The Ministry of Finance (MOF) on June 17 issued two batches of local government bonds valued at 42.2 billion yuan ($6.85 billion). Although having invigorated the local economy, swelling local debt has become a cause for concern.

According to the National Audit Office, local government debt in 36 Chinese cities hit 3.8 trillion yuan ($619.9 billion) at the end of 2012, up 13 percent from 2010. Debt-to-GDP ratios of some cities even exceed the internationally accepted standard. More severe problems are waiting to be disclosed. If debt in some regions keeps growing faster than the local economy in the coming years, there will be reason to worry.

Local government debt can help boost local economic development and further increase government revenue, which in turn can help local governments repay their debt. Capital raised via local government debt is often invested in long-term projects, which can't reap gains in a timely fashion to pay down debt. Local governments will then have to borrow more money to pay down its debt. Only after long-term investments produce adequate returns and economic growth outpaces debt expansion can debt risk be defused. The worst scenario is that debt was used on vanity projects, which may push up asset prices. In this sense, local governments have to roll over old debt with new borrowing. Once China's macro-economy cannot sustain high-speed growth, ballooning local debt will spark a massive financial crisis.

Since local governments mainly rely on land sales to pay loans, they have a strong incentive to push up land prices and produce property bubbles, thereby putting the macroeconomy at huge risk.

One third of new bonds issued by the MOF will be used to repay old debt. New borrowing will throw local governments off guard to address their debt issue.

If the Central Government only focuses on controlling the size of total debt, local governments will be eager to polish their balance sheets and use various financial innovation tools to avoid supervision.

As a matter of fact, controlling debt can't help local governments make fiscal decisions prudently while reaching economic growth targets. If we focus solely on controlling the debt size, local governments will seek risky methods of borrowing (such as high leverage ratios and repeatedly using the same mortgaged property as guaranty). If the capital borrowed is invested in commercial projects, local governments must assess their profitability.

In the future, any evaluation of local government officials should include both short-term economic growth and long-term development. The Central Government supervision over local government debt should be based on local economic strength and potential. It should make clear the level of debt that a local government can afford, improve transparency of investment decisions and evaluate short- and long-term debt performance.

This is an edited excerpt of an article by Wu Weixing, Deputy Dean of School of Banking and Finance at the University of International Business and Economics, published in Securities Daily