China’s Local Government Cash Management – Regulation or Centralization?

Posted by Holger van Eden

Not all governments around the world are anxiously looking at their empty state treasury coffers. The Chinese central and local governments have accumulated large cash reserves over the past decade. In part these accumulations represent continued under-execution of the budget over a number of years, a quite common phenomenon in the developing world. These reserves, however, also reflect the success in setting up Treasury Single Account (TSA) structures by central, provincial, and larger city governments. The liquidity that in the past would have accumulated in line ministry and agency commercial bank accounts at various levels of government–China has 5 distinct layers of government–has in part been brought back into TSA accounts held at the People’s Bank of China (PBoC).

Local government reserves in China represent an estimated 3-4 percent of GDP. This represents a sizable amount by any international standard and raises the question of how these resources should be managed: to what extent should treasury management power of local government be centralized? What sort of autonomy in financial investment management should be granted to local government to maximize financial return while preserving investment security, etc.?

From the viewpoint of treasuries in central and provincial government in China there is considerable interest in placing funds which are temporarily not needed in financial market instruments, and earning a, hopefully handsome, return. Since a number of years, the Chinese central government places moderate amounts of central government liquidity in term deposits in commercial banks. These term deposits earn a higher interest rate than deposits at the PBoC and are adequately collateralized to avoid any undue risk for government. Of course the question of what local government should do also has an important monetary angle to it, as placing liquidity in the banking system would ease monetary conditions considerably if done abruptly.

Governments around the world have defined treasury management powers of local government in very different ways. On the one hand there are countries like France where cash, and treasury management more broadly, is centralized and executed through the Trésor in Paris. Not only do local governments not have any choice in where they invest temporary surpluses, the payment and accounting process itself is integrated into the central government’s financial management system. The positive side to this approach is that French regional authorities and municipalities do not need to build capacity in treasury management. Returns on surpluses are remunerated to municipal coffers, and central government also has a watchful eye on local government goings-on. It should be understood that in the centralized model, treasury management does not need to detract from full budgetary autonomy. Local government can spend its budget as approved by the local council. It just needs the services of central government to execute its budget and manage its surpluses and deficits.

The downside to the French arrangements is that a central treasury covering all of government can become a large and bureaucratic organization that does not always provide local government with the most flexible or profitable investment options (at least according to some French local governments!). The French State Treasury used to have around 50 thousand employees. In recent years automation and efficiency drives have brought the size down somewhat. Many smaller transition and developing countries have chosen, often under the advice of the IMF, for the centralized model of treasury and cash management, given the low capacities for financial management in local government in the developing world, and also given the excellent functionality of modern integrated financial management information systems. Not only does the centralized option provide a solution to cash management issues, it also provides an efficient mechanism for local government accounting and payment processing. The desire of central government to exert supervision and control, over local government expenditures, in times of economic crisis, has of course also played a role in this choice, as has the wish to exert some fiduciary control over local government use of public moneys.

On the other hand, many countries have avoided centralized treasury management. In large federal states, but also in many unitary states local government has own powers to manage cash reserves. One of the reasons is often the Constitution. Local governments are granted fiscal autonomy by the Constitution and this has been translated in autonomy on treasury management (although, as said before, one could argue, that centralized treasury management can be provided as a service only to local government with no options for interventions by central government on local budgets). Other reasons for decentralized treasury management are differences in accounting systems, and the sheer scale and complexity of centralized treasury operations needed.

Even in countries with autonomous treasury entities, a legal framework usually exists to limit the investment options of local government. This includes specification of the type of investments allowed and the reporting requirements on outstanding investments. The risks of allowing local government to invest surpluses [temporary or not so temporary] in financial instruments is considerable. It is clear that investments in stocks, real estate, commercial equity, and foreign assets should be explicitly forbidden for short-term surpluses given their extremely risky nature. However, even term deposits can be risky if not collateralized. One example is the recent failed investments of UK and Dutch local governments in the Iceland internet Bank Icesave. Local governments needed to be bailed out for billions of pounds and euros by respective central governments. This while local governments in both countries prided themselves on a certain level of financial management sophistication.

Such sophistication is not yet present in China at the local government level. Local capacity in financial management is still weak in most provinces and larger cities. Market access to the appropriate instruments, such as collaterized deposits may not be available. Sophisticated markets for buying and selling back bonds on a temporary basis, the so-called repo market, are still in development. So would centralizing cash management work in a vast country like China? The full centralized treasury model where payment and accounting systems are centralized is probably not feasible. Given the extensive and broadly layered local government sector existing in China such a solution would require an extreme amount of centralized systems development, coordination and government bureaucracy. A back of the envelope calculation would suggest that in China a French style central treasury to service a population of over 1 billion would require a million employees (assuming same productivity levels). The fiscal autonomy aspect is also not unimportant. Despite some perceptions in the West, Chinese provinces pride themselves on their autonomy. The old Chinese saying “The Mountains are high and the Emperor is far away” still has a lot of resonance. Suggesting that Beijing should monitor all expenditures may raise eyebrows with many provincial and city administrations.

A more feasible and intermediate solution for China would probably be for the center to continue to provide support to provinces and lower levels of government on how to set up treasury single account structures, payment systems, and government accounting frameworks on the one hand, and regulate financial investment of short term cash reserves on the other (a different regime will be needed for long-term surpluses, but that would be the topic of another post). What the center also could provide, until financial markets develop further, is intermediation of provincial and larger city surpluses towards the banking system on a voluntary basis. Provinces should be able to ask the central government treasury in Beijing to place temporary cash surpluses in the market on their behalf. For the more developed provinces this mechanism would probably not be needed. However, such an intermediation service could provide a safe and assured mechanism for provinces and cities with low financial management capacity.

This is a summary of a much broader presentation (copy attached) on local government cash management provided at an International Seminar on Local Government Treasury Cash Management in Sanya, Hainan Province, People’s Republic of China on December 10-11, 2009.

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