Paper tiger: China's potential debt disaster

China’s National Audit Office has finally released its country-wide survey of government liabilities just a day shy of 2014, assuaging concerns and stoking fear at the same time.

54,000 auditors undertook the largest audit of government debt last year. They examined 730,065 projects and checked nearly 2.5 million loan and quasi-loan agreements. Their forensic investigations covered mighty central government agencies like the Ministry of Finance as well as small towns in far-flung corners of the country.

The undertaking is by far the most ambitious and thorough investigation of China’s worrying debt problem, which many investors and commentators regard as a time bomb waiting to go off.

The results have shown an explosive increase in local government debt, averaging 19.97 per cent growth for the last three years. The collective debt of local governments increased nearly 3.9 trillion yuan ($A720 billion) to 10.6 trillion yuan by June 2013.

Chinese local governments also explicitly guaranteed 2.7 trillion yuan worth of debt. In addition, they are also expected to shoulder at least part of 4.3 trillion yuan liabilities incurred by other corporate and semi-government entities.

The total size of government debt including official debt, explicit and implicit loan guarantees amount to 19.6 trillion yuan, or about the third of China’s GDP.  However, it is improbable that all of these officially guaranteed debts will turn sour, leaving local governments to pick up the tabs.

The audit office calculates that local governments are expected to cough up only a small percentage of these guaranteed amounts in the event of default: 19 per cent for the explicitly guaranteed loan and about 15 per cent for implicit debts.  

The central government debt, which is far more transparent and less controversial, is about 9.7 trillion yuan, including explicitly and implicitly loan guarantees. The total debt level (both central government and local government) is about 54 per cent of China’s GDP, which is below the 60 per cent threshold set by the European Union for admitting new members under the Maastricht Treaty.

China’s debt picture looks much rosier if we accept the National Audit Office’s assumption that local governments only need to a pay small percent of their contingent liabilities, which include both explicit and implicit debt guarantees. The audit office estimates China’s total debt-to-GDP ratio is about 40 per cent.

Whatever the size of debt – be it 40 per cent or 54 per cent – the total amount is concerning, but not on the verge of implosion.  The total debt level falls somewhere between the worst-case scenario of optimists and best-case scenario of pessimists.

Chinese stock markets posted modest gains on the news of the audit office’s report. Shanghai index increased 0.88 per cent and Shenzhen stock exchange was up by 1.53 per cent.  The Chinese market is relatively comfortable with the overall debt level.

However, the biggest risk factor is the rapid growth rate of debt, which is outpacing both China’s economic growth and its increase in tax revenue.

Despite an official crackdown on the local debt binge since 2010 after China unleashed the 4 trillion yuan stimulus package – which is partly credited for saving Australia from a recession – local debt levels surged nearly 60 per cent in the last two and half years.

If such trend was allowed to grow unchecked, China’s local debt problem could very easily turn from a tamed beast into an unshackled monster.

During the same period, China’s GDP growth decelerated from the customary double digital growth to 7.6 per cent.  Similarly, growth in tax revenue collection also slowed from 24.8 per cent in 2011 to a mere 7.5 per cent this year. China’s slowing economy casts further doubt on the ability of local governments to service their debts.

Apart from the worrying trend of rapid debt growth, certain local areas and industries of China are more heavily indebted than others. For example, the audit report reveals that three provinces, 99 cities, 195 counties and 3465 townships have a debt-to-GDP ratio of more than 100 per cent and are likely to experience hardship in repaying their debts.

The audit office is also expecting debtors, who have borrowed heavily to build China’s extensive highway system, to come under acute pressure as well.  It must also be noted that Chinese local governments are also heavily dependent on land sales to service their debts.  It is estimated that more than one third of the 9.3 trillion yuan local debt will be paid for by proceeds from land sales.

China’s total debt level is manageable at the moment and is still below the internationally accepted red line of a 60 per cent debt-to-GDP ratio. However, we don’t have to go back that far in history to know that such threshold is far from infallible during a crisis.  

Ireland had a very respectable debt-to-GDP ratio of 25 per cent before the sub-prime crisis in 2007. However, when the global financial tsunami swept across the former Celtic tiger, the debt level soared, reaching 121.5 per cent in 2012. The country’s bank guarantee alone amounted to 40 per cent of GDP.

This is the first part of a series of articles exploring China’s burgeoning debt problem. 

Follow Peter Cai on Twitter: @peteryuancai