Since the tax reform of 1994, revenue-sharing between the central and local governments has averaged 53% vs. 47%, but local governments are responsible for around 75% of fiscal expenditures. This kind of institutional design comes with a price, since most local governments have to heavily rely on land transfer revenues to make up the funding gap and back up their financing vehicles, which inevitably ties the interests of local governments to those of property developers, both private and state-owned, and banks to drive up land and property prices.

For instance, land transfer revenues averaged less than RMB40bn in 1993-2000, or 9% of local government revenues in China. By 2009 it had soared more than 40 times, to RMB1.6trn, averaging 45% of local government revenues over 2005-09 (Chart 10). This also largely explains why it's so hard to rein in land and property prices in China.

Logically speaking, then, to address the roots of the local debt problem, the central governments need to i) reform the two-tiered central-local fiscal system to better match revenue and expenditure for local governments, which could run the risk of weakening the control of the central government; and ii) introduce a more sustainable revenue source, such as imposing the long-talked-about property tax for local governments because land transfer revenues will be increasingly unsustainable going forward and it aligns the interests of local governments with those of property developers and banks, rather than local citizens.

Reforms of such significance require strong political will from the top, and this has yet to emerge given the impending party leadership reshuffle in October 2012 and the government leadership reshuffle in March 2013. The property tax issue also needs to be handled with extreme caution because of the high stakes involved Zhiming Zhang, HSBC's Head of China Research, estimates that the total value of property in the country tops RMB100trn, or 3-4 times GDP (Chart 11). Hence a 10% price swing could imply a wealth effect of 30-40% of GDP.

Eoin Treacy's view China May Float Yuan, Shun One-Off Jump, Survey Shows by Bob Chen and Rupiah Gains 5 Times More Than Yuan on Revaluation by Bo Nielsen and Matthew Brown both from Bloomberg may also be of interest to subscribers.

The Chinese, along with a number of other countries, are looking at how to manage the aftermath of the massive liquidity injection in late 2008 and early 2009. The banking sector extended a record amount of credit and is getting ready to tap the market for additional capital. (This story from Bloomberg carries more detail). The housing market has rallied impressively with questions being raised about overheating, there are anecdotal reports that borrowers are overleveraged and inflationary pressures have picked up.

Chinese policy makers have demonstrated they are more than willing to embrace whatever options are necessary to achieve their political and macro economic goals. We can expect this to continue. President Hu has also reiterated that China has every intention of marching to the beat of its own drum on domestic and foreign exchange issues and is unlikely to be swayed by external pressure.

Reports state that a capital gains tax on property investment is being considered which could help to cool investor interest in the sector. Separately, a local property tax is being mooted which might diminish the reliance of local governments on land deals. Raising interest rates would help curb inflationary pressures but need to be weighed against the pressure this would put on the wider economy. Lifting reserve requirements further could be counter productive since banks are already in need of additional capital.

Allowing the Yuan to appreciate is another policy option. Two big questions occupy the minds of investors betting on a Yuan appreciation; when will it happen and how best to profit from it? Allowing the Yuan to strengthen somewhat would disadvantage low margin, often high employment, manufacturers. On balance, the benefits of any Yuan appreciation in the form of lower raw material import costs will need to outweigh the disadvantages for domestic manufacturing. No one, other than highly placed officials in the Communist Party, knows if and when the Yuan will be allowed to strengthen, but the ramifications of such a move could be broadly positive for stock markets.

It is no mistake that some of the best performing stock markets also have some of the best performing currencies. Here are overlays of Indonesia and the Rupiah, Brazil with the Real and Korea and the Won. The concomitance of a firm currency and strong stock market is unmistakable. All of these markets have benefitted from increased investor interest over the last decade and particularly since the post Lehman bankruptcy lows.

Here is the same overlay of the Shanghai A-Shares Index with the Yuan. The Yuan and stock market both appreciated together from 2005 to 2007 and the Yuan was re-pegged from mid 2008. China's stock market was among the early leaders from October 2008 but has been consolidating its advance since August. At the same time, other indices and their respective currencies have outperformed. With investor interest returning to China and speculation growing as to the timing of a revaluation, a stronger Yuan, whenever it is allowed to occur, could be a catalyst for a stronger performance from domestic Chinese shares.