* Explosion in local govt debt on agenda for reform meeting in Nov
* Govt think-tank favours expanding municipal bond market
* Current pilot project is tiny but shows promise
* But some worry that municipal bonds would only worsen debt problem
SHANGHAI, Oct 21 (Reuters) - China may decide next month to expand a trial programme allowing local governments to sell bonds, in response to concerns that their huge borrowings are largely hidden from view and pose a risk to the stability of the nation's financial system.
A government think-tank that advises China's cabinet, the Development Research Center, has put forward a proposal calling for greater use of municipal bonds ahead of a policy-making meeting next month to decide Beijing's long-term reform agenda.
Local government debt totals up to $4 trillion or 42 percent of gross domestic product, according to some unofficial estimates, but much of it has been raised via financing vehicles that do not disclose details on the size and health of loans.
That lack of transparency - akin to the kind of off-balance sheet lending that froze international debt markets and led to the 2008-09 global financial crisis - could be addressed through use of bonds, which require disclosure and spread the risk of default across a wide array of investors.
"'Open the front door, block the back door,' and expand the scope of local government independent bond issuance," the Development Research Center said in its draft proposal submitted recently to leaders of the ruling Communist Party and published last week on the website of Beijing's Renmin University.
Chinese law bans local governments from selling debt directly in a measure that was meant to restrain their borrowings, but local officials have skirted it by raising debt through financing vehicles to fund infrastructure projects.
Borrowing through so-called local government financing vehicles (LGFV) exploded in 2008-09, when China pumped 4 trillion yuan ($656 billion) in stimulus spending through the economy to cushion the impact of the global financial crisis.
"The rise in local government debt is ... a concern, given the complexity and opacity of municipal finances," the World Bank warned in a regional economic update this month.
"This lack of transparency has led to debt levels higher than would otherwise be acceptable to lenders, investors and policy makers."
Many reform advocates hope new policies announced during the party's Third Plenum in November will include aggressive expansion of a pilot municipal bond programme launched in 2011.
They argue that local governments' current reliance on bank debt and loans from trust companies - another form of opaque lending - contributes to profligate local spending. The use of LGFVs adds to the opacity.
Economists say a real municipal bond market would be key to addressing the local debt issue, with disclosure requirements helping to impose a hard budget discipline on local officials.
In another sign authorities are poised to expand municipal bond issuance, another influential think tank, the China Academy of Social Sciences, teamed up with a major credit ratings agency last month to issue ratings of local governments.
LOWER COSTS, BETTER FIT
The local bond pilot remains tiny compared to the scale of local financing needs. The finance ministry in March set a quota of 350 billion yuan ($57 billion) under the programme for 2013.
Still, bonds have been well received by investors and yields have hovered around 3.8 percent to 4.5 percent, nearly as low as Chinese treasury bonds of the same maturity.
By contrast, weaker localities forced to resort to trust-company loans and other sources of shadow-banking finance often pay more than 10 percent annual rates.
That suggests expanded bond issuance could enable many localities to cut borrowing costs.
The use of longer-term municipal bonds could also relieve the worrying mismatch between infrastructure investments that may take decades to produce financial returns and the short-term loans that are often used to finance such projects.
"Take a highway project as an example. It may take 20 or 30 years after it's built to repay principal and interest. But the bank loans are typically three to five years," Wu Xiaoling, a former Chinese central banker, told Reuters last month.
But low yields on the small pool of existing municipal bonds may simply reflect investors' assumption that the finance ministry has chosen fiscally strong localities for the pilot.
"If you suddenly let everyone issue bonds, then the market no longer sees it as a special privilege. So then the market will have to go back to looking at fundamentals," said a bond analyst at a mid-sized fund management company in Shanghai.
Chinese media quoted Finance Minister Lou Jiwei last month as calling for "gradually forming a standardised local government debt financing mechanism based mainly on municipal bonds".
The question is what "gradually" means.
The results of an official audit of local government debt, due this month, could determine whether the bond pilot is expanded or left to wither.
The last audit showed local debt at 10.7 trillion yuan ($1.76 trillion) at end-2010, though it used a narrower definition of local debt than that used by banks such as Standard Chartered which see it as high as $4 trillion.
A dramatic rise could make authorities balk at expanding the pilot.
Official media quoted an unnamed audit officer last month as saying the new audit may show local debt nearly doubling between 2010 and 2012. The article was later deleted from the website of Economic Information, a newspaper run by the official Xinhua news agency.
Indeed, some in the finance ministry worry that allowing more municipal bonds would only fuel local officials' appetite for borrowing, making the debt problem worse. Such caution has led most analysts to predict that authorities will permit only a modest expansion of the bond pilot.