Research On The Risk Constraint Mechanism Of Local Government Debt In China

The recent years have witnessed the rapid expansion of China's local government debt, the emerging risk of which has drawn the attention of the central and local governments, the domestic and foreign academics as well as the public. In the2013Central Economic Work Conference, it was set as a priority in2014to properly handle the local government debt risks. Against the backdrop of rapid urbanization, increasing administrative power of local government and gradually emerging debt risks, to build an effective risk-constraining mechanism is key, not only to the risk prevention per se, but also to the sustainability of local government financing and the regional economic growth. It is also of great importance in terms of China's fiscal and taxation reforms, the avoidance of mid-income trap, the sustainable economic growth and social stability.There are mainly three deficiencies in the previous researches on local government debt risks. First, when looking at the cause of local government debt formation, previous researches are mainly based on two aspects:one is the asymmetry of fiscal and administrative powers between the central and local governments, and the other is the local economic competitions. And they analyze local government debt risks from the perspective of debt sustainability. However, seldom of them has had a comprehensive and systemic analysis of local government debt risks from the risk-constraining perspective. Second, for those researches focusing on risk constraining, they mainly concentrate on the external surveillance mechanisms, but rarely on the internal constraining mechanisms. Neither do they bring fiscal constraints, market constraints and public opinions into a common framework to analyze the risk-constraining issue of local government debts. Third, in terms of risk prevention and mitigation, existing literatures mostly refer to the mature experience of other countries and emphasize the use of market-constraining mechanism in handling local government debt risks in China. However, countries in economic transitions, such as China, are featured with larger governments and smaller markets, soft budgetary constraints and the lack of government bankruptcy mechanism, which cannot be changed within the near future. Therefore, the solution based on market-constraining mechanism to handle local government debt risks is not practical in China's case.China is currently in a crucial phase of shifting growth pattern, economic restructuring and speeding up urbanization, with large local government debts and corresponding emerging risks. This paper tends to achieve the following three goals. Firstly, from the debt constraining perspective and at the macro level of system design, the paper tries to define clearly the boundary of local government's administrative power. Secondly, while ensuring the financing availability and debt risk constraints, the paper starts with enhancing the incentive mechanism of self risk constraining for financing entities and develops a local government financing mechanism encompassing the financing availability, external surveillance and risk constraints in the principle of incentive compatibility. Thirdly, based on the principle of incentive compatibility, the paper establishes a local government debt-constraining framework which includes elements of fiscal constraints, market constraints and public opinions.The paper employs the methodology of deduction and induction, comparative analysis, and mathematic analysis. It begins with the basic connotation and fundamental theories of local government debt management, makes analysis of the status quo and the cause of China's local government debt risks, and provides an overall picture of local government debts risks. Secondly, from the three perspectives of fiscal constraints, market constraints and public opinion constraints, the paper makes an analysis of the risk-constraining mechanism of China's local government debt risks, and specially focuses on the institutional arrangements to see how the local government debt risk constraining mechanism is weakened. Thirdly, based on the formation logic, development path and form of constraints of China's local government debt risks, the paper raises three standards for evaluating the effectiveness of local government debt risk constraints. Furthermore, with the objective function of local government, the paper develops a theoretical model of self-constraining mechanism for local government debt risks, which is then used as the theoretical basis for improving China's local government debt constraining mechanism. Fourthly, from the angles of fiscal arrangements, financing pattern and bankruptcy mechanisms, the paper compares the features and effectiveness of local government debt constraining mechanism in major economies, which are expected to serve as useful reference in China's case. Finally, based on said theoretic analytical framework and by referring to the foreign experience, the paper keeps an eye on China's economic and fiscal institutions as well as the objective of social development, applies the principle of incentive compatibility to strengthen the self risk constraining, and provides policy recommendations for improving the risk constraining mechanism of local government debts, while basically maintaining the current institutions. The main recommendations include the designing of incentive mechanism which links local government debt risks to their performance evaluation, retention ratio of land transaction fees, power to issue bonds and transfer payments from upper governments. These measures could improve the willingness of local governments to repay debts and contain risks. At the same time, the paper recommends fiscal measures, such as improving the local debt risk mitigation mechanism and strengthening local budgetary management, as well as risk prevention and isolation measures such as asset securitization, to complement the self risk constraining of local governments.The paper has the following innovations:First, in terms of analytical angle.1) the paper does not confine itself to merely dealing with local government debts risks. Instead, it focuses on the macro level institutional design and tries to clarify the boundary of administrative power of local government from the perspective of debt constraints.2) while ensuring the financing availability and debt risk constraints, the paper starts with enhancing incentives for self risk constraining of financing entities and develops a local government financing mechanism encompassing the financing availability, external surveillance and risk constraints in the principle of incentive compatibility. This could help solve the problem of insufficient external constraints (from upper fiscal authorities and financial supervisors).3) based on the design of incentive mechanism, the paper suggests the use of necessary external constrains and market supervision to solve the problem of externality of local government debt risks and the information asymmetry. It also designs a tri-party framework of local government debt constraints, which encompasses market constrains, fiscal constrains and public opinion constrains.Secondly, in terms of viewpoints.1) based on the current institutional arrangements and in line with the incentive compatibility of different constraints, the paper provides recommendations of strengthening budgetary management, limiting the scale of local government debts, increasing local government's willingness to repay debts, containing risks and improving risk mitigation mechanisms.2) based on the results of the theoretical model, the paper holds the view that, in order to change local government's blind pursuit of economic growth, it is a must to change their performance evaluation system which only emphasizes indicators related to economic growth; that only by exiting from areas with higher output elasticity can local government be more incentivized to invest in areas with lower output elasticity and supply more public goods; and that measures, including reducing local government's control of land, lowering their leverage of land-collateralized borrowing and lessening their reliance on land-related fiscal revenue, could better contain the investment impulse of local governments and reduce their debt risks.Thirdly, in terms of analytical approaches. The paper applies the method of optimization analysis in analyzing the behavior of local governments. Based on the principle of incentive compatibility, the paper establishes an objective function of local government behaviors and brings fiscal and market constraints into the objective function as exogenous variables. By maximization of local government interests, the function yields the set of solutions and shows the most favorable risk constraining mechanism.