How can China future-proof its public finances?

China’s public finances are among the world’s soundest, thanks to years of strong economic growth. However, there are a number of threats to its fiscal stability, including a slowdown in growth, an increase in social spending, the needs of an ageing population, rising local government debt and a cooling housing market. With its economy still growing steadily, the Chinese government has time to ward off some of these threats and strengthen its fiscal outlook through a range of measures.

China has to change its economic growth model from being investment-dependent to consumption-driven. Investments in fixed assets made up an estimated 65% of GDP in 2011, roughly doubling from around 33% in 2000. Over the same decade, household consumption as a share of GDP dropped to about 34% from about 40%, far below the world average of 60%.

Real estate plays a particularly important role in this transition. Investment in real estate development as a share of GDP has almost tripled to 15% in 2012 from 5% about a decade ago. Over time, China will have to give up its reliance on the real estate sector to drive economic growth, and on land sales to drive fiscal income growth.

Further fiscal and tax reforms are necessary to balance the government’s budget, fulfill promises of better social welfare and alleviate income inequality. During the first quarter of 2013, fiscal income rose by only 6.9%. This was much slower than the year before. Given that fiscal income is likely to grow more slowly in the future, central and local governments need to be more prudent and transparent about their expenditure.

Reforming the financial sector and developing capital markets could help raise the government’s debt capacity and encourage fiscal transparency. With the development of corporate and municipal bond markets, local governments and their financing vehicles will be able to raise capital transparently. Formal capital markets will provide much-needed access to financing to local governments, as well as powerful incentives to pursue sustainable growth and fiscal soundness.

Through tax reforms and the development of capital markets, China’s central government may eventually succeed in creating some distance between itself and local governments, at least as far as balanced budgets and fiscal sustainability are concerned.

Last but certainly not least, the government has to cut waste in its own operations, while state-owned enterprises have to improve their operating efficiency and investment returns. In Chinese tradition, conserving resources is just as important as boosting income to ensure a sound financial future.

Read more blogs on finance.

Author: Zhu Ning is Deputy Director and Professor of Finance at the Shanghai Advanced Institute of Finance. He is a member of the Global Agenda Council on Fiscal Sustainability.

Image: A one yuan coin is seen above a 100 yuan banknote REUTERS/Petar Kujundzic.