For months, Beijing has been trying to stimulate the country's sick economy by cutting interest rates, giving incentives to exporters and encouraging more foreign investment. However the economy remains in a deflationary state.
Last year the government administered another potent prescription – massive public spending financed by treasury bonds. Setting aside fiscal prudence, the Ministry of Finance in 1998 issued a staggering Yn647.3bn of bonds, 2.6 times the total of a year earlier. Some 270bn of the proceeds were used to recapitalise state-owned banks, while much of the remainder went on funding public works such as irrigation projects, rural electricity grids, bridges and highways. The spending succeeded in nudging up economic growth by an extra one or two percentage points by end-1998 to attain a growth rate of 7.8 percent for the year.
With the economy still growing at a slow rate, Keynesian-style spending will continue for some time. That means the ministry will have to borrow more to fund public projects and it is already scheduled to sell Yn316.5bn of government paper this year, less than half the 1998 figure but still a substantial amount. By end-1999 China's outstanding bonds will reach Yn1,100bn, nearly three times that of 1996. In the early 1990s, new government debt increased only by double digits annually.
With government debt increasing at such a fast rate, economists say there is an urgent need to reform China's inefficient administration of its public debt. Otherwise, it could eventually face a fiscal crisis. Economist Yang Xiaojun of Jiangxi Finance and Commerce College says Beijing has focused much attention on a potential banking crisis but not enough on the possibility of a fiscal crisis.
"If we do not quickly address the problems associated with our looming public debt, we will be taken by surprise," he says, adding that the experience of Russia and Brazil should serve as a warning to China.
Planned economy mindset
China's public debt, despite its growing size and importance, is still managed very much as it was in the days of the old planned economy. Finance bureaucrats decide on the interest and the distribution of the bonds, with scant attention paid to movements in the bond market. Most bonds are still issued to individuals and are not tradable. As a result, the 11-year-old bond market is moribund, with transaction levels a fraction of the heady days in 1996.
In short, the finance ministry still runs its mountain of debt paper with the sole purpose of using them to finance its deficit. Economists argue that the government should adopt a more sophisticated fiscal policy and use bonds to promote financial stability.
To start with, Beijing needs to have a better idea of how much debt it can issue in the long run. At the moment, there is no stated target guideline on the appropriate size of the debt.
Some analysts say the government has become too dependent on bonds to finance its spending. Last year the national budget relied on proceeds from bond sales to fund one-quarter of its spending. The debt-dependency ratio was even higher for the budget of the central government, at 56 percent. Provinces and municipalities are in a better fiscal shape than the central government because they can impose random levies and other fees on local businesses and individuals.
Other economists argue that the government debt is still manageable, provided that it is administered efficiently. At end-1998, the outstanding volume of treasury bills was 8.12 percent of GDP – a comfortable ratio when compared with the international standard of 20 percent.
The State Planning Commission uses another yardstick to argue that there is still room for deficit spending – the country's budget deficit was a modest two percent of GDP last year, compared with the international standard of three percent. Using three percent as a benchmark, China can allow its debt to grow an annual 13.4 percent in the next five years, the commission estimated in a recent report.
Broadening subscriber base
The commission, however, has warned the government that its debt could be much larger than the bond figures indicate. Quasi-government debt not counted in the official statistics include the contingent liabilities of the state banks, losses of state-owned enterprises, and arrears of salary and pensions due to state-employed workers.
"If all these quasi-public debts are included, the room for issuing more public debt will be much smaller than it appears," says Jia Kang, vice president of the Institute of Fiscal Science under the Ministry of Finance.
Size aside, the next urgent issue is broadening the base of treasury-bill sub-scribers. For many years, the finance ministry had restricted financial institutions from buying treasury bonds and preferred individuals to own them. Again, this is a legacy of the planned economy under which tens of yuan were withheld each year from a worker's annual salary to buy ‘patriotic bonds.’ Subscription is no longer compulsory, but the ministry continues to target individuals for its bond sales.
Economists say that this has to change because international experience shows that financial stability will be promoted if more institutional investors own treasury bills. Financial institutions buy bonds as a kind of low-risk, liquid asset, while individual investors tend to be more speculative. Institutional investors own 50 percent of the country's treasury-bills in the US and 80 percent in the UK, according to a report published by the Chinese Academy of Social Sciences.
Last year the finance ministry began to target more institutional investors. Of the total bond issue, Yn270bn was designated for state banks – a move that instantly bolstered the weak balance sheets of the banks. Insurance companies took up another tranche of Yn60bn.
The People's Bank of China also needs to hold treasury bill bonds, economists say, so that it can control money supply through buying or selling in the market. Such open-market operations began in 1996, but the volume of treasury bonds traded in the market is too small to make any impact yet.
Shrinking trade volumes
Another urgent priority of China's debt management is to revive the sluggish bond market. Trading volume has shrunk from a peak of Yn10bn a day to the current Yn100m-300m. The range of bonds traded in the market has halved to five this year, as the government has issued only non-tradable bonds since September 1997. "There are just not enough bonds around to get investors excited," says Li Hungxian, a manager at Citic Securities in Beijing.
Brokers like Li are urging the government to include more tradable bonds in this year's Yn316.5bn bond tranche, but Beijing is moving with great caution. Its focus is on stability, not the liquidity of the bond market. "The priority of the government now is the stock market, not the bond market," says Li. The stock market has soared in recent months, thanks to tax and other incentives provided to traders.
Industry analysts say the government needs to do the same to the equally important bond market. Without an active bond market to provide liquidity and a barometer to price bonds, investors may become less interested in buying treasury bills and the government will then experience major difficulties in selling its paper.