The Connection Between Political and Economic Cycles – Part 1

8 Jun

Most readers will be familiar with interplay between the economic and political cycles in democracies.  By way of example, many will be familiar with recent press reports (and in the spirit of political impartiality I hasten to add that these are press reports – not my analysis!) discussing the expansionary type policies of the outgoing UK government just prior to the recent election.

This phenomenon is not uncommon, and post election governments are often forced to squeeze their budgets and enact tightening policies.  Obviously, this contributes to the cycle of boom and bust.

Despite China having a different political system from a European style democracy, this trend is even more exacerbated with politics playing a vital role in the economy. How?

Firstly, the government plays a very central role in fixed asset investment.  Secondly, local government account for the majority of public investment.

In other words, despite years of reform, opening of capital markets etc, China is not as private as first meets the eye. In fact in 2008 State Owned Enterprises (SOEs) still accounted for around 40% of urban fixed investment.  What’s more, this 40% is concentrated in primary sectors, such as banking, energy, transport, chemicals, and telecoms.

The Power of Local Government
In addition, the Government also holds the reigns of land supply. On one hand, local Governments can lease land to industry cheaply in an effort to entice investment.  On the other hand, they can sell land at high prices to developers in a bid to expand their coffers

According to the World Bank, local government spending in China accounted for 73% of national government expenditure in 2006.  That is significantly higher than 32.4% in OECD countries.  In other words, local spending has a relatively larger impact on the economy in China than the OECD.  Since 2003 local projects have accounted for almost 90% of fixed asset investment in China.

With little control over local money supply through fiscal means, FAI is a great tool for local governments to stimulate (or cool) their local economies. In addition, boosting the economy in this way is a great method to increase tax revenues for the local government.  Local government picks up a portion of the local VAT tab (I’m not sure what percentage). Now seeing that there’s a correlation between GDP and VAT, local officials are thus incentivised to target GDP growth.  I also note, that the local government gets to keep all taxes collected from construction and services.

Part 2 coming next week


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