The debt crisis in Europe and the downgrade of the United States sovereign rating have raised questions about the soundness of government debt in China.

In April, a few alarm bells went off when a potential debt default was reported in the southwestern Chinese province of Yunnan.

The Yunnan Road Development Investment Ltd, known as Yunnan Express, wrote to creditors saying that it might be unable to pay interest owed on nearly 100 billion (US$15.6 billion) of loans from China Construction Bank, China Development Bank, Industrial and Commercial Bank of China and a few other lenders.

Yunnan Express is responsible for the construction, financing and operation of modern highways in the province. It said toll collections alone are not enough to pay the costs of maintaining the highways.

The firm's financial difficulties, compounded by the debt woes in foreign countries, have sparked some market concerns. In recent months, banks have become more careful in lending and sales of government-issued bonds, Xinhua news agency reported.

It is difficult to explain to foreigners where China's local governments are getting all the money to fund the construction of so many roads, bridges, subways and airports across the country, Shanghai Vice Mayor Tu Guangshao told a financial forum last month.

"It took me time and effort to explain the financing mechanism to my counterparts in the United States during a recent visit there," Tu said. "I can tell they are still a bit confused."

Local governments in China are restricted from borrowing money directly from banks and from selling bonds unless they are specifically given permission by the central government. To get around these restraints, provincial, municipal and other local governments set up arms-length financing vehicles to raise money. The nature of these financing vehicles is what Tu tried to explain to US officials.

Simply put, the financial vehicles are government-backed investment companies that are allowed to borrow money from banks or sell bonds. Because of government backing, banks and bond buyers are willing lenders.

China now has more than 9,800 financing vehicles at all levels. At least 10 percent of them are permitted to issue bonds.

Shanghai Chengtou Corp is one such investment company. It was authorized by the Shanghai government in 1992 to construct infrastructure projects.

During the past 15 years, it has raised more than 200 billion yuan and invested in over 60 infrastructure projects, including roads, bridges, tunnels, subways, water supply, gas and public housing.

Financial vehicles also played a pivotal role when China implemented its 4 trillion yuan stimulus package in 2008 to stave off the impact of the global financial crisis by investing in many new infrastructure projects.

Lower debt level

According to the National Audit Office in late June, China's local government debt hit 10.7 trillion yuan at the end of last year, equivalent to about 27 percent of gross domestic product in the world's second-largest economy.

But the total debt of the central and local governments represents less than 50 percent of China's economic output, the office said.

Compare this with the massive debt level that the US and some countries in Europe have to bear.

In the US the government debt is now over US$14.5 trillion, or nearly 100 percent of its GDP.

In Europe the debt levels are even higher. Greece, Ireland and Portugal have had to seek bailouts from the International Monetary Fund and the European Central Bank to handle their debt crisis, and the situation in Spain and Italy has been looking rather fragile too. Even in solid euro members like Germany and France, the debt level is close to 80 percent of their GDP.

Xu Lin, head of the fiscal and financial department of the National Development and Reform Commission, said that local governments in China are unlikely to default on their debt.

"There is little chance for a potential government debt default in China, as governments and regulators at all levels are paying more attention to risk controls," Xu said in a statement posted on the NDRC's website.

In separate data released by about 10 provincial governments, Hainan Province showed the highest debt rate, at about 70.2 percent of its economic output. Four-fifths of that debt was long term.

Shandong Province (excluding Qingdao) said its government debt reached 475.2 billion yuan, the highest of the 10 provinces. But to the relief of many its debt was only 14.1 percent of its GDP.

However, some local governments might face liquidity risks where short-term debt is concerned, economists said.

"Although the risks of local government debt are under control, there are still short-term regional risks," said Lu Zhengwei, chief economist at the Industrial Bank. "The concentrated payments will increase local government's exposure and some may face tight cash flows and liquidity risks."

According to the National Audit Office, about 24 percent of local government debt is due in 2011 and about 17 percent will mature in 2012.

In Shandong Province, six government-backed colleges and 15 hospitals were reported to be paying off debts with newly- borrowed money.

Ba Shusong, a senior economist at the State Council's Development Research Center, said in a recent interview that China's government debts need "a soft landing" in the economy.

"The current huge debt is a by-product of stimulus measures," Ba said. "It was an active part of the fight against economic recession, but now it's time to limit those powers and avoid similar tragedies as in the US and Europe."

Ba suggested that more private capital should be introduced into government projects in a bid to decentralize risks.

Since the end of 2009, as part of efforts to restrict their expansion Chinese regulators have started to tighten supervision over the financial vehicles set up by local governments. Government-backed investment firms that want to issue bonds have to meet stricter requirements, including being profitable for three consecutive years with profits being able to cover interest payments for at least one year. Also, the size of bond issues can't be more than 40 percent of net assets. If debt levels exceed 100 percent of local GDP in a province, all local government financing vehicles are forbidden from further borrowing.