Fanning the fears was an official report, released Dec. 30, showing that the debt of localities had jumped 67 percent since the end of 2010 to 17.9 trillion renminbi (about $3 trillion) in June 2013. In a separate report to clients, economist Tao Wang of UBS said the debt level was “manageable” but its rapid rise was “alarming.” Local debt now equals about 33 percent of China’s economy (gross domestic product), up from about 10 percent in 2008 and almost nothing in 1997.

After the global financial crisis broke in late 2008, China relied heavily on new construction — financed by localities — to cushion the adverse effects on employment and economic growth. Now, Wang writes, dependence on this investment spending poses a dilemma for China. If construction and the accompanying debt are cut too rapidly, the economy will suffer. But if the spending isn’t curbed, the financial risks may multiply as the projects become less viable.

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Economist Nicholas Lardy of the Peterson Institute agrees that revenues from many projects won’t cover loan repayments. “A lot of the money is being used to build metro [subway] systems,” he says. “Like all metro systems, except Hong Kong’s, they lose money. Their revenues mostly cover operating expenses.” Lardy ultimately expects a deal between the central government and localities, transferring more tax revenues to localities but requiring them to cover construction debts.

Meanwhile, he doubts the existing debts will cause a financial crisis. He points out that China’s overall government debt — combining the amounts for the local and central governments — compares favorably with most major countries. In mid-2013, China’s debt was 56 percent of GDP, estimates Wang. By contrast, U.S. federal, state and local debt was about 100 percent of GDP in 2010, according to calculations by Lardy’s colleague, Ryan Rutkowski.

If there were defaults, Lardy thinks the government would respond quickly to prevent a loss of confidence in banks, which are the biggest lenders. “In the few cases of bank runs,” he says, “the government pours in money” to reassure depositors.

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