The fiscal policy and soft budget constraints of China

Academic Paper, 2019

8 Pages, Grade: A


Table of contents

Fiscal sustainability in China

‘Soft’ budget constraints (SBC) in China

Literature summary and research hypotheses


Literature review on china fiscal policy sustainability and soft budget constraints


This chapter provides a critical review and discussion of studies that have been conducted in the past regarding the current topic. In the first part of the chapter, the researcher explains the concept of fiscal sustainability and reviews some of the fiscal policies adopted by China to realise fiscal sustainability. The researcher also evaluates the challenges towards attaining fiscal sustainability in China. In the last part, the researcher discusses the concept of soft budget constraint and how it has been cultivated into China’s fiscal policies. The final part summarizes the gaps in literature and suggests hypotheses for the current study.

Fiscal sustainability in China

Fiscal sustainability (public finance sustainability) has been defined in numerous ways. According to European Commission, fiscal sustainability is simply defined as government’s ability to maintain current levels of spending and taxation without threatening solvency in the long run (Celacean and Aligica, 2004). Fiscal sustainability is also defined as the government’s ability to maintain public finances within a credible and serviceable level over a long period of time. In this regard, to achieve fiscal sustainability, the government will be expected to continually engage in strategic forecasting of the future revenues and liabilities, analysis of the environmental factors as well as various socio-economic trends (Lu and Zhong, 2018). Though researchers and economists around the globe have defined fiscal sustainability differently, the researcher adopts the European Commission definition as it is more consistent with the definition used in published reports which attempts to analyse sustainability of fiscal policies based on the long run economic projections of various countries. Based on this definition, researcher has assessed the sustainability of various fiscal policies by analyzing the size of long-term fiscal imbalances. In many studies, government deficit has been identified as the main indicator of fiscal imbalance (Tian and Estrin, 2007). The use of deficit in assessing fiscal sustainability is also important in identifying challenges that hinder attainment of fiscal sustainability.

Multiple reports showed that there are numerous challenges and threats to fiscal sustainability ranging from institutional weaknesses to fiscal responsibility laws among others (Ben-Bassat, Dahan and Klor, 2016, Fan and Arghyrou, 2011, Luo, 2014). Though the factors are important in determining the fiscal position of a country, some studies indicated that the proportion of government debt to GDP is the core indicator for assessing the health of the country’s public finance sector. For example, where a country’s public finance is characterised by a high debt to GDP ratio then it becomes more susceptible to interest shocks and negative growth rate. Given that China had one of the most impressive GDP growth rates in the last two decades, one might assume that it has a healthy public finance. For instance, in the last decade, China recorded an average growth in fiscal income of 20 percent annually with a budget deficit of around 1.5 percent as of 2012 (Tsuji, 2015). However, one cannot ignore the role of fiscal decentralization in Chinese fiscal income growth. In this regard, to get a true picture of Chinese’s public finance health, one must also look at the local government programmes especially their source of funding.

Fiscal decentralization encompasses the national government shifting some of the spending and revenue collection responsibilities to lower levels of government. The primary element of fiscal decentralization is giving subnational entities significant autonomy in determining the allocation of their expenditures (Chow, Song and Wong, 2010). In China, local government initiatives played a crucial role in the country’s development success of the past decades. For instance, the local governments provides massive physical infrastructure boost that supported rapid economic growth of the past decades. However, with slowing economic growth rates, average returns from public investments have also decreased significantly leading to increases in debt, misallocation of capital and increasing microeconomic risks (Jianhai, 2008). Due to the massive levels of debt accumulated by the local governments, China’s national government adopted a major fiscal reform in 2014 with an aim of bringing subnational debt under control and reorienting budgetary institutions towards fiscal sustainability (Vahabi, 2014). However, the government has found it difficult to keep these local governments under fixed budget thus nurturing ‘soft’ budget deficit constraint phenomenon. Woo (2017) indicate that this phenomenon has enhanced other fiscal challenges such as higher spending than revenues, heavily indebted local governments, rising social welfare costs and a vulnerable housing market.

‘Soft’ budget constraints (SBC) in China

SBC can be described as a phenomenon that arises when the source of funding finds it impossible to keep a public entity on a fixed budget (Maskin and Xu, 2001). For example, SBC occurs when a public enterprise is extracting more than efficient levels of loans and subsidy. The national government can also offer financial bailout to state owned corporations to rescue them from financial failure (Bignebat and Gouret, 2008). In China, indebted or insolvent local government entities rely on the national government to rescue them. In summary, when an organisation has a soft budget constraint, it can count on the government for financial support implying that the budget constraint is constantly breached. SBC theory indicates that state ownership is the main catalyst of SBC effect. In China, the SBC effect is more severe due to high levels of state ownership. Apart from the local governments, the state owned banks and retained state ownership in China’s SIP firms provide fertile grounds to nurture the SBC effect. Studies indicate that state owned enterprises in China have better access to credit from state owned banks and can count on financial assistance from the government during distress.

According to Janos Kornai, a government can always deploy multiple fiscal means or indirect support to state owned entities to soften their budget constraints (Megginson, Ullah and Wei, 2014). Kornai observed that during Hungary’s transition to a market economy in the 1970s, chronic loss making state-owned enterprises was constantly bailed out so that they do not fail. Li, Lin and Selover (2014) found that persistence of SBCs led to problems such as poor financial commitment and moral hazard. Budget constraint organisations expected preferential treatment in case of financial trouble. To help these organisations, the governments consistently use fiscal means such as subsidies and tax concessions among others. Due to the SBC effect, IMF indicates that the Chinese banking sector has a significantly higher average of non-performing loans compared to major developed and developing countries (Boubakri and Saffar, 2019). This is attributed to the fact that China’s banking system plays a major role in enterprise financing. China also has weak investor protection, corporate governance, accounting standards and quality of government laws and institutions than in those other countries (An and Chong, 2015). In this regard, Chinese institutional environment is very conducive for the SBC effect.


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The fiscal policy and soft budget constraints of China
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Difrine Madara (Author), 2019, The fiscal policy and soft budget constraints of China, Munich, GRIN Verlag,


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