Ratings agency Moody's Investors Service Inc said on Tuesday that there is another potential 3.5 trillion yuan ($541 billion) of local government loans that Chinese auditors did not discuss in a recent report.

"Since these loans to local governments are not covered by the National Audit Office (NAO) report, this means they are not considered by the audit agency 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, vice-president at Moody's Investors Service.

China's local government debt stands at 10.7 trillion yuan, of which 8.5 trillion yuan was funded by bank loans, according to a report the NAO released on June 27.

Moody's said in a report that the potential scale of problem loans at Chinese banks could be closer to its stress case than its base case, according to an assessment that it conducted after the release of new data by the NAO.

It also said the credit outlook for the Chinese banking system could potentially turn negative, considering the apparent absence of a clear master plan to deal with the issue.

"We assume that the majority of loans to local governments are of good quality, but based on our assessment of the loan classifications and risk characteristics, as provided by the NAO and other Chinese agencies, we conclude that banks' exposure to local government borrowers is greater than we anticipated," said Zhang.

The rating agency said the NAO figures indicated that about 24 percent of outstanding local government debt is due by year-end, with 17 percent due next year.

Concerns are rising that local government debt could destabilize China's financial system if it is not managed properly.

Central government property-tightening measures could affect local governments that depend heavily on land sales for revenue, making debt repayment more difficult.

China's ambitious five-year plan to build 36 million affordable homes, including 10 million in 2011 and 10 million in 2012, has exacerbated worries about increasing capital demand and rising non-performing loans in commercial banks.

Moody's estimates that the Chinese banking system's non-performing loans could reach 8 percent to 12 percent of total loans, compared with 5 percent to 8 percent in the agency's base case and 10 percent to 18 percent in its stress case.

But Lu Zhengwei, chief economist at Industrial Bank Co, said the risks posed by these loans are quite limited.

"Some local governments cannot repay loans on time mainly because the deadlines were too concentrated, not because of a deteriorating ability to repay."

Wang Tao, head of China economic research at UBS Securities, said a savings rate above 50 percent, a fiscal deficit of less than 3 percent and huge assets give China the resources to cope with public debt as high as 50 to 60 percent of GDP.

"Even if local government loans that amount to 30 percent of GDP all go into default, the probability of a debt crisis in the next one or two years is very slim," she said.

Moody's said it expected the Chinese authorities to implement gradual discipline to tackle the issue, which means the authorities will leave banks to manage some problem loans on their own.

Beijing plans to clean up billions in local government debt by shifting 2 trillion to 3 trillion yuan of debt off the books of local governments, Reuters reported earlier, quoting anonymous sources.

Stocks of Chinese banks declined after Moody's report was released on Tuesday, as Industrial and Commercial Bank of China Ltd, the world's largest lender by market capitalization, fell 0.23 in Shanghai and 0.7 percent in Hong Kong.