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China Plans Urgent Audit of Public Debt

July 28, 2013, 6:43 a.m. ET

China Plans Urgent Audit of Public Debt

Burgeoning Borrowing Adds to Stress on China’s Financial System

PAUL MOZUR and TOM ORLIK

China MS 2_0 China Corporate Debt to GDP_0 China MS 1_0 China MS 3_0 China MS 4_0 China MS 5_0 China MS 6_0

BEIJING—China will conduct an urgent review of overall public debt, highlighting concerns about burgeoning official borrowing that are adding to stress in China’s financial system and limiting Beijing’s capacity to support flagging growth. In a one-line statement on Sunday, China’s National Audit Office said it would carry out an examination of total government debt, acting on the orders of the State Council, China’s cabinet. A separate article in the Communist Party mouthpiece People’s Daily said the order came Friday and that work would begin on the audit on Monday. The article, citing unnamed sources, said the Audit Office would temporarily suspend other projects to begin work on the audit, suggesting the urgency of the task.China’s government has taken on a heavy and growing burden of debt as public investment has replaced exports as a key driver of growth. Economists say high debt hobbles the government’s efforts to provide further stimulus to a slowing economy.

China’s gross domestic product growth slowed to 7.5% year-to-year in the second quarter of 2013 from 7.7% in the first quarter, and many economists expect it to slow further in the second half. One option for the government to prevent a sharper slide is to ratchet up public spending.

But high debt means there is a limit to the government’s ability to act. China’s central government debt is low—14.4% of GDP in 2012, according to the International Monetary Fund. Concern centers on rapid growth in borrowing by local governments.

In response to the 2008 financial crisis, many circumvented rules preventing them from taking on debt by setting up investment vehicles to borrow, funding a wave of infrastructure investment. The People’s Daily article said the audit will move quickly into China’s provinces.

With many infrastructure projects providing low returns, there is a risk that some local governments will be unable to repay their borrowing, raising concerns about bad loans in the banking system. Bank-sector experts worry that a big share of new loans is already being used to roll over bad loans.

The audit also underlines the opacity of the problem, with even the central government in Beijing in the dark about how much borrowing town halls around the country have done. This month, Vice Finance Minister Zhu Guangyao said counting up local debt is a crucial task for the new Chinese leadership that took power in March.

The previous full audit of local-government debt in China was published in 2011 and found debts totaling 10.7 trillion yuan ($1.75 trillion) for the end of 2010. A separate audit of a subset of 36 local governments found they had outstanding debt totaling 3.85 trillion yuan in 2012, up 12.9% from 2010.

In an estimate released in July, the IMF said China’s government debt totaled 46% of GDP. While lower than the debt levels of the U.S., Japan and other developed nations, that figure is considerably larger than suggested by the official data, which don’t currently include borrowing by local governments.

Independent estimates often come up with public-debt levels of 60% of GDP or more, typically by ascribing a higher value to local-government debt, including that taken on by the railways ministry and policy banks such as China Development Bank that are seen as part of the government.

It wasn’t clear Sunday whether the results would be made public.

China to Audit Government Borrowings as Risks to Growth Increase

China will begin a nationwide audit of government borrowings, as the nation’s growth slowdown puts pressure on the new leadership to determine the extent of potential bad debts weighing down the economy. The State Council, under Premier Li Keqiang, requested the National Audit Office to conduct a review, according to a statement from the audit office’s website yesterday, without providing any more details. The first audit of local government debt found liabilities of 10.7 trillion yuan ($1.8 trillion) at the end of 2010, the National Audit Office said in June 2011.

The International Monetary Fund said this month risks are increasing that China’s growth this year will fall short of the lender’s forecast, citing risks from borrowing by local governments and an expansion of non-traditional sources of credit. The government must be on “high alert” to the dangers of rising borrowings, Vice Finance Minister Zhu Guangyao warned on July 5, after central bank Governor Zhou Xiaochuan said in March that about 20 percent of the debt is risky.

China last week announced measures to support the economy such as ordering companies in 19 industries to curb overcapacity and tax cuts for small firms amid signs growth will ease for a third quarter. A report on July 27 showed 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.

