EXECUTIVE SUMMARY

The purpose of this PEFA assessment is to provide an objective analysis of the present performance of the public financial management (PFM) systems in the county of Chaling, using the new 2020 Subnational PEFA Framework. The results of this assessment will inform the design of the Hunan Subnational Governance and Rural Public Service Delivery Program-for-Results lending operation and local specific PFM reform initiatives and appropriate technical support from development partners, as well as provide a baseline against which the future developments of PFM systems of Chaling County can be measured.

The assessment covers the county of Chaling, more specifically its government administrative units (GAUs, 行政单位) and public service units (PSUs, 事业单位), including budget-funded service delivery entities such as schools, hospitals, or agricultural service centers. While there are no extra-budgetary units (EBUs) in Chaling County, the social security fund is managed separately from the core budget system—that is, the general public budget (GPB) and government fund budget (GFB), and thus is classified as an extrabudgetary operation in this assessment. Following China’s legislative classification, state-owned enterprises (SOEs) are assessed as public corporations (PCs). China’s laws and regulations prohibit any SOE, including local government financing vehicles (LGFV), from financing government investment projects on behalf of the government. LGFVs that have been undertaking quasi-fiscal operations are required to be transformed into commercial entities, operating according to market rules, producing goods and services at market price, and bearing risks on their own. The government does not have any legislative obligation to bail out SOEs. Considering that they may present potential fiscal risk to the government, Annex 7 provides complementary information on the financial management performance of LGFVs in Chaling. At the time of assessment, there were three LGFVs in Chaling still in the process of transforming into commercial entities.

The assessment was undertaken in March 2020 via a series of video conferences. The fiscal years (FYs) covered for indicators that require an assessment of a three-year period, are FY 2016 to FY 2018.

Impact of PFM systems on the three main budgetary outcomes

Overall, the PFM systems of Chaling perform well in the budget preparation process, in-year budget reporting, and budget control, as well as to public asset management and legislative scrutiny. The main weaknesses pertain to budget reliability and transparency, performance and medium-term orientation of the budget, public investment and procurement management, the monitoring expenditure arrears, internal audit, and annual financial reporting. The context in which Chaling sets its budget is important. Chaling generally complies to the PFM practices mandated by the central and provincial governments. Improvement in the county’s PFM perform requires enhanced predictability of information on transfers to be received from higher-level governments (HLGs).

Fiscal discipline

In Chaling, fiscal discipline is imposed only partially. The variation between budget outturn and budget estimates for aggregate expenditure (PI-1.1) and expenditure composition (PI-2.1) is rated D, and there are significant budget adjustments for expenditure with information shortage (PI-21.4, rated D*). The lack of predictability of HLG transfers (HLG-1 rated D) and land sales revenues (PI-3 rated D) are the main factors. In-year resource allocation is frequent and unpredictable (PI-21, rated D), and monitoring for expenditure arrears is missing (PI-22.2, rated D). More efforts are needed in cash management, including consolidation of cash balances (PI-21.1, scored C) and cash forecasting and monitoring (scored D), and the internal audit system (PI-26, rated D).

Effective control over expenditures by budgetary units helps to enhance fiscal discipline. No government operation takes place outside the financial reports (PI-6, rated A). Payroll control is effective and supported with centralized payment arrangements and auto-reconciliation through an IT system (three dimensions of PI-23 are rated A). Strong internal control for non-salary expenditure (PI-25, rated B) helps ensure strict control over spending during budget execution. There is a good reporting and recording system for debts (PI-13.1, rated C) and contingent liabilities (PI-10.3, rated B).

Chaling County recognizes the role of enhanced management over SOEs to the success of imposing fiscal discipline. The government debt management system has enhanced the government’s monitoring of contingent liabilities. However, there is no evidence that the Chaling Finance Bureau makes use of this information to assess the implications that PC finance may have for fiscal sustainability or to impose any discipline on aggregate public investments.

