We know about the Federal Reserve taper and we are no longer afraid. We know about those indebted Mediterranean euro zone states and we still worry just a little. What keeps us awake in the small hours, to misquote a famous American general, are those risks that we don't know we don't know. So, right on cue to disturb our holiday slumber comes the Chinese National Audit Office with the news that Chinese local government debt has risen to 17.9 trillion Yuan ($3.1-trillion), a 67 per cent increase since the last audit in 2010.
Rampant spending on bridges, town halls, social housing and even entire new cities has accumulated some $3.1-trillion in borrowings since the 2008 financial crash. It's a headache for the new president, Xi Jinping, as he takes on the task of reforming China's financial system. The more immediate concern is whether any part of this accumulation of civic debt, much of it off-balance-sheet in special purpose vehicles, is exposed and at risk of default, due to a growth slowdown and rocky local government finances. The central government in Beijing reckons the audit is good news because it shows that total government indebtedness at all levels is little more than half of China's GDP, a level far below the indebtedness of the U.S. and many Western countries.
Outsiders are less convinced, not least Fitch, the ratings agency, which as early as April this year downgraded China's local currency sovereign rating. Fitch cited the explosion in credit, which has been rising at a rate faster than economic growth since the crash. Half of the local government debt comes due by the end of the next year and analysts are concerned that the large number of uneconomic civic projects mean that debt is being rolled over, not repaid. Notwithstanding the sanguinity at official levels, Fitch reckons that total credit in China was twice the size of the Chinese economy at the end of last year, thanks to the extraordinary expansion of China's "shadow banking" sector, consisting of non-bank private lending institutions. These have provided much of the funding for the real estate boom, and are actively lending to local governments.
Frequent reports of China's soaring property market tend to focus on the hot spots, such as high-end apartment complexes in Shanghai and Beijing, but these are not the problem. The market for prime real estate in China is as low-risk as it is in any world city. It is in the provinces that the problems lie, where entire towns have been constructed, in anticipation of huge industrial developments which have not yet arrived. Fingers frequently point at Ordos, a notorious "ghost town" in Inner Mongolia which was built to house a million in expectation of huge mining developments, but which remains largely empty. Yet vacant housing complexes lie on the edges of many provincial Chinese cities, a consequence of official policy to enlarge the urban environment, and to import surplus labour from the countryside into factories and urban service industries.
At the heart of China's public sector debt problem is the issue of where the public ends and the private begins. Debt is also rising in the corporate sector, where state-owned enterprises still control a vast portion of the economy. If China's growth rate in the coming year fails to generate sufficient jobs and revenues to finance the huge provincial debt load, President Xi may be faced with municipalities demanding rescues. The choice is between a bailout from Beijing, which will only encourage more reckless borrowing in the shadow market, or the implementation of harsh market medicine. No one knows what a municipal default might look like in China, but it is reasonable to suppose that anything substantial would have implications for China's unofficial banking market: A rush to the exit; soaring loan costs; and local bankruptcies.
The unravelling consequences could be unpleasant, unless you believe that the command apparatus of central government will smooth over any bumps in the road with edicts to banks and undisclosed distributions. That was the policy after the Lehman Brothers crash – but a homegrown credit crisis might look very different.