BEIJING, Dec 31 (Reuters) - China's quest to solve its $3 trillion-and-growing public debt problem by starting a domestic municipal bond market hinges on the one thing its officials are most afraid of: transparency.
As markets absorb the results of China's latest audit of its state finances, Beijing's long-standing vow to develop a municipal bond market to curtail rapid growth in other types of hidden public debt will take centrestage once more.
By letting local governments sell bonds for cash, China wants to rely on nimble markets rather than inflexible regulations to keep spendthrift units in check.
The stakes are high. A bond market is the centrepiece in China's blueprint to mop up fiscal troubles and keep its economy growing at an even pace, giving it needed room to start other bold financial reforms.
But analysts say China's dreams of a municipal bond market are so far just that, as building one has been impeded by a lack of disclosure from local governments on how much money and assets they have, and how much they owe.
"If you want to lend to a specific government, you need to have a clue as to what the financial conditions are like," said Tan Kim Eng, a senior director of sovereign ratings at Standard & Poor's in Singapore.
"There's still a lot of work to be done on the fiscal transparency front."
In the meantime, some investors are increasingly alarmed by the speed at which local governments are piling on debt to pay for public works.
China's state auditor said in its report on Monday that local governments had total outstanding debt of 17.9 trillion yuan ($2.96 trillion), including contingent liabilities and debt guarantees, at the end of June.
Although the debt load shows China's government to be far less indebted than fiscally-troubled Japan and Greece, it raised eyebrows among analysts for its 67 percent jump since the last state audit was published in 2011.
The auditor did not say which provinces have the heaviest burdens or face the biggest risks, except to note "certain" dangers in some unnamed regions.
"Any improvement to fiscal transparency will be limited unless the central government regularly publishes similar audit reports," Standard & Poor's said separately in a note on Tuesday. "It's also unclear whether China will disclose the debts of individual local and regional governments."
Investors have long viewed China's mountain of local government debt as one of the biggest threats to its economy.
Market fears that China's banking system will be compromised if a portion of the government debt is not repaid were amplified by a dearth of information in the past year.
CASTING SUNLIGHT ON DEBT
Amid growing public scepticism about China's fiscal health, Beijing in August ordered a comprehensive review of all government balance sheets. A delay in its release - publication had been expected by October - fed speculation the debt-total could top $4 trillion.
In China's defence, the audit is a massive task. The audit office said it deployed nearly 55,000 workers, who examined nearly 2.5 million loans and reviewed the books of 62,215 governments and organisations.
The need for transparency is not lost on Beijing.
In a plan published in November about China's most ambitious road map for financial reforms in 30 years, Beijing said it would create a "standardised and transparent budget system" for local governments and the funding of public works. This was on top of frequent government pledges to "cast sunlight" on debt.
To be sure, China is mulling other options for cleaning up its debt mess, including allowing private investors to pay for public works, and letting the central government absorb more spending responsibilities.
But no plan resonates better with reform-minded officials than that for a municipal bond market, partly because it fits perfectly with China's goal of reducing central planning to let financial markets work their magic.
Underscoring the importance placed on restructuring the economy, state news agency Xinhua said President Xi Jinping will head a group that will lead reforms which include relaxing state control over the yuan.
MORE TRANSPARENCY NEEDED
Under China's laws, local governments are not allowed to borrow from banks even though they are responsible for as much as 80 percent of all public spending, but take only around half of fiscal income.
To get funds, local governments set up firms that borrow for them. When Beijing clamped down on this in 2011, governments changed tack and turned to shadow banks. Monday's audit showed shadow banks accounted for at least 13 percent of all local government borrowings.
Facing savvy local officials quick to change financing strategies to evade rules, Chinese experts have championed creation of a municipal bond market. Such vehicles, they say, will decide which governments deserve funding, and spendthrift ones will be punished with higher borrowing costs.
Beijing appears to like the idea, and is testing the ground for such a bond market in six prosperous cities including Shanghai and Guangdong.
But short of full disclosure of just how much governments take in and borrow, analysts doubt China's experiments with its local bond market will go far.
"Banks and rating agencies do not have easy access to local governments' overall fiscal position, which includes not only budgeted revenue and expenditure but also extra-budgetary revenue and expenditure," the International Monetary Fund said in October.
"This lack of transparency prevents banks and rating agencies from pricing credit risk properly and prevents local governments from managing related risks prudently," it said.
(Editing by Richard Borsuk)