Here's the real deal behind China's 'urgent' debt audit

Is it really in a debt emergency?

According to Bank of America Merrill Lynch, with the National Audit Office’s (NAO) “urgent audit announcement” of China’s local government debt last Friday, markets were rattled on Monday. 

"We are not saying that markets should be complacent about local government debt, but we  see little new news," said BofAML.

Here's more:

Actually, the Chinese ” in the context of the NAO announcement simply means “important” instead of “urgent”. We believe the audit has been planned for several months as part of the new government’s mandate.

We may take this audit as a first step in the new leaders’ “kitchen sinking” move (i.e., all debt recorded at this point in time is the previous government’s responsibility), and a bit more transparency is always welcome.

What’s the approximate size of local government debt?

We believe the results of this audit won’t surprise markets. The previous national audit of local government debt took place in 2011 with the conclusion of RMB10.7tn local government debt as of end-2010.

Note that the previous audit did not include township government debt while this time township governments will be covered. Our calculation put the total local government debt (including townships) at around 15tn to 16tn as of end-2012, or about 30% of China’s GDP.

Why isn’t China in a government debt emergency?

Though we believe the new leadership should take the local government debt seriously and seek solutions to restructure it, we don’t think China is on the brink of a government debt crisis, especially if the new leaders can take sensible measures in coming years.

This is because (1) The central government has a very low debt to GDP ratio at 20%, and it has cash savings at the PBoC equivalent to 6% of GDP;

(2) Almost all government debt is denominated in RMB and owned by domestic entities, meaning that the PBoC can prevent a government debt crisis with its unlimited capability in liquidity supply;

(3) China has a huge national savings with US$3.5tn FX reserves, 20% reserve requirement ratio and only 65% loan-to-deposit ratio, implying that room for the central bank to support the government in an emergency is quite large;

(4) The government, both central and local, owns significant assets; and (5) Despite a slowdown, China still has relatively high economic growth (7.6% yoy in real term in1H13) and fiscal revenue growth (7.9% yoy in nominal terms in 1H13).