For the past few years, China watchers have worried about the mountainous debt levels being carried by local governments. Now, it appears, Beijing has finally resolved to take action.

Last week, there were reports that China’s regulators were planning to shift 2-3 trillion yuan ($US308 billion-$US463 billion) of debt off the balance sheets of debt-laden local governments, in a bid to reduce the risk of a wave of defaults that could threaten the stability of the world’s second largest economy (Beijing will be burnt in provincial bailout).

The reports said that as part of Beijing’s overhaul of local government finances, the central government would pay off some of its debts, while state banks would have to write off some of their bad debts. They added that Beijing also intended to lift the current restrictions that prevent provincial and municipal governments from selling bonds. This will allow local governments to improve their finances using more transparent sources of funding.

There’s little doubt that Beijing needs to come up with a plan for dealing with local government debts. Local Chinese media reports suggest that local governments’ financing vehicles — hybrid structures that local governments use to get around restrictions that limit their ability to borrow money directly — now owe Chinese banks about 10 trillion yuan.

Many of the loans date from the lending spree that the banks engaged in as part of Beijing’s massive economic stimulus program in late 2008 to counter the effects of the financial crisis. This saw trillions of yuan flowing into local government financing vehicles, which then spent the money on new investments, such as building new highways and airports.

But not all of these loans to these vehicles were channelled into worthwhile investments. In many cases, the projects simply don’t — and never will — generate sufficient revenue to service the loans. In some cases, local governments used the money to increase their land reserves. Others embarked on social projects, such as creating new parks or planting trees. In other cases, loans were likely to have been squandered on bad investments or on corrupt payments.

The problem is that at this stage, no one knows how much of this 3 trillion yuan in problem loans the banks will be forced to shoulder. Essentially, Beijing faces a choice. It can bail out the local government vehicles, and rescue the banks. Or it can force the banks to bear the brunt of the losses, and then assist them by, say, forgoing dividend payments, or giving them tax credits for bad loan write-offs, and contributing to any future capital raisings by the banks. Alternatively, Beijing may choose a middle course, taking over some of the bad loans directly, but also forcing the banks to swallow some of the losses.

In his latest report, Societe Generale’s strategist, Dylan Grice, predicts that Beijing might adopt the approach it used in recapitalising the Chinese banks in between 1998 and 2005. In that case, Beijing set up asset management companies to buy the bad loans, and they pay using non-tradable government-guaranteed bonds that don’t show up in official measures of Chinese government debt.

But, he says, that’s a long way from solving the problem. “A bailout of $463 billion is half the size of the TARP, introduced by Paulson at the nadir of the 2008 crisis, for an economy which is only one-third the size of the US. So adjusted for GDP, China has just announced an emergency bailout of one and a half TARPs!

“If we calibrate the magnitude of the economic crisis with the size of the bailout, one and a half TARPs implies a financial crisis one and half times the order of magnitude of 2008.”

Papering over the problem, he warns, doesn’t make it disappear. “While we can’t predict where complex systems will go, we know that the longer their volatility is artificially suppressed, the more emphatic will be its release when it does come. It is more likely that China has one and a half times (and counting) the 2008 financial crisis ahead of it.”

*This article first appeared at Business Spectator.