The Enigma of China’s Debt Crisis — Explained

China’s economic growth trend, which continues to stall, has become an important and attractive research topic for economists worldwide. Since Q3 of last year, China’s central government has begun to launch a series of fiscal and monetary policies in order to stimulate the economy to get back on track. Amongst all of the policies, the most striking is the “debt reduction plan” of up to 10 trillion yuan (1.36 trillion US dollars). The Chinese government has launched this unprecedented economic stimulus policy as a response to the current debt crisis, which has become the primary factor affecting many of China’s de facto predicaments, such as sluggish consumption, declining investment, shrinking exports, declining income and deflation, etc. If the current debt crisis cannot be properly resolved, it will gradually become the last straw that breaks the camel’s back for China’s macro-economy.

Explicit and implicit debt

In contrast, the debt referred to in this article is China’s domestic debt. More specifically, it mainly refers to the debt of Chinese local governments. At the same time, the Chinese government’s debt reduction plan is also aimed at local government debt rather than the debt undertaken by the central government.

To date, although China’s mainstream media is still doing its best to build a positive image of China’s economy and block all negative news, some clues about the true fundamentals can still be sniffed out from data released by the National Bureau of Statistics of China. For instance, according to the data, in 2016 there were merely six developed provinces that maintained fiscal surpluses; by the end of 2024, there were only two. The remaining 35 provinces were all in fiscal deficits. In addition to the drastic decline in government tax revenue, the main cause for the sharp increase in China’s local fiscal deficit is the depletion of the “land finance”—the rapid shrinkage of local land transactions. In 2024, China’s land transaction revenue was only equivalent to 50% of that in 2021. As a result of the main sources of fiscal revenue gradually shrinking, local governments have been compelled to rack their brains to explore new methods to increase their revenue. In this respect, in 2024, local governments’ total “non-tax revenue” increased by 25% year-over-year.

Furthermore, some local governments even disposed of massive fixed assets to increase liquidity. Some others did their best to charge and impose fines, regardless of the impact of such reckless behavior that disregards the rule of law on the local business and/or investment environment. In some extreme and absurd examples concerning the criminal or civil judicial cases involving local areas, some local governments only arrested suspects from other cities, while giving local suspects light sentences, as they were worried that these cases would affect the operation of local enterprises, particularly tax revenue collection for local governments. In some provinces, the governments have even traced back 30 years of tax evasion allegedly committed by enterprises, subsequently ordering them to pay back the taxes they should (or should not) have paid 20 or 30 years ago, along with high fines.

However, many observers have overlooked a key factor—the leverage ratio of government finances, which has been largely ignored for a long time.

In fact, 40 trillion yuan of the debt of China’s local governments is only the “explicit debt” (ED) — debts that are formally recorded and payable. In reality, local governments also hold a sizable amount of “implicit debt” (ID) that is obviously understated and difficult to estimate. As for this part (ID), the total balance that is announced officially is 13.4 trillion yuan. By contrast, some Chinese economists estimate it to be around 40 trillion yuan. In this respect, the data obtained by the author from channels that temporarily cannot be made public is that the most accurate figure should be—60 trillion yuan. Therefore, the main target of the Chinese government’s 10 trillion yuan debt reduction plan is essentially pointed at the ID instead of the ED.

The root cause of the implicit debt

The emergence of implicit debt is a long story that can be traced back to the fiscal relationship between the central and local governments in China’s history. Since ancient times, there have been continuous conflicts between China’s central and local governments over financial and administrative power. Since Qin Shihuang (秦始皇) unified China and established a centralized institution in 221 BC, the contradiction of central and local power allocation has never been eliminated. On one hand, centralization represents the top-level ideology and administrative decision-making power. On the other hand, local power thus becomes a relatively broad concept, as it is on behalf of a huge bureaucratic system that specifically implements centralization nationwide. In thousands of years of China’s history, the relationship between the two has been “as one falls, another rises,” and vice versa. Therefore, the competitive relationship between centralization and local power has almost determined China’s economic development model over the

past thousands of years.

The benefit brought by this is the stability of the central government, but it simultaneously stifles the vitality of the private economy and the diversification of social development. In other words, the fundamental purpose of the continuous adjustment between centralization and local power is aimed at enabling local forces to obtain sufficient rights and interests while simultaneously ensuring the central government’s control over the regime and economy. This is a longstanding major contradiction in the history of China’s economic development. In contemporary economic terms, it could be interpreted as stimulating the private economy and high-quality local development while maintaining the strong centralization and macro-control capabilities of the central government at the same time.

Instead, local governments shared as much as 75%, making the fiscal strength of local governments significantly stronger than that of the central government. Consequently, local governments took advantage of the reform and opening up policies in 1979, which prompted China to partially get rid of the original planned economic system. In other words, to promote local economic development, the central government began to gradually delegate power to local governments since 1979, and local governments began to independently formulate budgets and enjoy a certain degree of fiscal control.

Later on, the tax-sharing reform of 1993 once again broke this even. Since then, the income distribution ratio between the central and local governments has gradually changed to 50/50. However, this consequently caused a serious imbalance in the division of power and responsibility between the central and local governments, which laid a huge hidden danger for the subsequent development of China’s economy.

The primary aim is to adjust the income distribution radio evenly between the central and local governments.However, the responsibilities on local governments’ shoulders are apparently heavier than those of the central government, since the task of promoting local economic development mainly lies on local governments. Slowly but surely, the result of this kind of uneven distribution is that in the situation of limited resources available, only those provincial government officials who could do a better job in the local economic development are more likely to get a chance to be promoted. Consequently, it leads to the rise of the so-called “China’s characteristic”, a term often used in Chinese media to refer to the breathtaking competition between localities. 

In essence, such a development strategy is a strong reflection of China’s long-term “top-bottom” political institution, that is, government officials only have to be responsible to their upper level. As for the lower level, it usually does not involve them. As one can imagine, the most direct way to exhibit their achievements to the upper level is how much GDP has grown and how much the output value of local enterprises has expanded. Incidentally, this is also the essential reason why China’s economic development concept has long emphasized investment over consumption, enterprises over people’s livelihoods and land assets over technological advancement.

Naturally, under such an economic development strategy, local economic development must require a large amount of fiscal expenditure and public spending. This finally leads to the fact that the local fiscal expenditure in total accounts for more than 80% of the national fiscal expenditure at its peak. In other words, the central government leaves half of the fiscal revenue to local governments, but the latter have to bear 80% of the responsibility for China’s economic development, which substantially increases the burden of local governments.

Therefore, in order to stimulate the enthusiasm of local governments and the longevity of local economies, the central government began to assist the latter in making up for the fiscal gap through increasingly large subsidies (also known as the “payment transfer”). As for the central government, this approach can balance the differences in revenue and expenditure among different regions, while still maintaining the power in its own hands. However, due to the limited total amount of the subsidies, the payment transfers can only meet the regular fiscal expenditure needs of local governments. Particularly, the funds are only allocated to the provincial level. The fiscal conditions of most cities and counties are still not guaranteed. Therefore, the central government once again invented two important policy tools: one is to allow all of the income from land sales to remain in the local finances; the other is to gradually designate local governments the right to issue local bonds. In connection with the payment transfer tool, ultimately, three major “wallets” of local governments have been officially formed: local government bond issuance, central government subsidies and land finance.