UPDATE 2-China's reforms not enough to arrest mounting debt - Moody's
* China facing dilemma of deleveraging without hurting growth
* Economic slowdown hitting government tax revenues
* To balance books, officials cut infrastructure spending
* But this investment is crucial driver of growth
By Dagmara Leszkowicz and Marcin Goettig
PABIANICE, Poland, Jan 23 The Polish town of Pabianice is broke. The mayor is selling off property to raise cash but still cannot afford to fix the paving stones and the local hospital has racked up more debt than the annual municipal budget.
Poland has weathered the economic slowdown better than most other European Union members but public finances are under stress in small towns and the state treasury alike, and this may deepen a downturn that is forecast for this year.
A handful of smaller local authorities including Pabianice, a community of 70,000 which lies 150 km (95 miles) southwest of Warsaw, are so indebted that the finance ministry has had to step in with loans.
"We're living in a state of poverty," said Zbigniew Dychto, Pabianice's mayor. "I don't have money."
Tax revenues are falling across the country as the economy slows, forcing Poland to cut the kind of spending which has played a crucial role in driving economic growth: state investments in projects such as new roads and public buildings.
The 2012 budget deficit has yet to be announced, but Reuters calculations based on finance ministry data show central government revenue was about $2 billion lower than projected in the budget, about 0.4 percent of gross domestic product (GDP).
Such problems are mirrored at the local level. Out of Poland's roughly 3,000 municipalities, only 2 percent were running a budget surplus last year, data obtained by Reuters shows. Several of the biggest cities are at, or near their debt ceilings, so cannot borrow much more to make ends meet.
By comparison, in Hungary, the most indebted of the EU's eastern countries, the central government took over a huge chunk of local debt last year to give municipalities a fresh start.
These problems - falling tax revenue leading to budget shortfalls - have grown familiar to most EU countries since the financial crisis four years ago.
Poland is more exposed than most of its neighbours for two reasons. First, it is committed to cutting its deficit and debt as it wants to exit an excessive deficit procedure this year. This was imposed by the European Commission for breaking EU budget rules, and Poland cannot resort to more borrowing to ease the pressure on public finances.
Secondly, economic growth depends to a much greater extent than in many other EU countries on public investment spending, the item most likely to be cut because other items of budget expenditure are mandatory.
Public investment amounted to 5.7 percent of Polish GDP in 2011, European Commission data show, compared with 2.3 percent in the euro zone.
This investment has been used to fund the new roads, public buildings and sports stadiums that have turned Poland into a big construction site and helped to make it the only EU member to avoid recession over the past four years.
"Capping investments is a double-edged sword for the government," said Wadim Tyszkiewicz, head of the association of local governments which represents mayors struggling to balance their budgets. "It will hit economic growth for sure."
The strain on the budget comes at a tricky time for Poland because EU funding, which pays for a large chunk of the public investments, is slowing. The European Commission forecasts that Polish public investment will fall 15 percent this year and another 14 percent in 2014. This follows average annual growth of 16 percent between 2007 and 2011.
The Finance Ministry estimates GDP grew just over 2 percent last year, a sharp fall from 2011, but this compares with recessions in the neighbouring Czech Republic and Hungary.
The Polish central bank forecasts growth will slow to 1.5 percent this year, its lowest rate in a decade.
Prime Minister Donald Tusk's administration relaxed the general government deficit target for last year and is now aiming for 3.5 percent of GDP. Debt has stayed below the 55 percent of GDP ceiling laid down in Polish law.
At the same time, there have been no swingeing cuts in spending or radical tax increases, and Tusk has promised that big public investment projects will continue.
However, this robust picture masks problems. For instance, receipts from value-added tax, a major source of government income, were 9 percent below the budget target, deputy finance minister Hanna Majszczyk said.
There are ways of mitigating the shortfall. The central bank handed over a dividend - the profit it made on its operations - of 8.2 billion zlotys ($2.6 billion) to the government. The Tusk government has also dipped into its own reserves.
This has covered only part of the shortfall. Borrowing to bridge the gap is not an option as that could lead to the government missing its debt reduction targets, unsettling financial markets.
As a consequence, there is no alternative but to cut into the investment spending, despite the risk to economic growth. Majszczyk said investment spending in 2012 was lower than projected in the budget, though she did not say by how much.
The drop off in public investment, with other factors, means "the chances that Poland will slip into recession in the first half of 2013 are growing", said Ernest Pytlarczyk, chief economist at BRE bank in Warsaw. Poland has not suffered a full recession year since 1991 when the economy was undergoing traumatic "shock therapy" market reforms after the fall of communism.
In Pabianice, the lack of public cash is filtering through into the real economy. Zamkowa Street, once the main shopping thoroughfare, is now potholed and almost deserted. It is lined with empty shop-fronts, their windows smashed.
Jakub Morawski's DVD rental shop is one of the few businesses still operating. "Look outside and see what our pavements and streets look like," he said. "It's a disaster."
NO MORE ROUNDABOUTS
Krakow, Poland's second-biggest city, illustrates the squeeze on public finances, and the way it will affect the broader economy. Mandatory spending on items such as education and health is going up, but revenues have not increased for the past three years, local officials say.
Until now Krakow avoided the problem by borrowing to pay for infrastructure projects, such as a new southern road gateway, with beautifully-illuminated flyovers and paintings of tourist attractions on its pillars.
Now it can no longer borrow because its debt-to-revenue ratio reached 62.5 percent in the first half of 2012, according to the finance ministry, exceeding the 60 percent legal limit.
"The only thing we can do is to reduce expenditure on investment because it is not mandatory," Jacek Majchrowski, the mayor of Krakow, told Reuters in an interview. "But when we do that, construction companies have nothing to do and they will fire people. Unemployment will rise and people will line up for welfare that we need, partly, to finance."
* China facing dilemma of deleveraging without hurting growth
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May 26 The following are the top stories on the New York Times business pages. Reuters has not verified these stories and does not vouch for their accuracy.