China’s struggles to deal with its mounting burden of local government debt continue to make headlines, giving the dry topic of intergovernmental fiscal relations an unusual amount of relevance these days. The proximate cause of all this local government debt is obvious enough: when the world was falling apart in late 2008, the central government wanted to do a big stimulus, but didn’t want to pay for it. So instead it told local governments to spend whatever they needed on infrastructure to get growth going, and told banks to lend the local governments whatever they needed, and turned a blind eye to any irregularities in all this borrowing. But many scholars and analysts argue that the roots of the problem lie even deeper, that they are the result of a system where there is a fundamental mismatch between the huge burden of public services that local governments have to provide, and the scanty revenues the central government permits them to raise. It’s not just in infrastructure that Beijing pushes the burden down on local governments, the argument goes, but in schools and hospitals and so on. Exhibit 1 in this argument is usually some variant of this chart: From these figures, it is easy to get the impression that China’s central government is just rolling in money and not spending any of it–so no wonder local governments have to borrow so much just to make ends meet! Yet this impression is totally false. What is the central government doing with all this revenue? Simple: giving it back to local governments. Of the 6.45 trillion RMB in revenue that the central government collected in 2014, it sent 5.16 trillion back to local governments as transfers (it also spent 2.25 trillion itself, so it was running a deficit). These enormous transfers account for about 60% of total local government revenue, and are the main method by which money is redistributed from richer provinces to poorer ones. If these transfers are treated as what they really are–the main source of local government revenue–then the apparent mismatch disappears: So while it is fashionable these days to blame excessive centralization of revenues for the mess in Chinese local government finances, this clearly is not a sufficient explanation. Yet it is equally clearly the case that there are real problems in local government finances, and that many localities have to resort to extra-budgetary or extra-legal means to raise money, for infrastructure projects as well as other spending. So how to understand this? As Linda Chelan Li and Zhenjie Yang put the question in a recent article (available for free for a limited time):

The dominant view is that excessive centralization of revenues and decentralization of expenditure responsibilities have precipitated a fiscal crisis in many Chinese counties and townships, with dire consequences to local governance. The ‘gap’ argument emphasizes the relative ratio of central vis-a-vis local revenues and the impact of decentralization of expenditure, and slights the impacts of other parallel fiscal developments, in particular the large flows of central subsidies to local coffers since the 1994 tax sharing reform. As pointed out by the few sceptics, the presence of a large and growing central fiscal subsidy, of a comparable size to the centralized tax revenues, means that logically the latter cannot in itself constitute a sufficient condition for local fiscal difficulties. What then accounts for the difficulties, as localities are not blatantly short of monies?

The answer is that there is not one thing called local government in China: there are multiple levels of local government (at least three). Money does not just have to flow from the central government to local government, but between different levels of local governments. And it is easy to see that this flow might not always be smooth, or that “leakage” may happen along the way as different officials get their hands on the funds. This in fact is the key problem: the central government sends plenty of money to local governments in aggregate, but it does not end up in the right places. The lowest-level governments (counties) are where spending responsibilities are concentrated (see table below), but they are the furthest away from the flow of money from the top. And since responsibility for spending is often assigned without regard to where the revenues come from, mismatches abound. So the lowest-level governments do in fact have many fiscal obligations and often not enough resources to meet them. The better recent research on China recognizes this more complex reality. Li and Yang’s article demonstrates it through a case-study approach that documents how higher-level local governments undercut those below them, while the OECD’s urban policy review of China has a more data-driven presentation (see pages 189-212). The issue is not that the central government does not give enough money to local governments; it is that the money does not go to the right local governments. As the OECD notes, transfers are often made based on assessments of need that do not match up well with reality:

One of the limitations of the Chinese system is that the need for transfers is assessed mostly based on registered rather than actual population in a province. The problem is that the actual population is generally lower than registered population in low-income provinces, given that migrants remain registered in their home province, regardless of where they live. The government is set to henceforth include 15% of the difference between actual and registered population in the formula for determining transfers. This will partly take into account the cost of migrants to a province.

It’s understandable why the simpler account of a central-local fiscal imbalance dominates the discussion: “the central government has too much money” is a much better slogan than “the fiscal transfer system is suboptimal.” But the first the step in fixing the problem is coming to an accurate diagnosis.

One of the most interesting developments in the first year of Xi Jinping’s tenure was his iconoclastic approach to farm policy. He gave a major speech on agriculture in December 2013, in which he outlined a relaxation of China’s policy of maintaining 95% self-sufficiency in grains. As usual for speeches announcing a change in policy, there was much fiery rhetoric about why the old policy was correct: “We cannot look at grain security only from an economic perspective, we must also look at the political perspective,” he said. But in substance what Xi proposed was allowing a higher level of food imports, and focusing efforts at self-sufficiency on only a few crops with sustainable levels of domestic production. (The full text of the speech is not online, but is available in a book of Xi’s speeches, which I’m sure you own.) The new grain security slogans, with included a prominent mention of “appropriate imports,” then made their way into numerous government policy documents.

