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China needs to develop sustainable government debt

WANG LIYONG | 2021-01-06
(Chinese Social Sciences Today)

A bank staff member counts cash at a bank in Hangzhou, capital of East China's Zhejiang Province. Photo: CHINA DAILY

Since the global financial crisis of 2008, global economic uncertainty has surged significantly, and all countries have, to varying degrees, suffered economic slowdown. In recent years, the effective combination and coordination of China's fiscal and monetary policies has made China’s economy more resilient to withstand erratic risks and shocks. As a result, China's economic performance stood out amid the low growth rate of the global economy in 2020.
In order to mitigate the adverse impacts of COVID-19 and avoid a sharp economic downturn, governments around the world have implemented a set of proactive fiscal policies and loose monetary policies to make counter-cyclical adjustments. However, given the high deficit ratio and the scale of national debt in various countries, policymakers and academics are concerned whether there is still room for further issuance of government bonds and the underlying risks. In China, the Fifth Plenary Session of the 19th CPC Central Committee clearly stated the goal of "perfecting the government debt management system." Building a sustainable government debt system is an important part of such an endeavor.
Measuring government debt
There are four sets of criteria used to measure room for government debt and evaluate debt risks.
First, the government debt-to-GDP ratio should not exceed 60%, which is the standard proposed by the Maastricht Treaty in the European Union. Countries all over the world regard this as the international warning line for the government debt-to-GDP ratio, and it is presently the most commonly referenced standard.
Second, the international warning line for the government debt ratio (the debt balance to be repaid with public funds by the government divided by that government's comprehensive financial resources), stands at 100%-120%. It is one of the common red lines used to determine the debt size. However, in the process of actual economic development, there are great differences in the specific warning line standards adopted by various countries.
The third criterion is the volume of external debt. According to the 2019 China Balance of Payments Report released by the State Administration of Foreign Exchange (SAFE), the internationally recognized acceptable limits of a country's external debt liability ratio, debt ratio, debt servicing ratio, and the ratio of short-term external debt to foreign exchange reserves are 20%, 100%, 20%, and 100%, respectively.
Fourth, the debt space or the limit of government debt estimated by scholars is usually the optimal debt size calculated from a certain perspective. If the optimal debt ratio is determined from the perspective of economic growth, the increase of debt exceeding the optimal ratio will have a negative impact on economic growth. This is different from the definition of debt space in this article. Here, the debt space refers to the debt ceiling, and once a country's debt surpasses it, it will face default or crisis.
Upon clarifying the aforementioned standards, the status quo of China's government debt is as follows.
First, statistics show that China's government debt reached a record high in 2009. According to the Chinese Ministry of Finance, China's government debt-to-GDP ratio was roughly 36.27% in 2018, 36.04% in 2017, 36.61% in 2016, and 39.4% in 2015, and the average government debt-to-GDP ratio for the past five years was about 37%. 
If combined with local government contingent liabilities, which include the debt that the government assumes with a certain guarantee of responsibility and the debt which may incur due to financial rescue, the annual government debt-to GDP ratio may rise 2 to 3 percentage points, according to the National Audit Office. The office argues that if contingencies (debts of government-owned financing vehicles) are included in the caculations, in the worst case, the government would only have to cover a small portion of the debt (20% in June 2013). Including contingencies, China's government debt-to-GDP ratio would be calculated as 41.5% in 2015, lower than the EU’s warning line, which is 60%.
Second, in 2018, the local government debt reached 18.39 trillion yuan (about $2.74 trillion) in China, equivalent to 76.6% of the total fiscal revenue. By the end of 2019, local government debt totaled 21.31 trillion yuan ($3 trillion), with a government debt ratio of 82.9%.
Third, according to SAFE, by the end of 2019, China recorded $2,057.3 billion in outstanding external debt denominated in both domestic and foreign currencies (excluding those of Hong Kong SAR, Macao SAR, and Taiwan Province), an increase of $74.5 billion or 3.8% compared to the end of 2018. By the end of 2019, the liability ratio was 14.3%, the debt ratio was 77.8%, the debt servicing ratio was 6.7%, and the ratio of short-term external debt to foreign exchange reserves was 38.8%. China's major external debt metrics were all within the internationally recognized thresholds, indicating that the external debt risk is controllable.
