Local government debt has been a hot topic both in Hong Kong and the mainland recently, with concerns about asset quality weighing on sentiment for Hong Kong-listed mainland banks.

I believe the default risk will largely depend on macro economic policies and the development in the property market. As long as local government financing vehicles (LGFVs) are able to secure new funds through credit or bonds, there is relatively little chance LGFVs will turn bad in large numbers.

In fact, we have conducted a thorough analysis of the underlying problem and I would like to share some of the findings here:

First of all, the actual amount or scale of local government debt has always been mysterious as different sources show vastly different figures.

The most authoritative is the Audit Commission's National Audit of Local Government Debt, according to which the debt balance of local governments nationwide stood at 10.72 trillion yuan at end-2010, and of which bank loans accounted for 8.47 trillion yuan ($1.66 trillion) or 79 percent.

In addition, the People's Bank of China (PBoC) elaborated on LGFV loans in its 2010 China Regional Financial Performance Report. While not providing any balances, it did mention that there were more than 10,000 such vehicles being monitored (Meanwhile, the Audit Commission indicated that there are 6,576 vehicles in total). The PBoC report also states that "LGFV loans make up less than 30 percent of all yuan loans".

Given the different sources for the statistics, we estimate that the balance of LGFV loans by the PBoC may be higher than that mentioned in the Audit Commission report.

According to a meeting conducted by the China Banking Regulatory Commission (CBRC) last year, the total balance of LGFV loans stood at 7.66 trillion yuan as of June 2010. Some media reports have quoted the CBRC as saying that the balance stood at 9 trillion to 10 trillion yuan as of end-2010. In addition, all listed banks have made public their LGFV loan balances.

Based on their disclosures, the proportion of LGFV loans to total loans amounted to 8.4 percent as of end-2010. Seeing National Development Bank as the main forces behind LGFVs, we estimate a total balance of 8 trillion to 9 trillion yuan.

However, a major weakness of the statistics is that banks all have differences in terms of LGFV loan classifications, so these statistics may underestimate the actual figures. After considering various sources, we estimate the LGFV loan balance at between 8 trillion and 10 trillion yuan.

Taking into account other forms of local government debt, we put the overall debt balance in a range of between 10.3 trillion and 12.3 trillion yuan.

Based on the assumption of a 10.3 trillion-12.3 trillion yuan local government debt balance, the debt burden of the central government was around 6.7 trillion yuan in 2010. As such, the overall government debt balance would have been 17 trillion-19 trillion yuan. China's 2010 GDP stood at 39.8 trillion yuan, implying that the nation's debt ratio was around 45.2 percent of GDP. Based on the 60 percent standard of the European Union, China's debt ratio remains at a manageable level.

In addition, according to the Audit Commission's report, the local government debt ratio stood at 70.45 percent at end-2010. Also, at end-2010, 1.1 trillion yuan was yet to be spent, putting actual debt expenditures at 9.6 trillion yuan.

Of this, the debt the government bears responsibility for repaying is only 5.88 trillion yuan, and the overall strength of local government finances (including revenue at the local level, central government transfer payments and revenue form land use transfer) amounted to 10.9 trillion yuan, putting the debt ratio at 53.9 percent.

The author is Executive Director at BOCI Research Ltd. The opinions expressed here are entirely his own and do not represent BOCI or any other affiliated companies within the group. Nothing in this article constitutes an investment recommendation.

(HK Edition 07/20/2011 page2)