China's tolerance for borrowing by local government financing vehicles (LGFVs) is fading as debt levels rise. This could lead to the inevitable: a default by the government-backed LGFVs.

"The Chinese government might decouple from the LGFV. That could be a big blow for LGFVs," says Angus To, executive director and deputy head of research at ICBC International at The Asset 12th Asia Bonds Market Summit in Shanghai.

"Moves by China to reduce debt could weigh on LGFVs. Defaults are inevitable," he adds. For now the size of defaults are still small. "The government is trying to avoid any systemic risk arising from such defaults," To says.

LGFVs are finance vehicles that started in 2008 as a product of the Chinese government's stimulus package. Since then they have amassed record debt now at 16 trillion yuan, raising investor worries over defaults by these vehicles.

Although they carry much risks for investors, some LGFVs credit standing remain solid. "For the market, the ratings of LGFV and the government is the same. Since LGFV is founded by fiscal policy, its debt rating follows government debt," explains Jianguo Jiang, head of corporate ratings at China Lianhe Credit Rating.

There are other criteria. "We look into the main business and the counterparty risk embodied in the LGFV," says Ivan Chung, associate managing director at Moody's Investors Service. "Many LGFVs are now transforming themselves."

He notes that some projects LGFVs venture into carry more risks than others. Chung says metrorailway and subways are projects that are preferred by creditors over highways or expressways for example.

There is also expectation that offshore LGFV bonds will perform better than their onshore counterparts. "Offshore LGFVs are better than those in the onshore, because most of the offshore LGFV are dominciled in bigger cities in China," he says.