China's clean-up of $1.7 trillion (1.08 trillion pounds) of local government debt must boost the credit worthiness of loans on bank books without changing underlying lending policy, a source with direct knowledge of the matter said on Tuesday.

The China Banking Regulatory Commission (CBRC) has issued an instruction to banks containing just 16 Chinese characters and provides no guidance on how to implement the directive, said the source, who has seen the notification.

Only a 16-character policy is given: no change in policies, clean-up to deepen, prudent pull-out, and the focus is to boost credit worthiness, said the source who declined to be named as he is not authorised to speak to the media.

I'm still trying to understand it, he said when asked how the clean-up instruction would work in practice.

China's mountain of local debt piled up after the 2008-09 financial crisis when Beijing ordered local governments to spend massively on infrastructure projects to buoy economic growth, which they did by borrowing heavily.

The government had vowed as early as June 2011 to clean up its local debt either by shifting 2-3 trillion yuan of debt off local governments, forcing state banks to take some bad debt losses and selling select projects to private investors, sources told Reuters earlier.

The CBRC is now soliciting opinions from Chinese banks on how to implement the new rules and roll over some loans, a step that is usually taken to finalise details of policy, a separate source close to regulators in Beijing said on Tuesday.

Banking sources said they were interpreting the instruction as an opportunity to adopt greater flexibility in rolling over the problem loans from those lent to local governments.

Xia Bin, an adviser to the central bank and the Chinese government, advocated a roll-over when he spoke with journalists on the sidelines of an economics conference on Monday.

The problems can be solved by re-classifying and re-booking of the debts, Xia said, adding that government debt risks were best solved through a gradual approach.

China's audit office put the total value of local government debt at 10.7 trillion yuan at the end of 2010 with 41.7 percent of the outstanding debt due to mature by the end of 2012.

The national audit office also said that it had uncovered irregularities on local government loans worth 530 billion yuan, citing a litany of bad practice.

Economists and financial analysts estimate as much as 2-3 trillion yuan of loans made to local governments have gone bad and that the scale of the problem may push up non-performing loan ratios in the banking industry to around 5 percent from their current average of 1.1 percent.

MATURITY CYCLE MIS-MATCH

A problem faced by many local government borrowers is that the money has been invested in long-term projects such as roads and bridges, which do not generate returns fast enough for them to meet the repayment terms, analysts said.

About 20 percent, on a conservative estimate basis, of the debts will turn sour without rollover, said an analyst with a Chinese credit rating agency, who cannot be identified because he is unauthorised to speak to the media.

Rollover is certainly reasonable. Ultimately, the debt of local government financing vehicles are government debts; and state banks are also owned by the government, so why there should be such a hurry of moving the money from the right pocket to the left? he asked rhetorically.

Analysts believe wrinkles in the rollover treatment of loans has been the main obstacle to progress.

Liu Mingkang, when still chairman of CBRC last August, said that banks were not now allowed to roll over loans to local government financing vehicles -- a decision that was controversial among bankers and economists.

CBRC, under its new chairman Shang Fulin, appears to be taking a more pragmatic approach.

About 20 percent of local governments' loans matured last year and the banking regulators reportedly allowed for the extension of loans that are in good condition or are supporting sound investments, Wang Tao, a China economist with UBS in Hong Kong, wrote in a note to clients.

This practice will undoubtedly continue in the next few years when more of the loans come due, she said, adding that there was little alternative to debt rollovers while China's bond market remained relatively undeveloped.

(Reporting by Xie Heng, Aileen Wang, Zhou Xin and Nick Edwards in Beijing; and Victoria Bi in Hong Kong. Editing by Ramya Venugopal)