HONG KONG (MarketWatch) — China’s banking system will require an eventual bailout by the central government, according to some analysts, who said figures released last week on the size of local-government borrowings point to the need for a rescue.

Credit Suisse economist Dong Tao said the numbers backed up concerns he’s been voicing for the past two years on China’s toxic loan problem.

“Ultimately, we believe that the central government will need to separate the local government’s bank debt from banks’ balance sheets and recapitalize the banks,” Tao said in a note following the release of data on China’s local-debt obligations by the National Audit Office.

The National Audit Office said on June 27 that local-government debt totaled 10.7 trillion yuan ($1.65 trillion), or about 27% of China’s 2010 gross domestic product. The total represented the tally at the end of 2010 and marked the first time the NAO had released official data on these obligations.

China risks property-bubble burst

The audit office figure included debt directly and explicitly liable by the local governments and 6,576 financing vehicles established by the governments. Figures released by the China Banking Regulatory Commission in November, which counted local-government financing vehicles and subsidiaries, put the figure at 9.09 trillion yuan.

Tao said a government-led rescue wasn’t likely within the next 18 months, as there were few signs of an imminent crisis, although he added that recent press reports have indicated preliminary government steps towards a bailout.

Reuters reported last month that Beijing is considering a bailout that could see the central government accept to 2 trillion to 3 trillion yuan of local governments’ outstanding debt in an effort to ensure against a mass default, which could bring down the economy. See report on China’s initial bailout plans.

Stress is building within the system, Tao said, as local governments face a growing pile of debts coming due at a time of declining land sales, normally a key revenue stream for the provincial authorities.

Meanwhile, local governments are also having trouble finding new sources of lending as state-controlled banks grow increasingly wary of their deteriorating ability to service existing debt.

Emerging crisis

Standard Chartered said last week there were early signs of major financial distress building at the local government level.

Anecdotes of local-government investment vehicles in Shanghai and in Yunnan province struggling to meet loan payments “signal the beginning of the wave of difficulties,” Standard Chartered’s China economist Stephen Green said in a note Thursday.

Green said he was upbeat on China’s ability to grow its way out of the problem, given its relatively modest debt profile, which he estimates at 71% of GDP.

Still, he also expects painful work ahead, estimating interest expense due this year on local government debt and their vehicles at 880 billion yuan.

Some local governments, he said, were working with banks to arrange emergency funding to avoid default, Green said.

Increasingly, governments are having to pledge more collateral, in addition to other assurances, Green said, adding that “such meetings will become more problematic” as financial pressures mount.

Standard Chartered forecasts 4 trillion yuan to 6 trillion yuan of loans owed by these local-government vehicles will never be repaid. The final resolution will likely see the central government assume 5.7 trillion yuan of local-government debts, Green said, without saying how long a period the work-out would take.

“At some point the central government will have to enter the field — it cannot have rumors circulating about hundreds of local-government investment vehicle defaults undermining the banking system,” Green said.

These investment vehicles have combined debts of about 9 trillion yuan, when accounting for informal loan guarantees, according to estimates by Standard Chartered. China’s audit report last week put the debt for these entities at $4.97 trillion yuan, but their figure does not include certain type of informal loans.

Another worry for the mostly unprofitable government vehicles is the huge pile of debt obligations coming due. Of the total loans extended to these entities, 24% is due to be paid back this year, and 17% in 2012, according to the audit.

In spite of the gloom, Standard Chartered’s Green said the debt crisis appears survivable.

“China is not badly placed, and certainly not badly enough placed to warrant all the talk of ‘imminent collapse’ that has been filling the airways,” Green said.

China’s debt ratio should ease to around 45% as a share of the economy by 2015 if economic growth rates hold up, according to Green.

Macquarie Securities was similarly upbeat, saying the trend will begin to favor local-government balance sheets from the beginning of next year onward.

Only about 11% of outstanding loans will come due in 2013, part of an overall easing in the risk profile from 2011, Macquarie said, adding that the gloom over the loan picture is set for faster improvement than it had original forecast.

Laying track for bailout

Credit Suisse’s Tao said it noteworthy that the auditor report labelled 85% of the debt at the local level as guaranteed or the direct responsibility of local governments.

In classifying such a large extent of the borrowings as “government debt,” the audit report appears to be laying track for Beijing to ultimately take responsibility for the potential losses, Tao said.

“From a strictly legal standpoint, these are corporate debts and should be the liabilities of the financing vehicles only,” Tao said.

The audit, however, is not legally binding, and China’s legislature could still rule the toxic loans remain the responsibility of the local financing vehicles, Tao said.

Meanwhile, Victor Shih, a professor at Northwestern University, said truer figures for local-government obligations can be gleaned by combining the People’s Bank of China’s and CBRC estimates on government vehicles’ debt outstanding, along with the auditor’s report.

Combining the figures, he said, yields total local-government debt of between 15.4 trillion to 20.1 trillion yuan, or 40% to 50% of China’s GDP, according to a a recent editorial in The Wall Street Journal.

“Important pieces of the local-debt puzzle remain hidden” Shih said in the commentary.