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China debt audit expected to rip the lid off hidden liabilities

Chinese data confirms that its economy is accelerating. However, an upcoming nationwide audit on regional government debt is lurking behind the optimism like the ominous music in a horror movie.

The stronger data makes stocks exposed to China-related assets like copper and iron ore ripe for short-term trading activity. But the mid-term outlook for the Chinese economy is so fraught with landmines that longer-term investors should limit their portfolio exposure.

To be fair, there are no imminent signs of danger. But a comprehensive audit on the estimated $3.1-trillion (U.S.) – yes, that's with a "t" – in regional government debt is expected ahead of an important series of government meetings in November.

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Why is this a problem? Nomura economist Zhiwei Zhang classifies 53 per cent of regional debt as "non-sustainable," or a strong candidate to become non-performing loans. Mr. Zhang cites a China Banking Regulatory Commission report from 2010 claiming that just 27 per cent of the regional bodies making loans had enough cash flow to service their debt.

The audit will be an important official recognition of what many global investors have feared for a number of years: local governments are sitting on a mammoth pile of impaired debt that will need to be addressed.

Mr. Zhang also notes that the timing of the report, which is scheduled to arrive just before November's Third Plenary Session of the 18th CPC Central Committee, is no accident. The audit's findings are expected to spark reform measures aimed at curbing the financial creativity of local governments, and to reduce overall investment growth. Slower investment growth means less infrastructure expansion and, by extension, slowing demand for commodities.

So we have sketchy, barely-performing debt of $1.7-trillion (that's 54 per cent of $3.1-trillion) and an apparent plan to slow investment growth.

China bulls argue that the People's Bank of China (PBoC) can use its more than $3-trillion hoard of foreign reserves to cover bad debt, and then cruise forward at an annual seven per cent growth rate.

But that wouldn't solve the problem. Though the PBoC technically can use its foreign reserves, to do so would be no different than borrowing the funds through a new bond issue. As University of Peking professor Michael Pettis writes:

"PBoC has been forced to buy the reserves as a function of its intervention to manage the value of the RMB. And as they were forced to buy the reserves, the PBoC had to fund the purchases, which it did by borrowing RMB in the domestic market. any transfer of foreign currency reserves [to solve a debt crisis] would simply represent a reduction of PBoC assets with no corresponding reduction in liabilities."

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There is no easy way out for the Chinese economy. Non-performing debt will have to be recognized – the liabilities are likely to wind up as central government debt – and credit and investment growth will slow. The recent string of stronger economic results are only a postponement of the inevitable.

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