China contains local govt debt

Among 388 city construction companies the rating agency surveyed, only 53 percent of them have sufficient cash to cover estimated debt and interest payments in 2013 without resorting to borrowing more. Local government debt has been a major feeder of China's shadow banking.

The regulators have banned banks from directly providing loans to LGFVs after realizing they had lent too much, but local governments are still able to have their ambitious investments funded irregularly through instruments like trust loans and wealth management products.

Analysts say many shadow banking activities are actually new channels designed by and for banks to pump money to LGFVs. Local governments are willing to pay much higher interest rates than other bidders, as the current fiscal system imposes few restrictions on debt.

"Local government debt is China's biggest medium-term risk. Local governments can't be allowed to add to their borrowing without limit," said Jian Chang, Chief China Economist at Barclays. "The core issue is to work out standards to restrain the current financing which does not take cost into consideration."

At the conference, the leaders promised that strict procedures for raising debt would be put into place.
Analysts said local governments would have a harder time to borrow next year, especially if they try to pay old debts with new borrowing.

"We believe that local government bonds will gradually replace LGFV borrowing from banks and shadow bank channels, and thus reduce the non-performing loan risk faced by banks," said Ma Jun, Chief Economist at Deutsche Bank Greater China.

To establish an effective bond market in which prices truly reflect risk, the central government must dampen expectations that it will bail out default by local governments.

A statement released after the conference said local governments are to be responsible for their debts.

While the rising debt may undermine financial stability, few expect a wave of default even though GDP growth is dipping.

"The possibility of massive defaults is very small," Ding said. "To roll over a debt is still easy, and local governments are able to at least pay the interest."

Moody's does not expect widespread LGFV defaults. "We are not aware of any bond default having occurred," the rating agency said last month. "We believe that government would step in to prevent such a scenario and avoid the potential loss of liquidity in the market."  

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