China's Growing Government Debt in a Computable Overlapping Generations Model

Document

Cited in

Author	Yan Wang,Shuanglin Lin,Fan Zhai,Shiyu Li
Published date	01 August 2018
Date	01 August 2018
DOI	http://doi.org/10.1111/1468-0106.12172

Pacif‌ic Economic Review,••:•• (2016) pp. 1-29

doi: 10.1111/1468-0106.12135

bs_bs_banner

CHINA’S GROWING GOVERNMENT DEBT IN A

COMPUTABLE OVERLAPPING GENERATIONS MODEL

SHIYU LIChina Financial Policy Research Center, Renmin University of China

SHUANGLIN LIN*Peking University, and University of Nebraska Omaha

YAN WANG George Washington University, and The World Bank

FAN ZHAI China Investment Corporation, and The Asian Development Bank

Abstract. This paper simulates the effects of China’s growing government debt in a computable

equilibrium model of overlapping generations. Our model assumes that the government increases

debt to f‌inance its spending in the short run, and then increases taxes or cuts spending to keep the

debt–GDP ratio constant. The spending-driven government debt increases public capital and output

in the short run, but decreases private investment, total capital stock, output, and net exports in the

long run, and makes the future generations worse off. Among various means of debt control, a de-

crease in government spending seems to be the least harmful to private investment, capital stock,

and output while an increase in capital taxation is most detrimental.

1. INTRODUCTION

Many years of expansionary f‌iscal policies have resulted in growing government

debt in China, which threatens China’sf‌iscal sustainability and long-run economic

development. The present paper simulates the effects of China’s growing govern-

ment debt in a computable equilibrium model of overlapping generations (OLG).

The Chinese Government had neither domestic nor foreign debt before 1978.

In the 1980s and early 1990s, China’s government debt and def‌icits were kept at

a low level. In the aftermath of the Asian f‌inancial crisis in 1997 the government

adopted an expansionary f‌iscal policy and rapidly increased government spend-

ing. The budget def‌icit reached 2.6% of GDP in 2002.1As f‌iscal policy turned to

be ‘prudent’, budget def‌icits declined to 2.2% of GDP in 2003 and 0.8% in 2006.

In 2007, the economy was overheated and the budget was in surplus, although a

budget def‌icit had been planned at the beginning of the year. In 2008, the global

f‌inancial crisis occurred. The Chinese Government adopted a rather aggressive

expansionary f‌iscal policy, with a 4-trillion-yuan investment plan. The govern-

ment budget def‌icit–GDP ratio accounted for 2.3% of GDP in 2009, 1.7% of

GDP in 2010, 1.1% in 2011, 1.7% in 2012, 1.9% in 2013 and 2.1% in 2014.2

*Address for Correspondence: China Centre for Public Finance, National School of Development,

Peking University, Beijing 100871, China; Department of Economics, University of Nebraska,

Omaha, NE 68182, USA. E-mail: shuanglin@pku.edu.cn; slin@mail.unomaha.edu. The authors

thank Bert Hofman, Laurence J. Kotlikoff, Shantong Li, Roumeen Islam and Yingyi Qian for their

invaluable comments. Shiyu Li acknowledges the f‌inancial support from the National Natural Sci-

ence Foundation of China (Project No. 71403280) and the Beijing Social Science Fund, China (Pro-

ject No. 14JGC118). Views expressed here are entirely those of the authors and should not be

attributed to the institutions with which they are aff‌iliated.

1Based on the Maastricht Treaty and the subsequent ‘Stability and Growth’Pact, in EU countries

the government debt–GDP ratio cannot exceed 60% and the def‌icit–GDP ratio cannot exceed 3%.

2See National Bureau of Statistics of China (2010–2013, 2014) and Lou (2014).

Pacif‌ic Economic Review,••:•• (2016)

doi: 10.1111/1468-0106.12172

Pacif‌ic Economic Review

, 23: 3 (2018) pp. 359–384

doi:10.1111/1468-0106.12172

Pacif‌ic Economic Review

, 23: 3 (2018) pp. 359–384

doi:10.1111/1468-0106.12172

China’s debt–GDP ratio was 5% in 1994 and it has been increasing since.3In

addition to the central government debt, local governments have also accumu-

lated a huge amount of debt through borrowing from banks. Based on a recent

report of the China National Audit Off‌ice, by the end of June 2013, total govern-

ment debt (including central and local government debts) accounted for more

than 50% of GDP.4

Many believe that if both the contingent and implicit debt are included in the

total government debt, the debt–GDP ratio will be much higher.5As the resi-

dential housing market bubbles burst, the debt of many state-owned real estate

developers will undoubtly increase, and the debt of local governments, which

have relied on land sales to the real estate developers, will also increase. In addi-

tion, China’s government healthcare expenditure is low, and if the government

increases its healthcare expenditure in the future, China’s government debt will

rapidly increase. Moreover, with population aging, the implicit pension debt

arising from China’s current pay-as-you-go system will also turn into an explicit

debt. Recently, with China’s economic growth slowing down, the central gov-

ernment has continued its expansionary f‌iscal policy and local governments have

been allowed to issue revenue bonds. Li (2016) suggests that the Chinese Gov-

ernment will pursue a more proactive f‌iscal policy and that the government def-

icit to GDP ratio will be 3%.6Thus, China’s government debt will continue to

grow. The growth of debt has signif‌icant implications for China’sf‌iscal sustain-

ability, private investment, capital accumulation, output, trade balance, and the

welfare of current and future generations.

