The national budget that China released over the weekend shows the government is tackling its large debts and deficits. This marks the beginning of fiscal repair work after the large budget deficit of 2020. However, this process involves reduced support for lower level governments. S&P Global Ratings believes improved headline ratios at the national level mask chronic weakness among local governments.

China projects a decline in official government debt issuance by the central government. We likewise anticipate the level of net general government debt should decrease as a share of GDP this year.

Below the surface, local governments' sustained deficits and large capital spending continue to exert heavy fiscal strains. Many lower-tier local governments are continuing with ambitious, debt-funded capital spending. Meanwhile, land sales--an important source of revenue for local governments--may not match 2020's levels.

China Signals Cautious Budgetary Support

Prime Minister Li Keqiang has signaled continued support for the economy. Indicatively, he announced over the weekend that the 2021 budget deficit will equal 3.2% of GDP. This is a little lower than the 3.6% estimated for 2020, and remains above the government's unofficial 3% guideline. This is in line with Beijing's view that it should only slowly unwind its policy support for the economy.

But the figures are based on conservative estimates, and they point to a more disciplined fiscal stance. The national budget deficit should decline to Chinese renminbi (RMB) 3.57 trillion this year, from last year's RMB3.76 trillion.

The 3.2% figure references nominal GDP growth of close to 9.8% in 2021. If the general price level increases hit the 3% growth rate that the government targets for the consumer price index in 2021, then the implicit real GDP growth should be close to 7% for the year.

This is below most external forecasts for Chinese growth this year. The IMF's forecast in January, for instance, is for China to grow by 8.1% this year. It is also slightly lower than the weighted average growth that provincial governments' target for the year (see chart 1).

Chart 1

If GDP growth comes out better than the government's cautious expectations, the 2021 budget deficit could be close to the size of shortfalls seen in recent years, before 2020.

Chinese finance officials are also cautious in drafting their budget estimates. Despite the near 3.9% decline in general budgetary account revenue in 2020, they project that revenue will rebound by only 8.1%.

An increase in the value-added tax threshold, and a cut in income taxes for small and personal businesses, account for some of the weakness in growth. Even so, it remains a conservative estimate.

On the spending side in the general budgetary account, officials are planning for a 1.8% increase in spending. This is modest, considering that the growth in 2020 was just 2.8%.

Beijing To Transfer Less Cash To Local Governments

Along with a smaller deficit, the central government will not be launching another special Treasury bond issuance program this year. This follows RMB1 trillion in such issuance last year. The debt proceeds were used to fund healthcare spending, provide relief to pandemic-hit businesses, and to generally boost the economy. The central government transferred most of the proceeds of special bond issuance last year to local and regional governments.

Our back-of-an-envelope calculation is that the end of the central government's special bond program should translate into a 10% reduction in cash transfers to local governments. We estimate total transfers in 2020 equaled almost one-third of local government revenues.

The official budget is only part of the fiscal story in China. Below the surface, we believe that local governments will continue to borrow heavily. This includes off-balance sheet borrowing through state-linked firms. This is important because the liabilities of such entities may redound to the local or central government, if the firms fail and threaten systemic instability.

China publishes no official statistics on the volume of off-balance sheet debt issued by government-linked entities. We make our own estimate of such debts in assessing the net general government burden in China.

Central Government Take Steps To Reduce Hidden Debt

China has done much work to reduce use of off-balance sheet funding, and to deter local governments from pushing their debt raising onto state-run firms. For example, Beijing has restricted since 2014 local governments' use of state-owned firms to raise debt for public service activities.

The China State Railway Group Co. Ltd. has substantially reduced its borrowing. This is an enormous borrower with RMB4.4 trillion of net debt. Such is the company's scale and close state linkages, we include its net debt in China's general government debt.

Following the company's reorganization in 2019 under China's Company Law, China State Railway has changed the way it finances railway infrastructure. Last year, the Chinese government allocated budgetary funds to augment the company's capital position to support its spending on railway building.

