Chinese local government debt audit ordered

The Chinese government has ordered an urgent audit of all debts in its local governments. There is concern that the country’s economic slowdown may affect its financial sector badly. An audit is a formal examination/inspection of an organization or sector.

After the global financial crisis, Chinese local governments borrowed heavily as they tried to sustain growth levels.

An audit published two years ago revealed a total debt of $1.7 trillion (10.7 trillion yuan) by the end of 2010 in Chinese local governments.

Financial experts abroad and within China are starting to wonder whether local governments will be able to repay their loans.

The national auditor announced online “In line with a request of the State Council, the NAO (National Audit Office) will organize auditing agencies across the country to carry out an audit of government debt.”

The NAO says it is acting on the orders from the Chinese cabinet – the State Council.

No deadlines were given for the completion of the audits. The NAO did, however, say that all other projects have been put on hold until the audits are completed.

After the worldwide financial crisis, the Chinese government injected 4 trillion yuan ($0.63 trillion) into the economy to make sure growth continued.

At the end of 2010, local governments in China accounted for four-fifths of all bank lending in the country, according to data from the China Banking Regulatory Commission.

While much of the borrowed money was invested in improving rail and road connections (infrastructure), a sizable amount was also spent on property construction.

The key driver for China’s growth used to be exports. After the global financial crisis, public investment took over as the main driver of the economy.

To achieve this, national and local governments have borrowed heavily. According to economists, when a government has high debts, its efforts to provide further stimulus to a slowing economy are undermined.

Analysts have been warning for some time that Chinese local government projects may not be financially sustainable.

The BBC quoted Dariusz Kowalczyk, a senior economist with Credit Agricole-CIB in Hong Kong who said “A lot of the projects that were invested in will not have the kind of returns that they had initially estimated.”

Add an economic slowdown into the mix, and potential problems start to look more serious.

Has Chinese local government debt been played down?

According to the IMF (International Monetary Fund), China’s central government debt was 14.4% of GDP at the end of last year. Nobody is sure what the total size of China’s government debt is including local government. Many believe local government debt has been underestimated.

Most financial experts and economists believe Chinese local government debt is much higher than 25% of the country’s total GDP (gross domestic product). This figure was reported when the last audit was published.

Economies don’t like the unknown

Psychological factors are often as important as current, reliable economic data in determining how an economy progresses.

If the size of China’s local government debt is “unknown”, that in itself could eventually harm the economy. Ordering a debt audit is a good thing, because it will clear the air.

Chinese GDP grew at an annualized rate of 7.5% during the second quarter of this year. This is less than the 7.7% in the first quarter, and much lower than a couple of years ago.

In order to prevent the slide from gathering momentum, one option is to increase public spending. This cannot be done if debt is too high.

New loans used to roll over bad loans

The 2008 global financial crisis forced many local governments to ignore the rules which would have prevented them from taking on loans. They set up investment vehicles to borrow, and borrowed heavily.

As mentioned earlier, many of the projects provide low returns. The number of local governments that might not be able to pay back what they borrowed could be very high. This will result in bad loans circulating in the banking system.

According to The Wall Street Journal, “Bank-sector experts worry that a big share of new loans is already being used to roll over bad loans.”

CNN Interview with Nomura’s Chief Economist

Zhiwei Zhang, chief economist with Nomura, is interviewed on CNN about China’s debt audit.