LGFV Debt

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

LGFVs may hold more than 20 trillion yuan of debt, former Finance Minister Xiang Huaicheng said in April. That’s almost double the figure given by the National Audit Office in 2011. 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.

To contact Bloomberg News staff for this story: Judy Chen in Shanghai at xchen45@bloomberg.net

China To Kick Bad Debt Hornets Nest

Tyler Durden on 07/28/2013 14:30 -0400

The last (and first) time China’s National Audit Office conducted an audit of local government debt two years ago, in June 2011, it found that local governments and their various financing vehicles had taken on 10.7 trillion yuan of debt as at the end of 2010, which brought the issue of “underreported” high leverage in China to the fore. In the then words of Liu Jiayi, the country’s auditor-general, “some local government financing platforms’ management is irregular, and their profitability and ability to pay their debt is quite weak.

Others quickly chimed in: UBS estimated that local government debt could be 30 percent of gross domestic product and may generate around 2 to 3 trillion yuan of non-performing loans. Credit Suisse economist Tao Dong said it was the biggest “time bomb” for China’s economy. This was the most explicit warning about a credit bubble in China both internally and from “credible” outsiders (not fringe blogs and “conflicted” short-sellers) that had be uttered to date. It certainly wouldn’t be the last as the recent aggressive attempts at deleveraging and reform in the financial system have shown.

Overnight, nearly two years after the first such audit, China announced it is conducting a follow up nationwide inquiry into government borrowings, “as the nation’s growth slowdown puts pressure on the new leadership to determine the extent of potential bad debts weighing down the economy.”

So why now? Bloomberg has some suggestions:

The State Council, under Premier Li Keqiang, requested the National Audit Office to conduct a review, according to today’s statementfrom the audit office’s website, without providing any more details. The first audit of local government debt found liabilities of 10.7 trillion yuan ($1.8 trillion) at the end of 2010, the National Audit Office said in June 2011. 

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

LGFVs may hold more than 20 trillion yuan of debt, former Finance Minister Xiang Huaicheng said in April. That’s almost double the figure given by the National Audit Office in 2011. 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.

In other words, China is preparing to admit that the level of problem Local Government Financing Vehicle debt is double what was first reported just two years ago, something many suspected but few dared to voice in the open. But not only that: since the likely level of Non-Performing Loans (i.e., bad debt) within the LGFV universe has long been suspected to be in 30% range, a doubling of the official figure will also mean a doubling of the bad debt notional up to a stunning and nosebleeding-inducing $1 trillionor roughly 15% of China’s goal-seeked GDP! We wish the local banks the best of luck as they scramble to find the hundreds of billions in capital to fill what is about to emerge as the biggest non-Lehman solvency hole in financial history (without the benefit of a Federal Reserve bailout that is).

Of course, now that China has set off on a reform path of active deleveraging, the “disclosures” about the true state of the world’s biggest housing bubble (one that makes even Bernanke green with envy) are about to start coming fast and furious. And since LGFV debt is just one small part of the Chinese debt bubble and accounts for a tiny fraction of total consolidated Debt/GDP (recall that just Chinese corporate debt is the largest relative to the nation’s GDP anywhere in the world), another theme we have covered extensively in the past, most recently here, one can only wonder what other “discoveries” lie in store.

For a few suggestions of what else may be uncovered soon, here are some excerpts from Morgan Stanley’s recent report “China Deleveraging: A Bumpy Ride Ahead“:

In the aftermath of the global financial crisis, monetary rather than fiscal policy likely played a bigger role in boosting domestic demand in China. This can be seen by the rise in bank credit to GDP. China’s total outstanding bank credit picked up from 102% of GDP in December 2008 to 133% of GDP in June 2013, thereby boosting domestic demand. Indeed, total outstanding bank credit has increased by US$7.2 trillion over December 2008 to June 2013 (Exhibit 9). Also, the non-loan sources of credit such as wealth management products, trust loans and bonds (total social financing) increased by US$3 trillion over the same period. Though policy makers’ stimulus was targeted at both investment and discretionary consumption by households, a  large part of this funding was channeled into investment, with 70% of the loans going towards the corporate sector over this period.

