Debt threat: Analyst warns Chinese government on risks from bank defaults

We believe the recent debate about the size of local government debt misses the point. Whether RMB10.7trn (the official figure) or RMB14trn (unofficial estimates), it is still below 36% of GDP. If the central government's debt is included, China's total government debt is around 54% of 2010 GDP - not low, but still manageable compared with the developed world and most emerging countries.

Remember that more than 70% of the proceeds of local debt has gone to finance infrastructure and land investments, boosting the amount of assets in government hands. So, overall, we think central and local government balance sheets are still pretty strong.

That said, there is liquidity risk because of the mismatch between the maturity structure of bank borrowings and the payback period of long-term infrastructure projects. As more than 50% of total debt will mature by the end of 2013, we think Beijing will need to take action to restructure the local debt and prevent a major bank default. We believe the authorities have three options:

• Kick start the issuance of longer-term municipal bonds to enable local governments to pay back bank loans. Demand should not be an issue, given the huge pool of private sector bank savings (RMB64trn).
• The medium-term option is to sell assets to repay loans. Local governments still own toll roads, ports, subways and more than 20,000 state-owned enterprises, with over 70% of them making profits. In any case, we believe this is a necessary step to shift local governments away from business activities so they can focus on public services - a key objective of Beijing's reforms.
• Longer term, the ultimate solution is to give local governments a greater share of fiscal revenue so they can fund infrastructure investment sustainably.