China has played down the risks in a wave of borrowing by local governments, saying that officials were getting to grips with a debt problem that economists warn could yet destabilise the financial system.

A statement issued by the Ministry of Finance and the China Banking Regulatory Commission (CBRC) gave a largely clean bill of health to the pile of debt racked up in a surge of stimulus spending during the global financial crisis last year.

The majority of loans would be repayable from cash flow generated by the investments they are financing, and banks had set aside more than enough provisions to cover any defaults.

“There are indeed some risks in loans to financing vehicles, but currently the overall risk is manageable and will not cause systemic risk,” they said.

The announcement helped push China's benchmark stock index up 0.8 percent to a three-month closing high.

Investors have been worried that local government borrowing, the bulk of which has funded infrastructure projects, could sow a new crop of bad debt in the banking system.

Dong Tao, an economist with Credit Suisse in Hong Kong, said China was not out of the woods yet.

“While I do respect the conclusions that they have given, I would remain quite cautious in the sense that a large part of the bank lending that went out in 2009 will not generate cash flow in the near future,” he said.

Clearing the brush
Local authorities are barred by law from borrowing directly. To get around the ban, they have established some 8,000 special purpose funding vehicles that, by the end of June, had borrowed an estimated 7.7 trillion yuan ($1.1trn).

Although that accounts for only about 20 percent of China's GDP, economists have warned that the increase in indebtedness could shake the financial system if left unchecked.

“Most of these loans can generate steady and sufficient cash flow, which can cover both the principal and the interest,” the finance ministry and banking regulator said.

To keep the problem from growing any further, they said Beijing was working to develop a mechanism to standardise fund-raising and debt management by local governments.

Xu Jian, an analyst with China International Capital Corp in Beijing, said that a new framework would make borrowing by local financing vehicles more transparent and thus help rev up a crucial engine for the economy.

“The government has made the policy clear and banks can resume extending loans to such vehicles, as long as this is done in line with the new rules,” he said.

“Local projects are mainly financed by bank lending, so this is an important contribution to the economy, especially after growth moderated in the second quarter,” he said.

Three-front battle
For months, Chinese regulators have been trying to piece together how much local governments owe and to devise a blueprint for reining in the debt.

They have also been working to shore up confidence on two other fronts: telling banks to bring loans funnelled through trust firms back onto their balance sheets and ordering stress tests to gauge the potential impact of a collapse in property prices.

“Property is the mother of all crises,” Dong from Credit Suisse said. “If the property market goes down, local government lending will face a much bigger problem than what the government currently claims.”

The CBRC fears that some 23 percent of loans to local financing vehicles could go sour, but the agency and the ministry said in their statement that broader risks were not that grave.

For those loans that may not be repayable, debt can be restructured and collateral increased, they said.

And with provisioning ratios set at a minimum of 150 percent, banks are sufficiently prepared to absorb defaults, they said.

They added that the scale of the problem was already on the wane. As a proportion of total bank lending, new loans to local financing vehicles had dropped by a third in the first half of this year compared with 2009.

Commercial bankers have also expressed confidence about the knock-on effects of a tumble in property prices. The real estate market has soared over the past year, fuelling concerns that some parts of the country were experiencing a bubble.

Asked by regulators to test for the impact of a 50 percent fall in property prices, Bank of Communications, China's fifth-biggest lender, said recently that the ratio of bad loans in its mortgage business would rise by only 1.2 percentage points.