China Economics Seminar

Why is China auditing local government debt again?

Here is what the FT says: 

China will conduct an urgent audit of all government debt, underlining concerns over rising financial risks in the world's second-biggest economy.

The National Audit Office said in a one-line statement on Sunday that it had been instructed by the state council, China's cabinet, to come up with a tally of how much money is owed by all levels of government from villages up to central authorities.

So why do we ask the question in the title?

Because this would be the third audit report on local government debt, only one month after the last report was published, and it comes much earlier than everyone expected, including the National Audit Office (NAO) itself.

Two audits have been done on this subject so far. The first audit covering more than 3000 local governments was conducted from March to May in 2011 and the report was published in June 2011. The second audit was done on a much smaller scale as it only included 36 local governments. It was done during November 2012 to February 2013 and a report was published on June 10th, just a month ago. According to the information provided by the People's Daily, the official newspaper of the Party (in Chinese, for English see the FT report), the third round of the audit was required by the State Council and it will start immediately on August 1st. The NAO has called off other projects to focus on this one and many auditors were asked to cancel their holidays. 

This news has raised tremendous discussions in China and apparently a lot of people are very worried about the local government debt as Shanghai Composite Index fell 1.72% today.  The People's Daily tried to calm everyone down by saying “it was just routine work”, but clearly it was not routine as the last report was just published a month ago and the state auditors have other jobs to do (and some are supposed to take vacations) if they did not get the call from the State Council. So why does the State Council want another audit only one month after the last audit report came out? My bold guess is that someone on top was not satisfied with the last report so this VIP wants another one to help him better understand the debt level.

So the real question is, why wasn't this VIP satisfied with the last audit report? This table below can show you that the second audit was far less comprehensive than the first one and it is extremely doubtful whether the sample of 36 local governments can reflect the whole picture. In fact the last report could be misleading in many ways.


First audit

Second audit


End of 2010

End of 2012


More than 3000 local gov'ts

36 local gov'ts


10.7 trillion yuan

3.85 trillion yuan

Growth rate

on average 30% annually from 2000-2010

12% from 2010 to 2012

Why do I say this? The growth rate of debts in 36 local governments was 12% in the last 2 years, while it was on average 30% annually in the first decade of this century. If we believe the sample of 36 local governments is representative then we will see a very positive picture as local government debt growth has slowed down significantly in the past two years while GDP growth continued to be high. The first NAO report said that total local government debt was 10.7 trillion yuan and if we apply the 12% growth rate here, total local government debt would be 12 trillion yuan by the end of 2012, accounting for 23% of GDP, smaller than the ratio of 25% in 2010.

Figure 1 Total local government debt (in billion RMB) if we believe in the last NAO report

That local government debt totalled 12 trillion by 2012 simply looks too good to be true. Even the government officials won't believe it. Xiang Huaicheng, a former finance minister, said in April that China's local governments might have already borrowed more than 20 trillion yuan. Needless to say that research institutions also have various estimates. Three years after the government started the first audit, the total local government debt number still looks like a black box! And whether the number is 12 trillion or 20 trillion has significantly different policy implications.


Optimistic estimate

Pessimistic estimate

Central government debt



Local government debt



Policy banks bonds



Former Rail Ministry



Asset Management Cos.









% of 2012 GDP



Let's do a quick calculation on total government debt of China, which covers not only explicit debts of the central government and local governments, but also contingent liabilities including policy bank debts, former Ministry of Railway debts, and the debts of the four asset management companies. Total debts would equal to 32.9 trillion yuan or 40.9 trillion yuan, which was 63.4% or 78.8% of total GDP, depending on which local government debt number you want to believe. Of course our calculation might have missed items, such as pension fund liabilities, so the debt level could be even higher.  

Figure 2 how fast is China's debt-to-GDP growing?

What's more, if Xiang Huaicheng is right that total local government debt has mounted to 20 trillion yuan, it means that the debt-to-GDP ratio has been climbing and that China is wasting more resources to keep GDP growing. However, if local government debt was only 12 trillion, then the debt-to-GDP ratio has declined, which means that China has become more efficient. If we believe the first scenario, then China needs to reform as quickly as possible to adjust the situation. If we believe the second, China is already on the right track and the government can just let it go.

In fact even if we believe in the second scenario, the situation does not look very good either. According to the last NAO report, 37.6 percent of LGFV assets, worth 900 billion yuan, were “illiquid or difficult to liquidate.” While it is not exactly clear what this means, it appears to suggest that the local governments would be unable to recover the full value of these assets should they be forced to liquidate them – and both the amount and the ratio look huge. 

Figure 3 Total gov't debt (in billion yuan)  if we believe in Xiang Huaicheng

Which number should we believe? We are in no position to judge that because Xiang Huaicheng did not offer any solid analysis while the NAO's number looks too small to be true. But we do not have to feel too frustrated, because the VIP in the State Council does not seem to know much more than we do (or maybe we should feel very frustrated since the top leaders know as little as we do...). He is as worried as we are, if not more, and that's why he asked for another round of research on a more thorough basis. It is hard to bet what number the third report will come out with, but I would say it is even likely to beat the upper limit of previous estimates, and that would be a real challenge for the new government. 

ps: there are some updates on this audit on July 30th. According to Caixin, the audit will include not only provincial, city and county governments, but also central government and small township governments, which will be the most comprehensive audit ever done. Therefore it is more likely for us to see a gigantic number. 

Central Banking Seminar

Chen Long