Local Government Debt Audit Sheds Light on What’s Ailing China

For the last year Chinas credit growth has been going gangbusters, with total social financing up 13.2% in the first 11 months of 2013 from a year earlier. Meanwhile, growth in the real economy slowed to about 7.6%, its slowest pace in years.

That has led analysts to wonder where all that money is going. Has China run out of productive ways to invest?

An audit of government debt published Monday hints at a possible answer. The National Audit Office surveyed not just the central government but thousands of regional and local governments around the country to find out just how much theyre on the hook for. Unlike most countries, Chinas localities owe more than the central government.

The results came in below some estimates, but theyre worrying all the same. Local government debt and liabilities came to 17.9 trillion yuan ($2.95 trillion) at end-June, a rise of 67% in two-and-a-half years.

Much of that was channeled through local government financing vehicles, corporate entities set up to sidestep restrictions on direct borrowing by governments. These vehicles are a financial black box: Much of the money may have been siphoned off into kickbacks or wasted on pointless construction projects.

Even where the money has been spent on worthwhile, genuinely productive infrastructure investments, it will be a long time before these projects can generate meaningful cash flows. Meanwhile, much of the borrowing that funded them is about to come due.

According to the NAO, which took a snapshot of outstanding debts halfway through 2013, 22.9% were due to mature before the end of the year. The report didnt provide any details on what happened after that, but so far there have been no known defaults. That suggests some of the debt is being rolled over and counted as new lending.

As long as local governments are servicing their interest payments, it is not uncommon for Chinese banks to roll over principal and count the exposure as performing, Fitch Ratings said in a report in September. This makes these assets more akin to perpetual bonds that derive a steady stream of cash interest but limited or zero principal.

This extend and pretend strategy helps prevent local governments woes from erupting into a financial crisis. But in the long run it spells trouble for the banks.

Still, in a way its good news: It means China may not have run out of productive ways to invest. Perhaps new lending could generate real growth if it were directed to people who struggle to borrow, like farmers or entrepreneurs.

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Local Government Debt Audit Sheds Light on What’s Ailing China