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January 23, 2014

Financing China’s Future

China’s rapid urbanization strategy requires a financing system that can keep up. So far, the evidence isn't promising.

Shusong Ba

Increased urbanization is the central tenet of China’s long-term economic plan. The strategy is designed to address income inequality while boosting domestic demand for Chinese goods and services, thereby reducing the country’s dependence on exports. Meeting this objective, though, will require implementing a basket of political and economic reforms aimed at helping local governments develop and deliver the infrastructure and public services that this growing population will demand.

Local governments are already struggling to keep up with the country’s rapid urbanization. Between 1978 and 2012, China’s urban population grew from 18 percent to 52.7 percent of its citizens. By 2030, it is estimated that between 65 percent and 70 percent of the country’s population, or nearly 1 billion people, will be living cities.

growth of Chinese urbanization

Given these projections, the accelerating demand for infrastructure and public services can only be met by allowing local authorities to expand their revenue sources. One way to do that is by creating a liquid, public market for regional bonds that can reduce local governments’ dependency on land sales to finance their needs while allowing the private sector to participate in market-based financing. This will also help create a more sustainable mechanism for financing China’s continued growth.

Equal access to public services is key challenge

China’s economic engine has pulled hundreds of millions of workers into the cities from the rural outreaches over the past two decades, creating a remarkable transformation in the country’s economic and social landscapes. At the same time, though, urbanization has produced a two-tiered society. People moving into the cities have become second-class citizens in their new homes because they are not allowed to share in the same public services, such as education and health care, that the cities’ native residents enjoy.

Fortunately, policymakers in China realize that the heart of any city is not found it its buildings but in its people, so they have determined that all citizens should receive equal access to social services. This would allow new arrivals to integrate more fully into society and share equally in the benefits of urbanization with their city-born neighbors. While a noble — and critical — objective, closing China’s welfare gap will require a complete overhaul of some deeply entrenched political and social systems.

The existing model no longer works

The first step is to de-link access to public services from a person’s hukou, or household registration. Under the current system, residents can receive public services only from the states or municipalities in which they are registered. Regional governments are reluctant to register new immigrants because they don’t want to add to their current financial loads, and often migrants aren’t ready to give up their family ties to their home states. Then China must redefine the roles of the central and local governments in delivering these services, creating a more centralized system that will allow workers to move more freely within the country without losing their access to these critical services.

Providing public services is only half of the equation, though. Financial reform must also address future funding of the country’s expanding infrastructure needs, which are built and paid for by local governments. Historically, local governments have depended on land sales or debt financing tied to land for the majority of their revenue. However, this source of income is declining.

At its peak in 2010, the income from land sales contributed 7.5 percent of China’s gross domestic product (GDP), which was almost equal to the sum up of the rest of all the other income for the local governments. In recent years, because of the increase of land prices and related costs, the income from land sales dropped to just 1.2 p ercent of GDP in 2012.

decreasing dependence on land costs

This dwindling revenue source means that China’s local governments can no longer generate sustainable capital to finance their growing infrastructure needs. Unfortunately, China’s current system of public finance provides few options for municipalities because it bans local governments from issuing their own bonds, even to finance capital expenditures.

New roles for the public and private sectors

Under a pilot program introduced in 2011, four of China’s largest provinces, Shanghai, Guangdong, Zhejiang and Shenzhen, were allowed to issue a limited number of short-term bonds. Expanding this program would not only open up a critical revenue source for all regional governments, it also would create an important market for private investors. Allowing local governments to directly issue bonds backed by tax revenue would provide a more market-oriented and transparent approach to financing growth while sharing the risk with the private sector, which directly benefits from infrastructure investment.

However, reform is not just needed to cover funding gaps. It should also rebalance the inherent disadvantages within the Chinese tax system that place a disproportionate burden on local governments. Therefore, an overall blueprint for reform needs to integrate all of these objectives into a coordinated process to restructure China’s fiscal systems. Some of the reforms should be easier to implement, such as creating a bond market for local governments. Other reforms, such as shifting some tax collection authority from the central government to local jurisdictions and the introduction of a property tax, will take longer.

In the end, though, an effective solution would include a centralized system that provides equal access to public services across all of society, which would promote migration and help workers integrate more fully into urban life. At the same time, it would make the movement of labor, enterprise and capital more efficient by allowing them to flow into the places and industries with highest potential rate of return.

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