Ⅲ．To Overcome the Soft Budget Constraints

A．The Soft Budget Constraints in Local Governments

Local debt problems urged us to rethink the administrative authority between central and local governments, and then we find the starting point is to put forward the degree of the relations under the rule of law in our country as a systematic solution to solve local debt problems．However, on the one hand, we shall realize that weather any policy suggestions have practical utility, it cannot be tested by some abstract principles．“The rule of law”or “fiscal federalism”is a kind of politically correct “top-level design”, an ideal imagination of the modern state governance, but if we cannot explore how to use them in detail, we will fall into the daydreams．On the other hand, any system cannot exist in vacuum, they always connect and mix with each other, so we cannot judge some systems only from a single perspective, and we also need to consider if there will be a better new system after we break up the existing system.

Furthermore, in the construction of the administrative authority relations in our country, one aspect that cannot be ignored is that how to effectively control the “Soft Budget Constraint”of local governments．Legalization and de-administration in central-local relations can help to clearly define the distribution of power between governments, reduce the unconstrained expenditure responsibility for decentralization, and the revocation of local financial power, and alleviate the pressure of the local spending and the subsequent financing debt demands; However, to improve the legislation cannot to restrain the expansion of the budget in local governments at present stage,^[1]China's political system can be used as an effective means of control in weak legislation, while if local autonomy entertains a high level of legal protection, the existing political control measures will be eliminated．That will bring us a worry: how can we use the mechanism to prevent the local budget “runaways”at this point? If we cannot give a satisfactory answer, local debt problem cannot be solved and will become more out of control, this is a “trap”that is reminded in this article.

From the public choice theory, the bureaucrats and ordinary people are the subjects of personal interests．The main factors of bureaucratic personal interests are power, status, money and privilege, etc．These goals are positively associated with bureaucratic organization's budget scale, and the budget size and scale of the government are positively associated with the government power, namely the government has more budgets, the powers are much greater, the head of agency's positions are higher and the agency's social resources are more．Therefore, to pursue their own status, power, and income, the government officials will try their best to expand the budget and the scale of the department.^[2]This is a general description of “soft budget constraint”on governments around the world in economic theory.^[3]In our country, we can see the reality that demonstrates this theory．However, we cannot limit the reality of China's administrative authority relations, local government officials and government in the financial market and debt instruments showed as enterprise's enthusiasm, the intrinsic motivation is actually made at the present with a series of written or unwritten governance mechanisms.

In many mainstream scholars' point of view, the separation of powers between central and local governments is a kind of “Chinese federalism”, which is demonstrated by the fact that there will be a competition between jurisdictions, which relates to factors of production, resource, foreign investment, etc.^[4]And that will make local governments financing excessive in order to meet the demand of current investment, which is different from the classical sense of fiscal federalism described that local governments have race to the top in order to know more about this jurisdiction's resident preferences,^[5]but have race to the bottom to strive for more economic growth through preferential policies or the government's debt financing to attract more scarce capital．In short, there is a strong display for political demand, and this kind of demand is a “like father, like son”product．More than 30 years of reform and opening-up, the central government has the main performance evaluation mechanism is the growth rate of GDP as the core indicators, this mechanism is a kind of “championship”political incentives for local officials,^[6]thus forming a kind of yardstick competition^[7]in local governments based on the evaluation of the higher level governments．This kind of “assessment measures”from the central government to the local governments hopes to win the competition of GDP, therefore the local governments will spare efforts to the construction of infrastructure, investment promotion, etc．hoping to have immediate “datum”, at the same time, they have no incentive to promote a long return cycle of basic public services of technical people, this is also one of the factors that lead to increasing social conflicts in our country in recent years.

