Saturday, August 13, 2011

China: Another Debt Bubble?

Although the national government of China is famously a net creditor with substantial sovereign investment assets, the national government in China isn't the only government in China. Closer to where the rubber meets the road, municipal governments stand responsible for building numerous infrastructure and even housing projects. Local government units in China are restricted in their fundraising. As a result, the frauds that are commonplace everywhere else in China (from fake Apple Stores to fake infant formula, nothing appears too sacred to defile) are equally common in government funding schemes.

In one example, Loudi raised infrastructure development funds with municipal bonds fully secured by numerous tracts of developed land. The problem? To secure the huge bond issue, the land – located in a place you've never heard, with an annual household income less than $2,500 and severe under-occupancy of existing housing – is given a fictitious value commensurate with fully-occupied Chicago suburbs with an average annual household income exceeding $250,000. And based on this Bloomberg report, payment on the bonds requires the claimed land values to go up.

Chinese rating agencies, unsurprisingly, are as easily motivated by politics and favor-trading as by financial reasoning. Ratings on the Loudi bonds range from junk status to one step above U.S. Treasury obligations. According to Moody's, the aggregate local government debt in China is understated by Chinese state auditors by 3.5 trillion yuan – reflecting the murkily unclear status of local debt issuance and whether some of the off-balance-sheet local government fundraising schemes even constitute enforceable obligations. To the extent that Chinese banks are debt holders, the safety of Chinese banks may be in jeopardy. To the extent that official Chinese debt accounting is off by as much as 25%, the reliability of Chinese financial reports is gravely in doubt.

Local Chinese debt may not look very big from the U.S – a mere couple trillion bucks – but they haven't been working to build it up very long, they have no apparent checks in place to prevent issuance scams, and they're working with the central government to issue more. CNBC's John Carney asks an interesting question: if the entire GDP of China has yet to reach $5 trillion when its debt exceeds $2 trillion, what should we conclude about the strength of the economy that's producing China's current output? (For comparison, the U.S. GDP exceeds $14 trillion, and its debt has been accumulating for decades at the local, state, and federal level until it presently exceeds $17 trillion. But the U.S. economy isn't rumored to have been on fire these last few years as the Chinese economy has been reputed.)

Asian study of American business strategies didn't end with the adoption of mass production facilities, did it?

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