LGD has ballooned because local governments need to spend more money, mainly to build and develop infrastructure, including highways, parks and drainage systems, and protect the environment. They also have to use funds to build and maintain more educational and medical institutions. The situation was not very different in other countries during their developing period.

From the 1840s to 1930s, most of the fiscal incomes of state and municipal governments in the US accrued from land sales and rents, part of which was used to build infrastructure facilities in urban areas.

In China today, despite being in desperate need of money for infrastructure, local governments don't have enough sources of finance because the country's fiscal system ensures that a big part of the funds flows into the central government's coffers. Also, local governments can no longer depend on land for finance because the past few years have created more bubbles in the real estate market. As a result, local governments still rely on central funds to cover their debts, especially because they can't yet issue bonds.

Following are some suggestions on how to overcome the current situation. First, small amounts of LGDs should be transformed into corporate debts. Many local governments have already established local investment companies to invest in infrastructure, and they should be run as normal companies that use their profits to cover their debts. This, in turn, will enable the companies to issue corporate bonds to meet their needs, which is quite a normal practice in China.

Second, local governments' budgets should be restricted in terms of fiscal expenses, compelling them to regulate their debts according to their monetary reserves and incomes. And although there is need to deliberate whether local governments that cannot repay their debts should be declared bankrupt, the central government should consider allowing local authorities to impose some form of tax to raise their revenues.

And third, local governments should use their debts to advantage. In economic theory, a certain amount of debt is actually healthy for a company, because it compels the company to perform more efficiently. So, instead of forcing local governments to repay all their debts, we should strengthen regional economies by solving their debt problem step by step, keeping the debt ratio within a healthy zone.

The author is a professor at and director of China Center for Public Finance, Peking University. The article is an excerpt from a recent speech he delivered at Peking University.