Market sentiment in Asia remained weak for a second straight day on a combination of weak earnings results and industrial profits in Japan and China, respectively. Losses were led by the Nikkei (-3.3%) which has now declined by a cumulative -7.6% since July 23, just after the ruling coalition’s Upper House election victory which was supposed to have bode well for the economic outlook and implementation of Prime Minister Abe’s growth strategy.

China gears up for urgent audit of local government debt

The National Audit Office (NAO) announced over the weekend that it will initiate a new audit of local government debt, to be published in October-November. The last nation-wide audit was two years ago, in which the NAO reported total local government debt of RMB 10.7 trillion (27% of GDP). We believe that local government debt probably increased to RMB 16.5 trillion as of end-2012, based on figures from the People’s Bank of China (PBoC) and the China Banking Regulatory Commission (CBRC). The audit reflects the central government’s continued concern about the level of local government debt, which has recently been heightened by a parallel build up of corporate sector debt, all of which pose risks to financial stability. The announcement may have contributed today’s decline of the Shanghai Composite (-1.7%), even though a comprehensive audit would be welcome in clarifying the magnitude of the local government debt burden.

China’s industrial profit growth moderates in June

Profit growth declined to 6.3% y/y from 15.5% y/y in May, resulting in first half growth of 11.1% y/y. The decline in June was partially due to a higher base effect last year, but was also dragged down by weakness in the coal mining, petroleum & natural gas acquisition and non-ferrous metals mining/smelting sectors. The modest industrial profit growth outturn and disappointing July HSBC Flash PMI reading (47.7) reinforce worries over an economic slowdown. We await the official manufacturing PMI outturn on Thursday (BBVA: 50.0; consensus: 49.8).

Mixed readings on the Japanese economy

Retail sales in June surprised to the downside, contracting by -0.2% m/m sa (consensus: 0.8% m/m) after gains of 1.5% m/m in May, mainly due to a drop in fuel sales on rising oil prices. On a year-over-year basis, retail sales growth still managed to record a positive 1.6% y/y in June after 0.8% in May. Separately, the June CPI data released last Friday registered positive inflation of 0.2% y/y (consensus: 0.1%) for the first time since June 2012, on signs that the aggressive monetary easing and yen weakness are working to end deflation, albeit still well short of the BoJ’s 2% target. All in all, the government’s growth strategy appears to be working, although uncertain prospects for the implementation and depth of structural reforms continue to weigh on market sentiment.