Debt ceiling under 'fiscal fatigue'
The term "fiscal fatigue" was coined by international economists Atish Ghosh, Johnathan Ostry and others in the research paper "Fiscal fatigue, fiscal space and debt sustainability in advanced economies."
In the paper, they argued that a non-linear reduced-form relationship exists between primary balance and public debt, which exhibits a fiscal fatigue characteristic. Specifically, at low levels of debt, there is no, or even a slightly negative, relationship between primary balance and debt. However, as debt increases, the primary balance also increases but responsiveness eventually weakens and then decreases at very high levels of debt, which leads to a fiscal fatigue.
Different from the analysis of debt sustainability, fiscal fatigue tends to explain the abrupt transition of governments into a state of unsustainable debt dynamics due to possible shocks to the primary balance in crisis. Fiscal fatigue also sheds light on the extent to which policy and institutional changes could help increase these countries' fiscal space.
This relationship of primary balance and public debt is robust, and adds to a long list of conditioning variables and a variety of estimation techniques. Such a complex determination of debt space, leading to fiscal fatigue, has yet to receive academic attention. 
This article used Ghosh and Ostry's model for reference, and applied the data of national government debt from both the central and local government, one-year benchmark deposit rates, one-year benchmark lending rates, the proportion of central government and local government debt in total debt, and on this basis, uses the 2000-2018 average government debt interest rates and economic growth differentials, the mean output gap, and average government debt interest rates to calculate China's government debt ceiling. The result is: When China's government debt level is set at 69% of the GDP, it might go into a state of fiscal fatigue. 
In reality, China's average government debt-to-GDP ratio in recent years has remained around 40%, lower than the estimated debt ceiling. At the same time, based on China's fiscal reaction function, we calculate the default probability of the current government debt is basically zero and the debt is in a controllable state.
Sustainable government debt 
First, a differentiated warning line applicable to China's national conditions should be stipulated. During the debt crisis in Europe, the government debt-to-GDP ratio of some countries in crisis was far lower than the international warning line, whereas others who went beyond the warning line remained intact, manifesting the difference in governments capacity to handle debt risk. There is no one-size-fits-all warning line. 
The international warning line of debt is dynamic and relative. When countries raise government revenue by issuing bonds, they should make a comprehensive judgment based on the economic environment, the stage of economic development and the use of funds, rather than strictly sticking to the international warning line. The scale of government debt can affect expectations and the economic behavior of micro subjects, so we should focus more on the sustainability of government debt.
Second, the government should pace itself when issuing government bonds and constantly improve the national debt maturity structure. For example, raising the issuance of national debt is conducive to increasing funds to achieve dynamic fiscal balance. Also, due to the special properties of national debt, debt can also create safe assets for the financial market and create a sustainable basic currency issuance mechanism for the macro-control of monetary policy. Improving the maturity structure of government bonds is vital for improving the transmission efficiency of short-term interest rates to medium- and long-term interest rates, magnifying the collaborative effect of fiscal and monetary policies in coping with economic uncertainties.
Finally, though China's overall debt remains manageable, and there is some room for government debt to grow, it requires constant monitoring. In recent years, uncertainties in socioeconomic development have increased significantly. With a set of macro policy tools at hand, it is necessary to focus on the path of policy intervention and its impact. 
In addition, the risk of government debt is relatively under control. However, if the central government and local governments are viewed separately, the sustainability of China's overall debt does not equate to sustainable local government debt. Given that the debt ratio of some provinces in China is slightly higher than the national average, we should pay close attention to these local risks. 
In the current situation, while enhancing the active fiscal policy so that it serves the real economy, we should also take note of the monetary effect of fiscal policy on the financial market, especially the potential risks caused by the flow of fiscal funds and the expansion of local government’s debt scale.
Wang Liyong is a professor from the School of International Trade and Economics at Central University of Finance and Economics. 

Edited by YANG XUE