SHANGHAI (Reuters) - With a nod from Beijing, China’s local governments have embarked on a massive new round of off-balance sheet debt financing, underpinning a fragile pick up in the economy but raising red flags on financial stability.

The junction of Yangtze River and Jialing River is pictured in Chongqing, China, January 25, 2016. Picture taken January 25, 2016. REUTERS/Sue-Lin Wong/File Photo

The increased borrowing for an economy already swimming in debt adds to concerns about growing bubbles in certain major asset classes, such as real estate and commodities, and a bond market seeing a rise in corporate defaults.

Economists say increasing public sector investment – most of it financed locally with debt – is behind improvements in China’s economy. First-quarter GDP rose at the weakest pace in seven years, but other data suggested growth was picking up in March.

“With new infrastructure projects effectively all funded by debt and more consumer mortgages, the leverage problem and risks on the financial sector are rising,” Credit Suisse analysts wrote in a research report.

Local government financing vehicles (LGFVs), which Chinese cities use to circumvent official spending limits, raised at least 538 billion yuan ($83 billion) in bonds in the first quarter, up 178 percent from a year earlier and the highest quarterly issuance since June 2014, Everbright Securities said, quoting figures from privately held financial data provider WIND.

Issuance in March alone was a monthly record of 287 billion yuan ($44.3 billion).

China’s planning agency, the National Development and Reform Commission, declined to comment on the sharp rise in LGFV issuance. Most of the LGFV debt in the first quarter was made up of so-called enterprise bonds, which the NDRC oversees.

Beijing had been trying to move LGFV debt on to municipal balance sheets via the 2014 creation of a municipal bond market. But policymakers retreated from this in the middle of 2015, easing borrowing restrictions as economic growth stumbled.

Consequently, LGFV issuance in the first quarter of 2016 was nearly 60 percent as large as the municipal bond issuance meant to replace it, up from just 37 percent in the fourth quarter of 2015, central clearinghouse and brokerage data shows.

“In the second half of last year, the government raised the percentage of project financing that can be funded with debt,” said Yang Zhao, chief China economist at Nomura in Hong Kong, helping spark the flurry of LGFV deals.

“If they continue on, the debt-to-GDP ratio could actually go up quite rapidly. I don’t think the policy is sustainable, and you’ll see policymakers slow down the pace of (credit) easing in a quarter or two.”

Much of China’s huge debt overhang from the global financial crisis was generated by these same LGFVs which – in addition to funding legitimate infrastructure – became infamous for building ghost cities and roads-to-nowhere as local officials took advantage of crisis level ultra-low borrowing rates.

This helped push China’s debt-to-GDP ratio to more than 240 percent at the end of 2015, estimates from the Bank for International Settlements show.

FLIGHT TO SAFETY

Despite the concerns flagged by analysts, LGFV bonds are proving relatively attractive to investors as a rising number of corporate defaults - including by some non-LGFV state firms with weaker backing - undermines confidence in company debt.

Defaults have been on the rise this year, including in industries, such as steel, that suffer from over capacity.

“Managers are increasingly concerned about corporate bond credit quality and so they’re getting back into government or quasi-government debt,” said a director at a foreign buy-side money manager in Shanghai.

Yields on three-year AA-rated LGFV bonds, which in mid-2015 were higher than regular enterprise bonds, now trade 30 basis points cheaper. Enterprise debt is a category of the market mainly used by state affiliated borrowers.

“It’s easier to raise money right now, after all LGFV bonds are basically half government bonds,” says Li Xiangdong at the Qinhuangdao Development Investment Holding Group Co Ltd, an LGFV owned by the coal port city of Qinhuangdao in China’s struggling Northeast. “Default risks are low.”

ROADS TO NOWHERE?

The latest local government debt binge has raised funds for a variety of projects from parking lots to renovations of tourist attractions in obscure regions.

Most new issues posted in April on the website of China’s main bond clearinghouse funded pipelines, or water treatment systems and, more worryingly, housing projects.

“There are some parts of the country where (housing) inventories have come down enough for new construction to make sense,” Rosealea Yao of Gavekal Dragonomics wrote in a research note.

“But there are also parts of China where inventories are still rising - and construction is nonetheless picking up, probably because of state-directed spending.”

In southwestern Guizhou, one of China’s poorest provinces, Jinsha County Construction and Investment Co Ltd, an LGFV, sold 800 million yuan of seven-year bonds on April 27.

Among other projects, the funds will help finance a 1.2 billion yuan athletic culture park, including a hotel, shopping street, and a 103,000 sq meters (1.1 mln sq feet) stadium and gym complex - roughly twice the size of Europe’s largest soccer stadium that is home to Barcelona football club.

The bonds carry an AA rating, the third highest credit rating, with the rater citing strong local government support as part of its rationale, even though Jinsha County Construction’s ratio of operating income before line items over interest payments due has fallen sharply. In 2012 it was 57 times interest payments due and in 2014 it was less than two times.

Calls to the head of Jinsha County Construction finance department went unanswered.

After the wave of LGFV deals, rising yields suggest some investors are starting to grow cautious amid a broader selloff in Chinese bonds. About $15 billion in debt issuance has been delayed in April, including by several LGFVs.