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China local government debt has risks for central government, says report

06 January 2014

Category: News, Asia, China
By Asia Asset Management

Moody's Investors Service says that a new report by China's National Audit Office (NAO) shows that local government debt and contingent liabilities are now much higher than what NAO had reported in its first audit on such debt in June 2011, a credit negative development.

Whether the new figures – as outlined in the report released on December 30, 2013 – reflect more thorough accounting procedures or an actual sharp rise in debt, or both, this sizable accumulation in local government debt will be a burden on and carry risks to central government finances.

Moody's conclusions were contained in a just-released special comment titled New Report Shows Sizable Debt Accumulation by China's Local Governments, a Credit Negative.

The Moody's report concludes that direct debt has grown beyond the capacity of many local governments to service it, and the central government may need to provide additional fiscal resources to local governments to bolster their finances and debt-repayment capacity.

The NAO's report also shows that the maturity structure of local government debt is relatively near term, thereby suggesting that general government gross financing needs will further increase.

However, the accumulation of combined local and central government direct debt has been offset to a considerable degree by the rapid rise in nominal GDP growth. As a result, local and central government debt rose relatively moderately as a share of GDP, to 37.1% of GDP in June 2013 from 34.1% in 2010. Nonetheless, Moody's estimates that the large accumulation of local government contingent debt pushed the total direct and indirect debt level to a much higher around 50% of GDP in June 2013.

But such a level is still manageable and future payment capabilities will be enhanced if China's GDP growth remains, in accordance with our central scenario, relatively strong at around 7% per year over the next five years.

Ultimately, the sustainability of the debt build-up will also depend largely on progress in implementing growth-enhancing supply-side reforms to offset the downside pressures on economic growth, which will ensue from efforts by the authorities to rein in local government debt-financed investment showing low economic or social returns.

Another important aspect of the new audit, despite the 2.5-year delay since the initial 2010 audit, is that its greater transparency reduces uncertainty over the actual level of indebtedness for local governments. Even the central government appears to have had been unsure about the level of local government debt prior to the new audit.

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