Beijing Still Has Fiscal Space

China’s decision to loosen monetary policy aggressively—and creatively—to support the stock market has got the attention of global markets. The banks have been called on to reduce the interest rate on existing mortgages and to provide more support to developers finishing already sold units—backed by a potential recapitalization. And there are hints that China’s leaders are adjusting fiscal policy as well. The Economist is optimistic, highlighting hints that Beijing will authorize more special bond sales to fund increased support for low income households. Others, though, remain far more cautious.

One thing is clear: China’s domestic economy decelerated rapidly in the third quarter, and was basically relying entirely on one engine (exports) for growth. The downturn the property market was increasingly squeezing local government finances, leading spending to be cut as well as revenue. And there are hints that local government’s ability to borrow to invest in new infrastructure projects has also come under pressure (this is the argument in recent research from Logan Wright of Rhodium, for example).

China’s capacity to emerge from this downturn, particularly if export growth runs into a few constraints, depends in no small part on China’s willingness and ability to provide the economy with additional fiscal support.*

There are two radically different ways of viewing China’s current fiscal position.

The IMF’s Current Case For Why China Lacks Real Fiscal Space

One of these views is generally embraced by the IMF (see the latest staff report). It holds that China has only a small amount of fiscal space. Broad measures of public debt that includes the off-balance sheet investment vehicles of local and provincial governments (think the Port Authority of New York and New Jersey, or the Kansas Highway Authority) show that China’s debt is already 120 percent of its GDP. Since China’s broad public debt is already too high and the underlying augmented fiscal deficit (which counts a lot of public investment projects) is too big, China has no choice but to start a pro-cyclical fiscal consolidation fairly soon.

In August, the IMF indicated “a gradual decline in the structural fiscal deficit can begin in 2025” and that “stabilizing public debt will require sustained fiscal consolidation in the longer term.” Sustained and massive—the IMF recommends a “0.7 percentage point” cut to the cyclically adjusted primary balance over (gulp) ten years, for a cumulative adjustment of 7 percentage points (see paragraph 39 in the staff report).

According to this view, which is broadly shared, the key reform for China going forward is weaning the economy off its current reliance on debt-financed public sector investment for growth. This seems to be the current view of China’s Ministry of Finance, and perhaps the view of Xi Jinping himself.

The Alternative Case the IMF Could Make: China’s Central Government has One of the Strongest Central Government Balance Sheets in the G-20

Another view starts from a completely different premise: China actually has the lowest amount of central government debt of any of the major G-20 economies.

Per the IMF, the central government will have debt of around 26 percent of GDP at the end of 2024. The central government’s 2024 fiscal deficit is a modest 3 percent of GDP (though that will be supplemented by a one-time ¥1 trillion/0.8 percent of GDP issuance of special central government bonds and perhaps by additional issuance of ultra-long bonds based on the latest announcements).

Moreover, the central government—even setting aside the foreign exchange reserves held by the PBOC—has more external assets than external foreign currency liabilities. China Investment Corporation (CIC), the central government’s sovereign wealth fund, has $300 billion in foreign assets; the National Council for Social Security Fund has a few more.

Including its large domestic assets—the Huijin, the large, profitable state commercial banks, and (through SASAC), the generally profitable national state firms in oligopolistic industries—the central government likely has as more assets than debts. Lam and Moreno Badin (in an excellent IMF working paper) put the central government’s equity stakes at around 35 percent of GDP.

So, the central government doesn’t have any net debt. The central government also can borrow for ten years at around two percent, a nominal interest rate well below even conservative estimates of China’s future nominal growth.

From this point of view, the needed reforms to China’s central government center around freeing itself from the set of largely self-imposed constraints. Such constraints have limited its ability to use its considerable fiscal space to help China sort out its current predicament (a shrinking property sector and falling household confidence).

The central government has ample space both to assure that the property developers deliver on “pre-sales” (or provide a refund) and to expand the provision of social insurance while reducing regressive taxes. The central government equally has scope to adjust the revenue-sharing formulas to provide fiscal help to embattled provincial governments, even if that means a larger central government deficit.

A Technical Debate With Big Stakes

The debate over China’s fiscal space seems technical. But it has enormous global implications. All the IMF’s macroeconomic models imply that a country’s fiscal deficit has a direct impact on the country’s external surplus or deficit. If pro-cyclical fiscal consolidation is necessary, as the IMF argued in April, China’s only path to full employment is a looser monetary policy and a weaker currency.

The IMF doesn’t quite say it, but its recommendations for China imply that China’s trading partners have to set aside their existing concerns about asymmetric trade with China and accept increased dependence on China’s manufacturing machine.

Conversely, if China’s central government has fiscal space—and it uses that space in way that gives households the confidence to spend more—China might be able to recover from its property downturn on its own, without relying even more on exports.

