Bad debts in China's banks painfully expose the shortcomings of an archaic financial system geared to lend to the beck and call of government economic policy, rather than when it is profitable.

The crux of the problem is rising distrust of official appraisals of China's 10.7 trillion yuan (1.10 trillion pound) local government loans, which surged on the orders of government as it rolled out a 4 trillion yuan economic stimulus programme at the end of 2008.

Banks say less than 1 percent of the loans are in trouble, a number some investors say is too low to be real as lending unleashed to spur economic growth at its weakest point implies a rising risk of bad debt as the economy slows again.

I talk to so many people and they say the same thing: they do not trust the data coming from Chinese banks, said James Antos, a bank analyst at Mizuho Securities Asia in Hong Kong.

China's state audit office said earlier this month it had uncovered 530 billion yuan worth of irregularities with local government debt, leaving investors wondering how much clean-up work remains to be done.

Lacking information, investors are jumping to conclusions. Some think all local government loans are bad. More sober guesstimates assume 2-3 trillion are sour and banks' non-performing ratios may quadruple to 5 percent, from an average 1.1 percent.

Investors' worst fears are a cover-up that threatens financial stability in the world's No. 2 economy.

This is especially so if Beijing orders banks to lend aggressively this year to support the economy and counter Europe's slowdown, fuelling a vicious cycle of state-directed lending with poor credit judgment that leads to bad loans.

More immediately, the risk is that rising loan losses hit banks' net profits and capital bases, forcing another government-led bailout like that a decade ago when Beijing spent billions on capital injections to shore up state-backed lenders.

OPTIMISTS EYE REPAYMENT

Optimists say Beijing will pay the debt, or let local governments sell bonds to repay loans used mainly for building infrastructure. Investors like the former option as it is clean and fast, but Beijing is non-committal.

Markets hate that uncertainty, which is one reason why Chinese bank shares have underperformed.

Their average price-to-book ratio of 1.3 is half that of Indonesian banks, according to Reuters data, after the Shanghai financial index plunged some 37 percent in the last two years.

Certainly a good number of loans made in the last three years will go bad, said David Madden, a managing partner at DAC Financial Management, a $425 million private equity firm in Hong Kong focused on trading Chinese bad debt.

They weren't necessarily made with the highest levels of credit analysis.

China's cumulative loan growth is the second fastest in the world's emerging economies at around 55 percent, after Belarus, and a third faster than India's 40 percent, Fitch Ratings said.

Yet Chinese banks insist bad loans are falling, not rising.

Their weighted-average non-performing loan ratio dipped 0.1 percent in the third quarter from the previous three months, Citi data showed. In contrast, Indian banks' weighted-average ratio rose 7.5 percent, hurt in part by a falling rupee.

Non-performing loans are those where borrowers have not made payments for at least 90 days and are in or close to default.

Investors suspect banks are concealing bad loans by adamently refusing to label them as non-performing when cash-strapped governments cannot repay.

Instead, analysts say banks have -- or will -- quietly restructure loans by extending maturities, violating best practice where loans are marked non-performing before being restructured.

China's top state-owned banks declined to comment.

CONSTRAINED BY ACCOUNTING RULES

The market does not like the fact that you are trying to hide loans which do not meet current terms, said an analyst at a foreign bank in Hong Kong who declined to be identified.

That Chinese banks are concealing bad debt would be even more apparent if they continue to report enviably low non-performing loans in their 2011 results in March, analysts said, since a fifth of all local government loans matured last year.

In banks' defence, they could argue their provision coverage of 190 percent is among the highest in Asia, meaning they have put aside 1.9 yuan for every yuan of dud loan -- although this ratio looks good when banks recognise lower levels of bad debt.

Margarita Ho at PricewaterhouseCoopers in Beijing said banks are also constrained by China's accounting rules.

The accounting rules do not permit banks to provide reserves for losses based on future events, regardless of how probable they are, she said.

But some investors argue the economic reality is that China has more bad loans than it is admitting to, especially with its economy now slowing, and so its financial stability is at stake if Beijing does not act more forcefully.

You kind of let the bad news ride until you are forced to accept it, said Madden from DAC. But I don't think kicking the can down the road is, ultimately, a smart thing to do. ($1 = 6.3095 Chinese yuan)

(Reporting by Koh Gui Qing; Editing by Nick Edwards & Kim Coghill)