Perhaps as a result, the company's net and total debt positions in September 2020 were slightly lower than levels at the end of 2019. This was despite likely heavy spending last year. The government prioritized railway infrastructure spending in 2020 to support economic growth.

More generally, a series of recent high-profile defaults by companies close to local governments has likely increased banks' and investors' caution in lending to these entities.

Local Government Finances Stay Strained Despite Recovery

Although the reforms and fiscal repair work described above are largely positive, the financial situation at some Chinese local governments is still precarious. The central government's decision not to issue another round of special bonds will translate into a sizable cut in their financial support for lower level governments.

Central authorities will likely let local governments run historically high deficits this year as regions continue to grapple with the economic effects of COVID. Local governments in the regions with already high debt stock may see a worsening in credit metrics.

Key metrics on local government finances confirm that fiscal stimulus remains vital to the recovery across China. China's local governments may not see much fiscal improvement compared with 2020 levels, notwithstanding the unfolding economic recovery.

Heavy Dependence On Land Revenues Adds Volatility

We assume local-government deficits will come in at close to 15% of total revenues in 2021, given most local governments will sustain their high capital spending. The National People's Congress--China's lawmaking body--gave local governments RMB3.65 trillion in fresh quota to issue special bonds in 2021.

This is fractionally below the RMB3.75 trillion quota that officials allocated in 2020. This indicates that central authorities continue to want local governments to support GDP growth. The very small cut to the quota, however, likely signals that local governments should prepare for further reductions.

Revenue growth could remain fragile until the economy fully stabilizes. Local government deficits will likely come in at 15% for 2020. While this is better than our previous estimates, volatile land-sale revenues largely explained the gains. Local governments may not be able to match such extraordinary proceeds in 2021, given the government's focus on reining in property prices.

Chart 2

Local governments face practical challenges to completely unwinding stimulative fiscal policies. Most industrial sectors may not restore their credit metrics to pre-pandemic levels till 2022, and beyond. Moreover, China's recovery is unbalanced, depending heavily on exports and investment, while consumption stays soft. Industries that are more consumer focused may continue to need support.

We assume local governments' tax-supported debt will remain high, at about 240% of consolidated revenues over the next two to three years. This will include off-budget borrowings by state-linked entities. Local governments are likely to grow their direct debt stock by 10%-15% annually, largely driven by issuance of special bonds for capital spending.

Even though the central government will not repeat the special bond issuance in this year, we believe it will continue to support local governments, as large fiscal deficits turn into large debts for many of them. This support should include large recurring fiscal transfers. The recurring transfer amounts should remain largely unchanged in 2021.

We estimate the fiscal hit of the pandemic took the general government debt to GDP ratio to above 60% of GDP in 2020. Disciplined spending and the unfolding economic rebound will likely lower this ratio in 2021.

Somewhat below the surface, however, are large and oft-invisible liabilities linked to local governments. As these entities are unlikely to suddenly reduce their spending, their debt strains will likely continue to build, albeit at a more gradual pace than before.

Related Research

• Sovereign Debt 2021: Asia-Pacific Central Governments To Borrow US$4.1 Trillion, March 2, 2021
• COVID-19 Heat Map: Some Bright Spots In Recovery Amid Signs Of Stability, Feb. 17, 2021
• Sizing Sovereign Debt And The Great Fiscal Unwind, Feb. 2, 2021
• Asia-Pacific Sovereign Rating Trends 2021, Jan. 28, 2021
• The Missing Factor In China's Remarkable Recovery, Jan. 19, 2021
• Public Finance System Overview: Chinese Provincial Governments, Jan. 13, 2021
• Comebacks, Setbacks, And Divergent Tracks, Dec. 7, 2020
• No Hiding Off-Budget Risks For China's Local Governments, Dec. 1, 2020
• Asia-Pacific Forecasts Stabilize, Risks Now Balanced, Nov. 20 2020
• China Debt After COVID-19: Flattening The Other Curve, June 4, 2020