By Judith Ugwumadu | 19 November 2014

China will introduce an accrual-based financial reporting system in an attempt to improve the alignment of local government tax and spending with central government.

Such a change would create a standardised risk-warning system to better deal with a debt crisis.

The announcement was included in a statement on changes to fiscal governance issued by China’s ruling Communist Party on November 15.

Mounting government debts led to concerns over the strength of the Chinese economy. The creation of an improved budget management system would seek to implement comprehensive, standardised, open and transparent budget structures, the government said.

Its statement pledged to ‘deepen the reform of the tax system’ by enhancing local tax systems and gradually increasing the proportion of direct taxes. China also plans to reform VAT and simplify taxation.

A reformed tax system would optimise the allocation of resources, encourage fairness and promote state stability in the long term.

To achieve this, China said it would improve legislation and clearly define how responsibilities are split between central and local government.

Responding to the measures, ratings agency Fitch said: ‘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.

‘The most obvious impact of improved budget management is that it would help ease the debt burden of [local and regional government bodies], by reducing unsustainable dependence on land sales and other forms of unstable financing activity. Ultimately, this would reduce the risk of a credit crunch.’

The agency noted that a stabilisation or lowering of local government debt could also benefit the China’s credit profile by reducing contingent liabilities. However, this would work only if the process did not impair central government finances, for example by increasing transfers from central to local government.

The ratings agency continued: ‘The proposed reforms are ambitious in scope, although implementation will not be so straightforward. The main challenge could come from vested - and increasingly powerful - interest groups at the local level.’

Back in July China ordered an urgent and comprehensive audit of government debt.

Meanwhile, the Organisation for Economic Corporation and Development said today that China would remain weaker than previously projected in most other major emerging market economies.