China's growing level of local government and corporate debt has become a major issue for the nation's financial system, and requires the authorities to work on solutions to reduce the risk of a hard landing, according to experts.
The banking system can only handle possible external impacts if debt restructuring is immediately pushed forward, said Liu Yuhui, an economist with the Chinese Academy of Social Sciences.
China lacks institutions and the mechanism to deal with the impact of investment decisions, which has led to the current financial risks, Liu wrote in the China Securities Journal on Monday.
Many companies are no longer able to deliver returns that can cover the interest on their debts due to misplaced resources, and their income growth will be increasingly surpassed by expanding debts, said Liu.
At a conference in April, Xu Xiaonian, professor of finance at China-Europe International Business School, said: "In localities with relatively good financial conditions such as coastal cities in eastern and southern China, local government debts are about twice the annual fiscal revenue ... and some overseas institutions estimate that debts at various levels of government in China may be 100 percent of China's GDP."
Liu added: "A comprehensive plan must be drawn up to deal with debts, which may include financial measures that help to realize asset swaps and push forward debt restructuring. It is dangerous to allow a huge amount of bad loans to remain in the banking system, which will tighten liquidity."
Rising social spending, shrinking revenues from land sales, diminishing or negative returns on investments and deteriorating cash flows have become major issues of concern for local governments which are facing growing debts, many of which will be due by the end of this year.
A recent report from Barclays Capital said local governments used to rely on various channels to raise investment capital, from fee collection and land sales to borrowing via local government investment vehicles.
"These are all gone or at least diminished significantly. During the past year, they raised some funds through bonds issued by local infrastructure development corporations, but we think this also may slow in 2013," added the report.
In the first quarter of 2013, China saw a surging number of trust and entrusted loans, funding channels that are favored by many local governments.
According to the People's Bank of China, trust loans grew 360 percent year-on-year in the first quarter to 823 billion yuan ($134 billion), while entrusted loans grew 86.3 percent to 523.5 billion yuan.
Earlier this month, the China Banking Regulatory Commission ordered banks to stop extending new loans to local government financing vehicles in 2013 amid concerns over increasing amount of bad loans.
Shadow banking has become a vehicle for those who need to extend their debts as they will soon be due, according to Liu.
Between 2009 and 2012, combined debts in China's economic system increased by around 60 percent, while growth in social financing significantly surpassed GDP growth in the first quarter of 2013, according to statistics from China's central bank.
"Many banks face the risk that a large amount of non-performing loans may emerge if local governments and enterprises are not performing well due to their previous unwise decisions to push forward some projects, many of which are infrastructure-related. We are not quite positive that the debts can be paid on time," said a source with the risk management department of a Beijing-based commercial bank.
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