Lujiazui Financial District in Pudong, Shanghai. Photo: AFP
Lujiazui Financial District in Pudong, Shanghai. Photo: AFP

What most Western pundits ignore about the Chinese economy is the strange relationship between local-government debt and its informing framework to the central government. The components of this relationship are not grounded in the rule of law, transparent markets or independent courts. Often, thuggish behavior in land grabs is compounded in failed public services. The cause of much public unrest throughout China originates in poor governance, whose impact is evidenced in President Xi Jinping’s power grab.

A security guard walks at the bund near the Huangpu River across from the Pudong New Financial District, Shanghai.

The proximate cause of this failure is the dysfunctional relationship between local governments and the central government in Beijing. Local governments have extremely limited scope in tax-raising authority. The year 2014 saw local government bond auctions tied to opaque high-level bureaucratic procedures that mimicked a rule-based system, but the auctions required that all monies be redistributed back to the provinces after having been deposited in the coffers of the central government. When local officials don’t have significant social gravitas, they use shadowy financial vehicles to borrow.

Zhou Xiaochuan, former governor of the People’s Bank of China, noted before his retirement early this year that “huge debts are the root weakness in China’s macro financial system.

This disharmony between the central and local governments has a political origin. Without real political reform from above evidencing norms suppressing murky financing vehicles, the fracturing between the center and the periphery will grow.

Currently, local governments receive about half of total tax revenues but remain responsible for nearly two-thirds of government spending. The result is keeping local authorities dependent on transfers originating from a commanding center.

To escape dependency, local governments create from local capital investment companies under their own authority called “local government financing vehicles.” Because these LGFVs are not regulated banks, they are run as state-owned enterprises, permitting them to ignore budget constraints.

Relations between competing layers of state authority have remained endemic throughout Chinese history. What’s different now is that Xi Jinping has openly sought to address this fundamental flaw by stressing the need for unity. Lou Guanzhong’s epigram during the Han Dynasty perfectly embodies Chinese federalism: “The empire, long divided, must unite; long united, must divide.”

Persuading local-government officials to limit their autonomy has not worked, and Xi’s effort at centralization is an attempt to forestall obstruction from below. Xi’s effort is aimed at clarifying divergent fiscal roles between the two centers.

In 2013, Beijing discovered 10,000 LGFVs commanding more than 7 trillion yuan or 13% of gross domestic product. China has 31 provinces and 2,800 county administrators covering 330 prefectures. The math indicates that three LGFVs operate per jurisdiction. Couple this with China’s total outstanding credit and we arrive at 250% of GDP, an insurmountable level of opacity and distortion.

China’s persistent debt problem reveals how difficult governing China has become under Xi’s tenure. We should anticipate indigenous limits to Xi’s power grab at the center

Typical of Keynesian accounting, they seek to hide or couch errors that ameliorate their responsibility, for after having discovered a morass of failed fiscal vehicles, Xi ordered provincial leaders last July to reclassify these loans so they no longer appear in official statistics. Currently, Beijing’s commanding center permits public-private partnerships to disguise debt as private capital.

According to Huo Zhihu of China Securities Credit Rating, a domestic ratings agency, China’s persistent debt problem reveals how difficult governing China has become under Xi’s tenure. We should anticipate indigenous limits to Xi’s power grab at the center.

What proposals should Xi pursue in his endeavor to formalize governing fiscal norms between the center and its periphery?

He should formalize distinct governing authorities regarding local tax-raising power. To lessen any immediate or future mismatch between spending and revenues, Xi needs to implement a Chinese version of federalism that complements the principle of subsidiarity while openly promoting ethics (functioning fiscal norms) between competing sources of authority.

Xi should openly permit local governments to source projects from newly regulated property taxes. This would in effect parlay China’s democracy deficit in a meaningful direction toward political transparency while underwriting economic growth.

However, it’s a foregone conclusion that this won’t happen, because the locals don’t trust politically appointed cadres in the center. And both levels of authority have publicly sustained defense mechanisms to thwart each other’s initiatives.

Those residing at the center firmly believe that the locals need to be reined in, not rewarded with a new tax base. Those who make their living at the periphery continue to evade the center by sustaining new elaborate fiscal schemes aimed at justifying what little autonomy they possess. And China’s new emerging middle class doesn’t want to pay any value-added or property tax that opens them to public scrutiny.

The West has hyped Xi Jinping’s move to eliminate term limits for himself without knowing the state of China’s domestic-policy fault lines that moved Xi’s tenure toward militant centralization. By seeking authority reminiscent of previous monarchs, he is attempting to resolve China’s local debt crisis. This will be a dramatic test of his leadership.

William Holland is North American recruiter for Wikistrat global consultancy monitoring Pakistan's nuclear program.

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