Addressing the estimate by China's state auditor that its local governments have chalked up 10.7 trillion yuan of debt, Moody's said it found more potential loans after accounting for discrepencies in figures given by various Chinese authorities.

"The potential scale of the problem loans at Chinese banks may be closer to its stress case than its base case," Moody's said in a statement.

In view of that, the non-performing loan ratio for Chinese banks could be as high as 8-12 percent, compared with 5-8 percent in the base case and 10-18 percent in the stress case.

Unless China comes up with a "clear master plan" to clean up its pile of local government debt, the credit outlook for Chinese banks could turn negative, the ratings agency said.

In a bid to assuage investor worries about the potential souring of its massive local government debt, different Chinese authorities including the state auditor, the bank regulator and the central bank have tried to assess the situation.

But all three agencies have used different definitions and accounting methods to review the debt, resulting in a hodgepodge of official forecasts.

Moody's said it derived the additional 3.5 trillion yuan of debt after comparing the estimates of China's state auditor with that of the bank regulator's.

The ratings agency said the Chinese state auditor likely ommited the 3.5 trillion yuan of debt from its assessment because they were not considered as real claims on local governments.

"This indicates that these loans are most likely poorly documented and may pose the greatest risk of delinquency," said Yvonne Zhang, a Moody's analyst.

Moody's said it expects Beijing to "implement gradual discipline" over the stock of government debt, and that would involve the Chinese government leaving banks to manage a part of the problem loans on their own.   

Copyright Reuters, 2011