The government of China has ordered an urgent audit of local debt, down to the village level, ahead of plans to get cap the nation’s annual deficit at 3 percent of GDP. A similar, but less comprehensive audit was done for the first time in 2011 and the announcement that the national government would be taking an even closer look at local affairs brought the Shanghai Composite Index down by 1 percent.

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State council of China request debt audit

The government debt audit was requested over the weekend by the State Council, China’s equivalent of the Cabinet, and will be conducted by the National Audit Office. The first such audit found that local governments had a total debt of RMB 10.7 trillion ($1.75 trillion), and Societe General estimates that number has risen to RMB 17.5 trillion ($2.85 trillion). Such high levels of local debt have many investors concerned that policy decisions made at the national level to avoid a Chinese financial crisis could be undermined by local officials.

Even though it was announced separately, it’s hard not to see a connection between this audit and the Chinese government’s decision to reduce its deficit to 3 percent of GDP.

“For the deficit-to-GDP ratio, 3 percent could be potentially a very stringent requirement, if Beijing were to consider all the off-budget spending,” said Societe General economist Wei Yao. “Taking into consideration the increases in local government debt, China’s fiscal deficit has been hovering above 5 percent of GDP for several years now.”

China’s GDP growth

Most analysts have been trying to figure out whether the national government would be willing to introduce an economic stimulus either to increase GDP growth or to reduce unemployment, but now there is some chance that the government could cut spending just as its economy is slowing down. Along with deteriorating productivity growth and unused capacity, this new problem is renewing fears that China may have a hard landing somewhere in its future.

Yao says that the decision by China’s leadership to take its debt position seriously is a sensible choice, but that he does expect it to contribute to even more “growth deceleration in the near term.” Which leaves analysts with the trillion dollar question, can China’s national government maintain control of all this decelerating growth.