By Pei Li and Kevin Yao
BEIJING (Reuters) - A firm controlled by a city government in China's Inner Mongolia region has failed to make interest and principal payments on nearly 4 billion yuan ($629 million) in off-balance sheet loans, two sources with direct knowledge of the matter said.
The rare loan default highlights growing funding strains on Chinese local governments as the central government cracks down on riskier types of financing and rising debt which some outside agencies have warned could lead to a banking crisis.
It also points to the tightrope that Chinese leaders must walk as they try to rein in risks to the country's financial system without undermining economic growth and market stability.
Xilinhot Geipaishui Co, a local government financing vehicle (LGFV) controlled by the government of Xilinhot city, has failed to repay loans provided by more than 20 mostly state-run leasing firms, said the sources, who were from two of the leasing companies involved.
Chinese regulators are in the third year of a campaign to clamp down on risky lending practices, including the so-called shadow banking sector, squeezing borrowers that have binged on off-balance sheet loans in the past.
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Outstanding local government debt rose 7.5 percent to 16.47 trillion yuan ($2.56 trillion) at the end of 2017 from the previous year, according to Reuters calculations, but remained within the government's target.
Highlighting the potential risks to the world's second-largest economy, regional governments account for around 90 percent of total public spending in China, but have more limited sources of direct revenue.
That has seen an explosion in off-balance sheet borrowing by LGFVs that has created pools of hidden debt, a trend that has raised official concerns.
Local governments, which before 2015 were banned from issuing bonds, previously used LGFVs to raise funds to finance projects and drive regional economic growth, resulting in massive liabilities that now threaten financial stability.
Amid Beijing's drive to slow a rapid build-up in debt, financing to LGFVs is shrinking, and LGFVs with vulnerable cash-flows are struggling to service their debt obligations.
Xilinhot Geipaishui had borrowed on behalf of the local government to fund infrastructure construction, the sources said, declining to be identified.
The Xilinhot city government declined to comment.
"Sometimes payments are late by a week or two, we wouldn't consider it a break of contract or even wouldn't charge any penalty. But this one case is different, the government is very firm it wouldn't be able to pay back," said one of the sources.
Company executives have conducted several rounds of talks with local officials but they have yet to break a deadlock, according to the sources.
Local government officials have insisted on rolling over the loans for another year as the city authorities struggle to boost their fiscal revenues, the sources said.
"The government's argument is that only interest will be paid," said one of the sources.
(Reporting by Pei Li and Kevin Yao; Editing by Ryan Woo and Kim Coghill)