Since the 2008 financial crisis, Chinese economic policymakers have been grappling with rising debt amid worries about slowing growth momentum. The front line of this battle is fought by local government officials, who must juggle the conflicting targets of reducing public sector borrowing and ensuring that China hits the central government's goal of doubling gross domestic product in the decade to 2020.
To this end, the Chinese government has so far relied on a massive expansion of credit. Most observers however, including Chinese policymakers and academics, believe a new approach is needed to keep GDP growing. In 2016, a 25 trillion yuan ($3.68 trillion) increase in new credit in the economy resulted in a mere 6 trillion yuan increase in GDP.
One alternative has been the public-private partnership model, which has been promoted by the government since 2014. Though it was slow to gather momentum, PPP appears to be becoming an important driver of China's economic growth.
By the end of 2016, the National Development and Reform Commission had approved 19.5 trillion yuan worth of PPP projects. Mainly focused on local infrastructure development, these projects actually represent the continuation of the old fixed-asset investment growth model, effectively a form of stimulus by stealth.
Government support for the PPP model ensures positive media coverage, but within Chinese social media, comparisons are being drawn with the government's 4 trillion yuan stimulus package in 2008. This was roundly criticized by Chinese economists for producing wasted investment and increased debt. A recent popular blog post draws parallels between that package and current policy, raising the concern that PPP investment might be "storing up trouble in five years' time."
Local government debt totaled 10.7 trillion yuan in 2011, but had reached 24 trillion yuan by 2014, according to a 2015 report to the National People's Congress.
The major catalyst for this rapid accumulation of debt was China's real estate market. Following land reform in 2003, local governments were able to confer land usage rights on local government financing vehicles (LGFVs), which could then sell the rights to property developers and state-owned enterprises working on local infrastructure projects. Since land auction revenue far outstripped the compensation paid to local residents, local governments used LGFVs to obtain more land to secure revenue for their localities.
Local debt carousel
The problem was that increasing amounts of money were required up front to pay for land compensation and development, triggering the local debt carousel. This involved first tapping out bank loans, then using the land as collateral for more loans, then switching to more expensive unsecured trust loans, then swapping the bank loans for cheaper bonds. Then came the PPP model.
If deleveraging cannot be achieved in the short run, at least local government debt burdens can be eased by rolling over old debt with new debt at lower interest rates. In practice though, the PPP model is replicating earlier loan patterns. Land sale revenues are relied on to pay a fixed return at regular intervals to a private partner -- comparable to loan interest -- and the local government promises to buy out the private partner's equity share at the end of the project, equivalent to the repayment of loan principal.
According to Chinese media reports, fiscal revenues are being offered as guaranteed security on loans, making the PPP model a contingent liability for public finances.
The difference this time around is that PPP debt is recorded off of government books, helping Beijing to meet its 3% budget deficit target for 2017. The danger with this approach is that officials may conceal debt risks, creating future budget shortfalls.
Vice Finance Minister Shi Yaobin expressed concerns in December that some local governments are raising debt for unsuitable projects, have expanded the scope of projects for the sake of boosting GDP growth, or have merely stuck the PPP label on commercial projects.
"These practices... affect the promotion of the PPP model, and increase local governments' debt risk," Shi said.
In March this year, the finance ministry warned again that higher borrowing has increased "the hidden debt risks of local government." The same month, economists from the World Bank warned that after 2015, "LGFVs continued to borrow and increase their liabilities at a very rapid pace" while provincial governments "have very limited information about the off-balance sheet finances of local governments."
So why is China gambling on an economic growth model haunted by ghosts of policy past?
The PPP model has a key advantage over the old local government financing model, and this relates to investment efficiency in an economy where 4 yuan of credit is now needed to create 1 yuan of GDP growth. According to Yin Heng, a researcher at the National Academy of Development and Strategy of Renmin University of China, an important countermeasure to declining credit efficiency is to "relax market access restrictions for private investment."
If implemented properly, with proper legal protections and fair rules for competition between state entities and private investors, then the PPP model could help to jumpstart private investment and boost local project efficiency.
However, without such protections in place, private companies will remain reluctant to invest, which means that the long-term benefits of the PPP model risk being undermined by short-term local government targets.
Christopher Aston is an associate consultant at global risk consultancy Control Risks in Shanghai.