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Why China’s Local Government Debt Is So Scary

Tuesday, 5 Jul 2011 | 10:14 AM ET
Yuan
Frederic J. Brown | AFP | Getty Images
Yuan

The economy of China is either the twenty-first century's greatest economic story or a treadmill to Hell. It depends on whom you ask.

There are bright and admirable people on both sides. Jim Chanos of Kynikos Associates and Hugh Hendry of Eclectica have been warning that China’s economy is much more fragile than it appears—and attempting to profit from any collapse by shorting various angles of the China story. Jim Rogers says they are “dead wrong.”

From my perspective, this is part of the problem. The Chinese economy is so dominated by the state—and the state so dominated by a ruling clique dedicated to preserving both power and reluctant to embrace informational transparency—that it remains extremely murky.

The opacity of China doesn’t necessarily mean China’s economy is going to fall off a cliff. But it does mean it’s hard to trust the road maps the government is printing and selling to investors.

Just last week China’s official national auditing board said that local government’s owed about 10.7 trillion yuan ($1.65 trillion).

This morning, Moody’s is out with a report that says China's local government debt may be 3.5 trillion yuan ($540 billion) larger than auditors estimated.

Before your eyes glaze over at looking those trillion and billions, let’s reduce them to something a bit more understandable. If Moody’s is right, this means China’s auditors missed around one-quarter of the debt of local governments. That’s a huge gap between the official figures and reality.

If this was purely an error, it is a terrifying error. It would mean the guys credited with managing China’s economy have badly skewed perceptions of the country’s economic reality. How can Chinese authorities manage a soft landing for the Chinese housing bubble, effectively fight inflation, or prevent a financial collapse if they do not know to extent of their domestic credit expansion?

And there is always the possibility this is worse than error. It may be a cover-up. Back in May China's financial regulators announced plans to shift 2-3 trillion yuan ($308-463 billion) of debt off local governments and onto the balance sheet of the central government. Is it just a coincidence that the secret debt discovered by Moody’s is very close to this amount?

Why would the government cover up or turn a blind eye to local government debt? Perhaps because these extreme levels of indebtedness threaten to spark a financial crisis or derail plans to fight inflation. China’s banks have huge exposures to these local governments. A slowdown in the economy could result in defaults, which would show up as losses on the balance sheets of the banks. Chinese monetary authorities could face pressure to ease up on inflation fighting in order to prevent the collapse of large Chinese banks.

The level of local government debt also threatens to undermine the perception that the economy is growing organically. China’s entire GDP is just under $5 trillion. With local government debt at over $2 trillion, you have to wonder how much of China’s growth is driven by markets and how much is just artificial demand created by government spending.

Regardless of whether it’s a cover-up or an oversight, the murkiness of China is frightening. Even if this is just a miscount by Moody’s, investors have cause for alarm. We just do not know that much about what’s really going on with the Chinese economy.

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