Written by Lina Song.

In July 2011, I argued in a debate published in the New York Times that China’s local government debts were a ticking time bomb. At the time, China’s National Audit Office reported that 36 selected cities each owed an average of $174 billion. By comparison, Detroit was forced to apply for bankruptcy when its debts reached US$180 billion. Other commentators in the NYT debate were more optimistic, but since then China’s local government debts have continued to worsen, causing increased concern in the context of the slowdown in the country’s economic growth. The new government, inaugurated in 2012, shows signs of changing tack. Public spending has been tightened and promises made not to bail out bad investments. It seems that the new leadership is trying to find a way forward and reduce the debts it has inherited. Last week, the Chinese central government ordered its National Audit Office to send agents across the country to generate accurate information on the size of debts.  Current statistics exclude “hidden debts” in the form of loans to private firms or agents which the local authorities have acted as the guarantors. If the loans are not repaid, they would become the liabilities of the local governments.

The proximate explanation for the local government debt problem is the centralised financial budgeting system established in the mid-1990s. While the system seemingly shares tax revenues between central and local governments, in practice, central revenue is guaranteed and local governments are poorly funded. The most stable and lucrative taxes, like sales and excise taxes, go to the centre. Local governments take only small proportions of these reliable taxes and large proportions of taxes which either provide little revenue or are difficult to collect. At the county and township levels, due to the lack of funds, wage payments of the public sector workers are often delayed, or have to be sought from other sources. Due to lack of sufficient revenue from tax, local governments accumulate debts, often leveraging their assets such as land holdings.

More fundamental explanations for the debts lie in China’s institutional shortcomings. Government leaders and officials at all levels of government are unelected. The criteria to measure local officials’ performance for promotion are the ability to attract investment and to be able to obtain land by moving existing land-users away. There is no mechanism to safeguard local interests as the powerless locals cannot participate in the policy-making process. Officials can be promoted and leave their positions without needing to take responsibility for long-term development. As a result local resource use is governed by short-term needs. The official appointment system creates few incentives for efficiency in managing public services. Instead, debts accumulate as spending is out of control, often due to corrupt behaviour. Examples include constructing luxurious office buildings or residential housing for officials, spending on banquets and travel. Those who genuinely seek to provide good governance at the local level, especially in poorer or remote regions, are frustrated by a shortage of funds and lack of investment opportunities.

Under such a political system, local government debts should not be seen as just an investment issue. Without the fundamental changes in the political set-up, bad debts could be bailed out and liabilities start to accumulate again. Many Chinese ask if Detroit can announce its bankruptcy, will those cities of China with similar debts follow suit?

Lina Song is Professor of Economic Sociology and Social Policy at the University of Nottingham. She wishes to thank Michael Appleton for research assistance. A version of this post appeared in the Guardian on August 9^th.