July 08,2011

Why Moody's Makes It So Wrong On China's Local Government Debt

By Lu Ting, Hong Kong

Moody's, a ratings agency, captured market attention on July 5 with three main conclusions on China's local government debt: (1) China's National Audit Office (NAO) has understated China's local government debt by as much as RMB3.5tn; (2) The RMB3.5tn underreported by the NAO poses the greatest risk of delinquency; (3) Chinese banks' NPL ratio could reach 8-12%. We dissected the Moody's report by closely examining its data sources, assumptions and calculations, and we found a number of problems regarding the way it reached its overly pessimistic results.

Where does the RMB3.5tn number come from? And let's check those assumptions one by one.

Here are the data sources, assumptions and math in the rating agency's report: The PBoC estimated RMB14tn in outstanding local government funding vehicle (LGFV) loans and the CBRC estimated RMB9.09tn as of end-2010. The report took the "mid-point" of these two numbers to get RMB12.0tn (though it's biased towards RMB14tn), which is RMB3.5tn bigger than the NAO estimate at RMB8.5tn. The report treats that RMB3.5tn as underreported by NAO and argued it has the greatest risk of delinquency. We have quite different views on these assumptions.

The PBoC did not estimate local debt at RMB14tn

We disagree with Moody's reading of RMB14tn in local government debt from a recent PBoC report. In that report the PBoC said LGFV loans accounted for less than 30% of total outstanding loans in each region as of end-2010. Though the PBoC is meant to say that the 30% is the upper limit for each region, many commentators concluded that national LGFV loans made up 30% of total outstanding loans of RMB48tn at end-2010, or RMB14.4tn. But we do not read that conclusion in the PBoC report.

The NAO is not less trustworthy than the PBoC/CBRC

Moody's assumes the data from the two financial regulators (PBoC and CBRC) is more reliable than the data from the NAO, though it does not explain why. In our view, China's NAO has earned a reputation for being able to challenge powerful government agencies. And the NAO, instead of the PBoC/CBRC, has the authority and capacity to check books of all local governments and LGFVs. The central government also has strong incentives to let the NAO to assess local government debt. Actually the NAO's conclusion is also quite close to that of the CBRC.

Loans not covered by NAO have highest default rate? Not really

We do not support Moodys' claim that "loans not covered by the NAO report pose the greatest risk of delinquency". Even where there NAO and CBRC numbers differ (RMB8.5tn vs. RMB9.09tn), the small difference could be explained by the fact that it's a very difficult to define what counts as local government debt, and it is a huge undertaking that involves tens of thousands of government agencies.

(The author is the China economist with Bank of America - Merrill Lynch)

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