The argument that China does have fiscal space ultimately rests on three pillars:

a) The low level of debt of the central government does, in fact, matter; not all implicit local government debt should be consolidated up. A more sensible (standard) approach looks at the contingent liabilities the central government faces for the debt of the broader economy.

b) The “augmented” fiscal deficit was an analytic tool created to capture China’s unique post-global crisis stimulus, which was in many ways more of a credit easing in a state-heavy economy. It is not a useful guide to the current fiscal space available to China’s central or general government.*

c) A correct understanding of China’s public finances requires looking at state assets as well as liabilities, drawing on the insights of Lam and Moreno Badin. By that metric, China is in a better position than the IMF’s analysis in the staff report suggest.

Taking China’s Contingent Liabilities Seriously—but not Aggregating All Debt to the Central Government

Consider a standard analysis of the central government’s debt.

Direct Finance Ministry debt is incredibly small (under 30 percent of GDP)—and with a funding cost of around 2 percent, the underlying debt dynamics are quite favorable. A 3 percent-of-GDP deficit with 30 percent debt-to-GDP and even 3 to 4 percent nominal growth isn’t a concern —it doesn’t imply any increase in the central government’s small underlying debt stock.

There would be a bit of concern about China’s relatively low level of revenue collection (now only 16 percent, see the IMF’s selected issues paper on revenue mobilization) but that would be offset by the absence of any real external debt.

Obviously, the headline 30 percent of GDP ratio should only be the starting point of the analysis, as it doesn’t include an estimate of the central government’s contingent liabilities (financial losses elsewhere in the economy that the central government would need to cover to protect financial stability). Those are substantial.

For example, China’s property developers are a mess, and a number need to be shut down. Even if their existing creditors can absorb much of the associated financial loss, someone needs to pick up the cost of completing unfinished projects that were funded out of “pre-sales.” The IMF puts the cost of a completion guarantee that assures those who have already paid for an apartment either get an apartment or a refund at 5.5 percent of GDP (paragraph 25 of the August staff report). China’s government thinks that’s a bit high, but I suspect that it is actually a bit low, as the IMF’s modelling assumes existing creditors bear some of the costs. An earlier IMF paper put the financial liabilities of troubled developers at about 12 percent of China’s GDP. Conservatively pencil in 10 percent of GDP.

China’s local governments have another 35 percent of GDP in recognized debts, and per the IMF’s Lam and Moreno-Badin a comparable set of financial assets.

Let’s assume (based on the work of Shih and Elkobi) that a third of the provincial debt comes from parts of the country with weak economies and difficulties repaying. Assuming that the central government has to fully cover the cost of repaying, that debt would add 12 percent of GDP to the total—but think of it as an estimate that reflects some recovery on the debts of weaker provinces and some need to support the fiscally stronger provinces.

Local governments have another 50 percent of GDP in off-balance sheet debt (per the IMF; estimates vary)—the (in)famous local government financing vehicles (LGFVs). There is another 15 percent of GDP in debt tied to government-guided funds. These are essentially state-owned enterprises (SoEs) set up to perform various projects, so most do have assets. However, many seem to operate at a loss.

The IMF estimates (in the 2023 Global Financial stability report) that “More than 30 percent of LGFV debt has had an interest coverage ratio below 1 for the last three years and can be considered commercially nonviable without government support [and] … over half of the debt cannot be serviced by current earnings alone if average LGFV funding costs are more than 3 percent.”

The IMF also recommends (in the February Selected Issues Paper) that the central government pick up 30 percent of the financial loss from LGFVs that go bad). If the aggregate cost of LGFV financial loss is around 15 percent of GDP (30 percent of 50, which is just a ballpark estimate) that gives an estimates loss to the central government of only 5 percent of GDP.

Sum it all up, and the central government’s debt and contingent liabilities are under 60 percent of GDP.

Call me crazy, but I don’t find that to be a scary number.

The net debt of the central government, with an aggressive estimate of contingent liabilities—would still only be around 25 percent of GDP using the asset estimates in this IMF working paper.

Looking at the Fiscal Position of China’s General Government

The U.S. does its fiscal accounts at the level of the central government (state and municipal debt is not counted as part of the federal debt). European countries do consolidate provincial and central government in their fiscal accounts. But the argument doesn’t change much if the starting point is the 63 percent of GDP in recognized central and provincial government debts. The fiscal deficit is a bit high for the general government, but the underlying debt dynamics remain favorable with a nominal interest rate well below nominal growth.

Note that if provincial debt is fully backed by the central government the provincial governments would gain some fiscal space, at they should be refinance at 2 percent for ten years. There is no point in paying a risk premium on recognizing provincial government debt if there is no chance that the risk will ever be recognized.

The calculation of the general government’s contingent liabilities would include the same estimate of the recapitalization cost of the property developers, and adding in the IMF’s estimate of the provincial government’s share of bailing out the weaker LGFVs raises that cost to 10 percent of GDP, so gross fiscal debt (including contingent liabilities) rises to around 85 percent of GDP.

Net debt would be around 20 percent of GDP.

