China's Cities Face a Fiscal Cliff as Calls for More Spending Grow

Governments in Washington and Brussels are being told to spend less, yet Beijing is being urged to spend more. The contrast raises a puzzling question: why is China's government spending less, and what happens if its most indebted cities can no longer afford to keep going?

At the International Monetary Fund and World Bank meetings in Bangkok earlier this month, IMF Managing Director Kristalina Georgieva called the United States and European countries the "worst offenders" on debt. Her prescription was blunt: "China needs to spend more, the U.S. has to save more, and Europe has to invest more." She also pressed Beijing for more meaningful fiscal stimulus as its economy teeters on deflation. The IMF expects growth to slow to 4.5% this year from 5% last year, and to 4% in 2027.

On paper, the central government has room to borrow. The IMF puts general government debt at about 68.4% of GDP. The larger worry sits outside that balance sheet. Once local government financing vehicles and other off-balance-sheet borrowing are counted, the IMF estimates augmented government debt reached around 126.6% of GDP last year, a level comparable to developed markets such as the U.S. and Europe.

For decades, local authorities paid for roads, rail lines and industrial parks by selling land to developers. That income has collapsed since the property slump began in 2021. CF40, a Beijing think tank that co-hosted last week's Bund Summit in Shanghai, estimates land-sale income has more than halved, to 4.2 trillion yuan (about $590 billion) from 8.7 trillion yuan. Beijing has also moved to stop local governments from building up new hidden debt, which removed a key engine of growth.

The effect on spending has been sharp. Ting Lu, chief China economist at Nomura, estimates that combined fiscal spending fell 3.5% in the first eight months of the year, after growing 3.6% last year. He described it as a "true fiscal cliff" that is now a real drag on the economy. Urban fixed-asset investment fell 3.8% last year, its first decline in decades, and dropped 7.2% in the first three quarters of this year. Beijing kept its official deficit target at about 4% of GDP, but the Institute of International Finance estimates the real deficit could reach as much as 9%, and says even that looks insufficient.

Authorities have ordered state-backed borrowers to clear hidden debt and become market-oriented commercial state-owned enterprises by mid-2027. S&P Global Ratings says hidden debt in such vehicles shrank to 6.5 trillion yuan ($973.3 billion) last year from 14.3 trillion yuan in 2023. Many of them, however, still lack the cash flow to pay interest and remain weighed down by unprofitable public projects.

The IMF wants Beijing to adopt a medium-term fiscal framework that allows China to "expand fiscally in the near-term [to reflate the economy] but claw back the support over the medium term so that you ensure debt sustainability," said Krishna Srinivasan, director of the fund's Asia and Pacific department. The fund also urges China to abandon point growth targets, arguing they push local officials to overinvest to hit the number, leading to resource "misallocation" and rising provincial debt.

The stakes are high because a local government default could set a dangerous precedent. "No one wants to be the first local government official to default," said Logan Wright, partner at Rhodium Group. But once one does and Beijing steps in, he said, the rest can expect the same bailout, which means local officials' priorities may sometimes run counter to Beijing's. "They actually want to default."

Attention now turns to a busy calendar. China's Communist Party holds its fifth plenary meeting from Oct. 26 to 29, industrial profit data is due on Oct. 27, and the official manufacturing PMI for October follows on Oct. 31.