[SHANGHAI] Falling tax revenue and the plodding pace of local governments' refinancing through municipal bonds means that China could face a serious fiscal squeeze on the local level, forcing Beijing to intervene more aggressively to avert a Chinese "fiscal cliff".
A consensus is forming in financial markets that the People's Bank of China (PBOC) is behind the curve with its monetary easing. China's money supply grew at is slowest pace on record in April while HSBC said in a report on Tuesday that real monetary conditions in March were the tightest since 2009.
That makes fiscal stimulus even more important in reviving the economy but the worry is that local governments will not be able to spend enough as they have yet to refinance their debts.
To bolster the recovery, the government has projected a 10.6 per cent increase in spending this year and the largest budget deficit since 2009.
Beijing hoped that a quadrupling of the municipal bond market would provide a channel for local governments to refinance expensive debt, creating more room to spend.
But not a single municipal bond has yet been issued this year.
Jiangsu province is set to auction the year's first municipal bond on May 18 after a one-month delay that was widely blamed on a lack of buying interest from banks already struggling from falling interest rates and rising non-performing loans.
On Friday, highlighting these fears, the Ministry of Finance, the central bank and the banking industry watchdog jointly urged banks not to cut off funding to local government-backed construction projects facing a funding shortfall.
In the meantime, the central government may have to spend far more itself to make up for local governments' inability to do so, sources and analysts suggest.
The root of the problem is China's US$3 trillion pile of local government debt, mostly raised at high rates through off balance sheet "local government financing vehicles" (LGFVs).
To rein in this borrowing, Beijing has banned local governments from raising funds through LGFVs but freed them to issue on balance sheet municipal debt in a strategy dubbed"closing the back door, opening the front door." But with just 400 billion yuan in 2014, there are concerns that the municipal bond market is too small to do the job.
"If China stops local governments from borrowing through the existing illicit channels, but doesn't open up new ones, then the spending supported by this borrowing will stop," wrote Chen Long, China Economist at economic consultancy Gavekal Dragonomics back in January when the new policy was announced.
Local government spending is projected to rise 10.2 per cent and account for a significant portion of this year's overall 10.6 per cent increase in government spending.
However, such projections may prove unrealistic as municipalities battle slowing revenue from land sales - a big portion of their budgets.
"As of March 2015, land revenue has fallen 30 percent, worse than assumed in the budget," wrote Julia Wang, China Economist at HSBC in a research note on May 7. "The implication of weaker-than-expected revenue growth is that the government may be forced to scale back expenditures to keep the fiscal deficit in check."
In late April the finance ministry highlighted these concerns, telling local governments to "urgently" issue new municipal bonds to cover funding shortfalls.
The central government, meanwhile, may have to step in with additional fiscal stimulus and incentives to entice banks to buy municipal debt.
For one, the PBOC will soon offer cheap loans backed by the newly-issued municipal debt with the aim of spurring demand.
The central government also has plenty of firepower left, including 1.7 trillion yuan of fiscal deposits, Ms Wang added.
But mobilising funds and getting projects off the ground will take time, which means the economy could be in for a rough few quarters yet.