Central bank vows to deal with risks, use market mechanisms to resolve local govt debt problems

China's central bank announced that it "will take comprehensive measures to maintain financial stability and hold the bottom line to prevent systemic and regional financial risks".

"We will strengthen our efforts in monitoring local government debt and solvency and explore the use of market mechanisms to solve problems in local government debt," said the People's Bank of China in a quarterly monetary policy report released on Saturday.

The large-scale financing model for construction led by local governments in recent years stabilized gross domestic product growth, but it also increased economic operational risks, according to the central bank.

China's National Audit Office revealed the total amount of debt that local governments are responsible for repaying had reached 10.89 trillion yuan ($1.8 trillion) by the end of June.

"Investors are concerned with whether or not defaults will happen because of the rapid expansion of shadow banking, local government financing platforms and trust products in China and whether defaults will lead to a systemic crisis. It is likely to reverse the appreciation of the yuan and cause capital outflows," said Wen Bin, supervisor of macroeconomic research at the Bank of China's Institute of International Finance.

But even if such things do happen, the central bank and the State Administration of Foreign Exchange still have a number of measures to handle the problems, Wen added. For example, Chinese authorities are exploring market-based instruments such as a "Tobin tax" on financial transactions to deter speculative capital flows, said Guan Tao, the State Administration of Foreign Exchange official in charge of balance of payments, at a news conference in January. The Tobin tax is an excise on all spot conversions of one currency into another. The tax is intended to put a penalty on short-term financial movements into another currency for a quick profit.

The central bank also noted in the report that it will "use a combination of tools including the cash reserve ratio, standing liquidity facilities and short-term liquidity operations to adjust the liquidity of the banking system". In the meantime, it will guide commercial banks to strengthen liquidity and asset-liability management.

The central bank emphasized it will "improve systemic financial risk assessments and early warning systems". Apart from strengthening the oversight of defaults of local government financing platforms, industries with excessive capacity and the real estate industry, it will enhance the risk monitoring of cross-market financial products and push forward establishment of the deposit insurance system.

The Chinese economy is likely to remain stable and make progress in the period ahead because there is still a large potential for economic growth and the government is promoting comprehensive reform that will unleash economic vitality. Moreover, because of the acceleration of the US economic recovery, many financial institutions have forecast global economic growth in 2014 will be faster than in the previous year.

But it also pointed out the economy still faces many risks and challenges.

"The current base for economic growth is still unstable. The growth is increasingly relying on investment and debt. Resources are overwhelmingly concentrated in real estate, which will easily cause rising debt levels," said the central bank report.

The external environment is no less complicated and volatile than the internal one.

Following the US Federal Reserve's decision to start tapering its quantitative easing policy, emerging markets will have to deal with capital outflows, increases in finance costs and harsher export competition. Therefore, China needs to continue promoting economic restructuring and make major breakthroughs in the transition of its economic growth pattern, the central bank concluded.