Objectively speaking, the economic growth has become a successful experience in our country that by the competition between local governments and its officials in recent decades, it is an incentive effect based on the separation of the political structure of economic decentralization and political centralization.^[8]But at the same time, it also creates the opportunistic behavior in local governments, and brings some negative effects．The “promotion tournament”in local officials has some positive effects on the economic growth indicators, but on the other hand, it also inevitably amplifies the problems of the “soft budget constraint”．In order to win the competition to realize the political promotion, local officials will use all policy tools (including fiscal and financial tools) to support the expansion of business and other enterprises．These low-quantity expansions just pay attention to quantity rather than quality, which will lead to enterprise underperforming and fiscal deficit in governments.^[9]

In fact, in order to struggle for controlling resources, when governments face soft budget constraints and ambiguous financial property rights, they will do all kinds of financial “innovations”．In accordance with Table 1,^[10]which lists different innovation types by local governments in China at different periods of time, the mass debt financing is the performance of the current stage of development in local governments.

In this case, the relationship between central and local governments is tangled．On the one hand, economic development goals in the central need local governments to achieve, and the central government's macroeconomic policy implementation must also rely on local governments to cooperate due to the unsound market mechanism．On the other hand, the excessive debts of local governments make the central bear potential risks．Although, there is no law in China that has stipulated that the central government should bear joint liability for the debts of local governments in theory,^[11]but if local governments get into the debt repayment troubles, it is hard to imagine that the central government will stand aside．There are two main reasons: (1) the local debt repayment can directly affect the robustness of the financial system, and to maintain financial stability is one of the important political responsibilities for the central government.^[12](2) under the unified leadership of the ruling party, the relationship between central and local governments are not two separate entities, and central and local governments are integrated in essence, because it is a matter of the ruling party and the country's social trust．There is no doubt that such kind of political structure is a factor that local governments borrow too much debt.

Some people think that the ideal fiscal federalist states must satisfy a condition that the local governments have strict budget constraints to prevent the unconstrained financing demands in the government,^[13]because the local governments have neither money creation ability, nor the infinite borrowing channels．The central government will not save local governments in financial crises, only this can make a Market-preserving Federalism.^[14]Obviously, promoting only legislation in the relationship between the central and local in China is not enough to realize the real fiscal federalism, but may set up a “trap”．To this end, the conjunction in systems and policies are indispensable.

When discussing the legal transformation in administrative power in central-local relation and specially emphasizing the “soft budget constraint”in local government, we want to explain such a truth: one of the reasons of large-scale local debt is their unsmooth relationships, and the key point to solve this problem is to incorporate the relationship into a legal framework．However, the institutional reform is not simple, and this method may cause a further ease of the budget constraints on local governments, so we must make a systemic arrangement when we transform the system to avoid the “trap”．Specifically, on the one hand, we need to improve the legislation in the division of the central-local relation; on the other hand, to focus on reinforcement of local government budget constraints, namely to make the “legislation in central-local relation”and “hard budget constraints in local governments”these two policies become an organic combination.

B．The Moral Hazard in Local Governments' Debts

No matter in theoretical derivation or the reality, local governments in China have a natural tendency to expand．This fact worries the central government about the expansion of local debt which will bring serious negative effects on national financial system and its security．Therefore, since June 2010, “Notice of the State Council on Issues Concerning the Administration of Local Governments' Financing Platform Companies”(the State Council, No.19 ［2010］) released to clean up the financing platform companies to control the local debt scale and risk prevention work has become a political task．Actually, in recent two or three years, under the circumstances that the relation is not to be straightened out, a series of rectification work may be considered and the central government in the face of potential crisis take some periodical measures to strengthen “hard budget constraint”on local governments.

To improve the rule of law of central-local relation is considered to be a design scheme to solve the imbalance of the central and local fiscal relationship on rights, responsibilities and benefits．In theory, the legal transformation in central-local relation will help to change the relationship that “financial power centralized and the responsibilities are decentralized”between governments to prevent the heavy responsibility of local government expenditure．It also makes clear of the power that the local governments can independently exercise the authority over economic and social management．In short, to improve the rule of law in central-local relation in the present China's political structure may produce more obvious “local autonomy”．In a positive sense, it can contribute to the reduction of local government financing demands since their expenditure responsibility is legal and predictable, therefore, in the long run, it has the effect of controlling debt scale expansion.

