ways similar to the ways the securitized sub-prime mortgage loan risks triggered the global financial crisis of 2007-2009. With local government bonds and city investment bonds held almost entirely by banks and non-banking financial institutions, local government debt worth over 30 trillion yuan may generate regional fiscal risks that trigger systemic financial risks.

2. Consequences of the Fiscalization of Monetary Policies

The above section discussed the fundamental flaws in the decentralization of China’s fiscal system and fiscal policy. Apart from these, distortions also exist in China’s monetary policymaking, which is burdened with fiscal priorities. In the planned economy era, monetary authorities served as a cashier department affiliated to fiscal authorities and had no right to set their own policy. After reform and opening-up in 1978, the concept of a monetary policy took hold. Yet amid China’s transition and development, the monetary policy lacked independence and was often assigned fiscal functions with different manifestations before and after 1994.

Before 1994, the government could run up overdrafts and borrow funds from the central bank, i.e. “deficit/debt monetarization,” and banks were ordered to issue loans to loss-making state-owned enterprises over social stability concerns. The banking system’s reliance on central bank re-lending thus caused a serious excess money supply and inflation. During this period, monetary authorities played a secondary fiscal role outside the fiscal system. In 1994, China launched the first systematic fiscal and monetary reform since 1978. With the enactment of the Banking Law of the People’s Republic of China in 1995, the government lost its power to run up overdrafts or borrow funds from the central bank, putting an end to deficit/debt monetarization. Yet in the absence of fiscal policy functions, or under the impulse to maximize policy powers common to almost all public sector institutions at that time, the central bank still assumed fiscal functions in a more implicit way, i.e. “quasi-fiscal activities” as defined by the IMF, which should otherwise be undertaken by fiscal budgetary institutions through taxation, subsidy and fiscal spending.

On the central bank’s asset side, quasi-fiscal activities were carried out to (i) purchase “toxic assets” to rescue financial and non-financial institutions; (ii) offer re-lending on preferential terms to specific financial institutions or activities; (iii) hold massive forex assets to stabilize the exchange rate. On the central bank’s liability side, quasi-fiscal activities included: (i) the issuance of central bank bonds competing with Treasury bonds as safe-haven assets; (ii) the imposition of a high statutory deposit reserve ratio under the considerations of financial resource allocation or exchange rate stability; (iii) the payment of interest on reserve funds, which became de facto government debt assets held by commercial banks.

Through quasi-fiscal activities, the central bank was able to act as the lender of last resort and maintain economic and financial stability when China was yet to develop sound fiscal and economic systems. However, the marginal utility of quasi-fiscal activities diminished, and the marginal cost rose. I and other Chinese economists have discussed the negative effects of the central bank’s quasi-fiscal activities. Without regulating the monetary base through the purchase or sale of Treasury bonds in its open-market operations, for instance, China’s central bank weakened the status of China’s Treasury bonds as a safe-haven asset and led to renminbi’s de facto dependence on the US dollar. Without transparent information and explicit rules, the central bank’s re-lending programs that exist in the form of various lending facilities have disrupted China’s interest rate regime and increased the moral hazard.

Aside from these negative effects, we should be cautious about the potentially serious losses to the central bank that may be occasioned by quasi-fiscal activities. Such losses would greatly undermine the central bank’s credibility, monetary policy effectiveness and ability to maintain financial stability. As the sole issuer of base money, the central bank is supposed to never run short of money, let alone to make any losses. Yet the reality is that many central banks in emerging and developing economies are loss-making.[3] Recent years have seen central bank losses, mainly stemming from poor return on and revaluation of forex assets, followed by various “non-performing loans” on the asset side and interest payment reserves and central bank bonds on the liability side, come under the spotlight as advanced economies introduced quantitative easing policies.

