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January 9, 2014

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Home » Business » Biz Commentary

Reform implementation still key after China debt audit

By Fitch Ratings | January 9, 2014, Thursday | Print Edition

China’s public debt audit shows the continued growth of local and regional government (LRG) debt and highlights the importance of LRG reforms announced in November. The level of debt disclosed does not materially differ from Fitch’s estimates when the agency downgraded China’s sovereign Local-Currency Long-Term IDR to “A+”/Stable from “AA-”/Negative in April 2013.

The Chinese National Audit Office said late last month that total LRG debt stood at 17.8 trillion yuan (US$2.9 trillion) as of June last year. This is in line with Fitch’s 18.5 trillion yuan estimate for the first half of 2013, which included an estimate of at least 4 trillion yuan in credit extended to LRGs via shadow financing channels.

The official figure for total direct LRG and LRG-guaranteed debt of 13.5 trillion yuan (12.1 trillion yuan by end-2012) is also broadly consistent with our end-2012 estimate of 12.8 trillion yuan, or 23-24 percent of China’s GDP.

The audit improves transparency, which has been a key weakness for the Chinese LRG sector. Routine provision of data on aggregate LRG debt and other key metrics would be a major step toward addressing this weakness.

Nevertheless, the audit confirms that LRG debt is still rising, and the associated risks remain. The 63 percent increase in LRG debt since the previous audit at end-2010 outpaced the 40 percent cumulative GDP growth in the same period. The rising debt of sub-national governments was a key reason why Fitch downgraded China’s sovereign Local-Currency IDR in April. Further growth in government debt could eventually exert pressure on the sovereign credit profile.

The audit therefore highlights the importance of LRG reforms announced in November. These included a proposed change in how public officials’ performance is evaluated, and a more transparent and efficiently regulated financing system. Effective implementation of these reforms could improve fiscal transparency and overall budget management, which would be credit positive for Chinese LRGs. This could reduce the risks to financial stability and the sovereign credit profile associated with recent rapid credit growth and use of the shadow banking system.

We expect Chinese LRG budgetary performance to remain stable over the near-term, as economic growth, although slowing, remains strong (we forecast 7 percent growth in 2014), and revenues solid. Fitch expects revenue transfers from central government would be likely to smooth over any short-term volatility in debt-servicing, although this reinforces the connection between LRGs and the sovereign credit profile.

However, LRGs do face headwinds from slowing growth, structural tax reform, rising social expenditures and large indirect debt. Annual debt growth rates remain higher among lower-tier LRGs, which have less financial resources and more spending responsibilities under the current institutional framework in China. This makes them more likely to fill the funding gap by debt financing.

According to the audit results, around one third of LRG debt is serviced by sales proceeds of land use rights. Lower-tier LRGs especially could be exposed to property market volatility.

And the growth of shadow financing in recent years could increase the interest burden and refinancing risk for LRGs. The announcement by China’s National Development and Reform Commission that LRGs could issue new debt to complete projects that are not yet generating expected revenues appears to acknowledge the widespread rolling over of LRG debt, which may in turn increase refinancing risk in the future.

 

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