On July 28th, China’s National Audit Office (NAO) announced that it will conduct a nationwide audit of government debt as Beijing tries to ascertain the financial risks to China’s continued growth.
Ordered by the State Council, the audit will be the first full review of governmental debt in more than two years after the NAO reported local government liabilities of 10.7 trillion yuan ($1.75 trillion) at the end of 2010. Last year, a partial sampling looking at 36 cities found their debt burden had increased by 12.9 percent over what was reported in the last audit. Simple averaging shows that each of those cities has just over $17 billion in debt – almost on par with Detroit, which recently filed for bankruptcy.
Chinese local governments have borrowed heavily to finance infrastructure projects and other investments. Since these governments have restrictions on their capacity to borrow to fund themselves, many have started using non-traditional financing platforms know as “local government financing vehicles.” This makes it more difficult to cleanly assess the debt held.
The review found these vehicles accounted for 45.7 percent of total debt so the ability to repay these obligations has a large impact on overall debt sustainability. Many governments had staked their repayments on rising land values and land sales. Now, as land revenues decline, governments have turned to new borrowing to cover the interest payments on existing loans, exposing them to interest rate risk. In this light, the International Monetary Fund (IMF) viewed local government debt as one of the major sources of domestic risk in its latest Article 4 consultation with China. Although they saw the situation as currently manageable, “further rapid growth of debts would raise the risk of a disorderly adjustment in local government spending.” This would negatively impact growth and have “adverse global spill-overs.”
A lot of this borrowing had stemmed from the aggressive move to stimulate the economy through investment during the financial crisis. Now, Beijing seems to be looking to tighten lending as part of its strategy to turn the Chinese economy from an investment and export basis towards domestic consumption.
Recently, Chinese banks saw a substantial increase in the interbank lending rate (or “Shibor”), which spiked close to 14 percent in late June. The People’s Bank of China (the central bank) declined to provide more liquidity, effectively demonstrating its desire to rein in credit expansion. This parallels the desire of Chinese government officials to recalibrate China’s economic growth as noted in discussions with both the U.S. and the IMF. In the recent Article 4 review, the IMF reported that Chinese authorities “acknowledged that rapid growth had helped mask some of the problems in the past.” Furthermore, the Chinese stated they “were being especially vigilant, particularly with respect to risks in the fiscal and financial sectors.”
China has shifted toward slightly slower and more stable growth lately, targeting 7.5 percent GDP growth for 2013. One of the challenges with this transition is bringing the rate of investment into alignment with the pace of the economy. When GDP growth was above 10 percent, a higher investment rate was sustainable. Now, heavy investment at a lower growth rate could lead to lower returns and possible non-performing loans.
This would further exacerbate the problems of local governments and the banking system. Indeed, the IMF puts the risks of failing to rebalance as “moderate,” indicating that lower returns on investment would cause “bankruptcies and large financial losses.” This audit proves the Chinese government is serious about evaluating and mitigating financial risks within the government. While the audit might reveal some unwelcome financial positions, it will be an essential move to ensure systemic stability moving forward.