The issue of government debt is a policy and academic topic of international significance. Research and discussion of the issue of sovereignty or local government debt is common in academic circles in both developed and developing countries. In the development of government debt in mainland China, local government financing platforms and implicit debt occupy a particularly important position, which has also attracted the attention of many researchers at home and abroad.
This year marks the 30th anniversary of the 1994 reform of the tax-sharing system in mainland China, as well as the 30th anniversary of the establishment of the National School of Development and the China Center for Economic Research at Peking University. This is an important moment to rethink the fiscal and taxation relationship between the central government and the local government and the construction of the national system. Based on relevant academic research, we will analyze the difficulties and new ideas for preventing and resolving local debt risks and establishing a government debt management mechanism compatible with high-quality development from multiple perspectives such as local debt and corporate accounts, market discipline, judicial reform, fiscal and financial policies, and green and low-carbon transformation, and share and discuss with colleagues.
The Central Economic Work Conference in December 2023 proposed to plan a new round of fiscal and taxation system reform and implement the reform of the financial system. Using a package to comprehensively clean up the stock of local government debt, establish a long-term mechanism for local government debt management, combine market discipline and administrative means to break the expectation of implicit guarantees, and take debt as an opportunity for low-carbon and green digital transformation of the economy, it may become an important starting point for reorganizing the fiscal and tax relationship between the central government and the local government and effectively managing local government debt risks.
This is the second column in a series on local government bonds, based on the following working papers:
Hu, Jiayin, Wenwei Peng, and Yang Su. 2024.“Empowering through Courts: Court Capture and Municipal Financing in China.” Working paper. https://doi.org/10.2139/ssrn.4750742.
(Link to CCER discussion paper: https://www.nsd.pku.edu.cn/cbw/tlg1/535382.htm)
In the last column (we need to add the link to the article on the official account of the National Development Institute here: the problem of corporate account arrears in preventing and resolving local debt risks), we discussed the increase in the proportion of accounts receivable and the decline in the proportion of cash flow after 2017. The increase in equity pledge financing shows that local governments will transmit liquidity pressure to private enterprises under the central government's deleveraging policy of resolutely curbing the increase of implicit debt, demonstrating the complexity of debt as a systematic project and the importance of related supporting policies.
One of the solutions to the problem of the government and state-owned enterprises defaulting on the accounts of private SMEs is to rely on administrative forces, such as the central government to introduce various payment guarantee policies, provide special financial support, and punish units in arrears[1]. In addition, there is also a solution to rely on market forces, which not only refers to the financial services and market construction related to accounts receivable pledge financing, but also includes the role that the judicial system can play as the infrastructure of the market economy.
The importance of the legal system on economic development and the impact of financial markets has been discussed in many domestic and foreign literatures. A fair and efficient judicial system can not only play a role in clarifying the responsibility for payment and helping to recover arrears after the occurrence of account arrears, but also restrain the behavior of defaulting parties through prior deterrence, reduce their motivation to default on accounts, and play a role in "preventing problems before they occur". The fairness and impartiality of judicial decisions requires that courts and judges are not affected by the interference of relevant stakeholders, especially local governments. A relatively independent judiciary is particularly important in cases involving arrears in the public sector.
In my working paper, "Empowering through Courts: Court Capture and Municipal Financing in China", I work with Su Yang, an assistant professor at Chinese University of Hong Kong, and Peng Wenwei, a postdoctoral fellow at Harvard University, to explore the role of "delocalization" in judicial reform in reducing the dominant position of urban investment companies and constraining government lending. We found that when judicial independence was strengthened, the success rate of urban investment companies in judicial litigation decreased, which was conducive to the recovery of outstanding debts by construction companies and suppliers. On the other hand, the judicial reform has led to a decline in the net issuance of local urban investment bonds, an increase in financing costs, and the ability of local governments to borrow through urban investment platforms has been weakened, as well as a decline in urban investment expenditures and land acquisition and storage capacity.