And then things stopped. As the new line started to get more publicity and public discussion, media coverage and criticism started to mount. The furor got so intense that in February 2014, the Ministry of Agriculture ended up publicly denying that the new slogans meant that China was softening its commitment to grain security. Since relaxing the grain security standard was the whole point of adopting the new slogans, this of course was not really true. But it was significant that the government did not reinforce Xi’s decision to break with past policy, but rather reaffirmed the existing policy. Possibly as a result, there have been no specific measures that actually put into practice the new grain security policy: more than a year and half after the new framework was finalized, there is still no clarity on exactly what level of imports of what products are officially considered acceptable. There have also been possibly retrograde developments, like the new national security law that names grain security as one the key parts of national security. Agricultural economist Cheng Guoqiang summarized the situation in a recent presentation: policymakers remain divided, with some emphasizing the traditional approach to self-sufficiency while others urge change, and there is no consensus on how to move forward.

Why is it important for China to change its approach to grain security? The most obvious reason is that the old one isn’t working: China imports much of its soybean supply, and recently became a net importer of corn (the concept of grain used in China is really a broad category of staples, including beans and potatoes as well as cereals). But as the excellent and indefatigable Dim Sums blog has repeatedly documented, Chinese bureaucrats’ obsession with maintaining high levels of domestic grain output has led to many other problems, like the stockpiling of grain on a vast and wasteful scale, as well as huge overuse of fertilizers and increasing degradation of land. It has also required increasing levels of government subsidy and market intervention to maintain. As the OECD has documented, China has been steadily ramping up subsidies and other farm supports at a time when many other governments have been scaling them back (in absolute terms, China is both the world’s largest agricultural producer and the largest disburser of agriculture subsidies). So in environmental and financial terms, maintaining a high level of self-sufficiency looks increasingly unsustainable–and is only likely to become more so. The chart below shows some model results from Kym Anderson (from an online presentation; here is an ungated version of the supporting paper), arguing that maintaining self-sufficiency in key products will require implausible, and WTO-illegal, levels of tariffs and trade restrictions by 2030.

Grain security is probably not the most urgent short-term issue Xi Jinping has to deal with right now, so it’s understandable that he may not want to spend much political capital to push through this particular change. But many reformist figures in China view the overhaul of grain security as a key market of progress on Xi’s pledge to give market forces a “decisive role” in the economy. Since Chinese prices for grain are higher than world prices, if market forces play a greater role, then more market forces means more grain imports. Finance minister Lou Jiwei himself, in a now-famous rant about how China can avoid the middle-income trap, named agricultural reform as one of the top economic priorities. “From seed to table, the whole chain has subsidies and interference in resource allocation,” he said at an April forum at Tsinghua University (the Chinese transcript is online; here’s an English write-up). “What should we do? Liberalize prices, preserve crop rotation, give subsidies for fallow land, and import.” Such matter-of-fact acceptance of large food imports breaks is clearly still rare in China. The desire for self-reliance, and the related tendency to see their country as alone in an uncaring world, have deep roots.

Technical note:

How exactly did Xi Jinping propose relaxing the grain security policy? This is a bit hard to explain without resorting to some Chinese terms. The original self-sufficiency policy (laid out in a 1996 white paper) was that net imports of grain were not to exceed 5% of domestic demand. But grain is not just grain; the Chinese term liangshi also includes soybeans and potatoes, among other things. Since China is now a huge importer of soybeans, mostly to make animal feed, this is clearly a big problem for the old policy. Corn (maize) imports are also now growing, and also go mainly into animal feed.

One of the new slogans (谷物基本自给、口粮绝对安全) therefore does away with liangshi, and in its place introduces two new terms: guwu, or cereals, and kouliang, or food grains. There must be “basic self-sufficiency” in cereals (rice, wheat, corn), and “absolute security” in food grains (rice, wheat). Because liangshi is no longer the operative term, the requirement to maintain self-sufficiency in soybeans (and potatoes, for that matter) has been quietly jettisoned. And since corn is subject to the looser “basic” standard, the new policy also means greater tolerance for corn imports. The problem is that there is not yet a definition of what “basic” or “absolute” self-sufficiency might mean in numerical terms, and without that clarity it is hard for officials to know how to actually implement the new policy. The text of the new national security law also refers to the old formulation of grain security in terms of liangshi, further muddying the issue.

