shadow loan payments - sources@ (Updates with details of Fitch assessment of default risk)
BEIJING, Jan 15 (Reuters) - A Yunnan state-owned investment company that defaulted last month on two trust loans has secured financing to repay those loans and is set to get 2 billion yuan in additional equity capital from the provincial government.
Yunnan State-Owned Capital Operation Co, fully owned by the provincial government's state asset regulator, obtained the cash to repay the loans through one-month loans from three institutions, Liu Gang, the company's chairman, told Reuters in a telephone interview.
The loans will be repaid on Tuesday, Liu said, while declining to name the institutions providing the funds.
The Yunnan provincial government also is set to inject 2 billion yuan in the state-owned investment company, which defaulted on the two trust loans last month.
Those missed payments came amid growing fears that financing vehicles used by local governments throughout China, often for vanity projects that ran up large amounts of debt, may start to default this year.
Liu said Yunnan Capital was a platform to manage provincial state assets and carry out reforms at provincial government-owned companies. He said the anticipated capital injection had nothing to do with the loan repayments.
But, according to an internal memo from the trust company seen by Reuters and two sources with knowledge of the matter, the capital injection promised by the provincial government was to be used to help with the loan repayments.
On Dec 15, Yunnan Capital missed payments of more than 900 million yuan, representing principal and interest, that it had borrowed through two trust products issued by the Harbin-based Zhongrong International Trust, the two sources said on Monday.
The missed payments were the first known default of off-balance sheet, or shadow, loans borrowed by local governments, they said.
The case is closely being watched by investors and lenders concerned that China may be entering "a year of defaults" for off-balance sheet local government borrowing, one of the sources said.
The government capital injection to help the company repay loans, if it moves forward, could also indicate potential violations of the central government's ban that prevents local governments from providing implicit guarantees for local government financing vehicle (LGFV) debt, they added.
Yunnan Capital's Liu confirmed the government's capital injection plan but denied any relationship between it and the loan repayments. He said he did not consider his company to be a LGFV.
"Last week, Yunnan held four local governments accountable and punished a bunch of people for providing illegal guarantees - an activity that is not in line with the spirit of the central government," he said.
He said the 2 billion yuan capital injection from the government was aimed at boosting the company's capital strength and was pending budget approval by the local National People's Congress, the provincial legislature, which will convene later this month.
Ivan Chung, head of credit research and analysis for Greater China at Moody's Investors Service, said he expects the number of defaults by local government financing vehicles to increase in 2018 and 2019.
Thousands of financing vehicles have been created by local governments in recent years to fund large state-driven projects and hit economic growth targets.
They have taken on trillions of yuan in debt from banks, the bond market and shadow lenders such as trust firms, helping local governments bypass Beijing's limits on borrowing. Much of the debts come with implicit local government backing.
Beijing has increasingly cracked down on such debt-raising activities, stressing that it will not bail out local governments that run into financial difficulties.
One central bank researcher said recently that some cities should be allow to go bankrupt like Detroit.
Since late 2014, the central government has tried to address the situation of surging local government debt by revising the Budget Law, launching a municipal bond market, and stripping local government guarantees from debts held by local government vehicles.
At its annual economic conference in December, China's top leadership decided to take concrete measures to strengthen the regulation of local government debt in 2018 as policymakers look to rein in a massive debt pile and reduce financial risks facing the economy.
The finance ministry didn't immediately respond to a faxed request seeking comment. Zhongrong Trust didn't immediately respond to an email seeking comment.
In September, Fitch said the first defaults on public bonds by Chinese local government financing vehicles were becoming more likely. However, widespread defaults were a "tail risk" as the authorities relied on local government investment - supported by local vehicles - to hit economic growth targets, Fitch said. In simple terms, a tail risk refers to an event that has a small probability of occurring.
Fitch estimated that 4 trillion yuan in bonds issued domestically by local government financing vehicles since the new Budget Law came into effect in 2015 remained outstanding by September. The amount was equivalent to 5.4 percent of China's gross domestic product.
"The central government's attitude is that the local governments are not allowed to provide guarantees," said Chung, adding that the governments "have some space."
"The question is do local governments have the resources to rescue the next defaulted state-owned company or LGFV?"
($1 = 6.4278 Chinese yuan renminbi) (Reporting By Shu Zhang and Ryan Woo; Addtional Reporting by Matthew Miller; Editing by Philip McClellan)