Debt hangover to give nation the budget blues

Some worry, however, that a disruption in local government financing could trigger a "fiscal cliff". That phase came into circulation in 2012 in the United States, when many analysts warned that the combination of spending cuts and tax increases would trigger a recession.

The situation is not quite the same in China, because there are no tax hikes accompanying the effort to curb local debt and spending. But the fears of disruption are not groundless, either.

Steps taken last year underscored the central government's determination to tackle the thorny problem of local government debt, but observers are grappling with the implications of these moves.

In a landmark document issued on Oct 2, the State Council clarified for the first time that LGFVs can no longer raise funds for local authorities, and those local governments have no obligation to repay debt that was not raised to fund public projects.

A few days later, the Ministry of Finance issued a guideline on dealing with the outstanding debts. Local governments were ordered to classify their debts by Jan 5 into two categories: those that were to be included in their fiscal budgets and those that LGFVs were to resolve on their own.

"Outstanding local government debts will be cleaned up, reported and locked up. Once identified as government debts, they will be covered by the governments' budget management, repaid by corresponding budget income or gradually substituted by local government bonds," said Vincent Chan, an analyst with Credit Suisse.

Chan agreed that it is appropriate to defuse the risk of a debt crisis, but he said he was not sure how the nation could "ensure a smooth transition from current to new channels".

Li Yan, an analyst at China Chengxin International Credit Rating Co Ltd, said: "The current quota of local municipal bonds (400 billion yuan in 2014) is far from covering local governments' financing needs."

It is hard to imagine that the financing function of LGFVs can be covered with such one-off measures.

"There must be a transition period where the old system and new channels coexist," Li added.

The government envisions bridging that gap by issuing more municipal bonds and "special-purpose bonds", and inviting private capital to participate through public-private partnerships.

But those initiatives will take time to develop. Meanwhile, local governments need to repay debt from their fiscal revenue, which will constrain their expenditures. It is not quite a "fiscal cliff", but it could have a similar impact.

Analysts said that bolder initiatives are needed.