CASHED-UP CHINA'S MASSIVE DEBT PROBLEM

If there is one issue keeping investors awake at night about the Chinese economy, it is the local debt problem. Having just barely survived a debt crisis in the United States and the Eurozone, the thought of another debt implosion in the world's second largest economy is too scary to contemplate.

What's making people even more nervous is that very few seem to know the exact size of the local debt problem. And those who do know aren't saying a word. Beijing's National Audit Office just completed a comprehensive survey of the local debt problem and reported to the State Council, the Chinese cabinet, in late October.

The audit commission began its work in July, shortly after Detroit – the home of GM, Ford and Chrysler – filed for bankruptcy in US federal court. The commission looked at the debt levels of all tiers of government, from mighty central government agencies to the finances of small villages.

The project was carried out with great secrecy. Local auditors have been ordered not even to share the results with their finance departments before they are publicly announced.

The investigation is a complex one. Local governments have been using innovative financial structures such as trusts and even wealth management products to raise debt. Auditors have reportedly clashed with local governments over classification of debts.

So, what do we know about China's local debt problem so far?

The guesstimates range from 10 to 50 trillion yuan. The last official pronouncement on the extent of local debt levels was 10.7 trillion yuan, and that was back in 2010 before the explosion of growth of the shadow banking sector.

Because Chinese local governments can't issue bonds on their own, they have been using financing vehicles – akin to the kind of off-balance sheet lending that froze international debts market in 2008-09 – to raise money.

The total size of money lent to these local financing vehicles is about 10 trillion yuan as of first quarter of 2013, according to data from the China's banking regulator. That is a sharp increase of 30 per cent from the fourth quarter of 2009.

The large increase came about as a result of the 4 trillion yuan fiscal stimulus package unleashed by Beijing during the global financial crisis which played an important role in saving the Australian economy from recession.

A large part of the package was funded with debt from Chinese banks to the local governments. The National Audit Office also looked at books of 36 provincial capitals early this year. They have a collective debt size of 3.85 trillion yuan and nearly a third of them have a debt-to-GDP ratio of more than 100 per cent.

Though the audit office didn't release these names, they are believed to be Nanjing, Chengdu, Guangzhou, Hefei, Changsha, Wuhan, Harbin, Xi'an and Lanzhou, according to Caixin, a respected Chinese financial magazine.

Haitong Securities, which has one of the best research teams in China, estimate the total size of China's local debt problem is between 20 and 30 trillion yuan, or in other words, 40 to 60 per cent of the country's GDP.

To put that in some perspectives, the debt to GDP ratio in the United States is about 73 per cent according to the Congressional Budget Office. In the case of Japan, its national debt is about more than 200 per cent of its GDP. For the record, Australia's GDP to debt ratio is only 23.3 per cent. We don't have a debt crisis, at least in comparison to other major economies.

Xu Yifan, the chief economist of Haitong and a former economist at the World Bank says cities with a good fiscal outlook usually carry between 20 and 40 per cent debt. In comparison, cities that are in trouble usually have a debt level between 80 and 120 per cent.

On average, China's local debt level falls between these two camps. It is neither bad nor good. However, some local government entities are already struggling to repay their debts and have already requested extension of their loans.

Apart from the size of the local debt problem, the structure of the debts is another looming problem. In 2011, the National Audit Office reported that 53 per cent of local debts would be due in three years' time. This means 2014 will be a crunch year for a lot of people. A lot of these debts have been used to finance long-term infrastructure projects

China's local debt problem – at 40 to 60 per cent of GDP – is pretty serious. But it won't explode, because both central and local governments have enough financial firepower to backstop the whole system from collapsing.

Not only is Beijing sitting on the largest pile of foreign reserves in the world, which is more than enough to reduce the country's debt to zero. Its tax income per year is about 10 trillion yuan every year and increasing fast.

Like Japan, China's debt is largely domestically financed, so it is not subject to the whims of foreign debt vigilantes, who can dump debts at the first sight of weakness.