China’s incremental GDP return from leverage has been declining…

Credit-Driven Growth Has Reached Its Limits

Signs abound that the strategy of pursuing growth via credit has reached its limits. Indeed, policy makers are getting concerned about financial stability risks and the misallocation of capital. Some of the key indicators, raising questions about the sustainability of the current trend, are as follows:

#1: Weakening productivity of incremental credit

The asset quality issue in the banking system is the other side of the coin to the loss in capital productivity that we described earlier. Following the 2008 global financial crisis, there was only a brief period of four quarters in 2011 when nominal GDP growth outpaced credit growth. However, in the past six quarters, loan growth has again been outpacing nominal GDP growth. As of June 2013, nominal GDP growth was 8.0% compared with credit growth of 15.1% YoY (Exhibit 16).

This is a reflection of the weakening productivity of incremental credit in our view. If one instead uses social financing (the broadest possible measure of credit) as the gauge, the divergence with nominal growth is even more concerning. In light of current trends, we believe any attempt to push the overall investment growth engine further will only increase the risk of a deeper and prolonged shock later on as it exacerbates the problem of excess capacity, and the continued buildup of leverage and weak profitability growth weighs further on corporate  balance sheets.

#2 Interest rates higher than nominal output growth of secondary sector

The nominal benchmark 1-year lending rate at 6% and producer price inflation at -2.7% imply a real borrowing cost of 8.7% for the corporate sector. However, the true cost of borrowing for the corporate sector is likely higher, given that the weighted average lending rate in the banking system was 6.7% in March 2013 and non-banking borrowing would come at an even higher cost. In comparison, real growth in secondary sector output stands at 7.6%YoY in June 2013 (Exhibit 17).

While CPI is typically used to compute real rates, we have used PPI in China because the bulk of the leverage buildup has been predominantly due to corporates and not households. In any case, the conclusion remains unchanged even if we were to compare nominal interest rates with nominal output growth of the secondary sector (Exhibit 18).

The latter now is 5.1%, lower than nominal corporate borrowing costs. A higher interest rate relative to the underlying income growth means that debt is compounding at a much faster pace than underlying income growth and the debt trajectory ultimately becomes unsustainable. This challenge has emerged because nominal GDP growth has decelerated significantly in the last few quarters. On the other hand, policy makers have been hesitant to cut rates owing to concerns about sending the wrong signals to entities that have overinvested. The current real  interest rate environment will likely exacerbate the asset quality issues in the banking system. Indeed, historical episodes of risk aversion in the financial system in both the US and Japan have also taken place when real rates exceeded real GDP growth.

And so we get to the point where one more country has reached the end of the can-kicking road, and is about to kick the only remaining thing it can instead: the hornets nest of a truly epic debt bubble.

China orders nationwide government debt audit

1:18am EDT

BEIJING (Reuters) – China’s National Audit Office will conduct an audit of all government debt at the request of China’s State Council or cabinet, it said in a statement on Sunday, underlining concern over rising debt levels in the world’s second biggest economy.

The audit office, responsible for overseeing state finances, made the announcement in a one-sentence item on its website, but gave no details on the audit.

The official People’s Daily newspaper said separately on its website, citing unidentified sources, that an urgent order for the audit was issued on Friday and work will start this week.

The audit could indicate increased official concern over the systemic risk from rising debt levels in China, especially debt of local governments, as top leaders slow economic growth in order to promote reform.

A local government buckling under the weight of its own debt is a troubling scenario for the leadership, and one that Deutsche Bank has said could potentially pose a systemic and macroeconomic risk to the country.

Standard Chartered, Fitch and Credit Suisse have estimated local government debt in China at the equivalent of anywhere between 15 percent and 36 percent of the country’s output, or as much as $3 trillion based on World Bank GDP figures for 2012.

Vice Finance Minister Zhu Guangyao said earlier this month that the government did not know precisely how much debt local governments had built up.

The audit office warned in a June report that debt levels among local governments are rising and the financial burdens and risks are not being properly managed. It put total debt of a sample of 36 local governments at 3.85 trillion yuan ($628 billion) at the end of 2012.

China’s budget law forbids local governments from taking on debt directly, but they have borrowed heavily through special-purpose vehicles, while many have also borrowed from companies in private arrangements at high cost, with the money often used in speculative real estate projects.

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About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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