Beijing has announced an "urgent" nationwide audit of every level of government, another sign that China is embracing its economic slowdown and trying to manage it responsibly. The step is expected to cause some short-term pain but ultimately ease China's transition to a different sort of economy, one that grows more slowly. That's been the story generally with China's economy lately, something that has economists debating not whether China's economy will slow down – that's already happening – but by how much and whether it will be a controlled "soft landing" or a more-crash like "hard landing."
The bad news is that the audits are likely to turn up lots of local government debts and liabilities; just the announcement has sent Chinese stocks dropping. A 2010 audit found 10.7 trillion yuan, or $1.7 trillion, in debt carried by local governments. (By comparison, the U.S. economy is about twice as large as China's and has $16.8 trillion in government debt.) The audits may make those local government balance sheets look less healthy or sustainable than investors had previously believed, thus making it even harder for them to borrow money or, in a worst-case scenario, causing runs on the investments for fear of a crash. This worst-case, though, is unlikely for reasons explained below.
The other piece of bad news is that the audits may also shed a light on local governments juking their own economic statistics. Local Chinese governments are famous for over-reporting their own growth numbers. If you add up the reported GDP of every local government in China, it actually comes to more than the country's overall GDP – much more. While some of that can be explained by accounting practices and by inter-provincial trade being counted twice, economists presume, with good reason, that local governments are over-reporting their growth. A study by Quartz found that the gap between national GDP and combined local GDPs is actually rising; the latter is now 13 percent higher than the former. If those numbers are really inflated and the audit brings them back down to reality, then the readjustment could further worsen the perception of how healthy these local economies are.
Here's the good news: China was going to have to deal with local government debt sooner or later, and sooner is better, before the problem gets worse. An audit will help Chinese leaders get a sense of the scale of the debt problem and identify particularly troubled areas. But, maybe just as important, it will provide top leaders with an impetus for the broader fiscal reforms that might be necessary to reign in local government spending, according to a Citigroup economist named Ding Shuang who spoke to Bloomberg.
The other good news is that this is yet another sign for the world that Chinese leaders are intent on accepting that their economy is slowing down and making necessary reforms soon, even if those reforms mean that there will be some economic and political turmoil in their near futures. Beijing is also attempting to crack down on government spending and industrial over-production.
The two big questions are, first, whether or not Chinese leaders have the will and the capability to push through all the reforms they want and, second, whether this will be enough to ease China's transition to a slower economy. Michael Pettis, a finance professor at Peking University and respected voice on the Chinese economy, predicted in a CNN.com column that China's growth will continue slowing considerably but that the economy won't crash. The days of 10 percent GDP growth certainly seem to be over, though. Pettis writes, "Growth rates during the administration of President Xi Jinping are unlikely to exceed 3 percent to 4 percent on average if the economic rebalancing is managed well."
This is sort of the best and worst of the Chinese political system. One the one hand, the system often has perverse incentives and a sweeping bureaucracy that make it tougher to prevent individual officials or local governments from over-borrowing or misreporting statistics in a way that can hurt the larger country. On the other, top leaders are dealing with an incentive structure that sometimes allows them to privilege long-term thinking over short-term. While a vast audit like this is probably going to cause some short-term pain in the economy, and anger the other officials as well as regular Chinese people who will be affected, it's also hopefully going to make the economy healthier in the long term.