China Orders Government-Debt Audit as Growth Risks Rise

China will start a nationwide audit of government debt this week as the new Communist Party leadership investigates the threats to growth and the financial system from a record credit boom.

The State Council, under Premier Li Keqiang, ordered the review, the National Audit Office said in a statement yesterday. The office suspended other projects for this “urgent” work requested on July 26 and will send staff to provinces and cities this week, People’s Daily reported yesterday on its website, citing sources it didn’t identify.

Chinese stocks fell as the first full audit in more than two years underscored dangers to the economy from borrowing by local governments and an expansion of non-traditional sources of credit. The new leadership oversaw a showdown with state-owned lenders last month as the People’s Bank of China engineered a cash squeeze to pressure banks to better manage their liquidity and assets.

“Local-government debt has become a focus in recent years and is a source of concern about China’s growth,” said Ding Shuang, senior China economist at Citigroup Inc. in Hong Kong, who previously worked for the International Monetary Fund. “The new leadership is trying to give a clear answer.”

The benchmark Shanghai Composite Index fell 1.7 percent at 2:45 p.m. local time on the debt concern and a report on July 27 showing Chinese industrial companies’ profit growth slowed to 6.3 percent in June from a year earlier, compared with a gain of 15.5 percent in May.

Sustain Growth

Last week, China announced what Bank of America Corp. called a “small stimulus,” expanded a crackdown on wasteful government spending and ordered cuts in manufacturing overcapacity, as new leaders grapple with a slowing economy and public concerns ranging from house prices to corruption. Efforts to sustain growth include small-company tax breaks and speeding up railway construction, while frugality measures include a five-year ban on building government offices.

The first audit of local-government debt found liabilities of 10.7 trillion yuan ($1.75 trillion) at the end of 2010, the National Audit Office said in June 2011.

The audit’s urgency may be because “confidence in the Chinese economy from all sides has weakened recently,” Ding said.

Ding estimated China has at least 12 trillion yuan of local-government debt. The review may pave the way for future fiscal reforms, including changes to rules on local governments’ roles and responsibilities, Ding said.

The People’s Daily newspaper, the Communist Party mouthpiece, reported on the audit office’s statement on today’s front page, without mentioning the additional information given on its website.

Deficit Ratio

Separately, China’s government has decided to cap the ratio of the fiscal deficit to gross domestic product at 3 percent in a bid to avert a downgrade of China’s credit rating by international rating companies, China Business News reported today, citing an unidentified person familiar with the matter.

That “could be potentially a very stringent requirement” if the government “were to consider all the off-budget spending,” Yao Wei, China economist at Societe Generale SA in Hong Kong, said in a note today. The deficit has been “hovering above 5 percent of GDP for several years now” when considering increases in local government debt, Yao wrote.

China Development Bank, the world’s largest policy bank, signed a cooperation agreement July 26 with the government of the eastern province of Jiangsu on supporting economic restructuring, Jiangsu Daily reported yesterday without giving financial details. Jiangsu is China’s second-biggest economy after Guangdong province.

Shadow Banking

The first quarter’s record $1 trillion increase in economy-wide financing contrasted with an unexpected growth slowdown, suggesting China is becoming less responsive to credit. Data from June showed China made progress in curbing shadow banking while slowing money-supply expansion.

The government must be on “high alert” to the dangers of rising borrowing, Vice Finance Minister Zhu Guangyao warned on July 5, after central bank Governor Zhou Xiaochuan said in March that about 20 percent of local government debt is risky.

Local-government financing vehicles need to repay a record amount of debt this year, prompting Moody’s Investors Service to warn that Premier Li may set an example by allowing China’s first onshore bond default.

Regional governments set up more than 10,000 LGFVs to fund the construction of roads, sewage plants and subways after they were barred from directly issuing bonds under a 1994 budget law. A 4 trillion yuan stimulus plan during the 2008-09 financial crisis swelled loans to companies, which they have been rolling over or refinancing with new note sales.

Bond Sales

LGFVs may hold more than 20 trillion yuan of debt, former Finance Minister Xiang Huaicheng said in April. Refinancing will be a challenge after corporate bond sales slumped to a two-year low in the second quarter and policy makers cracked down on shadow-banking activities that bypass regulatory limits on lending.

An audit is the “first step to solve the local-government debt problem -- you have to know the details and then you’ll know how big the problem is,” Zhu Haibin, chief China economist at JPMorgan Chase & Co., said in a media briefing in Beijing today.

While local government debt may have increased to 13 trillion yuan or 14 trillion yuan, the amount as a proportion of GDP hasn’t changed much, Zhu said.

Debt Burden

Societe Generale estimates that the debt servicing cost of non-financial companies and local government investment vehicles was about 39 percent at the end of last year, based on an average interest rate of 6.3 percent and an average maturity of 4.4 years. Their debt burden was 145 percent to 150 percent of gross domestic product, economist Yao estimated in May, citing “rough” calculations made more difficult by limits on lending data, especially for shadow banking.

Charlene Chu, an analyst at Fitch Ratings in Beijing, has flagged the broader risks to the financial system from total lending by banks and other financial institutions in China that Fitch estimates grew to 198 percent of GDP last year from 125 percent four years earlier. Fitch cut the nation’s long-term local-currency debt rating in April, in the first downgrade by one of the top three rating companies in 14 years.

Elsewhere in Asia today, Japan’s retail sales unexpectedly fell in June from May, a report showed. Hiroaki Muto, an economist at Sumitomo Mitsui Asset Management in Tokyo, said the decline was “payback” after a jump the previous month and consumption “will probably continue to stay solid.”

European data to be released include U.K. mortgage approvals for June and Italian business confidence for July. In the U.S., the National Association of Realtors will publish its June pending sales index of previously owned homes, while the Federal Reserve Bank of Dallas will report on Texas manufacturing activity this month.

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