So far, there are few studies on the effects of China’s government debt based

on a rigorous general equilibrium model.7This paper investigates the impact of

China’s growing government debt in a computable equilibrium model of over-

lapping generations. With simple theoretical models, comparative static analysis

can be performed to examine the effect of a change in a policy variable. How-

ever, for analysing large policy changes in a complicated model based on

China’s actual data, simulation analysis is the best alternative.8Auerbach

and Kotlikoff (1987) developed a computable equilibrium model of overlapping

3See Krumm and Wong (2002) for discussions of China’s government debt in the earlier years.

4See China National Audit Off‌ice (2013). In one province, government debt–GDP ratio has reached

90% in 2013.

5Government liabilities can be classif‌ied into four categories: explicit and direct, explicit and contin-

gent (e.g. local government borrowing from banks), implicit and direct (e.g. social insurance expen-

diture), and implicit and contingent (e.g. liabilities in the event of bankruptcy of banks, SOEs and

social insurance funds). See Brixi and Schick (2002).

6In 2016, local governments can issue special bonds of 400 billion yuan to replace local govern-

ments’bank loans, and bonds will continue to be issued for this purpose. See Li (2016).

7Wang et al. (2001) are among the f‌irst to provide quantitative analyses of China’s pension reform

based on a large computable equilibrium model. The model, although very useful, has its limitations

when considering the issues involving saving behaviour, labour supply and intergenerational redistri-

bution. Lin (2003) and Li and Lin (2011) estimated the size of China’s government debt, but did not

rigorously analyse the effects of the debt.

8Shoven and Whalley (1972), Fullerton et al. (1983) and Ballard et al. (1985) were among the f‌irst

researchers to utilize simulation models to study the incidence and eff‌iciency effects of a variety of

f‌iscal regimes in both closed and open economy.

S. LI ET AL.2

generations, called the A-K model, to simulate various government budgetary

policies on the US economy. Altig et al. (2001) extended the A-K model by in-

troducing 12 different groups of heterogeneous agents and simulated the impacts

of f‌ive different types of tax reforms in the United States; and Li and Lin (2016)

employed the A-K model to study China’s social security reforms. Government

debt and def‌icits inevitably involve intergenerational redistribution, and, thus,

the A-K model is the most suitable one.

The present paper focuses on the effects of China’sf‌iscal policies on consump-

tion, private investment, capital accumulation, output, trade balance and indi-

viduals’welfare. The government increases spending for a short period

f‌inanced by government debt, and then raises taxes or cuts government spending

to keep the debt–GDP ratio constant. Both private capital and public capital are

included in our model. Throughout the paper, we assume that China is open to

international trade. However, China is able to control its cross-border capital

f‌lows.9

We construct a baseline growth path with the debt–GDP ratio being constant,

and then simulate the change of the economy over the baseline after increasing

the debt–GDP ratio. Our simulations show that, although increasing public cap-

ital and output in the short run, the spending-driven government debt reduces

private investment, capital stock, output, and net exports in the long run, and

makes the future generations worse off. Among various means of debt control,

a decrease in the government spending seems to be the least harmful to private

investment, capital stock, and output, while an increase in capital taxation is

most detrimental.

The paper proceeds as follows. Section 2 develops an equilibrium model of

overlapping generations with government debt. Section 3 discusses the data,

the model calibration and the baseline scenario. Section 4 provides simulation

analyses of the expansionary f‌iscal policy. Section 5 concludes.

2. THE BASIC MODEL

There are many multi-period-lived consumers in the economy. Each adult

chooses a sequence of consumption over his or her lifetime to maximize

his/her lifetime utility subject to a lifetime budget constraint. Firms, which are

owned by households, use capital and labour to maximize their values. The re-

source markets are competitive and the rate of returns to each resource is the

marginal product. The government lives forever, collecting taxes and issuing

short-term debt to f‌inance its spending. Public capital enters private production

9China still has capital control in place. For example, external borrowing is restricted, outward di-

rect investment by domestic enterprises must be approved by the government agencies and Chinese

currency is not freely convertible. The purpose of capital control is to prevent investments in certain

industries and especially to stop domestic capital from leaving the country. While before the eco-

nomic crisis in Asia China was under attack for having those capital controls in place, it shielded

the country’s economy against the worst fallout of the economic crisis. Many of the criticisms were

no longer heard following the crisis.

CHINA’S GOVERNMENT DEBT 3

S. LI ET AL.

360