However, in the existing China's political structure, to improve the rule of law in central-local relation is not only enough to create a full sense of “local autonomy”but a “pre-local autonomy”．A full sense of “local autonomy”includes not only the independence of the “power”, also emphasizing the independence of “responsibility”．If we just do the former, it is just “quasi-local autonomy”．While in the process of improving rule of law, we have to focus on the protection of local autonomy, the policy itself is difficult to strengthen local responsibility independence, even to make the responsibility independent problems more prominent．Specifically, in the original central-local relation, the central has the dominant power, so it can use the operation of the political mechanism to supervise the local governments to achieve “hard budget constraint”, if the approval of large infrastructure in urban rail transit constructions has been concentrated in the central government, or the approval rights centralized in the central government if the economy is heated, all these practices are to control the local fiscal expenditure, which can play a role in constraining the expansion of the local debt scale．Clearly, this is a political mechanism, not a legal governance mechanism for the local government to achieve “hard budget constraint”.

Let us imagine that if the rule of law of the central-local relation in China is significantly improved and the arrangement of this relation is based on laws, the existing control mechanism is likely to be less effective, so the thing is how to use these control mechanisms to ensure the local “hard budget constraint”, and to realize the market-maintained fiscal federalism?

In theory, if there is a complete sense of “local autonomy”, local governments as limited liability companies will have independent personality, independently bear debt, and the problems will not exist, because local governments have no reason to go beyond their ability to repay the ultra-limit financing, so the debt scale is be controlled naturally．However, it is hard to expect a limited liability company of local governments, especially in China．In fact, we can find that, in the process of local government debt financing, there are a lot of moral hazard^[15]problems (some problems are prevalent in other countries, and some are unique to China), thus making the local debt scale beyond the limits．Therefore it must draw some kind of control mechanism, otherwise, local government behavior will be out of control．Specifically, in the process of local government financing in China, the moral hazard problem can be divided into three levels.

The first is the moral hazard of local governments．The local government, which can independently take the responsibility, should not expect that the higher level governments will take joint liabilities on the incurred debts．However, in terms of the current relations at all levels of governments in China, the independent responsibility to each other is quite weak．When we emphasize that “subordinates obey superiors”, we also imply that the “superior should take responsibilities for subordinates”．In the case of local government debts, the central government's “recessive guarantee”or “catch-all responsibility”are actually encouraging the arrangement of borrowing system in local governments．An example is that China's local bonds are “sold”by the central government, rather than the local governments sell them at present．Based on October 20, 2011, “Measures for Pilot Independent Issuance of Bonds by Local Governments in 2011”, Shanghai, Zhejiang, Guangdong, Shenzhen will become the first pilot areas, but the interesting thing is the bonds winning rates in these four pilot areas, which have been undertaken by the central government, are lower than the market interest rate．It reflects that local government debts are closely linked with the central government credit in investors' sub-consciousness.^[16]

The second is officials' individual moral hazard to local governments, exemplified by “the former borrowing, the latter paying debts”．In incentive plans of enterprise managers, we can easily find the measures that can encourage the managers to pursue company's long-term goals, such as to give managers shares or options．However, it is difficult to make similar long-term incentives for local government officials and to make the local government's long-term goals ignored.^[17]Currently, the local debt problems are like “deficit spending”．Another thing needs to be mentioned is that the China's political system generally has a set of unwritten rules of “taking offsite positions”, in other words, the office location of a local senior official is often not long．This practice can cut off the official network of relations and prevent corruption, but it also can cut the constraint of relations network with local people, strength the individual moral hazard and make officials' behavior short-term.

