The role of local government in China’s economic development. Positive, negative,

partially positive, or partially negative?

Introduction

The Chinese have a popular proverb to describe the relationship between local government

and central government, “The heavens are high and the emperor is far away” (tian gao,

huangdi yuan). The meaning behind this saying is that the Central government in Beijing has

little control over local affairs. From the reform era of the 1980s, the Chinese central

government has encouraged decentralisation in its political system as a way of achieving

widespread economic reform. However, in the absence of an institutional framework, local

governments have been involved in enterprise affairs with varying success. Indeed, some

local governments have appropriated funds from private and state-owned enterprises,

diverting funds away from more productive enterprise investment. The role of local

government is not entirely negative however as they have often spearheaded economic

reform and in some cases their efforts to reform have been curtailed by Central government.

However, an embrace of a recent financial development, alternative finance (also known as

shadow finance), has caused a worrying surge in debt, threatening local government finances

thus casting a shadow on China’s future economic development. This essay will begin with

the case of corruption in local government, and how it hinders enterprise development in

China, followed by the positive aspects of local government involvement in economic

development through their role in spurring economic reform, and closing with a look at local

government finances and their threat to China’s economic development and a conclusion.

Local government and enterprise development: give with one hand, take with the other.

Since China’s economic reform, private enterprise has been an increasing contributor to

overall GDP with private sector profits increasing from RMB2.12 trillion in 2006 to over

RMB18trillion in 2012 (NBS, 2013). However, in the absence of an institutional framework,

Chinese companies still have competitive barriers, such as legal and legislative where

connections with local officials can be vital to firm success (Li et al., 2009). The state has

been known to add a variety of ad hoc fees and fines particularly from well performing

enterprises (Jie and Ward, 2003 pp. 113). Sun et al. (2011) use a case study of Kelon, which

was a darling of the Hong Kong stock exchange from the late 1990s to the early 2000s. The

government of Guangzhou had a 34% stake in Kelon, and was the largest single shareholder.

Though still a minority shareholder, the local government was still able to expropriate funds

from the company, which owed to a 3-year 600% increase in ‘other receivables’, which is the

item under which asset extraction was listed on Kelon’s balance sheet. Though this is just one

example of corrupt local government extraction, Jie and Ward (2003) highlighted other

examples including of a publishing company which originally moonlighted as a TVE to stay

away from local government, until the local government started turning up announced at the

factory gates asking for tanpai, which is an ad-hoc fine on a company, under the guise of a

sudden tax which is to be paid immediately. Feng and Wang (2010) report how especially

during the 1990s, it was a common concern among entrepreneurs that their property would be

seized by the state. In recent years, the state has been less blatant about the seizing of assets

and instead turned to ad hoc windfall taxes on firm profits. It would be easy to put the reason

down to local government greed, but the explanation is more complicated and multi-faceted

than just greed. Sun et al. (2011) purport that local governments are simply reacting to

pressure from central government to achieve a fast rate of GDP growth (Li and Zhou, 2005).

Therefore, if local government were involved in a private enterprise, short-term sales (which

can be taxed) were preferred to long-term profitability, and related-party transactions became

a mainstay of business practice, and private interests could be encouraged from pecuniary

favours to political point-scoring. Additionally, for the local officials that were able to meet

targets, promotion to more provincial roles (and later perhaps central government) would be

worthy reward (Liu et al. 2006). Indeed, an alternative career to Central government for a

local cadre is in the private sector. Fan et al. (2007) poll 790 newly partially privatized firms

in China and find that 27% of the CEOs were either former government bureaucrats or

currently working bureaucrats. Peng (2000) also notes that this phenomenon of local cadres

dabbling in the private sector is a common occurrence in transitional economies. Direct local

government in enterprise affairs can be problematic, Fan et al. (2007) assess the earnings of

firms after their initial public offering (IPO), and finds that firms with local government

involvement underperform independently governed private enterprises by 18% according to

stock returns, including extrapolated earnings three years post-IPO. Li et al. (2009) observes

local government involvement in Chinese multinationals, and finds that officials have a

negative influence on the innovative aspect of the business, with many differentiated products

in the R&D department never taken to marketable development stage. However, Sun et al.

