China Orders An Audit Of Government Debt Amid Slowdown And Concerns Over Impact Of Local Government Debt On Banking System

China’s top auditing body, the National Audit Office, or NAO, on Sunday, ordered an immediate nationwide audit of government debt, amid concerns over the effect of mounting corporate and local government debt on its banking system, as the country's economic growth falls to its slowest pace in decades.

The audit highlights worries that heavy borrowing by Chinese companies and local governments for housing, commercial, transportation and infrastructure projects, which have failed to generate adequate returns, may put the country’s state-owned banking system in jeopardy.

“In line with a request of the State Council (the highest state administrative body), the NAO will organize auditing agencies across the country to carry out an audit of government debt,” the national auditor said in a statement on its website, but did not provide any other details, nor a timeframe, for the audit.

Chinese media had reported earlier this month that the audit was one of the priorities set by the State Council and that government investigators were undergoing training to begin the process this week.

NAO’s last audit report, published in 2011, found that China’s local governments had a total debt burden of 10.7 trillion yuan ($1.73 trillion) at the end of 2010. In comparison, China’s gross domestic product, or GDP, was nearly 52 trillion yuan in 2012.

The International Monetary Fund, or IMF, in a report published on July 17, found “rising domestic vulnerabilities” in China’s financial sector and local government finances, and estimated the “augmented” government debt, including local government financing vehicles, or LGFVs, and off-budget funds, at 45 percent of GDP in 2012.

“The expansion of nontraditional finance has accompanied a build-up in borrowing by local government through off-budget financing vehicles, particularly since 2009,” the report said.

“While the size of augmented government debt and overall government resources suggests that fiscal challenges are currently manageable, further rapid growth of financial sector exposures to LGFVs would increase the risk of an eventual disorderly adjustment,” Markus Rodlauer, the IMF’s mission chief for China, said in the report.

The IMF said the vulnerabilities in local government finances were due to “a mismatch between expenditure mandates and revenue sources.”

“A by-product of this is local governments’ reliance on land sales for financing, which creates distortions in the real estate market—the third category of domestic risks examined by the Fund team,” the report said.

In March, the China Banking Regulatory Commission, or CBRC, asked banks to tighten lending to LGFVs, according to Chinese media reports, which cited an industry circular issued by the commission.

CBRC directed banks to reduce their LGFV loan limits, to exercise caution while lending to LGFVs with high debt ratios and to avoid lending to LGFVs with debt-to-asset ratios over 80 percent, Global Times reported.

CBRC Chairman Liu Mingkang had said, in 2011, that the Chinese government’s debt-to-GDP ratio was far lower than those in Europe and the U.S., adding that debt risks faced by local governments, which financed 80 percent of their cash flow needs through LGFVs and owed to banks, were controllable, according to a Xinhua report.

The audit order was issued a week after the central government imposed a five-year nationwide ban on construction of new government buildings, including expensive training centers and government hotels, as part of an ongoing frugality campaign, according to Xinhua.

The order, issued jointly by the Communist Party of China, or CPC, and the State Council, also bans the CPC and government bodies from collaborating with private entities for construction projects.