Rating Agencies Sound the Alarm on China’s Local Government Debt

Credit ratings agency (CRA) Moody’s has amended its outlook on China’s Aa3 credit rating from ‘positive’ to ‘stable’, reflecting uncertainty over the finances of the country’s local governments.

“Progress has been less than anticipated in the process of both reducing latent risks by making local government contingent liabilities more transparent and in reining in rapid credit growth; therefore, some of the upward pressure on the Aa3 rating has eased,” it said.

Moody’s said it affirmed the Aa3 rating because of China’s good credit fundamentals of continued robust economic growth, strong central government finances and an exceptionally strong external payments position.

Nonetheless, the CRA has followed peer Fitch, which last week reduced China’s long-term local currency credit rating to A+ from AA-, on concerns that excessive local government borrowing could present risks for the wider economy.

Fears about local debt arose after Beijing launched a massive economic stimulus package in 2008 as the global financial crisis intensified. Data suggests that local debt temporarily stabilised in 2011 but then grew again last year as policymakers agreed new infrastructure projects to prevent a slowdown of growth in the world’s second largest economy. Fitch has estimated that China’s overall sovereign debt stood at 74% of gross domestic product (GDP) at the end of 2012, of which 49% is central government and 25% local government.

Local government financing vehicles have been accused of making investments in vanity projects and ghost cities that are unlikely to produce sufficient returns to pay off bank loans.

According to a report by the ‘Financial Times’, a senior Chinese auditor has warned that local government debt is “out of control” and could spark a bigger financial crisis than the US housing market crash. The paper quotes Zhang Ke as saying that his accounting firm, ShineWing, had all but stopped signing off on bond sales by local governments as a result of his concerns.

“We audited some local government bond issues and found them very dangerous, so we pulled out,” said Zhang, who is also vice-chairman of China’s accounting association. “Most don’t have strong debt servicing abilities. Things could become very serious.”

He added that government debt had already got out of control and that a crisis was possible. “But since the debt is being rolled over and is long-term, the timing of its explosion is uncertain.”

Downgrade warning

At the end of 2010, China’s National Audit Office (NAO) estimated that ‘local level liabilities’ amounted to renminbi (RMB) 10.7 trillion, then the equivalent of 27% of China’s gross domestic product (GDP), of which RMB6.7 trillion was listed on local government budget balance sheets. However, Moody’s questions whether the figures realistically “represent the full extent of the contingent risks arising from local government financing vehicles”.

It added that the costs could “encumber the central government’s balance sheet and derail the transition to a more balanced and more moderately growing economy”. China’s former finance minister, Xiang Huaicheng, also cast doubt on the NAO figure this month and suggested that actual local government debt was twice the level it had estimated.

Moody’s added that China could potentially face a downgrade in its rating if the economic slowdown proves sharper than expected or if government finances deteriorate due to the risks that the face becoming reality. This scenario could be added to by increased social unrest which “distracts the authorities from the conduct of sound economic and financial policies”.

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