On the surface, China presents a fiscal study in contrast with the United States, keeping a remarkably low ceiling on debt even as it spends its way out of the financial crisis.

But when Chinese leaders meet their U.S. counterparts this week, they should pause for reflection before venting any criticism, because hidden liabilities mean China's books are uglier -- potentially much uglier -- than at first sight.

Thanks to successive years of fast economic growth and even faster government revenue growth, the official debt-to-GDP ratio was 17.7 percent at the end of last year, far lower than almost any other major economy.

The trouble is that excludes local government borrowing, the current surge in loans backstopped by Beijing and bad assets cleared from the banking system but still floating about.

When all are thrown into the pot, analysts estimate that China's debt may be closer to 60 percent of GDP, putting it in virtually the same league as the United States, which was at 70 percent at the end of 2008 before it launched its massive economic stimulus program.

To be sure, Washington is now set on a path of exploding debt that Beijing will largely avoid. The United States budgeted for a federal deficit of 12.9 percent of GDP this year, whereas China is aiming for just 2.9 percent.

But China's finances are deteriorating more quickly than the government expected, fuelling a rise in the stock of both explicit and disguised debt that will constrict its wriggle room.

It is serious because, one, much of it is hidden and, two, local governments are currently doubling down on their bets, said Stephen Green, economist at Standard Chartered Bank in Shanghai. As with all fiscal deficits, it limits space for further stimulus.

This is probably a moot point, for now. With China's economy back on track and private-sector investment kicking in, few think Beijing will need to ramp up spending beyond its existing 4 trillion yuan ($585 billion), two-year stimulus plan. But the narrowing of options still discomfits Chinese leaders.

Our fiscal work is very grim, Chinese Premier Wen Jiabao told officials last week.

ERODING FINANCES

Government revenues declined 2.4 percent in the first half compared to a year earlier, well shy of the official goal of an 8 percent rise. Expenditures were ahead of target and set to surge in the second half on the back of infrastructure projects.

Tax intakes are, of course, closely tied to economic activity, so China's upturn should deliver cash to government coffers. But improvement in June came mainly from land sales, a one-off revenue source that masks the difficult road ahead.

Even when we are already factoring in relatively optimistic revenue growth due to the economic recovery, the deficit is quite sticky at around 5 percent per year for the next three years, said Isaac Meng, economist at BNP Paribas in Beijing.

But the real worry is the thickening morass of indirect debt.

Officials at the Ministry of Finance estimated earlier this year that local government debt already topped 4 trillion yuan, or 16.5 percent of GDP, much more than previously assumed.

Above and beyond that are 400 billion yuan in bad loans in banks' hands and at least 1 trillion yuan in non-performing debt hived off their books and assigned to asset management companies. The buck stops with Beijing on all of these.

The record surge in bank lending this year means that its sum of liabilities is about to swell in size.

Banks have showered money on infrastructure projects that are seen as having iron-clad government guarantees. Green said he conservatively estimates that Beijing's bill for covering loans issued this year alone will be 1.75 trillion yuan, enough to push its 2009 deficit to 10 percent of GDP.

DEBT BOMB

Most troublesome of all is the potential for a debt bomb, in the words of China's Economic Observer newspaper, at lower levels of government as officials engage in financial engineering that is both opaque and highly leveraged.

Rules prevent Chinese banks from lending to governments the equity capital which they need to obtain further loans for investment. But local officials and banks are now exploiting a vast loophole thanks to intermediaries known as trust companies.

The process is simple enough. Trusts create specially designed wealth products, which banks sell to their clients. Banks then give the funds to the trusts and they, in turn, funnel them to governments as equity capital.

Local authorities, in short, are piling debt on top of debt. The Chinese banking regulator has started to warn trusts and banks of the growing risks, state media recently reported.

It was not long ago that bad loans in China's banking system seemed to pose a massive debt threat to the wider economy. The core solution over the past decade was sustained double-digit growth, vastly expanding the denominator in debt-to-GDP ratios and generating the taxes to pay down the numerator.

Beijing is already looking to raise taxes where it can -- increasing the levy on cigarettes, for example -- but a return to super-charged growth is again its principal debt reduction plan.

In the meantime, China needs to fund its rising deficit.

On that front, at least, the government can be supremely confident, even if it has to issue more than the planned 950 billion yuan in bonds this year and yet more to cover shortfalls in coming years.

There is so much saving and so much liquidity, so there is definitely not a problem that China will not be able to finance its deficit, said Tao Wang, UBS economist in Beijing.

($1=6.8314 Yuan)

(Editing by Kim Coghill)

BNP Paribas China