The end of the bubble is nigh

Prior to the 2008 Financial Meltdown there were ample signs that the US economy was heading for calamity, but no one chose to believe it.

Now in 2011 China's economy is showing equal amounts of red flags that its economy is is going to become unhinged in the near future. This is is happening, one can choose to believe it or not.

China’s National Audit Office has completed a review of the scope of local government debt. The report is politicized and conflicts with a similar report released by the People’s Bank of China, but it reveals some of the country’s risky financial practices. It also calls into question Beijing’s ability to manage its debt.

Analysis

China’s National Audit Office (NAO) has completed a long-awaited review of local government debt and submitted it to the National People’s Congress, Xinhua reported June 27. The report claims that total local government debt amounted to 10.72 trillion yuan ($1.7 trillion) by the end of 2010. This sum is close to the 10 trillion yuan estimate leaked in late May. The NAO’s 10.7 trillion yuan total is lower than the 14.4 trillion yuan estimated by the People’s Bank of China (PBOC) earlier in June. (The PBOC claimed its estimate covered only the “local government financing vehicles,” or LGFVs, that were set up to handle investment projects for local governments, which are, with a few exceptions, forbidden by law to run deficits and issue bonds.)

The NAO report is obviously politicized and has been used to argue that the local government debt problem is not as bad as many had assumed — indeed, the report downplays China’s local government debt problem. However, the report provides insight into China’s systemically risky practices, and it calls into question the assumption that China can manage its debt.

The NAO Report

The NAO investigation, launched by Premier Wen Jiabao in March 2011, was a long-anticipated attempt by China’s central government to get a reliable measurement of the full size of the local government debt problem. The office claims to cover a wider range of local government debt than the PBOC, relating to multiple types of agencies and entities in addition to LFGVs (though it did not survey as many LFGVs as the PBOC claimed to have surveyed). The NAO estimated LGFV-specific debt at about 5 trillion yuan — much lower than the PBOC’s estimate. The NAO’s estimate would put total local government debt at 27 percent of GDP, whereas the PBOC’s estimate for LGFVs would put that debt at around 35 percent of GDP.

If the NAO’s estimate for non-LGFV debt (5.7 trillion) is combined with the PBOC’s estimate for LFGV debt (14.4 trillion), then total debt amounts to around 20 trillion yuan, or 50 percent of GDP, for the fullest estimate of total local government debt, according to Victor Shih, an authority on China’s local debt issues. When combined with the central government’s debt — around 20 percent of GDP — the country’s gross public debt would be somewhere in the vicinity of 70 percent of GDP, making its public finances appear much worse than official announcements would indicate. Though this amount would still not reach the highest debt levels seen in some crisis-hit developed countries, it would be higher than China has heretofore allowed. More important, this moment of transparency reveals much that remains opaque in China’s public liabilities — and that debt is rapidly growing in the investment-driven economy.

It is unsurprising that the NAO report differs from the PBOC report and other reports, estimates and leaks. There is a fierce debate taking place in Beijing about the size the debt problem and ways to manage it, with the Ministry of Finance having proposed a 3-4 trillion yuan bailout plan — yet to be adopted — that suggests a large portion of local government debt could turn sour. Notably, the NAO did not provide an estimate for how much of the 10.72 trillion yuan local government debt would go bad. (Previous estimates suggest as much as 20-30 percent could go bad, an estimate conforming to China’s supposed 35 percent bad-debt ratio in the round of state bank bailouts in the 1990s and 2000s.) Nevertheless, the fact that official government reports differ not only on the total amount of debt but also on which organizations are liable and to what extent, suggests serious systemic financial risk.

Moreover, the NAO report gives some insight into the situation beyond the size of the debt, and what it reveals is fairly grim. This is because it reinforces the notion that local governments are rapidly accruing debt. It estimated local debt growth at 62 percent in 2009 and 19 percent in 2010, roughly supporting the PBOC’s previous estimates. It also reinforces the view that LGFVs are borrowing without sufficient collateral, and that they have used borrowed funds to speculate in stocks and property. Moreover, they are using new credit to pay off old debts, with 5 percent of LGFV’s reported to have done so but no specified value of the loans involved. As a result, there is widespread and rapidly building credit risk with ill-defined parameters, confusion as to liability (the NAO report says local governments are only directly liable for 63 percent of the debt, though indirectly for all of it), and the practice of state banks issuing evergreen loans. This practice of rolling over debt endlessly was characteristic of Japan and other Asian financial systems before suffering financial crises in the 1990s. And this is merely the “official” account of the situation; it therefore is likely to hide factors that would be deemed detrimental to the country’s stability if widely disseminated.

The ongoing bailout and bond issuance debate in leadership circles suggests that the local government debt is not felt to have reached a crisis yet. The PBOC claims 50 percent of the debt is not due till 2014-15, whereas the NAO claims 70 percent of the debt is not due until 2014-15. And according to the NAO, some LGFV debt is not being paid on time, but so far only 8 billion yuan is overdue.

Managing the Debt

The net effect of these varied reports is that China is sitting on a massive stock of debt amounting to around 27-50 percent of GDP that was incurred mostly within the past two years. This rapid debt accumulation has proved difficult to control in 2011, with government attempts to restrain bank lending leading companies and banks to evade controls by borrowing through channels outside of banks. The total new credit (total social financing) in 2011 is likely to equal the total in 2010, at roughly 14 trillion yuan. In other words, the build-up is continuing, as is the disguising of the problem.

Chinese authorities appear to be coming closer to authorizing wider local government debt issuance, which they have allowed as part of a trial program in recent years to provide the governments with a more reliable and transparent means of financing their spending. This would alleviate financial pressures on local governments that have led to their operating in gray areas, such as creating financing vehicles and disguising debt. However, such a move would also bring its own threats to central control. Wider allowances for local government bond issuance are likely to come only after wiping off bad debt from their accounts to make their bonds more attractive to investors, along the lines with the rumored Finance Ministry plan. The size of the local government debt suggests a massive bailout plan is in the works, even if it is not implemented immediately. The country’s financial system and economic planners must face these massive debt and bailout challenges — even as a leadership transition is under way.

It has been said that China’s rapid growth makes this debt manageable; this assumption is inaccurate. Though China has maintained an average of 10 percent growth per year for 30 years, this means a correction is coming sooner rather than later. Worrying signs in the export sector point to the fact that the current economic model is expiring. China may be able to delay debt payments, reshuffle among government entities and bail out indebted entities for a period of time, but ultimately the financial burdens on the system will further delay the process of building up household wealth and increasing household consumption. The result will be that rebalancing the economy will be further away than ever and growth rates will fall.

STRATFOR