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Good Times Are Over for Local Governments

By Hu Shuli

Two pieces of recent news have piqued the public's interest. First, local governments reported their latest debt figures to the Ministry of Finance. The numbers have not been made public, but sources say many officials reported large amounts in an attempt to account for as much debt as possible.

Second, in an attempt to revive the flagging property market, many local governments are easing requirements for the housing provident fund, which offers mortgages subsidized by the government. Some have also raised the loan-to-value ratio, extended loan periods, and decreased the down payment ratio for those buying their second property.

These two pieces of news point to one conclusion: the good times are over for local governments.

Despite the mismatch between government powers and their fiscal responsibility, local officials had nevertheless managed to keep their coffers flush with funds. While the economy grew at a breakneck speed, local government revenues increased at an even faster pace, often by 20 to 30 percent and morethanks in part to the pro-cyclical nature of the taxation system.

Further, the property boom also allowed them to make record sums from the sale of land. Even in the throes of the global financial crisis, local governments' land revenues rose rather than decreased. Using land as collateral, they were also able to borrow substantial sums from banks.

Inevitably, such exponential growth cannot be sustained, as the factors that enabled it began to weaken. For one, the Chinese economy is in the midst of transition, and the pace of growth has slowed. Thus, so have government revenues.

The Finance Ministry says that in the first 11 months of 2014, local government revenues rose by 6.4 percent year on yearslower even than the growth in gross domestic product, a first in many years. Separately, many provincial and regional governments have reported that their fiscal income last year grew at a slower pace than previously, with most falling between 7 to 8 percent. The slowdown is especially noticeable in provinces boasting rich resources or traditional industries.

Besides, the property market is unquestionably cooling down, and local governments can no longer rely on land sales to keep themselves afloat. Changing demographics are affecting the dynamics of housing supply and demand. Coupled with the government's cooling measures, these factors have left the country's property market languishing. Even the new rules to ease eligibility for a second property and lower interest rates have only boosted the number of transactions, while prices remained indifferent. In some smaller cities, they have even fallen.

Land sale revenues are set to drop. Deutsche Bank says China's middling housing market will hit fiscal revenues hard this year. Though the warning that China was facing the worst fiscal crisis of the past three decades may be overly pessimistic, government officials at all levels would do well to pay attention.

No doubt the central government's determination to improve management of local government debt has piled pressure on local officials, for now at least, to keep solvent. In October, the State Council released guidelines that stressed Beijing would not bail out local governments that failed to repay their debts. Soon after, the National Development and Reform Commission, the Finance Ministry, and the China Securities Depository and Clearing Corp. separately outlined new measures to strengthen debt oversight and improve risk management, as well as streamline the relationship between business and government.

In this period of transition, local governments' ability to raise funds will be curbed.

Local governments play a key role in the success of China's reforms. If local government coffers are lean, ordinary people will be the worse for it.

To improve their financial situation, local officials must stick to the two basics of budgeting: find new streams of revenues and keep spending to a minimum.

The first should not mean adding to the financial burden of companies and the people, nor should it be done through "innovative" financial products cooked up for profiteering. Instead, local governments should initiate changes in line with the broad strokes of China's fiscal reform, by gradually raising taxes on state-owned capital, rationalizing their budgets, and ensuring more efficient use of government funds.

As for the second, officials should continue to heed the directive from the top to cut their spending on international travel, entertainment, and vehicle purchases. To root out extravagance, there must be fundamental changes to how governments manage their budgets.