China Local Government Audit ‘Credit Negative,’ Moody’s Says

China’s government risks being forced to bail out some local authorities and take over their liabilities after a report from the nation’s audit office showed a jump in borrowings, Moody’s Investors Service said.

The National Audit Office review indicates that total local government direct and guaranteed debt may have risen 13 percent to 12.1 trillion yuan ($2 trillion) by end-2012 from end-2010, Moody’s said, citing its own calculations based on data in the report which showed a 13 percent increase in the debts of a sample 36 local authorities.

Moody’s lowered its outlook for China’s sovereign credit rating to stable from positive in April, saying the nation has made less progress than anticipated in reducing risks from local-government debt and credit expansion. Earlier that same month, Fitch Ratings Ltd. cut China’s long-term local-currency debt rating, citing increasing dangers to the country’s financial stability given the lack of transparency in local authorities’ borrowing.

“Both the amount of debt among the sampled local governments and the limited scope of the report are credit negative for China,” Moody’s said today, referring to the National Audit Office report. “The amount of local government debt makes it more likely its burden will eventually fall upon the central government and the limited scope of the report makes the size of that potential burden uncertain.”

China CDS

The cost of insuring China’s sovereign debt for five years has increased 41.19 basis points this year. The credit-default swaps rose to a 10-month high of 107.5 on June 12, according to CMA, which compiles data in the privately negotiated market.

The auditor’s report, released on its website June 10, a public holiday in China, showed the debts of the local governments chosen for scrutiny rose to 3.85 trillion yuan in the two years through Dec. 31. The 36 regions accounted for 32 percent of total local government debt at the end of 2010, the auditor said.

The report follows the government’s first audit of local government debt released in June 2011. The investigation found liabilities of 10.7 trillion yuan at end-2010 after local authorities, barred from directly selling bonds or borrowing from banks to pay for projects including roads and bridges, set up more than 6,000 financing vehicles to raise money.

Nine provincial capital cities had debt ratios higher than 100 percent excluding guarantees last year, with the highest at 189 percent, suggesting “protrusive” debt risks, according to the audit report. Some cities had to roll over debts, with five repaying more than 20 percent of debt last year with new borrowings, it said.

Rising Debt

“The pile up in debt is cutting down the effectiveness of economic policy and slowing down growth, reminiscent of ‘zombie companies’ in Japan in the 1990s,” Shen Jianguang, chief Asia economist at Mizuho Securities Asia Ltd. in Hong Kong, wrote in a note today. While the risk of a broad-based default is still controllable, “policy makers will have to take swift action before the situation deteriorates,” he said.

Local authorities face “large pressure” paying off loans where land sales or highway revenues were pledged as a source of repayment, the audit office said. Such debt rose last year while land sales and toll fees fell as economic expansion cooled, it said.

Some regions resorted to new funding channels such as trust loans, financial leasing, wealth management products and build-transfer arrangements after banks tightened lending, the auditor said. Such new channels “engender new, hidden risks” as they’re more difficult to supervise and funding costs are as high as 20 percent, it said.


The auditor’s latest report highlights the lack of transparency in local government financing, Moody’s said. It also shows growing use of “irregular financing” and that local authorities are increasingly rolling over their debt and refinancing, it said.

Moody’s estimated that China’s government debt, including contingent liabilities that have a “high likelihood of winding up on the government’s budgetary balance sheet,” may be more than 40 percent of gross domestic product rather than the 29.4 percent it estimated for the end of 2012.

“Although such a debt burden is relatively modest, especially compared with highly indebted mature sovereigns, the large amount of contingent liabilities illustrates the harm done to China’s balance sheet from unchecked moral hazard and a mismanagement of fiscal risks,” Moody’s said.

— With assistance by Dingmin Zhang

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