Chinese Banks - NAO report - Lower local government debt and risks show market fears overdone Local government debts lower than market fears The National Audit Office (NAO) released the findings of its audit report on China's government debt yesterday and reported that local government debt amounted to Rmb17.9tr as of June 2013, of which Rmb10.9tr was direct liabilities with repayment obligation. This audit is more comprehensive than the 2010 audit which showed local government debt of Rmb10.7tr. Adjusting for the wider coverage to include additional affiliates and financing means, we estimate the comparable figure to range from Rmb14.1tr to Rmb15.7tr (implying CAGR: 11.7-16.6%), which is notably less than the estimates of Rmb20tr quoted by WSJ on 13 September 2013. A more comprehensive review to assess risks and clear market concerns This audit is much more comprehensive than that of 2010 in terms of coverage; it includes: (1) central and village governments in concluding total direct national government debt of Rmb20.7tr as of June 2013. In 2012, total government debt was equivalent to 36.7% of China’s GDP (international level: 60%). The ratio will rise to 39.4% by including the risks of contingent liabilities being realized; (2) SOEs, JVs and self-financed business units owned by the local governments which reported debt of Rmb3.74tr; (3) additional sources of financing means such as BT, construction expenditure incurred but not paid, financial leasing and private funds, which amounted to Rmb2.16tr. A notable decline in bank loan mix to local governments to 13.9% of loans Bank loans to local governments amounted to Rmb10.1tr as of June 2013, of which Rmb5.5tr was direct liabilities with repayment obligation. The comparable figures for 2010 were Rmb8.47tr and Rmb5tr, implying an increase of 19.5% (or CAGR of 7.4%) and 10% (or GAGR of 3.9%) respectively. Indirect contingent liabilities had risen by 75% to Rmb2.7tr as of June 2013 (2010: Rmb1.53tr), probably reflecting a bigger scope of audit. Overall, total lending to local governments amounted to 13.9% of total bank loans, compared to 16.6% as reported by the 2010 audit. The overdue loan ratio was reported at 1.01% in 2012, adjusted for the accruals to be paid. Improving profitability and repayment abilities of LGFV Total debt incurred by the 7,170 LGFVs (2010 audit: 6,567) amounted to Rmb6.97tr, up from Rmb4.97tr as indicated in the last audit, implying a CAGR of 14.5%. Despite the relatively fast growth in debt, the average assets and profits of these LGFVs had increased by Rmb1.3bn and Rmb4.8m between 2010 and 2012, leading a decline in the ratio of liabilities/assets by 4.9% and stronger repayment abilities. Stay positive: market fears on asset quality concerns look overdone We maintain our positive view on the sector, with falling perceived asset quality risk as a catalyst for share price performance. On our estimates, Chinese banks are trading at 1x 2013E P/B and 5.6x 2013E P/E, with ABC and BOC as our top picks for the H-share listed banks and CEB and BOBJ as our top picks for the A-share listed banks. The key risks faced by the sector include weaker-than-expected economic growth leading to asset quality deterioration and faster-than-expected deposit rate deregulation.

• [Editor:editor]