China's 'bad' loans to its local governments

Chinese municipalities sometimes misuse loans from the central government. Do local governments have any incentive to allocate funds fairly?

Barry Huang / Reuters
Hu Jintao, China's president and general secretary of the Communist Party of China (CPC), delivers a speech as other officials applaud during the celebration of the 90th anniversary of the founding of the party, at the Great Hall of the People in Beijing July 1, 2011. When Beijing gives loans to local governments in China, the money sometimes makes it into the wrong hands.

China's local governments have borrowed a lot of money from the state government. Is a crisis brewing? To quote the article, "Liu Jiayi, the top auditor in China, said on Monday that at the end of last year local government debt had reached $1.7 trillion, or about 27 percent of the nation’s gross domestic product. He said better regulation was needed to manage the debt risks."

A government loan is "bad" if the net present discounted value of what it financed turns out to be less valuable than the next best alternative that could have been financed with this investment. So, this raises the issue of what local governments do with the $. Let's consider a couple of cases;

Case #1; The local government's bosses steal the money. In this case, the federal government is buying the peace and macroeconomic growth will slow.

Case #2; The local government has invested in local public goods such as transportation infrastructure, sewer systems and electricity generation. These investments will payoff in the long run (assuming they were purchased at competitive prices) but their short run returns are hard to measure. Using high quality, U.S data it has been hard for economists to tease out the effects of infrastructure investment on local growth. For an example of such scholarship read Fernald's paper.

Case #3; the local government has invested the $ in public infrastructure but has overpaid for this stuff by hiring their friends to do the work and demanding kickbacks. In this case, the same nominal loan will purchase less real output (because the price tag will be higher --- think of Boston's expensive Big Dig) and the total impact on local growth will be lower per $ invested by the national government.

Did the local governments have the right incentives to efficiently allocate the loans they received from Beijing? If they own land in the city, then they will. If they are a monopolist with no chance of losing their local power then they could just steal the $. There hasn't been enough discussion about the delegation of capital and whether there are any accountability mechanisms in place in China for monitoring local politicians.

In for profit firms, we have shareholders and boards of directors --- they have an incentive to monitor to make sure the firms are investing efficiently. Who is the equivalent in the China Communist Party?

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