A New Approach to Fiscal Stability: Enhancing Risk-Sharing Across China’s Provinces

The IMF study examines China's fiscal transfer system, highlighting its effectiveness in reducing inequality but identifying the need for improved risk-sharing mechanisms to better manage regional economic shocks. Proposed reforms include linking transfers to province-specific shocks for enhanced fiscal stability.

A recent IMF Working Paper by Fei Han, Bin Grace Li, and Chenqi Zhou, explores the challenges of fiscal risk-sharing across China's provinces. Conducted by the Institute for Capacity Development and the Asia and Pacific Department of the IMF, this study sheds light on how fiscal transfers have helped mitigate economic shocks among China's local governments. The backdrop for the research is the growing fiscal pressure on local governments, exacerbated by the COVID-19 pandemic and the country's ongoing property market stress. For decades, local governments in China have experienced increasing fiscal gaps due to a significant mismatch between their revenue-generating capabilities and high expenditure responsibilities. This gap, particularly pronounced before the pandemic, underscores the need for enhanced fiscal risk-sharing mechanisms to ensure financial stability at the local level. The current system of transfers from the central government (CG) has played a dual role: providing redistribution to equalize fiscal resources across provinces and sharing risk to mitigate the effects of region-specific economic shocks. However, the primary focus of these transfers remains redistribution, with a limited emphasis on addressing economic volatility at the provincial level.

Fiscal Gaps and the Role of Central Transfers

The paper points out that the existing transfer system is based on a framework where central government funds are allocated according to the relative fiscal strength of each province. This system ensures that poorer provinces receive larger shares of financial assistance to help them close fiscal gaps and meet their expenditure needs. While this has contributed significantly to reducing inequality between provinces, it has not fully optimized the ability of local governments to respond to economic shocks, particularly those triggered by crises like the pandemic. The COVID-19 crisis highlighted these shortcomings, as many local governments experienced widening fiscal deficits. Despite increased fiscal transfers and local government bond issuances during the pandemic, the ability of local governments to conduct countercyclical fiscal policies—measures that could boost local economies during downturns was constrained. Provinces hit harder by COVID-19 or property market slowdowns, such as Hubei and Heilongjiang, saw substantial declines in revenues, limiting their fiscal flexibility despite receiving more central government support.

A New Approach to Fiscal Risk-Sharing

The authors propose an alternative transfer mechanism that could improve risk-sharing without sacrificing redistribution. In this model, transfers would be linked more directly to the specific economic shocks experienced by each province. By targeting assistance based on real-time needs, the central government could enhance the ability of provinces to respond to localized economic difficulties, whether caused by natural disasters, market failures, or pandemics. The paper's counterfactual simulations demonstrate that this alternative approach could significantly increase the effectiveness of fiscal transfers in smoothing the effects of regional shocks. Under the proposed system, provinces facing significant economic downturns would receive larger transfers proportional to the size of the shocks, ensuring that fiscal resources are distributed in a way that maximizes risk-sharing while maintaining a comparable level of redistribution.

Data Shows Room for Improvement

Using data spanning from 2006 to 2020, the research estimates that China’s fiscal transfers have, on average, smoothed about 31% of permanent shocks across provinces, a figure higher than that observed in many advanced economies. In terms of temporary shocks, the current system has smoothed only 17% of the impact of idiosyncratic regional shocks, which is comparable to other major economies but still leaves room for improvement. The study finds that risk-sharing is more effective in less-developed inland provinces, which are more reliant on fiscal transfers, than in more developed coastal provinces. Coastal provinces, with their diversified economies and better-developed financial markets, rely less on central government transfers for risk-sharing and are able to absorb shocks through private channels such as financial markets and local revenue generation.

Reforms to Strengthen Fiscal Stability

The authors stress the need for ongoing reform in China’s fiscal framework. They suggest that incorporating cyclical economic factors into the transfer formula would help address the disparity in how provinces experience economic shocks and improve the system’s overall efficiency. This would involve adjusting the current rules to include provincial GDP fluctuations or regional business cycle data to better allocate funds in response to specific economic conditions. In addition, reducing the dependence of local governments on land sales for revenue generation—a key source of fiscal stress as the property market cools—is seen as essential for long-term financial stability.

The Path Forward for China’s Fiscal System

The study concludes that while China’s current system of fiscal transfers has been relatively effective at redistributing resources and mitigating some of the impacts of economic shocks, there remains significant potential to enhance the risk-sharing function. By reforming the transfer system to focus more on the specific economic conditions faced by each province, China could further strengthen the resilience of its local governments to future crises. This would not only improve fiscal stability but also support long-term economic growth and equity across the country. With stronger fiscal risk-sharing mechanisms in place, local governments would be better equipped to manage the financial pressures of economic downturns and other regional shocks, ultimately contributing to a more stable and balanced national economy.