China Faces Deep, but ‘Solvable,’ Debt Woes, Report Says

In the short term, increased MoF transfers to local governments could be "a relatively easy way" to support these projects and maintain financial-sector stability, according to the report.

Long-Term Solutions

Overall, Green says, Standard Chartered "believes the problem, though large, is solvable" due to a multitude of factors. "Given the low level of official government debt, forecast nominal GPD growth over 2011-15 of a brisk 12-15%, strong capacity in tax collection and conservative spending habits, low foreign debt and still-extensive capital controls, this problem need not trigger a banking or broader economic crisis," he wrote.

Still, he notes, China does need to rebuild its fiscal and financial systems to ensure that the same mistakes are not repeated the next time an economic crisis hits. "This is a huge undertaking," the analyst noted.

Regardless of when the principal is due, the interest burden is huge–with interest payable on LGIV and local government loans at 600 billion to 900 billion renminbi this year, or about $7 billion to $10 billion a month.

"As repayment stress spreads across the system, rumors of loan covenants being broken will proliferate, depositors will become more nervous about the small city banks most exposed to the LGIVs, budgetary tricks to cover up the problem will become murkier, land requisitions will become more frantic, and banks will become even more conservative in their lending behavior," the report explained.

As a result, Green says both banks and local governments will require a "sizeable bailout" from the central government. Still, he adds, resolving bad banking-system debts is not a new challenge to Asian economies.

Given the fact that the bulk of today's problem loans are concentrated in the public infrastructure, Chinese authorities must cope with the fact that there will be no market for these bad loans, given the non-commercial nature of the underlying assets, the analyst says.

In the medium term, China should expand spending on transport-related infrastructure, he notes.

"If properly handled, China's local government debt problem does not have to mean the end of the road for China's economic growth or its banking system," Green concluded. "Our proposals show that the ultimate impact on the central government's total balance sheet in solving this problem is limited. The last bank bailout cost some 22% of GDP; this one looks to be about the same size."