Moving Beyond the Augmented Fiscal Balance

The concept of the augmented fiscal balance was created to capture the nature of China’s post-global financial crisis stimulus, which generally didn’t happen through the central government’s balance sheet (see the fiscal deficit in the chart above) and wasn’t directed at supporting household income amid. That stimulus took the form of credit easing—letting the state banks lend more, but also allowing the “shadow financial system” to expand—and allowing local government to borrow more so as to raise public investment.

That “stimulus” was real, but it did create some offsetting assets—it thus wasn’t a pure fiscal expenditure either.

That is why continuing to use the augmented fiscal deficit to provide fiscal advice risks providing the wrong current fiscal advice to China.

Investment made through the LGFVs does need to be scaled back. And the LGFVs, basically loss making SoEs, are a contingent liability of the government. But since China’s government (especially the central government) doesn’t have much net debt, it can afford to offset the economic drag from lower levels of investment. China thus still has scope for counter-cyclical fiscal policy.

Remember that the market—such as it is in China—wants to lend to China’s government for ten years at 2 percent, in an economy that should, even under conservative assumptions, be able to grow by 4 percent a year (in nominal terms, on average) over the next ten years. The underlying debt dynamics remain surprisingly favorable.

A Recommended New Message From the IMF

So, I would encourage the IMF to start emphasizing China’s low level of central government debt, China’s exceptionally strong net debt position, and the substantial fiscal space that is still available to the central government. Moreover, the IMF should start to criticize the central government for not using that space.

The debt sustainability analysis should focus on recognized debts with an adjustment for contingent costs that need to be borne by the central government—not on a simple sum of all implicit and explicit debts that ignores the offsetting assets.

That is a more constructive message that continuing to argue with China’s government over whether China’s total debt is out of control or not.

More importantly, those voices inside China who share this broad analysis need to start emphasizing that the fiscal position of China’s central government is quite good and isolate the Ministry of Finance and other conservative voices who have put China in a position where policy has been paralyzed in the face of a massive (though unsurprising) property market correction. Current fiscal policy is exceptionally pro-cyclical, as a tight constraint on borrowing has interacted with falling revenue to lead to a contraction in public spending.

What Happens in China Doesn’t Stay In China: The Global Stakes

Let me conclude by highlighting the global stakes in this debate.

The top brass of the IMF, in a recent blog, correctly noted that trade surpluses and deficits are tied more to macroeconomic policies like the level of savings, the level of investment and the strength of demand than to sectoral industrial policies.

There is a debate about the current level of China’s external surplus. China’s statistical authorities report a surplus that has (inexplicably) fallen to about 1 percent of China’s GDP; I think that it is closer to 4 percent of GDP (after adjusting to remove the statistical changes SAFE made to the goods balance back in 2022 and adding in a more realistic estimate of the income from China’s large investments abroad).

But no one doubts that China’s goods surplus (as measured by the accurate customs data) is already massive.

The 7 percent of GDP fiscal consolidation (net of recapitalization expenses) recommended by the IMF implies a further increase in that surplus of at least 2 percentage points of China’s GDP. This is not controversial: the IMF’s standard macroeconomic work estimates that a 1 percentage point of GDP fiscal consolidation improves the current account balance by just under a third of a percentage point of GDP (see EBA’s table 3). 

On top of the adjustment to the current account surplus that has come with China’s real estate downturn, the IMF estimates that the equilibrium level of property investment will be about half its peak levels. Realistically, that could add two percentage points to China’s current account surplus (see the Box in this year’s ESR or see the IMF’s blog), though there is an argument that this is already in the data.

Point being that, using the IMF’s own numbers, its recommendations imply that China’s current account surplus needs to rise above 5 percent of its GDP ($1 trillion), which implies a customs goods surplus of more like 7 to 8 percent of GDP ($1.3 to $1.5 trillion) as exports offset a large fiscal consolidation.

That would, of course, put global trade under immense strain.

Net of processing imports (parts for re-export), China’s current manufacturing imports are less than 4 percent of its GDP, while its exports of manufactures (net of parts imports) are 14 percent of its GDP.

In order to increase that total by several percentage points to offset the drag from lower property investment and a large fiscal consolidation, China would need to import less than 3 percent of its GDP in manufactures while exporting 15 or 16 percent of its GDP.

That may not sound like much, but it implies that China’s already large ($1.8 trillion) surplus in manufactures would need to rise by $500 billion or so. I doubt either the G-7 countries or the other BRICs are keen to see their manufacturing sectors shrink to balance increased net supply from China.

Bottom line: a large pro-cyclical fiscal consolidation in a country that already runs a large external surplus poses risks for the entire global economy, not just China. Fortunately, China’s central government still has a lot of fiscal space. It it is time for the IMF and others to stop lumping all debts in China together, and to start highlighting those aspects of their own work which paints a more constructive picture of China’s scope to run counter-cyclical policy!

* Export volume growth has been around 15 percent in the last few months and year to date, which is exceptionally fast for an economy as large as China’s economy. No one should be surprised that China is encountering resistance from its trading partners, especially as import volumes are now close to flat.