I have a short post up at the Paulson Institute blog, in response to a question about the impact of the sharp fall in Chinese stock prices. The even shorter version:

If the rising stock market has been supporting the real economy, then that support could well be in the process of unraveling. It’s difficult to find much strong evidence of such support.

Issues considered include the wealth effect, corporate investment, and the surprisingly large contribution of the financial sector to GDP.

There was a lot of news out of China last week–stock markets tanking, interest rates being cut, etc–so it’s understandable that some other interesting developments slipped through with little notice. This one is worth highlighting as I think it may well mark the beginning of an important longer-term shift in China’s labor market and policies: the State Council lowered employers’ required contributions to two social insurance programs, injury and maternity insurance, a move it said would save firms 27 billion renminbi a year (see the China Labour Bulletin for an English-language summary). Yes, I know this sounds boring and technical, so why is it important? Because it starts to address one of the biggest but least-known issues in China’s job market: the very high costs employers face to hire workers.

It is not a very well-known fact that China has some of the toughest labor regulations in the world, and some of the highest required contribution rates to social insurance programs. As a result, the “labor wedge”–the percentage of the total cost of an employee that comes from things other than wages–in China is around 45%, as high as in a number of European countries (this is according to an estimate by John Giles in a World Bank paper; see chart below).

This fact does not square with the widespread perception of China as a nation of sweatshops employing hordes of migrant workers, and indeed is a relatively recent development stemming from the 2008 Labor Contract Law. But China’s problem with these generous worker protections is ultimately the same one that many other developing countries have encountered: strong legal protections and generous insurance programs are so expensive that in practice they only become available to part of the workforce. Effectively China has two labor markets: one for urban white-collar jobs with all the legal protections, and one for blue-collar jobs held by rural migrant workers that generally lack the full set of benefits. As John and his co-authors summarize the issue in their 2013 paper:

China’s urban social insurance system carries heavy burdens for both employers and workers, and may carry significant implications for China’s long–run competitiveness. Moreover, this high implied labor tax wedge likely encourages informalization of the labor market: employers under-report wages and game the system in numerous ways, while workers have incentives to opt out of participation in social insurance schemes. As in other developing countries, high mandated contribution rates provide strong incentive for employers to evade compliance through the use of labor dispatch services and under-reporting of employment and wages.

The IMF in its last Article IV report on China also, very correctly in my view, highlighted this issue and urged the government to change:

Social contribution rates, which are high and very regressive, should also be reduced as they distort the labor market, make growth less inclusive, and favor informal over formal employment.

So economists have for years been flagging this issue as an area where “structural reform” is needed. Having a relatively high cost of employment should, other things being equal, discourage employers from hiring. But there’s been little evidence that this was in fact a real problem over the last few years–instead, it was much more common to hear complaints and anecdotes about labor shortages. So the very high rates of social contributions did not seem like they were imposing much of a cost on the economy: the job market stayed tight and wages continued to grow rapidly. While high hiring costs may have lowered employers’ demand for workers relative to what it otherwise would have been, this effect was not big enough to seriously affect the balance of the labor market.

That has all changed in recent months, as the economy has continued to weaken. With employers finding growth in demand for their products continuing to soften, it’s hardly surprising that their demand for additional workers is also softening. Public data on China’s labor market is limited, but there is much labor data that is collected but not published, and this seems to have been enough to get policymakers worried. The State Council has warned of “growing pressure on employment,” and rolled out a whole series of measures designed to assist the unemployed, such as tax breaks for hiring new workers, cheap loans for small businesses, and support for laid-off workers to start their own companies. The most recent of these moves, the small cut in some social insurance costs, may indeed be a needed reform, but, as is so often the case, the timing of reform is being driven by the economic cycle.

We therefore seem to be at a tipping point in the labor market that is causing the government to look again at the cost-benefit analysis of its labor policies. And as China’s economic growth continues to slow in coming years, I expect the costs of its current set of labor policies will become increasingly apparent. So the balance of its policies should shift more toward encouraging employment, and preferring higher rates of enrollment in social insurance programs to higher benefit levels. European countries have often been criticized for preferring labor policies that reward people who already have jobs at the expense of people who want jobs. China’s latest move is a clear if marginal shift in the other direction: it would prefer that 27 billion renminbi not go to improve the welfare of people who already have jobs, but instead be spent on hiring new workers.

The fact that China is moving relatively early to make this adjustment–before there has been a big increase in unemployment–to me is a hopeful sign that it could be more flexible in navigating this transition than some other countries. That may not be the most obvious conclusion, since China is after all a Communist country that one might expect to have a strong ideological commitment to social-welfare institutions. But the “socialist market economy with Chinese characteristics” of the past three decades has in fact never been particularly keen on socialist labor market institutions, as a whole host of workers’ rights groups will tell you.