In the latest sign of the mounting risks to China’s debt market, a bank for the first time ever reportedly disclosed the default on a loan by a local government financing vehicle.

Over the weekend, the 21st Century Business Herald, a Chinese-language newspaper, reported Qilu Bank in Shandong Province told investors in its 2013 annual report that the Urban Construction and Comprehensive Development Company of Licheng District, Jinan City (located on China’s east coast) defaulted on a bank loan, according to Nomura.

The loan itself consisted of about $5.7 million in principal and just south of $1 million in interest. The financing vehicle initially defaulted when it stopped making interest payments two years ago.

Qilu Bank did not immediately respond to a request for comment. Urban Construction and Comprehensive Development Company of Licheng District, Jinan City couldn’t immediately be reached for comment.

‘Credit Bubble’

While the loan itself is small, the disclosure of the default shines an unsettling spotlight on the complex market for local government financing vehicles (LGFVs).

"It highlights the credit bubble that China experienced and now the aftermath as it slowly deflates,” said Peter Boockvar, chief market analyst at The Lindsey Group. “This will not be the last news on this as so many local governments have relied on property sales to fund themselves and that business is obviously slowing.”

LGFVs are the “backbone of local governments in promoting infrastructure development” across China, according to the International Monetary Fund. The tool is favored by local governments as a means of additional fiscal stimulus since local governments are legally prohibited from borrowing directly on financial markets.

While the structure varies, the IMF says local governments generally provide the vehicles with revenue injections, land-use rights, existing assets like bridges and roads, and receipts for bonds issued by China’s central government. Once the platforms meet capital requirements, they either raise funds on the equity and bond markets, or borrow directly from banks. The funding is then used on a variety of public works projects

“Basically, they act as principal financing agents for local governments, given that the latter are statutorily prohibited from engaging in direct market borrowing, including bank loans,” the IMF said in a research paper in 2013.

The total debt outstanding by LGFVs came in at around $3.9 trillion at the end of last year, according to an estimate by Nomura. That represents about 41.9% of the economic powerhouse’s gross domestic product, and accounts for more than half of its total government debt. In comparison, investors hold about $3.7 trillion in U.S. municipal debt, according to the Securities and Exchange Commission.

Funding Woes

Many of these vehicles have long relied local governments, new financing and fresh projects to stay afloat. But as China’s once red-hot economy and housing market cools down, municipalities have themselves run into financial challenges.

In a note early this year, Nomura said LGFVs’ “cash flows are still tight and profitability remains poor.” Indeed, operating cash flow was negative in 32% of LGFVs in a survey conducted in mid-2013, with median return on equity sliding to 1.9% from 3.5% in 2011.

Nomura, for its part, expects “some” defaults this year, although the Japan-based investment bank doesn’t expect it to become a systemic issue because the central government will probably be forced to step in.

“In the short term, we believe the government will likely sell some state-owned assets to cover losses at LGFVs, allow debt rollover and restructuring, and continue to provide subsidies at the local government level to avoid a broad based default,” Nomura said in a note earlier this year.

However, economists there warned the central government could allow an unknown number of defaults to reduce so-called moral hazard – a situation by which economic agents take on additional risk because they have an implicit assurance they will be protected in times of trouble.

At the same time, the IMF warns there could be contagion between China’s government and its financial institution because of “close linkages” between the two players. In a worst case scenario, an increase in government debt, and a drop in China’s creditworthiness, could “generate a loss of confidence in banks given the implicit government support for major banks in China.”

Follow Adam Samson on Twitter @adamsamson.