BEIJING - Chinese leaders have made cleaning up government debt a crucial task for next year, threatening to tighten fiscal discipline to defend financial stability.

Resolving risk associated with local government debt was a main theme of the Central Economic Work Conference that ended last Friday. The conference traditionally sets the tone for following year's economic policy.

Local government thirst for borrowing grew during the investment and construction binge that was part and parcel of a stimulus in 2008 to buffer against the global financial crisis. Since then, officials across the country have vied with one another to launch heavy industry and infrastructure projects that ensure skyrocketing economic growth and thus a fast track to promotion. A substantial proportion of the money invested was borrowed.

During the conference, the central leadership resolved to change an administrative mindset obsessed by GDP growth, only days after the Communist Party of China decided on a new system to evaluate officials, which includes local government debt as an important indicator.

"Designating government debt as a key task is a response to market concerns," said Ding Shuang, Senior China Economist at Citi. "It's expectation management, telling the market that local government debt will not expand without restraint."

"The risks are not impossible to diffuse if the central government pays adequate attention," Ding added. "The implied scenario here is to first tackle the increment. If the debt stops ballooning, China's debt level will decrease as its GDP grows."

Escalating local government debt has raised concern that hidden debt problems could bring instability to the banking system. so China's policymakers are vigilant against financial risk.

The National Audit Office (NAO) estimates local government debt at around 10.7 trillion yuan (1.64 trillion U.S. dollars) by the end of 2010. As the government debt level kept rising, the NAO announced a nationwide audit of government debt in July, but the results have yet to be published.

Many local government financing vehicles (LGFVs) have seen their cash flow stagnate or decline, while their debt levels have risen, according to a report released by Moody's earlier this year.

Among 388 city construction companies the rating agency surveyed, only 53 percent of them have sufficient cash to cover estimated debt and interest payments in 2013 without resorting to borrowing more. Local government debt has been a major feeder of China's shadow banking. The regulators have banned banks from directly providing loans to LGFVs after realizing they had lent too much, but local governments are still able to have their ambitious investments funded irregularly through instruments like trust loans and wealth management products.

Analysts say many shadow banking activities are actually new channels designed by and for banks to pump money to LGFVs. Local governments are willing to pay much higher interest rates than other bidders, as the current fiscal system imposes few restrictions on debt.

"Local government debt is China's biggest medium-term risk. Local governments can't be allowed to add to their borrowing without limit," said Jian Chang, Chief China Economist at Barclays. "The core issue is to work out standards to restrain the current financing which does not take cost into consideration."

At the conference, the leaders promised that strict procedures for raising debt would be put into place.

Analysts said local governments would have a harder time to borrow next year, especially if they try to pay old debts with new borrowing.

"We believe that local government bonds will gradually replace LGFV borrowing from banks and shadow bank channels, and thus reduce the non-performing loan risk faced by banks," said Ma Jun, Chief Economist at Deutsche Bank Greater China.

To establish an effective bond market in which prices truly reflect risk, the central government must dampen expectations that it will bail out default by local governments.

A statement released after the conference said local governments are to be responsible for their debts.

While the rising debt may undermine financial stability, few expect a wave of default even though GDP growth is dipping.

"The possibility of massive defaults is very small," Ding said. "To roll over a debt is still easy, and local governments are able to at least pay the interest."