China may have understated the debt burden of local governments by as much as $541.6 billion, and the proportion of bad loans could be higher than previously forecast, ratings agency Moody's said Tuesday.
In a stern warning, Moody's warned the lack of a plan to tackle bad loans to local governments meant it could downgrade its outlook for Chinese banks to negative.
The agency's findings came after it analysed an audit released in June by China's National Audit Office (NAO), which put the debt held by local governments at 10.7 trillion yuan ($1.65 trillion) as of the end of 2010.
The figure released by the NAO was the equivalent to about 27 percent of China's 2010 gross domestic product of 39.8 trillion yuan.
"We believe that the NAO report is understating the size of the local government loans that could become problematic," the Moody's report said.
Excessive borrowing by authorities to fund infrastructure and other projects has sparked concerns among China's leadership about the risks the loans pose to the financial stability of the world's second-largest economy.
Moody's said it uncovered an additional 3.5 trillion ($541.6 billion) in debt after checking the NAO's figures against reports by Chinese banking regulators.
The agency said the ratio of loans that cannot be paid back could be as high as eight to 12 percent, compared to its previous calculations of between five to eight percent.
"The potential scale of the problem loans at Chinese banks may be closer to our stress case than our base case. This is clearly a negative trend for creditors," Moody's said.
"But, for now, very few of these loans are recorded as NPLs (non-performing loans) by the banks, and it is unclear as to how they, or the Chinese authorities, intend to address the problem."
The ratings agency said it was concerned by the differences between figures given by government agencies and the banks' publicly stated lack of concern about bad loans.
The NAO had said 108.3 billion yuan of total loans had been issued or used improperly, citing methods such as providing fraudulent collateral or diverting the funds raised into capital or real estate markets.
Chinese banks last year loaned huge amounts to provincial financing vehicles intermediary agencies through which the governments take out borrowings because they are officially banned from assuming debt directly.
The credit was used to fund construction projects after Beijing called for nationwide efforts to spur the economy on the back of the global financial crisis.