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China's $3 trillion local government debt stirs alarm

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Calls for China to accelerate financial reforms grew louder on Monday after figures showed its indebted local governments owe nearly $3 trillion in a debt build-up that some analysts called alarming.

The National Audit Office, China's state auditor, said in a report local governments had total outstanding debt of 17.9 trillion yuan at the end of June, a sum that includes contingent liabilities and debt guarantees.

The debt load is in the middle of market forecasts and leaves China with total government debt of around 58 percent of gross domestic product.

Analysts said this suggested China is not on a verge of a fiscal crisis - the figure is less than half the debt burdens in Japan and Greece where public finances are strained - but warned the world's second-biggest economy needed to urgently reduce debt if it wanted to safeguard growth and financial stability.

This is especially because the long-awaited report showed some governments were using new loans to repay more than a fifth of their debt, and that authorities still relied heavily on selling land to pay off old loans.

(Read more: China's bad-loan skeletons to haunt markets)

China's mountain of local government debt is among the biggest threats to its economy as investors worry a good part of it cannot be repaid since most of the money borrowed had paid for non-lucrative public infrastructure.

The prospect of defaults have raised fears that they could saddle Chinese banks with a load of bad debt and destabilise China's financial system.

"While China's total government debt remains low by the OECD standards, the pace of the rise is still alarming," ANZ economists Liu Li-Gang and Zhou Hao said in a note.

"This national debt audit result could indicate that China's local government debt almost doubled in about 2-1/2 years."

New policies

Beijing acknowledges the risks and have promised to curtail fiscal dangers by revising policies. New policies include letting investors pay for the building of some public works, allowing governments to tap more financing sources, and pegging performances of governments to total debt incurred.

Monday's results are a first step in China's latest efforts to tidy its public finances. Beijing had ordered the audit in August, the first of such since 2011, amid growing public scepticism about the accuracy of official debt data.

Despite reiterations from Beijing that China's local government debt levels had stabilised in the past three years, Monday's results showed debt incurred by local authorities was up 67 percent compared to the 2011 audit.

However, the audit is more comprehensive than 2011's because it includes money borrowed by more than 33,000 township governments. In all, the auditor reviewed the finances of nearly 36,300 local governments to compile the latest figures.

Prior to Monday, the most pessimistic market estimates of what local governments owe have been close to $4.1 trillion.

"China's government debt risks are in general under control, but some areas have certain dangers," the state auditor said.

It said risks include fast rising debt levels, with county governments seeing the quickest increase in leverage, heavy debt burdens in some unnamed regions and sectors, and government dependence on land sales to repay loans.

(Read more: China eyes municipal bonds to clean up local government debt)

About 37 percent of debt owed by provincial, city and county governments are backed by land sales revenues, it said. Of all debt directly incurred by China's central and local governments, 5.4 percent are overdue and have not been repaid.

"Although current overall risks of local government debt are under control, risks would definitely increase sharply if the debt continues to rise so quickly," said Pan Xiangdong, chief economist at Galaxy Securities in Beijing.

"We expect the (central) government to restrict the borrowing behaviours of local governments."

Under China's laws, local governments are barred from borrowing directly from banks or investors to protect the country's fiscal health.

Yet despite not being able to borrow, local authorities are responsible for most of China's public spending but take only half of fiscal income. Local governments in 2010 received 48 percent of total fiscal income but were responsible for 80 percent of public spending.

The funding shortfall has forced local authorities to set up firms over the years to borrow on their behalf, leading to a rapid rise in government debt outside official balance sheets.

"We expect the government to unveil detailed plans for fiscal reform," said Shen Jianguang, an economist with Mizuho Securities in Hong Kong.

"The key to solving the debt (problem) depends on changing the distribution system for fiscal income between central and local governments, as well as (changing) local governments' over-reliance on land sale revenues." Shen said.

Rating impact?

No credit rating agency was immediately available for comment on Monday about whether the figures would have an impact on China's sovereign credit rating.

Fitch, which cut China's long-term local currency credit rating to A-plus from AA-minus in April, estimated then that China's government debt was equivalent to 49 percent GDP.

At 58 percent of GDP, China's total debt is a long way from Japan's 240 percent and Greece's 160 percent, ANZ data showed.

(Read more: Are fears over China government debt overblown?)

Still, if Beijing forces local governments to reduce their debt and borrowings in coming months, that may deal another blow to China's already slowing economy, ANZ warned.

As it is, China's $8.5 trillion economy is forecast to grow at its slackest pace in 14 years this year at 7.6 percent.

To keep its economy on an even keel, Ting Lu from Merrill Lynch-Bank of America said Beijing should aim instead to pick up some of the debt burden from local authorities, and replace short-term borrowings with longer-duration loans.

"To maintain both economic growth and financial stability, China should avoid simplistic deleveraging and debt reduction," Lu said.

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