Reform Implementation Still Key After China Debt Audit

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, Fitch Ratings says.


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.


Total LRG debt stood at RMB17.8 trillion (US$2.9 trillion) as of June last year, according to the Chinese National Audit Office (CNAO). This is in line with Fitch's RMB18.5 trillion estimate for the first half of 2013, which included an estimate of at least RMB4 trillion in credit extended to LRGs via shadow financing channels.


The CNAO's figure for total direct LRG and LRG-guaranteed debt of RMB13.5 trillion (RMB12.1 trillion at end-2012) is also broadly consistent with Fitch's end-2012 estimate of RMB12.8 trillion, or 23%-24% of GDP.


The CNAO's 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 towards addressing this weakness.


Nevertheless, the audit confirms that LRG debt is still rising, and the associated risks remain. The 63% increase in LRG debt since the previous audit at end-2010 outpaced the 40% 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.


Fitch says effective implementation of these reforms could improve fiscal transparency and overall budget management, which would be credit positive for Chinese LRGs. This could in turn 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% growth in 2014), and revenues solid," says Fitch.


Fitch also 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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