"Delocalization" of the judiciary: Reform of the unified management system of people, property and property of courts and procuratorates below the provincial level
For a long time, the mainland's judicial personnel and local courts and procuratorates have implemented a system of hierarchical management and hierarchical burdens of funds according to administrative regions, which is not conducive to eliminating improper local interference. Under such a system, judicial activities are susceptible to interference by local protectionism, which affects judicial fairness to a certain extent. In November 2013, the Third Plenary Session of the 18th Central Committee of the Communist Party of China (CPC) adopted the Decision of the Central Committee of the Communist Party of China on Several Major Issues Concerning Comprehensively Deepening Reform[2], which proposes to "ensure the independent and impartial exercise of judicial power and procuratorial power in accordance with the law." Reform the judicial management system, promote the unified management of personnel, property and property in local courts and procuratorates below the provincial level, and explore the establishment of a judicial jurisdiction system that is appropriately separated from administrative divisions, so as to ensure the uniform and correct implementation of national laws. ”
In June 2014, the Framework Opinions on Several Issues Concerning the Pilot Reform of the Judicial System were deliberated and adopted at the third meeting of the Central Leading Group for Comprehensively Deepening Reform, which clarified the reform path for provincial-level unified management in the pilot areas. The unified management of personnel is mainly to establish a mechanism whereby judges and procurators are nominated and managed by the province and appointed and removed in accordance with legal procedures. The unified management of property is mainly to establish a mechanism for the unified management of the funds of local courts and procuratorates below the provincial level by the financial departments of the provincial governments. [3]
In accordance with the central government's requirement that major reforms should be carried out on pilot projects, the Central Political and Legal Commission selected seven provinces and municipalities in the eastern, central, and western regions to launch the first batch of pilot projects: Shanghai, Guangdong, Jilin, Hubei, Hainan, Guizhou, and Qinghai. On the basis of the first batch of pilots, in May 2015, the second batch of 11 pilot provinces (autonomous regions and municipalities) such as Jiangsu, Fujian, Chongqing, Inner Mongolia and Ningxia were fully launched. In January 2016, the 19th meeting of the Central Committee of the People's Republic of China decided to launch a pilot reform of the judicial system in 13 provinces (autonomous regions and municipalities) including Beijing and Tianjin, as well as the Xinjiang Production and Construction Corps, which means that the reform pilot will be rolled out across the country[4].
We focus on the impact of the reform of the system of "unified management of personnel, property and property of local courts and procuratorates below the provincial level" in judicial reform. This judicial reform, which is under the control of the Ministry of Personnel, Finance, and Property, will help reduce the personnel and financial dependence of local courts on local governments, and will help local courts exercise their judicial and procuratorial powers independently and impartially to avoid interference from local protectionism[5]. For researchers, there are differences in the implementation time of this reform in different provinces and cities, so it provides a staggered difference (DID) test environment for causal identification.
Most of the judicial disputes involving urban investment companies are related to project arrears
In order to explore the impact of this judicial reform on the delinquency and external financing capacity of local urban investment companies, we integrated data such as judicial rulings (from the SPC Judgment Network), urban investment bonds (from Wind database) and VAT invoices. We first compiled data on all LGBC bonds issued by local LGFCs as of the end of 2023, which is the most publicly available measure of local governments' municipal financing capacity. Based on this, we have listed all the bond issuers and downloaded the corresponding financial statement information.
Based on this list of bond-issuing urban investment enterprises, we retrieved all the court judgments involving these urban investment enterprises from the judgment website. We are particularly concerned about cases of defaults by urban investment companies. Of course, given the difficulty and cost of judicial proceedings, this data is still incomplete in terms of portraying the problem of arrears of urban investment companies, but it is probably one of the best samples available in public data. Finally, we analyze the changes in the expenditure of the local urban investment companies by matching the list of local urban investment companies with VAT invoice data, which covers all the VAT invoices of 849 contractors and suppliers (excluding supermarkets, hotels or restaurants) between 2016 and 2023, and is used to analyze the contract prices and expenses of local urban investment companies and these contractors and suppliers.
It is worth mentioning that among the 3,201 local urban investment companies, 2,144 can match at least one court ruling (whether plaintiff or defendant), that is, nearly 70% of local urban investment companies are involved in judicial disputes. On average, there are 33 judgments and judgments involved in these urban investment companies, which is much higher than the average of non-urban investment enterprises. During the sample period, the average success rate of local urban investment enterprises was 0.59 when they were plaintiffs and 0.55 when they were defendants. In addition, 1,475 bond-issuing cities were able to match at least one VAT invoice, which means that the contractors and suppliers in these invoice data have business overlap with nearly half of the bond-issuing urban investments.
Most of the cases in which the city investment company is the defendant are related to the arrears of project payments. The plaintiff in the case is generally the contractor, and the basis of the lawsuit is concentrated on the arrears of the project payment (e.g., "only part of the payment has been made", "it has not been paid so far", "it has refused to pay", "the above amount should be paid to the plaintiff", "it has not paid on time as agreed", "the project payment is still owed", "the payment is delayed", etc.) and the deposit in arrears. The defendant in the case is generally the contractor's urban investment company, and its defense grounds include the contractor's delay in the construction period (e.g., "delay in the construction period", "causing related economic losses", etc.), the invalidity of the contract due to illegal subcontracting/illegal subcontracting, and the occurrence of quality problems (such as "quality problems", "quality defects", "substandard projects", "quality accidents", etc.). For example, when the construction contract is invalid but the project is completed and accepted, the court should support the contractor's request to pay the project price with reference to the contract.
