Rethinking China’s local government debts in the frame of modern money theory

Abstract

Local government debt is a great threat to China’s financial stability. Local government debt in China is in a dynamic process of financial innovation. The competition of local officials for promotion and the characteristics of China’s fiscal system are the reasons behind the growth in local government debt. The yardstick for the promotion competition is the local GDP growth rate and this drives local officials to increase expenditure to achieve their targets. Because in China’s fiscal system the central government often gives priority to reducing its fiscal deficit and the central government can largely determine the distribution of revenue and expenditure between itself and local governments, there is a tendency for the fiscal burden to be shifted from the central government to the local governments. Resolving China’s local government debt problem requires not only strengthening regulation, but also abandoning the central government’s fiscal balance target, because this target may make regulation hard to sustain in times of economic downturn. This paper discusses central-local fiscal relations in the framework of Modern Money Theory, suggesting that China’s central government should bear more fiscal burden because a central government with currency sovereignty can always afford any spending denominated in its own currency.