The United States economy seems to be on solid footing for now, and by the looks of it, the European Union has bottomed out. In recent weeks attention has slowly been shifting towards China, once viewed as the likely engine of growth for any major recovery. Sluggish manufacturing and service growth, along with a cash crunch and other issues, however, have cast doubts on China’s economy. Now, a recent audit has shown that local Chinese government debts have jumped to $3 trillion dollars, a 67% increase from the last tally three years ago.

China

Stimulus led to current debt problems

During the financial crisis, the Chinese government launched a massive stimulus plan and encouraged local governments to launch their own public work projects. A huge injection of cash did stabilize the economy and help China maintain growth as the world economy slowed. On the other hand, many now believe that much of the money was squandered on unneeded projects and the workmanship of many projects has also come under heavy fire.

Further, following the crisis, the national government began to tighten its belt, but many local governments continued to spend. In fact, in some cases the drive to fund public works projects resulted in a mini arms race with local governments competing against one another to attract investments and business. So even as the world economy has stabilized over the last few years and stimulus measures were less needed, local governments continued to invest in questionable projects.

This helped local government debt grow by some 67% during a time of relative economic stability, a worrisome trend to say the least. China’s economy has continued to grow through 2013, but the country has suffered some setbacks. Efforts to cool off the housing market have largely failed, while rising wages are eroding China’s cost advantage. At the same time, efforts to spur innovation and move China up the value chain have not borne as much fruit as government officials have hoped.

Government now faces tough choices

Local government debt could now become a serious problem. At the very least, the national government has to bring borrowing under control. Restricting local governments from borrowing money, however, could slow economic growth as demand slumps.

At the same time, if a local government defaults, the national government will have to make the choice of either backing the debt itself, or letting the local government go bankrupt. Both scenarios would be a lose-lose for the government. If the national government steps up to pay down local debts, it could find itself on the hook for billions, if not trillions, of dollars worth of debt. At the same time, if the national government lets local governments default, chaos in financial markets could follow.

This news comes at a time of flux for the Chinese government. When Xi Jinping assumed office as the General Secretary of the Communist Party, he promised reform and an emphasis on helping the average Chinese citizen improve their quality of life. So far, Mr. Xi has been delivering on his promises, increasing the social safety net, focusing on increased wages and lower housing costs, and liberalizing the economy.

China’s Communist Party in a precarious position

A major financial crisis, however, could derail his efforts to launch reforms, and put pressure on the government. It’s easy to take for granted the precarious position the Communist Party in China finds itself. While one might assume that the people would never be able to challenge a government as powerful as China’s, the country sees tens of thousands of protests every year and is very conscious about keeping the people placated.

If China were to suffer from a serious economic crisis and growth came to a halt, the government could find itself under a tremendous amount of pressure. Already faced with increasingly vocal civil society groups, and a working class demanding higher wages and better conditions, the Chinese government knows that it must maintain economic growth.