Take the People’s Bank of China, China’s central bank, for instance. In 2019, the assets of the People’s Bank of China reached 36 trillion yuan, including its own capital of 22 billion yuan. Hence, the central bank’s “capital adequacy ratio” was only 0.04%. In 2019, the People’s Bank of China held forex assets worth 21 trillion yuan. Given renminbi’s appreciation by around 10% over the past decade, the People’s Bank of China should have lost over two trillion yuan on forex assets. Moreover, the People’s Bank of China also has claims worth 16 trillion yuan against banks and non-banking financial institutions. Even a 1% NPL ratio would amount to non-performing loans in excess of 160 billion yuan, or eight times the central bank’s own capital. As such, a few years ago, China’s then central bank governor Zhou Xiaochuan warned about the impact of implicit fiscal risks on the performance of central bank duties,[4] calling for removal of the central bank’s quasi-fiscal functions.

3. Reforming Fiscal and Monetary Policy Systems

China’s current fiscal and monetary policy systems are unsustainable, as they contain growing systemic financial risks. With the central bank’s balance sheet deteriorating, it will become impossible for the central bank to rectify the situation. When systemic financial risks occur, how can a loss-making central bank struggling to pay salaries to its employees have cash reserves allowing them to purchase toxic assets? When inflationary pressures arise, how can a central bank sell assets that no longer exist to recoup base money?

In my view, China’s ongoing fiscal and monetary policy reforms should focus on the following three priorities: First, fiscal reform should be carried out. With respect to the fiscal policy, we should create a public finance system that brings the government role into better play. The central and local governments should properly divide their fiscal power and administrative responsibilities. The central government should fulfill its fiscal functions, especially those of providing national public goods and maintaining economic stability. With respect to monetary policy, we should phase out quasi-fiscal activities and establish an effective monetary policy framework based on indirect regulation with Treasury bonds as the main instrument of open-market operations.

Second, fiscal authorities should coordinate with monetary authorities. Monetary authorities may back fiscal authorities by purchasing Treasury bonds and thus bolster the status of Treasury bonds as a first-choice safe-haven asset with controllable interest rates. Fiscal authorities may also back monetary authorities by swapping the central bank’s excess interest payment reserves with Treasury bonds and offering open-market instruments as alternatives to forex assets. Fiscal authorities may also inject capital into the central bank to offset its potential losses arising from previous quasi-fiscal activities without disrupting the economy and price level in any significant way.

Lastly, the fundamental solution is to create a national governance system based on the rule of law to raise the efficiency of fiscal spending and keep government debt in check. There is a delicate boundary between deficit/debt monetarization and normal open-market operations based on Treasury bonds. The maintenance of such a boundary is entirely subject to the rule of law. Even without COVID-19, the Chinese government still has to cope with huge fiscal pressures arising from elderly support, healthcare and education in the context of an aging society. To reach the average level of OECD countries, China would have to spend an additional 6% of its GDP, which is equivalent to six trillion yuan or 1/4 of the national public fiscal spending in 2019, on social relief, healthcare and education each year. To ease fiscal pressures and raise the efficiency of fiscal spending, outlays on conferences and white elephant projects that contribute little to public welfare need to be further reduced.

On the issue of government debt, I would like to conclude by quoting David Stasavage’s Public Debt and the Birth of the Democratic State, which describes how Britain established its modern public finance and nascent central bank system after the Glorious Revolution. With only 1/3 of the French population, Britain repeatedly defeated French emperors in the 18th and 19th centuries. According to the famous French historian Fernand Braudel, “public debt effectively mobilized British forces and provided terrible weapons of war.[5]



[1]  IMF working paper, 2018, Intergovernmental Fiscal Reform in China, www.imf.org.

[2]  Yin Jianfeng, Wang Jiangjiang, Mai Lisi, 2020: “Study on China’s Local Government Debt Regional Imbalance,” Financial Review, Vol.1, 2020.

[3]  IMF working paper, 2012, Does central bank capital matter for monetary policy? www.imf.org.

[4]  Zhou Xiaochuan, 2012: Global Financial Crises: Observations, Analysis and Countermeasures, China Finance Publishing House.

[5]  Fernand Braudel, Afterthoughts on Material Civilization and Capitalism, 15th-18th Century, Sanlian Bookstore, 2002 edition.