Local govt debt, despite challenges, is controllable

China is tackling the challenges brought about by the pile-up of local government debt, but local government debt itself is a necessary financial tool to support the construction of local infrastructure.

International experience has shown that the appropriate division between central and local government's fiscal expenditure responsibilities is bound to require local government play an important role.

That is in the construction of infrastructure and the promotion of local economic development, through the optimal allocation of local government debt resources.

With its rapid economic growth, the problem of inadequate infrastructure is particularly acute in China, and the role of local government debt has become increasingly important. That debt increased from 10.7 trillion yuan ($1.6 trillion) in 2013 to about 15.4 trillion yuan at the end of 2014, according to the National Audit Office.

China has gradually established a local government debt management framework. It has selected a model, putting the debt under a system of quota management. The State Council has also established a local government debt risk assessment and early warning mechanism, emergency disposal mechanism and accountability system.

The Chinese local government debt management framework is effective. By the end of 2016, local government debt was 15.32 trillion yuan. Including central government debt of 12.01 trillion yuan, total government debt was 27.33 trillion yuan, with the debt-to-GDP ratio at 36.7 percent, which is lower than the level in major market economies and emerging market economies, indicating that the overall risk is controllable.

There is still a long way to go for China to improve its local government debt management.

First, debt management must be strengthened. In some cases, for example, some local governments borrow or provide guarantees in violation of laws and rules in various ways, and this may become a major hidden risk and must be stemmed.

The Ministry of Finance should continue to effectively supervise local government service procurement, regulate budget management for government service procurement and prohibit illegal financing by the use of real or fabricated government service procurement contracts.

It should require local governments to improve disclosure of information for government service procurement, and clarify requirements for various kinds of cooperation between government and social investors.

Second, China should further develop the local government bond market. International practices show that to effectively manage local government debt, a country must give full play to the role of the market to balance local government financing activities.

Third, regulation should be strengthened to solve the "back door" problem. While the "front door" is open for local government debt, the "back door" of borrowing in violation of laws and rules by some local governments has not been closed completely.

Without local self-discipline, regulation and restraint alone can only be a temporary solution and may even be trapped in a game of cat and mouse.

To establish a long-term mechanism to prevent local government debt risk, China also needs to further deepen the reform of the fiscal system and economic system, in particular the transformation of government functions. It would establish more reasonable fiscal relations between central and local governments and make local governments change their minds from just not being willing to touch the red line, to not daring to touch the red line.

The author is a researcher with the Chinese Government Debt Research Center, Central University of Finance and Economics.