China's leaders have ordered an "urgent" audit of local government debt, responding to warnings from the International Monetary Fund that rampant borrowing by the regions could trigger a crisis.
The State Council told the country's audit office to suspend work on other projects and launch an immediate inquiry to assess the gravity of the risk. The audit office in the northern port city of Dalian has cancelled holiday leave and will dispatch inspectors this week.
Andy Xie, a commentator at news site Caixin, said reliance on land sales to fund regional spending was an accident waiting to happen.
"While household income may have tripled in a decade, the average land price has risen by over 30 times," he said. "Income growth to come cannot justify the current price of land. Nor can a supply shortage. China has no shortage of land. The sustainable land value is probably 70 to 80 per cent below current levels."
He said there may be financial panic in months ahead but the government should ride out the storm.
"The impact on the real economy will be limited," he said. "China's land bubble has become almost entirely a financial phenomenon. Its problems should be contained within a small if vocal community."
The IMF is less sanguine. It warned last week that local government reliance on "off-budget activity" and land sales to pay its bills have pushed China's underlying fiscal deficit to 10 per cent of gross domestic product.
"Fiscal space is considerably more limited than headline data suggest," it said.
The IMF said these deficits "raise questions about local governments' ability to continue financing the current level of spending and service their debts, which has implications for financial system asset quality".
"Further rapid growth of debts would raise the risk of a disorderly adjustment in local government spending," the IMF said. "Financial distress would lead to a contraction in credit, a fall in domestic demand and lower growth, which would make it more difficult for highly leveraged borrowers to grow out of their debt."
An audit of the regions two years ago found that liabilities had mushroomed to $US1.7 trillion but the full figure is already higher and rising fast as officials turn to the shadow banking system.
Ma Xiaofang, a senior audit officer, said the chief concern was the reliance on land sales to pay off half of all past debts.
The new audit comes weeks after a "stress test" of Chinese banks caused interbank lending to seize up.
SHIBOR [the Shanghai Interbank Offered Rate] has fallen back from extreme levels in June but borrowing costs remain high and there are signs of capital flight.
Fitch Ratings said investors withdrew an "unprecedented" $US42 billion from Chinese money market funds last month, many fearing the funds would run dry.
Richard Koo, of Nomura, said that Beijing pushed regions into taking on more debt to keep growth going after the Lehman Brothers crash.
A third of local government debt cannot be repaid, yet officials are split over the wisdom of a central government bailout.