SPENDING SPREE: The Wuhan Tianxingzhou Yangtze River Bridge opened in December 2009. To finance their infrastructure construction, local governments have ramped up debt through financing vehicles (HAO TONGQIAN)

Control over local governments' financing vehicles will be tightened to fend off what some economists warn could turn into a mountain of hidden debts, the State Council vowed at an executive meeting on May 26.

While local governments are not allowed to directly get loans or issue bonds, many have set up special investment vehicles to finance projects of roads, subways and other infrastructure endeavors. These vehicles take out bank loans backed by assets—typically land—or are supported by implicit local government guarantees.

The State Council said it acknowledged the role of these vehicles in raising funds for local infrastructure projects and cushioning the impact of the financial crisis.

But there are also problems, including reckless expansion and operational mismanagement, it said.

"There is growing need that we enhance management over these financial vehicles to prevent fiscal and financial risks and steer the economy on a steady path toward recovery," said the State Council. Vigorous efforts must be made to get a clear picture of the loan situation, adequately deal with the issues of debt repayment and financing for projects already under construction, and keep local governments from illegal guarantees.

Looming concerns

The financing vehicles flourished across the country last year when local governments rushed to borrow money under the 4-trillion-yuan ($586 billion) stimulus package aimed to provide a floor for the buckling economy.

The Central Government was only responsible for investment of 1.18 trillion yuan ($173 billion). The rest fell on the shoulders of local governments.

Commercial banks pumped a record 9.6 trillion yuan ($1.4 trillion) of low-interest credit into the economy in 2009, a significant chunk of which went to the local financing vehicles, said Su Ning, Vice Governor of the People's Bank of China, the central bank.

But with less transparency and standardization in place, the roaring borrowing binge seems to pose more risks than reap benefits for the economy.

"The load of loans is not an issue when the economy grows rapidly and returns from the projects adequately cover the debt," said Li Yongsen, an economics professor at the Financial and Securities Institute of the Renmin University China.

But the risks could escalate if the economy sinks again, he said.

The worries are not unfounded. A string of austerity policies have put a squeeze on the once-feverish property market, with house sales falling rapidly. If the real estate sector continues to tumble, many fret that solvency of local governments might receive a heavy blow.

Land sales of China added up to 1.42 trillion yuan ($208 billion) last year, accounting for around 43.7 percent of the local governments' fiscal revenues, said the Ministry of Finance (MOF).

It is a particular problem for smaller, local level banks and credit cooperatives. These are likely to have weaker risk management, and tend to have fewer low risk loans in their portfolios, said a report by the World Bank.

The off-budget local debts now seem to be a sword of Damocles that hangs over the prospects of the Chinese economy. It stretches the nerves of economists in part because no one knows for sure how deep the financial black hole might be.

The China Banking Regulatory Commission (CBRC) said outstanding loans of local financing institutions stood at 7.38 trillion yuan ($1.1 trillion) at the end of 2009, a surge of 70.4 percent year on year. But the number is likely to further skyrocket to a whopping 12 trillion yuan ($1.8 trillion) by the end of 2011 if things spin out of control, said Shen Minggao, chief economist at Citibank Greater China Region.

If the local government debt sours, banks will be saddled with a pile of bad loans and the Central Government may be forced to dig into its own coffers to clear up the mess, said Shen.

Policymakers have been well aware of the reckless behavior. Earlier this year, the State Council started asking local governments to clean up these vehicles and step up a handle over bank lending. In addition, the CBRC reportedly ordered a ban on lending to local financing vehicles for new projects not included in the 4-trillion-yuan ($586 billion) stimulus package.

No need to panic

A serious fiscal crisis is unlikely to break out in China anytime soon, said Xu Lin, Director of Fiscal and Financial Affairs of the National Development and Reform Commission.

A vibrant economy has rendered local governments more able to repay the debt. And even if China has to bring some bad loans onto its books, sustainability of the debt is not a problem given buoyant economic growth and budget flexibility of the Central Government, he said.

Ba Shusong, a senior economist at the Development Research Center of the State Council agreed, citing that the burden remains bearable.

The off-budget loans could boost China's debt-to-GDP ratio to around 40 percent, still below Japan's 220 percent and nearly 80 percent of that of the United States, he said.

In addition, most of the loans went to provincial-level financing vehicles with a strong power of solvency, said Ba.

Commercial banks have also dismissed worries. "A review on the financing vehicles is underway and there is little pressure on our asset quality," said Li Lihui, President of Bank of China, the country's third largest lender.

Still, it is necessary to remain vigilant against looming risks and strengthen operational transparency of the financing vehicles and efficiency of their capital, said Liu Yuhui, a senior researcher with the Chinese Academy of Social Sciences.

Jia Kang, Director of the Research Center for Fiscal Science under the MOF, attributed the local debt scare to the financing systems within the country.

As a result of the country's finance system reform in 1994, local governments must hand over a majority of their revenues to the Central Government. Such financial strains and the urgent need to support local economies forced them to seek a hidden channel of capital, said Jia.

"So a viable solution is to bolster financial strength of the local governments and wean their dependence on land revenues, such as allowing them greater freedom to issue bonds," he said.