(2011) make the point that local government has vested interests in the continued success of

enterprises in their locality. Therefore, local government can serve a vital function in

encouraging nascent enterprises to spearhead China’s future economic growth. Private

businesses often seek out local government officials with which to partner, since the political

capital they have allows the fledgling firm to avoid tanpai costs (temporarily at least) (Wu et

al. 2012). In the case of Kelon, the Guangdong local government assisted the firm in gaining

favour with the central government (in order to receive approval for an overseas IPO), by

partnering with the province’s Machinery Building Bureau. Kelon could thus look like a

provincial SOE under the cloak of an affiliate, this strategy is known as wearing the ‘red hat’.

Local government involvement is not reserved for private enterprises however, there is of

course heavy official intervention in local SOEs as well. Wu et al. (2012) surveyed 1408

firms with heavy political connections to study the effect of over-investment existent in firms.

The idea behind the research being that in the pressure to deliver higher GDP and lower

unemployment, cadre-governed SOEs over-invest using the firm’s cash-flow to achieve their

means in decisions which are politically motivated. Therefore, politically connected local

officials are chosen in order to fulfil government objects as opposed to profit maximisation.

This conflict of interest between enterprise goals (profit maximisation) and political goals is a

hindrance to China’s economic development since productive capital is instead earmarked for

projects which are misaligned to a firm’s interest.

Local government spearheading China’s economic development

Reform seemingly originating from Central government has been spearheaded by local

governments in many instances, particularly in the financial sector. The development of the

stock market in Shenzhen, according to Walter and Howie (2009), occurred outside of

government control in over-the-counter markets. Instead of banning the capitalist practice,

the Guangdong government decided to use it to gain access to capital for one of its state-

owned banks, Shenzhen Development Bank (SDB). Owing to Guangdong’s proactivity, SDB

became the first bank to IPO on Shenzhen’s stock exchange. Indeed following on from this,

many regional exchanges were established also trading stocks in their own locales. However,

in the 1990s Central government stopped the practice of local government having legislative

authority over their own domestic markets. In 1997 the PBOC required all securities issuance

to have approval by Beijing first. The 1989-90 share boom and bust in Shenzhen’s stock

exchange added credence to central government’s argument of the need to restore control.

Local government spearheading reform was not limited to just the stock market. Regional

markets in Shenyang and Wuhan had even established their own local government debt

securities markets (Walter and Howie, 2009). This was an important step towards developing

a more sophisticated financial system since liquid methods for governments to raise funds as

opposed to bank loans. The pilot programs were stopped in 1997 because of scandal from

local governments in misappropriating debt investor funds towards extravagant public works

projects. China’s bond market is still in its nascent stage; central government only approved

local government bond issuance in 2011 with pilot programs in Zhejiang, Shanghai,

Shenzhen, and Guangdong (WSJ, 2011). In addition, the first securities investment funds

were approved by local governments before central governments, with Wuhan and Shenzhen

leading the way in 1991 through approving investment funds even before there was central

government recognition and regulation (which belatedly occurred in 1997). Throughout the

evolution of China’s financial system, local governments have demonstrated a positive role in

China’s economic development through embracing new developmental change, while the

Central government would later have wrestle back control over these experiments with

market forces.

In more recent years, the evolution of alternative finance markets have conducted in a similar

fashion; originating in the private sector back-alleys and subsequently encouraged by local

governments. The alternative loan markets include shadow banking, microcredit, wealth

management products, and local government finance vehicles (LFGVs). Zhang (2013)

accounts from his days running a microcredit outfit based in Guangdong province; 5000 have

been established since 2008 with the help of local governments. The PBOC once again

lagged behind local government, and curtailed their development by setting an interest rate

ceiling (four times higher than the PBOC ceiling for borrowing), and prohibiting microcredit

firms from penetrating other provinces outside of their approved locale.

