Liu proposed that the country study allowing provincial governments and some city authorities to sell an appropriate amount of debt. The plan should get an approval from the State Council, he said.

The financing vehicles will have to pay interest and principal by year-end, said Liu Li-Gang, who formerly worked for the World Bank and is chief China economist at Australia & New Zealand Banking Group Ltd. in Hong Kong. If the local governments can't issue debt in the next three years, they would have to cut their combined fiscal spending by 5 percent to 7 percent of GDP to meet obligations, he said.

"If the central government can allow local governments to issue long-term debt, then the liquidity problem won't look very serious," he said. "I don't think this will necessarily run into a banking crisis in China given the balance sheet condition of the central government is very good at this stage."

The audit gave a number lower than the central bank, which said June 2 that more than 10,000 financing vehicles had been set up. The banking regulator has estimated local government financing vehicle debt at over 7.7 trillion yuan.

"It seems the government doesn't have a concrete idea what is a local government financing vehicle and what isn't," Credit Suisse's Chan said. "The biggest problem is it's very difficult to define in China what is private and what is public."

Eoin Treacy's view The problems with funding China's local governments has long been an issue. Since there is no residential property tax and local governments do not have the ability to issue debt in their own names, they are forced to depend on land sales to raise capital. This has created an unseemly alliance between the interests of local officials and property developers which has led to some notable cases of overbuilding, graft and bad planning. The use of special purpose vehicles has also become ubiquitous in circumventing debt issuance rules and has contributed to the issue of bad loans.

Shanghai is currently experimenting with a residential property tax and there is talk of rolling it out nationally. Former Premier Zhu Rongji gave a speech in April describing the practice of allowing local governments to keep the proceeds from land sales as "plundering" from the people. These points highlight the fact that senior officials are well aware of the issues with funding local government. The tightening measures imposed on the banking sectors as well as limitations on the property markets all point towards an attempt to curtail speculative bias in the economy.

The fact that the auditor's estimated figure for outstanding debt was below that of the central government is a positive development which appears to have been welcomed by the stock market. The potential problem of bad debts remains serious but does not appear to pose a systemic risk to the Chinese economy at present. Significant additional reform will be required to remove the threat.

The Shanghai A-Share Index of large caps formed a weekly upside key reversal last week signalling a low of at least short-term significance. A break of the almost two-year progression of lower highs, currently in the region of 3400, would signal a return to medium-term demand dominance.