China has dealt with its mounting local government debt problem by kicking the can down the road so far, with a mixture of measures such as maturity extension and interest rate reduction.

The tinkering, however, has increasingly strained the banking system with an inevitable squeeze on earnings. Beijing may soon have to make the difficult choice on whether to bail out local governments and preserve a healthy banking system or else be confronted with mass defaults and potential financial instability.

Chinese banks have a 94 trillion yuan ($13 trillion) exposure to local government debt, making up about 29% of total assets, Goldman Sachs estimates. Even assuming a steady default rate — and that's a big if — the US brokerage still expects bank earnings to worsen over the coming years. Lending rates are coming down on both new and rollover government debt, resulting in poorer financial metrics such as net interest margin and return on equities.