China's hidden deficit

China: When China publishes its budget report on March 5, Beijing may congratulate itself for achieving 8.7 per cent GDP growth with a fiscal deficit that is just 3 per cent of GDP. But the real cost of stimulating the economy has been much bigger - thanks to frantic borrowing by local governments.

State media reported that China’s local governments borrowed 3.8 trillion yuan ($556 billion) from banks last year, to keep the economy humming. They also raised 450 billion yuan ($65.9 billion) indirectly via the bond market. Add those debts to Beijing's own, and the real 2009 fiscal deficit could be 15 per cent of 2009's GDP.

That sounds scary, especially as local governments may not have spent their borrowed funds wisely. But a sovereign debt crisis is unlikely. Even if Beijing absorbed all the local debts, total public borrowing would remain safely below 60 per cent of GDP.

Beijing is unlikely to acknowledge the debts as its own. That means future defaults could be left for banks to mop up. UBS expects 2009’s credit expansion to create up to 3 trillion yuan ($439 billion) of non-performing loans over the next few years, mainly because of lending to local governments.

That 3 trillion yuan is equal to 10 times the 2008 earnings of the three largest listed banks and would be enough to bring the non-performing loan ratio in the banking system up from less than 2 percent to 9 percent, based on current asset levels.

If bonds too default, any foreign investors could find their situation really bleak - based on the few previous defaults, they could end up with mere cents on the dollar. For now, Beijing may be happy to take a hands-off approach. After all, banks may be able to grow out of the problem.

But if banks do take big losses, and private investors are scared away, it is to Beijing that the lenders will turn for new capital. In that case, the game of "pass the parcel" could end up back in the central government's hands after all.