In the coming years, China's government will have to confront significant challenges to achieve stable, inclusive and sustainable economic growth. Policymakers must act quickly to design and implement prudent, forward-looking fiscal and financial policies.

The most significant medium- and long-term threat to China's fiscal position lies in the system of implicit guarantees that the central government has established for local government debt. In the wake of the global financial crisis, local governments borrowed heavily from banks to support China's massive stimulus program, accumulating 10.7 trillion yuan ($1.7 trillion) worth of debt by 2011.

China's leaders hope to control potential risks stemming from local-government investment vehicles (LGIVs) by limiting bank lending. The balance of bank loans to LGIVs increased only slightly in 2012, to 9.3 trillion yuan from 9.1 trillion yuan in 2011. The China Banking Regulatory Commission has called on banks to retain last year's LGIV loan quotas for 2013, and to ensure that the overall balance of loans to LGIVs does not exceed the 2011 year-end total.

But LGIVs obtained a massive amount of financing in 2012 by issuing bonds and trust loans. This includes 250 billion yuan in local government bonds, 636.8 billion yuan in urban-investment bonds, and technical cooperation trust-fund projects totaling 501.6 billion yuan, representing year-on-year increases of 50 billion yuan, 380.6 billion yuan and 247.9 billion yuan, respectively.

Even with these funds, however, local governments have struggled to make ends meet. Tax reforms implemented in 1994 caused local governments' share of national fiscal revenue to decline steadily, from 78 percent in 1993 to 52 percent in 2011. Over the same period, however, their share of total government expenditure increased from 72 percent to 85 percent.

The need to fill the resulting gap has forced local governments to depend on land sales. But land related income has plummeted over the last two years, from 32 percent of total revenue in 2010 to 20 percent last year. Measures mandated by the central government to control surging real estate prices will continue to reinforce this trend, increasing pressure on local government revenues.

The risk stemming from local government debt is exacerbated further by massive amounts of non-explicit debt acquired through arrears, credits and guarantees. When a local government is no longer able to service its debt, the central government will have to place its own fiscal capacity at risk by assuming the responsibility.

Lenders turn to unofficial channels to circumvent tighter government regulations on the formal banking system. Perhaps the biggest risks stem from China's rapidly growing shadow banking system.

Shadow banking can be conducted through trust loans (extended by trust companies), entrusted loans (company-to-company credits brokered by financial institutions), bank acceptances (drafts or bills issued by companies that are endorsed by banks) and corporate bonds (debt securities issued by companies directly to investors).

The combined worth of these instruments reached 5.9 trillion yuan in 2012, led by corporate bonds (2.3 trillion yuan).

New lending by trust companies - which rose by more than 400 percent last year - is generating significant solvency risk in China, given that it is frequently extended to higher-risk entities, including real estate developers and LGIVs.

More generally, the rapid expansion of credit risks increasing inflationary pressure and fueling the formation of asset bubbles. Conversely, when the monetary authority tightens credit too quickly, asset prices become more volatile, resulting in more nonperforming loans and triggering economic shocks.

China's government must implement prudent macroeconomic policies now to minimize escalation of these risks later. Medium- and long-term fiscal stability will require policies that account for the growing disparity between fiscal revenues, which are suffering from slowing GDP growth, and expenditures, which will be driven up by structural tax cuts and increased social welfare spending.

To manage growing pressure on public finances, China must establish highly efficient public-budget and fiscal-restraint systems. To this end, the government must tighten financial supervision, improve budgetary management and enhance the operational efficiency of fiscal policies.

As prudent fiscal and financial policies gradually stabilize China's economy, monetary policy must remain neutral. Loosening monetary policy would increase significantly the risks stemming from local government debt and shadow banking, while tightening monetary policy would fully expose those risks, posing a serious systemic threat.

With the right balance of vision and caution, China's leaders can tackle the buildup of fiscal and financial risk. And they cannot afford not to act decisively.

The author is a fellow of the China Information Center and the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform. Project Syndicate