China released a comprehensive review of the massive debt of its local governments on Monday and curtailed their future borrowing, taking its first major step to prevent widespread defaults from destabilizing its vast economy.

Releasing its first audit of local government debt, which amounts to 27 percent of the economy, China's chief state auditor Liu Jiayi said local government financing vehicles would be cleaned up and regulated depending on the type of debt they hold.

The results, presented to the Chinese parliament by Liu, showed local Chinese governments had chalked up about 10.7 trillion yuan ($1.65 trillion) of debt as of the end of 2010.

The audit and the proposed measures, the most comprehensive so far, underscored Beijing's determination to head off credit risks that may destabilize growth in the world's second-largest economy ahead of a leadership change in 2012.

Although the estimated figure for local government debt was in line with market forecasts and short-term risk appeared contained, some analysts were still worried local governments would struggle to repay their loans.

The property sector is feeling the pinch from government policy tightening, and it takes time for government-invested projects to generate returns, said Hua Zhongwei, an analyst with Huachuang Securities in Beijing.

These will create big pressures on local governments to repay their debt.

To contain the problem, the audit office said financing vehicles would be firmly barred from incurring new debt, while local governments would be allowed to sell bonds, but only with approval from Beijing.

FINANCING VEHICLES

The audit office said about half of local government debt, or 4.97 trillion yuan, was held by financing vehicles, well under market estimates for the vehicles to have borrowed 10 trillion yuan.

Analysts welcomed the surprisingly low estimate for debt incurred by these vehicles, but many warned against reading too much into what may well be an understated figure.

Different definitions for what makes a financing vehicle, and a recent consolidation in the sector in the face of tighter regulation by Beijing have skewed the picture, they said.

The lower-than-expected figure should alleviate some worries on a surge of new crop of bad loans in the banking system, said Li Xunlei, an economist at Guotai Junan Securities in Shanghai.

But we need to note that the way of calculating the debt varies from one ministry to the next.

Local government debt has long been identified by analysts as a weak spot in China's economy, responsible for a covert and fervent borrowing spree that has generated wasteful spending, with some loans believed to be in default.

About half of all local government debt was taken up during the 2008 financial crisis when Beijing unleashed a 4 trillion yuan fiscal stimulus to foster economic growth. This group of post-crisis loans is due to mature in 2013.

The audit office did not say what proportion of loans was in default or was at risk, except to say that of over 6,500 financing vehicles reviewed, around 2 percent, or 148 of them, had a default rate of 16.3 percent.

WELL-CAPITALISED BANKS

Monday's release of the audit findings confirms a Reuters story last month when sources said Beijing wants to start overhauling its local government debt mess by June to have the house in order by the next leadership reshuffle in late 2012.

To clean up the debt mess, the sources said Beijing would shift 2-3 trillion yuan of debt off the books of local governments. They said Beijing and China's Big Four banks will be forced to take some losses on bad debt.

Liu from the audit office said efforts would be made to clean up and regulate financing vehicles and that the borrower must bear responsibility.

But analysts thought any losses that Chinese banks may suffer would be manageable.

These are among the best-capitalised banks in the world. Disaster isn't going to happen, not this year, not next year, said James Antos of Mizuho Securities Asia.

The performance of bank shares suggested investors agreed, with most either steady or marginally lower.

To be sure, not all local government borrowing has gone to waste. Much has been used to fund the building of roads and railways, investment which many economists argue that China needs and is of value even if loans are not repaid on time.

Still, ambiguity around just how much debt Chinese local governments have chalked up has fed the overall investor concern about China's problem of bad debt.

Various Chinese government bodies, including the central bank and the bank regulator, have all provided varying estimates for the amount of outstanding debt.

China's central bank created a stir earlier this year when it estimated that local government debt accounted for less than 30 percent of total Chinese bank lending.

That led Chinese media to extrapolate that local governments had borrowed as much as 14 trillion yuan.

But given China's audit office was authorized by China's cabinet to investigate the debt mess of local governments, it is likely to have the final say on this issue.

The audit office has a much more narrow definition. My understanding is that the debt as defined by them are those that are government guaranteed, or are backed by government revenues, said Wei Yao, an economist at Societe Generale in Hong Kong.

But I think in terms of the size of the debt, it's largely consistent with the previous reports.

All said, few see a widespread banking fallout as they believe cash-rich Beijing will step in to absorb losses if needed.

As the owner of $3.05 trillion of foreign exchange reserves, the world's largest, Beijing has deep pockets to recapitalize its banks.

And despite the eye-watering amount of debt that has been incurred by local Chinese government, China's total government debt stands at 44 percent of its gross domestic product, well under the debt-to-GDP ratio of other major economies.

Japan's ratio is over 225 percent; the U.S. ratio is 93 percent, and Germany's debt-to-GDP is 75 percent.

($1 = 6.475 yuan)

(Additional reporting by Wang Lan, Kevin Yao, Terril Jones, Kelvin Soh, Langi Chiang, Emily Kaiser; Editing by Vidya Ranganathan)

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