Local and regional government debts in China have been under the spotlight lately. Given heightened concerns over government debts in Europe and elsewhere, some commentators are raising similar concerns about the affect of the Chinese LRG debt burden on the country's economic and financial stability. But we don't expect it to have an immediate impact on our China ratings. Nonetheless, it's worth examining several aspects of this issue and the broader implications.

What are these local government debts? China's Budget Law disallows local and regional governments from running budget deficits and issuing bonds. Nevertheless, it is no secret that Chinese local and regional governments have exploited loopholes to build up off-budget debts for many years. The most important of these are liabilities that state-owned enterprises (SOEs) accumulate.

China's still-developing financial market means that the bulk of local SOE debts continue to be loans from commercial banks and the two major policy banks, China Development Bank and Agricultural Development Bank of China. Some local SOEs have also issued enterprise bonds, although regulatory restrictions and the need for central government approval have limited their use.

What is the size of these obligations? This is difficult to ascertain because there is no official estimate for local and regional governments' off-budget liabilities, but most estimates suggest it's substantial. The range of estimates equates to 24 percent to 33 percent of 2009 GDP, or 17 percent to 23 percent of total outstanding domestic credit.

How wide is the spectrum of creditworthiness among so many entities? We believe it mostly ranges from moderate to very weak. We've looked at several local and regional government financing platforms and found that they tend to be undercapitalized from inception. Additionally, many exhibit weak ongoing financial performance. However, provincial financial platforms (or investment groups) with viable business lines - such as power generation, water, and heat delivery - are often in better shape.

Why have LRG debts become such a big issue suddenly? In 2009 LRG borrowing rose sharply as the government eased restrictions on bank lending, and this attracted widespread attention from investors and regulators who have focused on the risks that rising nonperforming loans or enterprise bond defaults might pose to bank profitability and financial sector stability.

Why do Chinese banks extend so much credit to entities with such weak credit characteristics? The sizable new loans to the local and regional governments' financing platforms showed that banks had eased lending standards significantly in 2009. However, this did not imply that commercial banks had abandoned their credit risk management practices. Banks that we spoke with often claimed that they based their lending decisions on the bank-assessed credit ratings of the financing platforms. However, the banks invariably also assess the local and regional governments' credit quality even if they do not borrow. We believe that the bank-assessed credit ratings of the financing platforms are closely related to those of their owner governments.

We also observed cases where companies' credit lines with commercial lenders shrank abruptly once the government ceased to be a major shareholder. Banks, therefore, expect local and regional governments to support their financing platforms when the need arises.

Will the central or local governments have to assume the bulk or all of these debts? We believe that the local and regional governments and the banks concerned are likely to have to share credit losses arising from local government financing platform debts. The central government is likely to avoid having to shoulder any of the resulting losses. Otherwise, it could lead to a moral hazard that may encourage local and regional governments-owned entities to borrow excessively again in future.

How is local government financing in China likely to change? We believe that the central government will require greater transparency in the local and regional governments' fiscal affairs. It is almost certain that the state will subject the relationship between local and regional governments and their SOEs to greater scrutiny and restrictions and we expect a rollback in the recent proliferation of financing platforms as unviable companies are allowed to fail or merge with healthier entities. The central government is also likely to strongly encourage a consolidation of such companies in industries where overcapacity is a problem.

What impact is the surge in local government debts having on banks' creditworthiness? In our view, the stress on the banking sector that we expect is unlikely to destabilize the major Chinese banks. This judgment rests on our belief that another economic slowdown that would require another round of fiscal stimulus and put additional pressure on Chinese companies is unlikely in the next one to two years.

Kim Eng TAN is director of Sovereign & International Public Finance Ratings at Standard & Poor's. The opinions expressed are entirely those of the author.

(HK Edition 04/10/2010 page2)