The last is the moral hazard of the creditors．The debtor's borrowing capability is decided by the creditor's willing to provide financing．Therefore, the debts of the debtors are always constrained in the financial market, because rational creditors have no reason to lend a debtor who is not sufficiently capable of paying off the debts．But in the operating level, the creditors in financial markets have different opinions about the local governments and its financing platforms compared with those about a company regulated by the Company Law．In financial institutions or other creditors perspectives, on the one hand, local governments' fiscal revenue (taxes, all kinds of charges, land use rights, the property rights of state-owned enterprises, etc.) in the future can be used as a guarantee to pay its debts; on the other hand, China's local governments will not be bankrupt like the states in the United States;^[18]when a solvency crisis appears, the central government will not stand aside．Based on this reason, our country's financial institutions are keen to carry out the cooperation between banks and governments in recent years, such as the increasingly popular “bundling loans”, “developmental financing”^[19]and “innovation business”．The scale of local debts is expanding, and the moral hazard of the creditors has become a serious problem.^[20]

[1] See Zheng Yongnian, De Facto Federalism in China: Reform and Dynamics of Central-local Relations, World Scientific, 2007.

[2] See Johnathon Rodden, Gunner S．Eskeland ＆ Jennie Litvak (eds.), Fiscal Decentralization and the Challenge of Hard Budget Constrains, The MIT Press, 2003.

[3] See William Niskanen, Bureaucracy of Representative Government, Aldine-Atherton, 1971, p.38.

[4] See Gabriella Montinola, Yingyi Qian ＆ Barry R．Weingast, Federalism, Chinese Style: The Political Basis for Economic Success in China, World Politics, Vol.48, No.1, 1995.

[5] See Charles Tiebout, A Pure Theory of Local Expenditure, Journal of Political Economy, Vol.64, No.5, 1956, pp.416-424.

[6] See Zhou Li'an, The Studies of China's Local Officials Promotion Models, Economic Research, Vol.7, 2007.

[7] See Zhang Yan, The Fiscal Policies and Economic Growth Under the Separation of Powers, Shanghai People's Publishing House, 2005, p.15.

[8] See Lu Ming, et al., The Development Road of China's Economic, The Encyclopedia of China Publishing House, 2008, pp.51-52.

[9] See Zhou Li'an, Li Hongbin, Chen Ye, The Relative Performance Evaluation: A Study of Chinese Local Officials' Promotion Mechanism, The Economic Journal, Vol.1, 2005.

[10] See Shi Hongxiu, Fiscal Decentralization, Government Competition and Local Government Debts in China, China Financial and Economic Publishing House, 2007, p.134.

[11] In previous framework of the Budget Law, the central government undertakes the first payment obligation, rather than complementary liabilities.

[12] See The Audit Results of Government Debts at 36 Local Governments (the announcement of National Audit Office: No.24, 2013), Jun.10, 2013.

[13] See Barry R．Weingast, Second Generation Fiscal Federalism: Implications for Decentralized Democratic Governance and Economic Devel-opment, Working Paper, Hoover Institution and Department of Political Science, Stanford University, 2006.

[14] See Barry R．Weingast, The Economic Role of Political Institutions: Market-preserving Federalism and Economic Development, Journal of Law and Economic Organization, Vol.11, 1995.

[15] See John Intver, Murray Mirgheit, Peter Newman, The New Palgrave Dictionary of Economics (3rd volume), Economic Science Press, 1996, pp.589-588.

[16] See The Principal Local Debt Rate Is Related to the Non-market Factors of the National Debt, http://money.163.com/11/1126/0917JPAS4CU00253BOH.html, visited on Jan.5, 2015.

[17] See Lu Ming, et al., The Development Road of China's Economic, The Encyclopedia of China Publishing House, 2008, p.80.

[18] See the nine chapter of Reorganization for Municipalities in Bankruptcy Code.

[19] See Li Zhihui, Li Weibin, The Developmental Financial Theory, Policy and Practice in PRC, China's Financial Press, 2010; Chen Yuan, Government and Market, Citic Publishing House, 2012.

[20] The Guarantee Law of the People's Republic of China, Article 8 provides that “State organs cannot act as guarantors, except for sub-lending of loans from foreign governments or international economic organizations.”