After the judicial reform, the success rate of urban investment companies has decreased, which is conducive to the recovery of arrears by the construction party
In judicial rulings involving the government, state-owned enterprises and urban investment companies, there is not only local protectionism that favors local companies and discriminates against foreign companies, but also favors local governments and related enterprises and discriminates against private enterprises. The judicial reform, represented by the unified management of people, property and property by local courts, is conducive to weakening local protectionism, especially alleviating the phenomenon of "court capture" in which local governments interfere in the judiciary.
Our empirical analysis shows that this judicial reform, which is under the control of the Ministry of Human Resources, Finance and Property, significantly reduces the bias of local courts towards local urban investment enterprises. After the judicial reform, the success rate of local urban investment enterprises relative to non-local plaintiffs decreased by 16.2 percentage points, and the winning rate of local plaintiffs decreased by 10.0 percentage points. The impact of judicial reform on foreign plaintiffs is greater than on local plaintiffs, most likely because foreign companies were subjected to additional local protectionist biases before the reform. We also found that the decline in the success rate of local urban investment was greater in cases with higher underlying amounts. The judicial reform facilitates the recovery of arrears from contractors and suppliers from local urban investment companies.
Figure 1: The success rate of urban investment companies has declined after the judicial reform
In terms of causal identification, we used the differences in the progress of judicial reform in different cities to conduct a staggered difference-in-difference analysis, and selected cities that had never carried out judicial reform during the sample period as the control group. The results show that before a city undergoes judicial reform, there is no significant change in the success rate of the city's urban investment companies compared with those in the control group of cities that have never implemented judicial reform. It was only in the years after the reform in the city that the success rate of the local urban investment company decreased significantly relative to the control group. This change is reflected not only in cases in which the Chengtou Company is the plaintiff and is accepted by the local courts, but also in the cases in which the Chengtou Company is the defendant.
We also conducted a series of placebo tests to illustrate the mechanism by which judicial reform affects the success rate of urban investment companies by increasing the independence of local courts vis-à-vis local governments. For example, jurisdiction in litigation follows the "plaintiff versus defendant" rule, so whether the defendant, not the plaintiff's, city has implemented judicial reforms is an important factor in the success rate of the lawsuit. Given that City A has implemented judicial reform and City B has never undergone judicial reform, the success rate of City A in City B should not be affected. Consistent with this inference, we find that there is no significant change in the success rate of local urban investment enterprises in the face of foreign defendants, as such cases are usually handled by the courts of the defendants' cities. Similarly, we do not find a significant change in the success rate of national and provincial urban investment enterprises, because the reform of the management of human resources and property is mainly to reduce the control of local governments at the provincial level by transferring the personnel and financial rights of local courts below the provincial level to the provincial government.
The impact of judicial reform on the success rate of urban investment enterprises has two aspects: breadth and intensity. In terms of intensive margin, given the same type of litigation case, the judge's motivation to favor the urban investment enterprise is weakened after the judicial reform, which leads to a decrease in the winning rate of the urban investment enterprise. On the extensive margin, the reformed courts will be fairer in their rulings, which will provide incentives for the counterparties of the LGI enterprises that narrowly lost their cases before the reform, giving them more incentives to file lawsuits against the LGI enterprises after the reform. We have observed that the reforms have encouraged smaller, weaker counterparties to file lawsuits against larger, stronger LGFVs. The reduction of the difficulty of "civil lawsuits for urban investment" is also one of the advances brought about by judicial reform.
The redistributive effect of judicial reform: the interests of creditors of urban investment companies are relatively damaged, and the financing capacity of urban investment is weakened
Theoretically, a fair and independent judicial system is conducive to enhancing the protection of creditors, such as reducing the interference of local governments in judicial decisions, reducing the favoritism of local courts to local urban investment companies, and avoiding strategic defaults by urban investment companies, so that investors are more willing to buy the bonds of urban investment companies and enhance the external financing capacity of urban investment companies.
However, the impact of mitigating judicial capture on the borrowing capacity of the city investment may not be as direct as theoretical predictions, especially when there are multiple counterparties (e.g., bond creditors and contractors) dealing with the company. We note that there has been no substantive default of urban investment bonds, and the direct impact of judicial reform on creditors is relatively small. The other party involved in the Chengtou company's case was mainly the construction party and the supplier.
