China's huge debts: At risk of default and instability in the world's second-largest economy

China released a comprehensive assessment of the debts of its local governments on Monday and barred those entities from borrowing any further, taking its first major step to reduce the risk of default and instability in the world's second-largest economy.

Releasing its first audit of local government debt, which amounts to 27 percent of the economy, China's chief state auditor Liu Jiayi said efforts would be made to clean up and regulate local government financing vehicles and the approach would be based on the type of debt.

Financing vehicles would be barred from incurring new debt, while local governments would be allowed to issue bonds, the audit office said.

The audit and the proposed measures, easily the most comprehensive so far, underscored Beijing's determination to head off credit risks that may destabilize growth in the fast-growing economy ahead of a leadership change in 2012.

The results, presented to the Chinese parliament by Liu, showed local Chinese governments had chalked up about 10.7 trillion yuan ($1.65 trillion) of debt as of the end of 2010.

About half of that, or 4.97 trillion yuan, was held by financing vehicles, well under market estimates for local government financing vehicles to have borrowed 10 trillion yuan.

These vehicles have been identified by analysts to be problematic as many have borrowed fervently, and covertly, for uses that are not always known. Some are now thought to be at risk of defaulting on loans.

While analysts welcomed the surprisingly low estimate for debt incurred by local government financing vehicles, they warned that the figure may be understated because different measures were used.

"The lower-than-expected figure should alleviate some worries on a surge of new crop of bad loans in the banking system," said Li Xunlei, an economist at Guotai Junan Securities in Shanghai.

"But we need to note that the way of calculating the debt varies from one ministry to the next."

Various Chinese government bodies, including the central bank and the bank regulator, have all provided varying estimates for the amount of outstanding debt.

China's central bank created a stir earlier this year when it estimated that local government debt accounted for less than 30 percent of total Chinese bank lending.

That led Chinese media to extrapolate that local governments had borrowed as much as 14 trillion yuan.

But given China's audit office was authorized by China's cabinet to investigate the debt mess of local governments, it is likely to have the final say on this issue.

"The audit office has a much more narrow definition. My understanding is that the debt as defined by them are those that are government guaranteed, or are backed by government revenues," said Wei Yao, an economist at Societe Generale in Hong Kong.

"But I think in terms of the size of the debt, it's largely consistent with the previous reports. The local government debt is about 25 percent of gross domestic product."

BARS FURTHER BORROWING

Ambiguity around just how much debt Chinese local governments have chalked up has fed the overall investor concern about China's problem of bad debt.

That said, few see a widespread banking fallout as they believe cash-rich Beijing will step in to absorb losses if needed.

Keen to contain the problem however, Beijing said on Monday it "firmly" prohibits local governments from taking on more new loans and providing guarantees to financing vehicles.

Liu said efforts would be made to "clean up and regulate" local government financing vehicles on a principle that "the borrower must bear responsibility," and that different approaches would be adopted to tackle different government debts in a "proactive and steady" manner.

The audit showed that by the end of 2010, provincial, municipal and county-level governments had 6,576 financing vehicles. Three provinces, 29 municipal cities and 44 counties had more than 10 vehicles each.

Of the 6,576 vehicles, 358 vehicles were found to have borrowed new loans to cover expiring loans and 148 were found to have defaulted, with the default ratio at 16.38 percent.

The central government would tap its deep pockets to repay the debts of some local authorities, the audit office said.

Monday's release of Beijing's investigation comes after sources told Reuters last month that China plans to clean up billions in local government debt by shifting 2-3 trillion yuan of debt off the books of local governments.

($1 = 6.475 yuan).


/Yahoo News/