CHINA'S first disclosure of the size of local government debt triggered a debate about the creditworthiness of all that borrowing.

In late June, the National Audit Office said local governments owed 10.7 trillion yuan (US$1.65 trillion) at the end of 2010 and 80 percent of the debt was held by banks.

The disclosure came after the audit office mobilized an army of 40,000 staff who uncovered 1.87 million debts of 79,000 local governments chalked up through the 6,576 financing vehicles they set up to circumvent a ban on them borrowing directly from banks.

Such finance arms are "numerous and burdened with big debts, and some are ill-managed with weak capacity to make profits," said Liu Jiayi, China's chief state auditor.

About 8 billion yuan of local government debt is overdue, and financing arms are too often relying on government land sales to meet repayment obligations, the report said.

The findings didn't come as a surprise to seasoned market-watchers.

"The audit report confirmed that a majority of the debt was incurred to counter the effects of the financial crisis because half of it was borrowed during 2009 and 2010," said Cui Li, Royal Bank of Scotland's chief economist in China. "Banks are the main financing source."

An undercurrent of concern about local government debt started mounting after China unveiled its 4-trillion-yuan stimulus program in late 2008. The program was aimed at shielding the economy from the worst effects of the global financial crisis. The stimulus program led to speculation of a borrowing frenzy by local governments that had pushed aggregate provincial, county and municipal debt loads above 10 trillion yuan.

In March, Chinese Premier Wen Jiabao ordered the audit office to probe local government debt in an effort to lift the veil of opaqueness.

Still, some think the auditor's discovery of loans totaling 8.5 trillion yuan falls short of reality.

A week after the audit report was released, Moody's Investors Service said Chinese banks' exposure to local government debt may be understated by 3.5 trillion yuan.

"Banks' exposure to local government borrowers is greater than we anticipated," Yvonne Zhang, a Moody's vice president, said in a report.

Unless China comes up with a "clear master plan" to clean up the problem, the credit outlook for Chinese banks could turn negative, Moody's said.

The agency pointed to disparities in data supplied by the audit office, the central bank and the top banking regulator.

In a June 1 report, the People's Bank of China indicated that claims on local governments represented up to 30 percent of total bank loans, or about 14 trillion yuan.

The China Banking Regulatory Commission, according to a report in the 21st Century Business Herald, said local government debt had reached 9.1 trillion at the end of November, or about 20 percent of bank-extended credit.

Moody's took the mid-point between the data from the two regulators and assumed that 25 percent of total lending, or 12 trillion yuan, was attributable to local governments. According to that calculation, the audit office findings were 3.5 trillion yuan shy of accuracy.

"Short of being ideal, this rough estimate at least has the merit of not ignoring a potential significant risk exposure," Moody's said. Moody's Zhang said it's possible the 3.5 trillion yuan discrepancy signifies that auditors don't believe all loans represent real claims against local governments.

"This indicates that these loans are most likely poorly documented and may pose the greatest risk of delinquency," she said. Moody's assumes a 50 percent delinquent ratio on such loans.

The ratings agency said a jump in local government loan defaults could push the non-performing loan ratio for Chinese banks as high as 12 percent, well above its best-case scenario that envisions losses in the range of 5 percent to 8 percent.

Concerns on loan quality

Rating firms have been questioning the quality of banking loans. Standard & Poor's said in April that up to 30 percent of loans to local government entities may turn sour, accounting for the biggest source of banks' non-performing assets. But other market watchers were less concerned.

"The Moody's report makes news because any story with dire predictions for the Chinese economy sells papers," said Simon Gleave, head of financial services of KPMG Asia Pacific.

"There is a lot of bad speculation," said Gleave. "The negativity surrounding these loans is being overstated from what I can see from our work with our banking clients"

Gleave said his confidence stems from the use of borrowed funds.

The audit report showed that projects financed under the local governments are essentially infrastructure related and most of the projects are already in Five-Year plans.

"So it wasn't as if people were inventing projects," he said.

The country needs infrastructure, and what has happened is that the government has accelerated the building of the infrastructure projects to stimulate the economy, he added.

Qu Hongbin, HSBC's chief economist in China, echoed the view.

He said that more than 70 percent of the loans have been channeled into public works projects such as railway and bridges, and into land purchases. That implies the net worth of assets of local government has been rising along with their liabilities.

By contrast, a lot of the government debt in European countries now facing problems has been spent on salaries and other expenditures that don't generate benefits, Qu said.

Debt liquidity is key

He said that China's local debt risks are under control, despite Moody's red flag.

"I don't think any institution can devote the same manpower and resources as the audit office did to look at local debt," Qu said. "Anybody can speculate, but speculation is a totally different story from investigation."

He said even if Moody's assumption holds true, local government debt could rise as high as 14.2 trillion yuan and still be manageable.

"For such a high-saving country as China, the scale of the debt is not the key concern," he said. "The key problem is not the scale but the liquidity of the debt."

There is a mismatch, Qu said, between the maturity of these debts and the payback period of the long-term projects where the money was invested.

Local debt is mainly short- to medium-term maturity, with nearly 70 percent due to mature by 2015. On the other hand, about 70 percent of the infrastructure projects may need a longer time-frame to generate cash flow or profit.

"The main task for China now is to help local governments restructure such debts to create liquidity," Qu said.

The central government is not turning a blind eye. Since 2010, China's top banking regulators have directed banks to conduct "prudent monitoring" of debts and to cut their exposure to local government borrowing, especially by financing vehicles. As a result, big banks' exposure to the vehicles did drop, according to the banks' financial reports. For instance, China Construction Bank's exposure to the financing vehicles shrank by 140 billion yuan to 400 billion yuan in the first quarter. The bad-loan ratio of loans made to such vehicles was 0.5 percent in the period.

At the end of 2010, the average bad loan ratio at Chinese banks was 1.6 percent, indicating sound assets quality. Still, the issue continues to be a talking point.

A day after the Moody's report was released, the State Council's Standing Committee met to discuss the issue of risk in local government borrowing. It placed a high priority on addressing the issue.

"It's a risky area and banks are being very careful to ensure the risks are well-managed," said KPMG's Gleave.

"I don't see any evidence to indicate these will become disastrous projects nor do I do see any evidence of high levels of default."