Therefore, the reduction in the success rate of urban investment under the judicial reform means that given the total cash flow of the urban investment company, the construction party and the supplier are more likely to recover the arrears, and the funds available to the creditor of the urban investment bond in the future are reduced. This will lead to less or more cautious demand for urban investment bonds, and a decrease in the ability of urban investment enterprises to borrow in advance. Consistent with the above analysis, we find that in cities that have implemented judicial reforms, the net issuance of urban investment bonds has fallen significantly, by 15%. The average yield of urban investment bonds has also gradually increased, indicating that the external financing costs of urban investment companies have also increased.
Figure 2: After the Judicial Reform, Urban Investment Bond Issuance Declined and Interest Rates Increased
Further, we use the financial statement data of the urban investment enterprises to find that the total assets of the urban investment enterprises decreased by 9.3% after the judicial reform, and the average borrowing rate also increased by 0.29%. However, unlike other sources of credit, business credit (measured as the ratio of accounts payable to the cost of goods sold) increased by 2.4%. The increase in commercial credit may be the impact of stricter financing constraints faced by urban investment enterprises, resulting in more serious arrears. This is a further reflection of the redistributive effect of judicial reform in the absence of the same overall cash flow for local governments: contractors who are collecting arrears benefit more, while the relative position of financial creditors and contractors who have not yet litigated decreases. Of course, it is also possible that a fairer rule of law environment makes suppliers and contractors of urban investment platforms more willing to provide commercial credit.
Although there has not been any default on urban investment bonds, in recent years, urban investment enterprises have defaulted on some non-standard debts (such as trust products). By calculating the proportion of urban investment enterprises that have defaulted on non-standard contracts, we find that the default rate has increased by about 2.0% after the judicial reform, while the average default rate is 2.7%, indicating that the increase is very large. The tightening of local urban investment and financing capacity has also had an impact on its own operational and public affairs functions. After the judicial reform, the expenditure of urban investment enterprises fell sharply. In addition, the annual supply of residential land at the city level has also decreased. This means that the reduction in borrowing capacity and expenditure has weakened the main role played by urban investment in land acquisition and storage.
Judicial reform is complex in terms of security limitations and government arrears
The political capture of the judiciary is more prevalent in developing countries and continental law countries (Glaeser and Shleifer, 2002 [7]; Porta et. al.，2008[8]）。 As a result, our findings have general implications for other developing countries that have problems with court capture and public debt. While an independent judiciary can safeguard the interests of creditors by deterring a government from a strategic default, our empirical analysis suggests that the situation is more complex when multiple creditors are involved, including contractors and bond creditors. The "de-localization" of the judiciary has played a role in restricting local financing through urban investment bonds.
It is worth noting that there are still a large number of local courts that are under the significant influence of local governments. For example, Fan Lisi of the Wuhou District People's Court of Chengdu City, Sichuan Province, compiled the budget and final accounts data of 1,535 grassroots courts in 2019 and 2020 in the article "Reengineering the Court Funding Guarantee Mechanism after Provincial Unified Management"[9], and found that 249 of the 741 courts that have completed the reform are still relying on the funding of the same level of finance, and among these 249 courts, the average proportion of the financial supply of the same level in the fund income is 43.22%. This shows that there is still a long way to go in the reform of "delocalization" of judicial personnel, financial and property management.
In addition, we can only see the results of judicial decisions from the judgment documents, but not the results of enforcement. It is unknown whether the local urban investment will pay the accounts in accordance with the judicial decision and whether it will continue to delay the payment [10]. From judgment to execution to payment collection, every link may become a stuck point. And for businesses, cash flow is life. The road to debt recovery is long, and every day of delay can lead to unsustainable business. The company also has its own suppliers, employees, etc. If the problem of liquidity shortage is transmitted downward, then it is the small and micro enterprises and individuals with the weakest risk-bearing ability who will ultimately bear the pressure and losses. This is very detrimental to the resilience of economic development, the boost of domestic consumption demand, and the protection of employment and people's livelihood.
More importantly, judicial reform alone is not enough. The problem of arrears in public sectors such as governments, urban investment and state-owned enterprises is not only a matter of their own will, ability, but also a political, economic and people's livelihood issue. The mismatch between local fiscal revenue and expenditure responsibilities, the promotion of local officials and the construction of debt under the motive of corruption, the accumulation of a large amount of implicit debt outside the budget, the limited capacity of the formal municipal bond market, the increase in epidemic prevention and relief expenditure under the impact of the epidemic, the sharp decline in land transfer income caused by the downturn in the real estate market, the "urban investment faith" of banks and financial institutions and the lack of market discipline, the imperfection and relative weakness of the judicial system, and the insistence on "no bailout" to prevent moral hazard in centralized debt The combination of prudent restraint in loose monetary policy is shaping the current situation.
