The debts of local government-backed investment units in China reached 7.66 trillion yuan (US$1.15 trillion) by the end of June, of which 2 trillion yuan is questionable, China Securities Journal on Thursday quoted an anonymous source as saying.

The report said the figure is the result of a national assessment and classification by regulators that started at the beginning of this year.

The China Banking Regulatory Commission (CBRC) classified one-fifth of the debt as "questionable" in July.

"The rise in questionable lending may be attributable to the economic slowdown since the second quarter as the government loosened lending a little to shore up the economy," said Dong Xian'an, chief economist with Industrial Securities.

A total of 26 percent of the loans face serious risks regarding their repayment, due to unqualified borrowers and problems related to collateral, according to the results. About 24 percent of the loans can be repaid by the projects' own cash flow, and about 4 trillion yuan, more than 50 percent of the amount borrowed, cannot be paid back by the original channel.

Local governments have used their off-budget investment arms to tap into the flood of bank lending unleashed during the stimulus programs, and have channeled those funds into local infrastructure projects, not all of which are based on solid commercial foundations, said the Asian Development Bank (ADB) in a report.

But there is no systemic risk as the regulators, while tightening guidelines for such lending, maintained that the banking sector is secure because the ratio of non-performing loans was just 1.3 percent by the middle of year and the average provisioning ratio was 186 percent, said Zhuang Jian, senior economist of the ADB in China.

The policy banks and large State-owned banks are major lenders to local government financing units. Policy banks made about 30 percent of the loans, while large State-owned banks accounted for 40 percent.

The Chinese government said risks related to the borrowing are "controllable" and would not cause systemic damage to the economy, as it issued detailed measures to clean up the financing of these vehicles on Aug 19.

Some economists are concerned that the problem of local government debt could destabilize the financial system of the world's fastest growing major economy if not managed properly.

They especially cite the central government's tightening of the housing market, which could affect local fiscal revenue highly dependent on land sales and make debt repayment more difficult.

"Most of the loans can secure steady and sufficient cash flow and cover the principal and interest. And for loans that may not be repayable, risks can be refined by restructuring debt and increasing collateral," said the Ministry of Finance and the CBRC in a statement in August.

(China Daily October 15, 2010)