Local governments embrace a new reform: alternative finance

While local governments have been at the forefront of economic reform, leading the way for

central government to recognise and regulate the reform as opposed to Beijing first issuing a

decree for the local government to follow suit, they have also been curtailed at every turn.

Central government wrestling control back from local governments has often occurred due to

a perception that local governments cannot regulate effectively (Walter and Howie, 2011). In

response to the Western financial crisis in 2008, China’s central government released a $486

billion stimulus program, which would be largely implemented by local governments; their

task being to identify investment projects and provide two-thirds of the capital. Local

governments responded by tapping alternative loan markets, once again encouraging and

embracing economic change. However, the reason for this was because they could not issue

their own bonds (Walter and Howie, 2011). Local governments instead listed themselves as a

limited-liability company meaning that they could utilise the shadow banks to obtain finance

in the form of LFGVs. The problem with local government embracing this particular new

development in the financial sector is that the maturities on these debt securities are short-

term (FT, 2014), whereas the infrastructure projects have a long-term return time horizon.

Therefore local governments’ finances are subject to volatile short-term money market

interest rates. The scale of local government debts was unveiled by an audit conducted by the

National Audit Office in 2013. The amount of outstanding debt of local government

investment and financing platforms has reached to nearly RMB7 trillion, and the proportion

to total local debt is about 39% in total, which is particularly high (FT, 2013). Despite a

protracted slowdown in GDP growth, 40% of the debt is due in 2014, meaning that the

Chinese government cannot grow their way out of the debt problem, and thus must either

bailout local governments or force them to trim investment expenditure, which will drag

down already slowing GDP growth (Fan et al. 2011). As can be seen from table 1, local

government has a 34% shortfall in revenue compared to expenditure in 2009. This shortfall

coupled with rising short-term debt levels mean that local government is indeed hampering

China’s economic growth rather than helping it, since if local governments are forced to

curtail investment projects in order to curtail expenditure, then there will be a negative

consequence on economic growth.

TABLE I. THE IMBALANCE BETWEEN LOCAL GOVERNMENT EXPENDITURE AND REVENUE (100 MILLION YUAN) Year Local fiscal

expenditure National fiscal expenditure

The proportion (%) (2)/(3)

Local fiscal revenue

National fiscal revenue

The proportion (%) (5)/(6)

1993 3330.24 4642.30 71.7 3391.44 4348.95 78.0 1995 4828.33 6823.72 70.8 2985.58 6242.20 47.8 1997 6701.06 9233.56 72.6 4424.22 8651.14 51.1 1999 9035.34 13187.67 68.5 5594.87 11444.08 48.9 2001 13134.56 18902.58 69.5 7803.30 16386.04 47.6 2003 17229.85 24649.95 69.9 9849.98 21715.25 45.4 2005 25154.31 33930.28 74.1 15100.76 31649.29 47.7

2007 38339.29 49781.35 77.0 23572.62 51321.78 45.9 2009 61044.14 76299.93 80.0 32602.59 68518.30 47.6 Fu (2011)

Conclusion

Local governments and enterprise have had a chequered relationship over the reform period.

On the one hand vitally contributing to China’s economic growth by trumpeting companies

for a stock exchange listing, while at the same time appropriating revenue from post-IPO

proceeds. In addition, the local government and central government have also had a

chequered history over China’s reform era period. Local governments have been the poster

children of China’s push to marketise its economy; being the experimental incubator for

reform until Central government decides to recognise the new change and attach subsequent

regulation. The new trend in China’s financial sector (alternative finance) is however more

opaque than stock markets and bond markets. Local governments have adopted alternative

finance as a key source of capital, yet the short-term nature of these securities mean they are

vulnerable to interest rate shocks. A shortfall in finance, and a subsequent curtailing in

investment can thus hamper China’s future economic growth.

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