How to promote the timely payment of enterprise funds is a systematic project. Appropriate account period management can help reduce moral hazard and quality problems in project construction, while the delay in payment after project acceptance reflects the lack of ability or willingness of relevant parties to pay. The promulgation of a series of relevant policies and regulations also reflects the great concern and attention of the CPC Central Committee and the State Council to the urgent issues in the development of small and medium-sized private enterprises. It is expected that future policies will start with enhancing the ability and willingness of the government, state-owned enterprises and large enterprises to make timely payments, start from the source of arrears, and improve supporting measures such as justice, supervision and information disclosure, so as to unravel the "triangular debts" and "serial sets" between the government and enterprises and between enterprises in a drastic way.
[1] Recent examples include the Ministry of Industry and Information Technology's public consultation on the Regulations on Guaranteeing Payment of Payments to Small and Medium-sized Enterprises (Draft Amendment) on 18 April 2024, which is a continuation and deepening of the Regulations on Guaranteeing Payment of Payments to Small and Medium-sized Enterprises (Draft) passed at the executive meeting of the State Council on 1 July 2020, which further clarifies the responsibilities of local governments, strengthens the supervision and punishment mechanism, strengthens the disclosure requirements for large enterprises, and improves the complaint and relief mechanism, all with the aim of optimizing the business environment. Safeguard the legitimate rights and interests of small and medium-sized enterprises. https://www.miit.gov.cn/gzcy/yjzj/art/2024/art_2ad343c9dd6349aa871f7cc881882ab0.html
[2] Decision of the Central Committee of the Communist Party of China on Several Major Issues Concerning Comprehensively Deepening Reform (Adopted at the Third Plenary Session of the 18th Central Committee of the Communist Party of China on November 12, 2013), Xinhua News Agency, https://www.gov.cn/jrzg/2013-11/15/content_2528179.htm.
[3] Remarks by the Head of the Reform Office of the Central Committee on the Pilot Work of Judicial System Reform, June 15, 2014, Xinhua News Agency, https://www.gov.cn/xinwen/2014-06/15/content_2701248.htm.
[4] Legal Daily, August 1, 2016, "The reform of the judicial system has been fully launched", https://www.spp.gov.cn/zdgz/201608/t20160801_160683.shtml
[5] Xinhua News Agency, July 6, 2015, "'Delocalization' Escorts Judicial Fairness: Focusing on the Reform of the Human, Financial and Material Management System of Courts and Procuratorates at the Provincial and Sub-Provincial Levels," https://www.gov.cn/xinwen/2015-07/26/content_2902804.htm.
[6] Interpretation (II) of the Supreme People's Court on Issues Concerning the Application of Law in the Trial of Cases Involving Disputes over Construction Contracts, October 2004, http://gongbao.court.gov.cn/Details/263f11512fa296b75953a66ad69e38.html. Interpretation of the Supreme People's Court on Issues Concerning the Application of Law in the Trial of Cases Involving Disputes over Construction Contracts (II), October 2018, http://gongbao.court.gov.cn/Details/6b4b7633fc2aac95bccf5e58516ab7.html
[7] Glaeser, Edward L., and Andrei Shleifer. 2002. “Legal Origins.” The Quarterly Journal of Economics 117 (4): 1193–1229. https://doi.org/10.1162/003355302320935016.
[8] La Porta, Rafael, Florencio Lopez-de-Silanes, and Andrei Shleifer. 2008. “The Economic Consequences of Legal Origins.” Journal of Economic Literature 46 (2): 285–332. https://doi.org/10.1257/jel.46.2.285.
[9] Fan Lisi. (2021). Reengineering of Court Funding Guarantee Mechanism after Provincial Unified Management. People's Justice, 000(022), p.72-78,105. https://www.pkulaw.com/qikan/01e0de5628b38873d16ff36571066843bdfb.html
[10] In April 2019, the Ministry of Industry and Information Technology (MIIT) launched a registration (complaint) platform for defaulting on payments owed to SMEs, and subsequently issued the Administrative Measures for Timely Payment of SMEs (Draft for Comments). However, this data is not available for analysis by external researchers.
Hu Jiayin is an assistant professor at the National School of Development at Peking University, a researcher at the China Center for Economic Research and a researcher at the Center for Digital Finance. Prof. Hu's main research areas are banking, corporate finance and fintech.