China's debt problem

File photo: Money at a bank in China Image copyright Reuters
Image caption China's gross debt-to-GDP ratio is around 43%

China's new government has ordered a national audit of government borrowing and announced that it is adopting a budget deficit limit of 3% of GDP, similar to the Maastricht Treaty's guidelines for the eurozone. The first move is welcome, but has the latter gone down the wrong line?

China's government debt, especially local government debt, would benefit from greater transparency. In the last audit, local government debt came to 10.7 trillion yuan, or $1.8 trillion, which equates to about a quarter of GDP at the end of 2010.

And more debt has been accumulated since then. Also, it's unclear as to whether this really is the total amount since large portions are held off balance sheets in so-called local government financing vehicles.

Taken together with central government debt, China's gross debt-to-GDP ratio is around 43%, which isn't too bad considering that the average debt level for advanced economies in the US and Europe is over 80%. But there is a lot of doubt around these numbers and the estimates that I have been given by sources in the Finance Ministry are closer to 60%.

Also, it is often pointed out to me that the US only counts federal government debt and not state debt, so why wouldn't China follow suit? I'll come back to this point in a moment.

In any case, greater transparency is a welcome development, especially as the new government can do a bit of housecleaning as anxieties grow over China's ability to manage its debt.

US analogy

The deficit cap, though, may be more contentious. Such caps limit the counter-cyclical impact of government spending. In other words, in a recession, government spending on unemployment benefits rise. So, to keep within the 3% cap, other spending - like discretionary spending - will need to be cut.

Besides they don't seem to work very well. Capping the budget deficit at 3% of GDP is similar to what the eurozone has done. You may recall that it was broken first by the core countries of Germany and France soon after its adoption.

And though the deficit rule has been criticised in the euro area, it may make more sense in a single currency area, where different governments are attempting to straitjacket fiscal policy with shared monetary policy.

But coming back to that point, the closer analogy for China is the US.

Chinese provinces are more like US states in that there is a federal structure for revenues and spending rather than separate national entities like the euro area.

If China is worried about local government debt, it may be more pertinent to consider balanced budget restrictions. Three-quarters of US states aren't allowed to run a deficit.

Balanced budget amendments don't always work well in the US, but they came about after a century or so of America attempting to control state debt.

Just restricting the overall fiscal deficit doesn't quite address the problem.