Paying for Urbanization in China

China is urbanizing, and the pace is accelerating. The National Bureau of Statistics (NBS) reported a population of 1.34 billion at year end 2010, fully half of them living in cities (CSY 2011). Rapid urbanization is a recent phenomenon that was unleashed by the country’s transition to a market economy. Starting in the early 1980s, the dismantling of agricultural collectives freed rural labor to leave the land. Since then, rural-urban migration has steadily accelerated as government restrictions on population movement were eased, and plenty of jobs were created in cities by economic growth that has averaged more than 12 percent per annum in real terms since 1990.

Providing infrastructure and public services to accommodate urbanization of this scale and pace is a gargantuan task that would strain any government. In China, the challenge was all the more daunting as the ongoing process of transition from a planned economy to a market economy transformed virtually all aspects of social and economic organization and brought a catastrophic collapse in the government’s revenue mechanisms that caused the budget to plunge from one-third of gross domestic product (GDP) in 1978 to a nadir of 11 percent before a new tax system began to restore fiscal health from the late 1990s onward (Wong and Bird 2008; World Bank 2002). The upturn in urbanization thus began in a difficult fiscal environment that worsened through the first two decades. The financial mechanisms and strategies for Chinese municipalities were forged in this harsh environment.

This paper describes and analyzes the financing of public services and infrastructure in municipalities in China. An examination of the practices of the past two decades makes it clear that municipal finance has evolved to rely overwhelmingly on extrabudgetary resources and borrowing, under a policy of benign neglect. The formal system of public finance in China has made few accommodations for the needs of municipal finance. Except for a few favored cities in the rich coastal provinces, the formal system does not provide sufficient resources for cities to meet their responsibilities to provision services. Moreover, municipalities are prohibited from borrowing even for capital expenditures, making it difficult to finance infrastructure. Yet the remarkable growth and development of cities have proceeded because political leaders have been willing to tolerate a plethora of informal, backdoor solutions that enabled cities both to obtain the resources needed and to limit eligibility for benefits.

The paper turns next to a brief discussion of China’s urbanization trends and the administrative structure of Chinese cities. A discussion of municipal finance follows, focusing first on evolution of the formal fiscal system and then on extrabudgetary components. Financing of urban infrastructure and the emergence of local investment corporations then are discussed, and the paper concludes with an analysis of the current system of municipal finance, noting both the achievements and accumulated macroeconomic risks of the strategy, and the adverse effects on welfare and distribution.

This paper was presented at a 2011 conference at The Brookings Institution organized by the Lincoln Institute of Land Policy and is Chapter 11 of the book Financing Metropolitan Governments in Developing Countries.