Shanghai unveils a $2.2 billion airport terminal on Tuesday, connected to the center of China's commercial hub by one of several new metro lines being built for the World Expo that opens in May.

The expansion is needed.

The old terminal at Hongqiao airport, which mainly handles domestic flights, is hopelessly congested. A good case can also be made for a lot of the roads, railways and other transport links being forged thanks to the investment package that Beijing launched in November 2008 to see the economy through the global credit crunch.

But investors are focusing on a darker side of China's relentless investment: vast sums borrowed by local governments and plowed, skeptics fear, into white elephant projects that will never pay for themselves. A financial reckoning is not a question of if, but when, they say.

Take Kangbashi, a huge new city near Erdos in Inner Mongolia.

Build it and they will come must be the motto of the city fathers, for Kangbashi's broad boulevards and plazas are all but deserted, visitors say. Media reports describe similar ghost towns dotted around China.

Clearly a problem is brewing, but the timeframe in which it becomes an issue from an investment perspective is not clear, a manager at a large U.S. equity fund said as he scrolled through photographs he had taken in Kangbashi.

Monumental public buildings out of all proportion to the size of the local population are common across China.

Local authorities, which are barred by law from borrowing directly, usually finance their grandiose schemes by setting up urban development investment vehicles (UDIVs), which take out bank loans backed by assets -- typically land -- or supported by implicit government guarantees.

The worry in markets is that the proceeds from land sales used to repay these bank loans are bound to fall short, especially if China's bubbly property market tumbles.


Ford to City: Drop Dead was the memorable headline of the Daily News in 1975 after President Gerald Ford refused federal assistance to spare the New York City government from going bankrupt.

It's a safe bet that Chinese papers will not be carrying the headline Hu to City: Drop Dead.

A key point for us is that we do not think Beijing would -- with rare exceptions to make a political point in corruption cases -- allow local governments to default on bank loans for public infrastructure, said Andy Rothman, an economist for CLSA in Shanghai.

Remember that this is all one big Party. The Chinese Communist Party controls all of the nation's banks, and all of the local governments. So any financial problems hurt the Party, which then has to decide which part of its balance sheet takes the hit, he said in a research note earlier this month.

And that's what economists are trying to figure out.

If the ruling party, led by President Hu Jintao, does have to step in and clear up the mess, would the central government directly assume the obligations, thus increasing public debt? Or would state-owned banks initially foot the bill in the form of an increase in bad loans?

Either way, Rothman reckons the burden is bearable. This is a significant long-term structural problem, but not a near-term threat to China's banking system or fiscal health, he said.


Markets are unsettled in part because no one knows how deep the financial black hole might be.

Victor Shih, a professor of political science at Northwestern University in Evanston, Illinois, set alarm bells ringing recently by estimating borrowing by UDIVs at a whopping $1.6 trillion.

Jia Kang, a Ministry of Finance researcher, gives a lower total of 6 trillion yuan ($880 billion), while China International Capital Corp, an investment bank, arrives at a figure of 5.6 trillion yuan.

That would boost China's total domestic and foreign government debt from 26 percent of gross domestic product to 43 percent, still below the level of most major countries. The so-called debt crisis is overblown, CICC said in a March 9 report.

But economists at Citigroup reckon UDIVs will have borrowed 12 trillion yuan by the end of 2011.

If about 20 percent of those debts turned sour in a worst-case scenario, banks would be saddled with 2.4 trillion yuan in bad loans -- a non-performing loan ratio of about 4.4 percent -- and could expect the government to make good their losses.

Assuming the rest of the economy is doing well, this overhang could be absorbed by the central government, but it would surely severely unsettle the market and the banking sector before this issue is finally resolved, they said in a March 12 report.


Beijing is aware of the gathering clouds: banks have been ordered to scrutinize the viability of local government projects, while the Ministry of Finance is drawing up rules to regulate UDIV borrowing.

One optimistic line of thought is that the debt morass could even spur financial reform, for example by leading to the development of a municipal bond market to give local authorities an alternative financing source.

Northwestern University's Shih said banks should be allowed to directly sell subprime or distressed loans, perhaps by securitizing them.

And if Beijing sold dud loans to foreign as well as domestic investors, it would also help advance its goal of promoting the use of the yuan, or renminbi (RMB), outside China.

Basically, I think the Chinese government can turn this into a great opportunity for market reform in the financial system and the internationalization of the RMB. However, it has to act soon before local debt gets too large to handle, Shih wrote on his blog.

(Editing by Mathew Veedon)