Trust companies in China face a rising risk of default as local governments accelerate their borrowings from non-bank lenders to fund infrastructure projects.

“Many trust products use land/property as collateral,” says David Cui, China strategist at Bank of America Merrill Lynch. “If the market is concerned about a potential decline in their value, investors may decide not to roll over these trusts, raising the risk of defaults.”

The next two years will be challenging for China’s financial market, he argues, citing the 2008 economic stimulus package that pumped Rmb4 trillion ($586 billion) into the economy.

“We are in year five of this credit explosion since late 2008,” adds Cui “which means the risk of some sort of credit event gets higher and higher. It may not happen, but my assessment is that it’s a big enough risk for us to pay attention.”

The point is that local governments are barred from borrowing directly from banks, but circumvent this by raising funds through financing vehicles within the bank and the non-bank sector. Over 6,000 such platforms have been used to fund infrastructure projects ranging from roads to stadiums, according to a National Audit Office report in 2011.

Borrowings from the non-banking sector by local governments in particular have grown. Trust loans to local government financing vehicles (LGFVs) grew by 54% to Rmb390 billion in the 12 months to September 30, overtaking the amount lent to the property industry, according to Mirae Asset Securities.

Such growth reflects the increased financing demand for infrastructure projects, following September’s announcement by China’s National Development and Reform Commission approving a $150 billion package for 60 new infrastructure projects.

This comes as commercial banks are limiting their supply of loans to local governments as they sense an increasing risk that local governments will default, says Cui.

Commercial bank loans for fixed asset investment (FAI) increased by Rmb4.1 trillion in the first 10 months of 2012, up 9.3% year-on-year, compared to YoY FAI growth of 21%, says Mirae. This has resulted in greater use of alternative infrastructure-financing channels.

And as the economy becomes less efficient at turning credit growth into economic growth, a continued build-up of credit stock is adding to systematic risks in the longer run, says Stanley Li, an analyst at Mirae Asset Securities.

BoA Merrill’s Cui agrees, predicting LGFV defaults in the future, but says the timing of them will be difficult to pinpoint.

The bank estimates that local government debt may end up exceeding Rmb15 trillion by the end of 2012, representing some 30% of GDP, Cui tells AsianInvestor. “A significant portion of the debt has been used to fund negative cashflow projects, by our assessment.”

To prevent moral hazard, the central government is unlikely to bail out all the LGFVs that have or will run into financial trouble, he adds.

Moreover, China has stepped up regulation of local government lending, with the finance ministry barring local governments from collateralising public assets to secure loans from December.

“Last year, there were at last three cases of ‘almost default’ by property trusts,” says Cui, “but they were bailed out, largely because the property market had already staged a recovery rebound, so people felt comfortable to buy [them].”

A related concern is the potential tightening of property policies after the National People’s Congress, expected to be held in early March, given the appreciation of the property market since mid-2012, Cui notes.

China’s National Bureau of Statistics saw house prices increase in 54 out of the surveyed 70 Chinese cities, up from 53 in November. The Wall Street Journal calculates that average property prices in the 70 cities rose by 0.31%, the fastest pace in nearly two years.