Managing Local Debt in China: Insights from Europe’s Long Experience with Fiscal Rules

The ADB brief shows that Europe’s long experience with fiscal rules highlights the importance of transparent, flexible, and enforceable frameworks to manage local government debt and safeguard financial stability. For China, the key lesson is that stronger medium-term planning, clearer local revenue sources, and attention to fiscal–financial links are essential for sustainable growth.

Prepared by the Asian Development Bank with contributions from its People’s Republic of China Resident Mission and the University of California, Berkeley, this policy brief draws on European experience to shed light on China’s growing local government debt challenge. Authored by Yothin Jinjarak and Akiko Terada-Hagiwara of ADB, together with Barry Eichengreen of UC Berkeley, the document argues that as China’s economy slows and its growth model evolves, stricter and more transparent fiscal rules are becoming essential. Europe’s long and sometimes troubled history with fiscal rules offers practical insights into what works, what fails, and what must adapt over time.

China’s Fiscal Pressures at the Local Level

China’s fiscal system is facing mounting strain from demographic changes, weaker land-sale revenues, and a structural mismatch between spending responsibilities and revenue authority. Local governments carry the bulk of public spending but rely heavily on transfers from the center, leaving them with limited own-source revenue. To sustain growth and infrastructure investment, many have turned to local government financing vehicles, building up large off-balance-sheet debts that obscure true fiscal risks. While Beijing has tightened borrowing rules and launched large debt-swap programs to convert hidden liabilities into official bonds, the brief argues that administrative controls alone cannot guarantee long-term debt sustainability. What is missing is a more integrated framework that links annual budgets, medium-term plans, and clear debt limits.

What Europe’s Fiscal Rules Tried to Do

Europe’s fiscal framework, centered on the Stability and Growth Pact, was designed to support a common monetary policy by preventing excessive deficits and debts among member states. Its well-known targets, deficits below 3% of GDP and debt below 60%, were shaped more by political compromise than strict economic logic. Over time, Europe added monitoring systems, corrective procedures, and sanctions to enforce discipline. Yet repeated crises exposed weaknesses. During downturns, strict rules risked forcing governments to cut spending at the wrong time. Reforms shifted attention to “structural” deficits and multi-year planning, but this made the system complex, hard to explain, and politically fragile. Persistent rule-breaking by major economies further weakened credibility.

Key Lessons on Debt and Financial Stability

One major lesson from Europe is that debt sustainability must be assessed over several years, not judged by a single annual deficit number. Recent EU reforms now require countries to submit multi-year fiscal plans and focus on controlling public spending, which is easier to observe and manage than abstract deficit measures. For China, this highlights the importance of stronger medium-term fiscal planning and expanding local governments’ own revenue sources, such as consumption-based taxes, to reduce their dependence on borrowing.

Another lesson concerns the close link between public finances and the financial system. Europe’s debt crisis showed how government stress can quickly spill over into banks, forcing costly rescues. In response, the EU built new supervisory and resolution mechanisms to limit taxpayer exposure. China faces similar risks through banks’ exposure to LGFVs. Recent debt swaps help by lowering interest costs and extending maturities, but the brief stresses that fiscal rules must explicitly consider financial stability risks, not treat them as separate issues.

Enforcement, Flexibility, and Final Takeaways

Europe’s experience also shows that enforcement is the hardest part of fiscal rules. Sanctions exist on paper, but political resistance often prevents their use, and rigid penalties can worsen crises. Even Germany’s constitutionally anchored “debt brake” has been applied flexibly in emergencies. The lesson for China is that credible enforcement depends less on harsh punishment and more on clear responsibilities, transparency, and incentives that encourage prudent behavior by local governments.

The brief emphasizes that fiscal rules are never perfect or final. Both Europe and China show that such frameworks must evolve with economic conditions and political realities. For China, the priority lies in improving transparency, strengthening local revenue capacity, integrating medium-term planning with annual budgets, and carefully monitoring financial spillovers. Europe’s experience serves as a cautionary but valuable guide: rules must be simple enough to understand, flexible enough to adapt, and credible enough to shape behavior if they are to support sustainable, high-quality growth.