Strategic allocation of resources

The main PEFA indicator concerned with medium-term budget strategy (PI-14) is rated D+. Budget preparation includes estimates of revenue, expenditure, and transfers, but no forecasts are based on macroeconomic indicators or fiscal or sectoral strategies. In addition, costing information of major investment projects is not included in the budget documents (PI-11.3, rated D).

The oversight arrangements, including those related to the budget preparation process and legislative scrutiny over the budget, have been assessed as reasonable (PI-17, rated B and PI-18, rated C+).

Other indicators that relate to the strategic allocation of resources are satisfactory. While no clearly defined and published standard criteria for investment project selection exist, the government executive selects and prioritizes major projects (PI-11.2, rated C). Budget documentation is considered to meet three basic requirements (PI-5, rated C). However, costing information of major investment projects is not included in the budget documents (PI-11.3, rated D); and budget classification is not in accord with international standards (PI-4, D).

Efficient use of resources for service delivery

Chaling’s PFM system encourages the efficient use of resources for service delivery. The share of the budgetary units which publish performance targets is not high (PI-8.1, rated C) and performance evaluation is not regularly conducted (PI-8.4, D). The low budget reliability and predictability of in-year resource allocations (PI-21, rated D) may adversely affect the capacity of service delivery units in making efficient resource use.

Required mechanisms are in place to reduce the possible leakage of funds, such as the asset management system (PI-12, rated B) and the internal controls over payroll (PI-23, B+) and non-salary expenditure (PI-25, B). As for the procurement management system, there is strong monitoring of large value contracts, and largest contracts adopt competitive methods. But there is no monitoring of, and no procurement methods for, small-value contracts (both PI-24.1 and PI-24.2 are rated D*).

Ratings of the oversight arrangements are mixed (C+ for PI-30 and B for PI-31). Audit coverage is high, and the audit reports are submitted to the People’s Congress within nine months. Effective and timely required follow-up actions are taken by the concerned entities. However, the representatives of the budgetary units that have issues disclosed by the auditors, except for that of Finance Bureau, are not required to attend the hearings, and hearings on audit reports are not accessible to the public.

In summary, the Chaling PFM system performs at sub-optimal level, but there is great potential for improvement if the regulatory framework of the CG and provincial government allows. The ongoing reforms, promoted by the CG and fully embraced by Hunan Province, provide a good opportunity and foundation for the City Government to carry out the necessary PFM reforms.

The assessment results are to be interpreted with an important caveat in mind. As Annex 7 shows, LGFVs carried out sizeable quasi-governmental activities while operating outside of the PFM system (Annex 7, PI-6, D). The Chaling Government has basic monitoring obligations over the investment projects that LGFVs implement (Annex 7, PI-11.4, C) and their liabilities (Annex 7, PI-13.1, A). A comprehensive assessment for LGFVs is warranted to reveal the impact of LGFVs on the PFM performance of Chaling County.

China has launched ambitious fiscal and taxation reforms since 2014. The revised landmark Budget Law and its associated directives have laid out a solid foundation for a modern fiscal framework. The main motivation has been to better serve the transformation of the government functions from boosting growth, more toward delivering quality public goods and services. The major changes mandated by the revised Budget Law fall into five areas: 1) making the budget comprehensive and transparent; 2) improving credibility and medium-term perspective of the budget; 3) allowing provinces to borrow on budget within the regulatory framework; 4) making transfers transparent, fair and pro-equalization; and 5) hardening budget constraint. The recently released Government Investment Decree in 2019, if effectively implemented, could enhance the discipline and scrutiny around government investment projects and contain contingent liabilities associated with their financing.

The reforms that are currently being pushed by the Central Government (CG), and fully embraced by Hunan Province, provide a good opportunity and foundation for the city government to carry out the needed PFM reforms. PFM in China is a long-term endeavor, requiring requiring the concerted effort of all tiers of government and coordinated adaptation of all public-sector institutions.