Four key challenges for China’s fiscal health

Given China’s impressive economic growth, vast foreign reserves and modest budget deficit, its fiscal situation seems to be the last thing economists should worry about. China’s fiscal income grew by an average of more than 20% annually in the past decade; its budget deficit came in at about 1.5% of GDP in 2012. In contrast, the United States’ fiscal deficit stands at about 10.9% of GDP.

However, an economic slowdown paired with expanding social commitments to support an ageing population is creating a number of threats to China’s financial future. Here are four reasons to be concerned:

1. China’s government is spending more than it earns.

In 2012, the Chinese government’s fiscal income grew by 12.8% to 11.72 trillion RMB Yuan, while fiscal expenditure grew by 15.1% to 12.57 trillion RMB Yuan. Both income and expenditure grew much more slowly than the year before due to China’s overall economic slowdown. However, growth in spending outstripped income growth by a wide margin. According to China News Agency, the fiscal deficit is projected to increase by about 50% to 1.2 trillion RMB Yuan in 2013 from 0.8 trillion RMB Yuan in 2012.

2. Local governments have borrowed heavily.

Many local governments have taken on large amounts of debt to provide basic welfare, build infrastructure and stimulate the local economy. Government officials are typically evaluated for the speed (not quality) of economic growth within their limited tenure. This means they tend to focus on short-term growth rather than long-term debt problems. At the same time, government policies to curb property deals and rein in surging house prices have hit land sales, a major source of income for China’s local governments. According to some estimates, total local government debt grew about 19% between 2011 and 2012.

3. China will need to spend more on social welfare.

China has pledged to improve social welfare in areas such as public education, healthcare, and environmental protection. Government spending will have to increase accordingly. The government also needs to support its rapidly ageing population, a result of the continuing one-child policy. As overall economic growth slows, people will grow more dissatisfied with issues such as income inequality. According to an official report from China’s Ministry of Human Resources and Social Security, the annual income of the top 10% households in China is 65 times higher than that of the bottom 10% households. In this context, spending too little on social security could cause political uncertainty and economic problems.

4. China’s main providers of financing are tethered to the housing market.

All of China’s major banks are state owned, and banks are the main providers of government financing. Over the past few years, China’s banks have channelled much of their credit into real estate and infrastructure projects. The cash flow projections for those projects are not very healthy, especially since the housing market is expected to cool. This means that a slowdown in the real estate sector will not only hurt the quality of assets owned by the government, but will also affect its ability to seek further financing from banks.

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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: 100 yuan banknotes are seen in Beijing REUTERS/Jason Lee.