On June 27, China's National Audit Office (NAO) released a comprehensive audit report on
local government debt, which provides greater clarity on the size and breakdown of such
liabilities. The NAO assesses this debt at RMB 10.7 trillion, of which RMB 8.5 trillion are
funded by bank loans.  
However, we believe that the NAO report is understating the size of the local government
loans that could become problematic. When cross-examining the findings -- in conjunction
with reports from Chinese banking regulators -- we find that they could understate banks’
exposures to such debt by as much as RMB 3.5 trillion (i.e., somewhere between RMB 1
trillion and RMB 6 trillion).
We assume that the majority of loans to local governments are of good quality, but based on
our assessment of the loan classifications and risk characteristics, as provided by the different
Chinese agencies, we conclude that the potential scale of the problem loans at Chinese banks
may be closer to our stress case than our base case. This is clearly a negative trend for
creditors.  
Overall, when considering the loans examined by the NAO, together with other loans, we
estimate that the Chinese banking system’s economic non-performing loans
1
This conclusion suggests that Chinese banks may have to deal with an NPL burden which is
closer  in size to that of our stress scenario.  But, for now, very few of these loans are recorded
as NPLs by the banks, and it is unclear as to how they, or the Chinese authorities, intend to
address the problem.
(NPL) could
reach between 8% and 12% of total loans, compared to 5% to 8% in our previous base case,
and 10% to 18% in our stress case.