The series of reforms announced recently in China could begin to alter the way the country’s local and regional governments (LRGs) operate. Execution will not be easy. But, if implemented effectively, these measures could improve fiscal transparency and overall budget management. Both of these would be credit positive.

We continue to await the National Audit Office’s compilation of a detailed account of the fiscal conditions of the LRGs. But the reform announcements hint at medium-term improvements that could be achieved by the LRGs for two key reasons.

The first is that these reforms aim to change the incentives of local government operations and raise their overall level of transparency. This is evident from a proposed shift in the performance-evaluation system of public officials away from a GDP-growth-focused framework to one which incorporates several socio-economic parameters, some of which would discourage LRGs from accumulating further debt. The establishment of a more transparent and efficiently regulated financing mechanism, and a step-up of private participation in urban infrastructure investment and operations, are also significant.

Better incentives and heightened transparency could ultimately help ease dependence on debt-funded efforts to boost local activity, and limit a further run-up in over-capacity in urban infrastructure projects. Furthermore, these measures could begin to lower the reliance on opaque and unregulated local government financing vehicles that have begun to pose wider systemic risks.

The second reason is our expectation of gradual improvements in overall budget management. These include compilation and disclosure of LRG balance sheets, transition to an accrual-based accounting system, and establishment of debt monitoring and risk-alarm systems. The announcements also included proposals to allow the levy of property taxes at the local level. Last but not least, the reforms also target the establishment of a more balanced mechanism to improve the alignment of local governments’ spending responsibilities and fiscal revenue powers with those of the central government.

The most obvious impact of improved budget management is that it would help ease the debt burden of the LRGs, by reducing unsustainable dependence on land sales and other forms of unstable financing activity. Ultimately, this would reduce the risk of a credit crunch. A stabilization or lowering of LRG indebtedness would therefore also benefit the sovereign’s credit profile by reducing contingent liabilities, in so far as the process does not impair central government finances, for example by increasing transfers from central government to LRGs.

The proposed reforms are ambitious in scope. The main challenge could come from vested interest groups at the local level. The government is signalling a growing political determination to tackle such administrative challenges by the formation of a powerful new central leadership team on reform. But, in any event, implementation remains the key to actual credit improvements.