Those who don't worry about China's mounting debt levels point to the central government's deep pockets. Even if something goes horribly wrong, surely Beijing can fix it.




That premise will be tested as weak points in the financial system break open. The latest break is news that Shanghai Chaori Solar Energy Science & Technology may become the first company to officially default in China's $1.4 trillion domestic corporate-bond market.

In theory, such a default is welcome. A functioning market needs failures to help investors price risk. The bond in question is worth 1 billion yuan ($165 million), small enough to pose little widespread damage. One reason no bond has ever defaulted is because the biggest bond investors are China's big state banks. In a pain-free financial system, even a pinprick isn't tolerable.

If the solar default is the first, it won't be the last. Borrowers in beleaguered industries such as steel, ship making, and coal mining face similar pressures. China's overall debt-to-GDP ratio has sprung to over 200% from about 120% in five years. Most of this is from local governments and state-supported companies.

A long-term solution, although one fraught with moral hazard, is for China's central government to absorb some debt before a crisis emerges. Beijing has the capacity, thanks to its enormous taxing powers and a modest central government debt level of 23% to GDP. The financial system overall runs a current-account surplus, meaning there are no foreign creditors to please. Shifting debt burdens within an economy is filled with perils, however, as Europe and the U.S. have seen.

In his big policy speech at the National People's Conference on Wednesday, Chinese Premier Li Keqiang promised to "defuse debt risks." A government debt-reporting system will be implemented, and local governments will gain access to the bond market. Both promises have been made before.

Other moves seem timid. Beijing will increase the amount of bonds it issues on behalf of local governments, but only by 50 billion yuan, hardly enough to make a difference to the 17.9 trillion yuan in local government liabilities. The central government budget deficit will stay stable at 2.1% of GDP.

Redistributing debts to the central government without causing economic dislocation is like crossing a six-lane highway with buckets of hot soup. It can be done, but it won't be easy.