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The entrepreneurial spirit of Ma Yijiayi, a 43-year-old businesswoman in China’s struggling construction sector, should have been celebrated by the government. Instead, she was arrested earlier this year by local police in the poorly developed mountainous province of Guizhou in southwestern China for trying to recoup unpaid fees from a city government. Her arrest sparked public outcry in China after it was reported by a state-run newspaper.
According to reports verified by the Wall Street Journal, the district government owed Ma RMB220 million (approximately $31 million) in unpaid fees for multiple government-financed construction projects, among countless such projects backed by local governments trying to jumpstart their economies across the country. Offered only RMB12 million (or $1.7 million), Ma and her lawyers rejected the offer, only to find themselves detained by local police soon afterwards.
This episode illustrates some of the most formidable economic challenges China faces today. Because of the worsening fiscal situation of local governments, driven by their plummeting land revenues and massive debts, missed payments to private enterprises are on the rise, contributing to China’s slumping business confidence.
Moreover, it reveals the flaws in a key aspect of China’s growth model that some economists call the “mayor economy,” which refers to the pivotal role played by local governments in the nation’s rapid economic growth. Yet over time the mayor economy has also given rise to many distortions in the Chinese economy, including corruption, massive debt, local protectionism, and overcapacity. Chinese policymakers are now struggling to deal with the legacy created by out-of-control localities like Guizhou.
Private firms bear the brunt of local governments’ worsening fiscal situation
The construction projects that Ma’s company built in the city of Liupanshui in Guizhou are typical of the extravagant investments pursued by many local officials seeking to grow their economies. The projects include a whipping top-themed museum, part of which has now become a grocery store, a resort that is now abandoned, and a partly completed bike racetrack. The local party boss was hoping these attractions would transform his sleepy city from one reliant on coal and steel production to a popular tourist destination. But it did not work.
To build all those projects, the local party boss raised RMB150 billion or $21 billion in debt (the city’s annual output is only RMB130 billion or $18 billion) through six newly established financing vehicles, backed by the sale of local land parcels or income projections from future land sales as collateral. These vehicles were an attempt to circumvent the formal fiscal system, a common practice pursued by many other local officials. On top of that, the local government also incurred “hidden” debt in the form of promises to pay contractors like Ma. The government is now struggling to repay both its explicit and hidden debt.
Other local governments face similar situations, marked by different degrees of revenue shortfalls caused by the property collapse. Many are also delaying payments to their private contractors. Government audits in 2023 already found that this debt crunch afflicts many provinces. In Henan, for example, local governments and state entities owe at least RMB10 billion to private companies, the audit reported.
In such dire situations, private businesses are presumably among the last to receive promised fees from local governments, after other creditors like local banks or state firms. As a result, the Chinese economy is suffering from low confidence among private entrepreneurs, many of whom are reluctant to make long-term investments. Any serious government efforts to restore business confidence must therefore include repayments to private enterprises.
Another noteworthy aspect of this episode is the role of the local court, which initially ruled that the local government needed to repay Ma and ordered to freeze part of the assets of the debtor state entity. Yet the court lifted the asset freeze shortly afterwards, reportedly at the order of local party leaders.
The dubious role of the local court in Ma’s case speaks to a fundamental concern of many private entrepreneurs about China’s judicial system. Local courts largely answer to local party secretaries. In cases like Ma’s where there is a conflict of interest between a private business and a local government, interference from the party boss can obviously undermine the private business’s legal rights.
While it is unlikely China will have an independent judicial system any time soon, it should at least try to minimize administrative interference in local courts. China is in the process of making a new law to promote the private economy. The law should emphasize proper protection of the private sector’s legal rights and the important role of independent local courts.
The “mayor economy” model needs to be fixed
The bad financial decision making by local party bosses is rooted in the way China promotes its bureaucrats. To get promoted, local officials must achieve economic growth in their jurisdictions, what scholars call a “promotion tournament” that encourages competition. But an unintended consequence of the tournament is that it also tends to reward profligate behavior.
China’s fiscal system is decentralized on the spending side but centralized in revenue collection, giving local governments many spending obligations but not enough resources to support their spending. To fill the gap, local officials resort to land sales and off-budget borrowing to try to expand their local economies.
Also incentivizing irresponsible behavior, China frequently moves local officials from post to post across the country. The rationale is to prevent officials from developing overly close local interests that could lead to corruption and even rebellion against the central government. But this system also encourages officials to borrow recklessly without worrying about the consequences because they know that they will move on to another location and won’t be held accountable.
As shown by Professor Justin Yifu Lin of Peking University and his coauthors, public investment in infrastructure financed through off-budget channels has played a positive role in generating rapid growth. Yet local officials competing to outdo their peers has also led to overinvestment and excess capacity. And the beggar-thy-neighbor policies adopted by many localities have resulted in the rise of local protectionism. China’s booming electric vehicle industry is a case in point in this regard.
To be fair, the thousands of entrepreneurial mayors across China have played a critical role in creating the country’s economic miracle. But the distortions created by the mayor economy model are now increasingly a barrier to sustaining growth. China’s leaders proclaim the need for high-quality growth. That goal cannot be reached without fixing the way they promote local officials. Greater coordination and cooperation among local officials should be encouraged. In the meantime, the current fiscal system needs a revamp to better align local governments’ revenues with their spending needs.
Data Disclosure
This publication does not include a replication package.
