* Weak Dec bank loans reflects drop in bill financing
* But discounted bills not used to finance investment
* Drop shows banks' increased risk appetite
* Surge in undiscounted bills reflects shadow finance
SHANGHAI, Jan 10 (Reuters) - While weak bank lending figures in December may prompt worries that China's economic recovery is faltering, most of the recent decline is due to a fall in discounted bills, which have little relationship to investment.
In fact, analysts say the lower proportion of bill discounting in overall lending may signal improving risk appetite by banks as China's economic outlook improves.
At the same time, a surge in undiscounted bills in recent months suggests that overall credit demand in the world's second-largest economy remains strong but is now being satisfied through off-balance sheet credit.
Net new loans in December totaled 454 billion yuan ($72.92 billion), well below market expectations of 550 billion yuan.
The lending breakdown shows that bill financing loans fell by 191 billion yuan.
That makes corporate bills the main source of volatility in the headline total. If outstanding bill financing had merely been flat, rather than declining, net new lending in December would have been 643 billion yuan, well above market expectations of 550 billion yuan.
In fact, bill financing has declined by a total of 518 billion yuan since September, compared to 1.46 trillion in net new loans in this period.
This trend is a dramatic reversal of the pattern seen in early 2012, when bill financing accounted for 17 percent of net new loans in January through August, including 35 percent in April.
But the recent trend may actually be good news for China's economic recovery, while the previous rise in bill financing was likely a symptom of China's economic slowdown in mid-2012.
Discounted bills are short-term loans typically used by smaller firms to boost cash flow and working capital. All are less than one year, and many are less than three months. That means the trend of such loans don't track the trend in investment spending.
"If banks want to shorten the duration of their credit risk, they will use bill financing to fill up their loan quotas," said Ethan Mou, rates strategist at Bank of America-Merrill Lynch in Hong Kong.
"If the proportion of bill financing is dropping and the medium- to long-term new loans are picking up, that's a sign that loan demand is picking up and banks are now less risk-averse," he said.
Market watchers have traditionally paid close attention to monthly new yuan bank loans as a gauge of investment demand.
But in 2011 the People's Bank of China introduced a new data series called total social financing (TSF) in an effort to capture a broad range of fundraising channels.
Central bank officials have said recently that they view TSF as the key metric to gauge the impact of monetary policy.
Just as bill financing explains much of the volatility in overall bank lending, undiscounted bills - also known as bankers' acceptances (BAs) - are among the most volatile components in TSF.
BAs are commonly used around the world as a tool for settling international trade transactions. But in China they have also increasingly been used as off-balance-sheet financing for the domestic economy. The PBOC's decision to include BAs in TSF was an attempt to better track this channel of shadow financing.
When an exporter receives a letter of credit from an importer and submits it to his bank, the bank may issue a BA to the exporter - essentially a promise by the importer's bank to pay the importer at a future date.
But a BA, which the issuing bank records off-balance-sheet, need not be issued based on a letter of credit. The bank also requires the importer to place margin deposits at the bank worth 10-50 percent of the value of the BA.
If the importer wants cash right away, he may redeem the BA immediately at a discount to its face value. At that point the discounted bill appears on the discounting bank's balance sheet as a loan.
PBOC considers undiscounted bills a form of financing because in China they are commonly used as payment for supplies, utility bills, or even taxes. In that case, the payee is essentially extending credit to the payer, since the payee will not receive cash until the BA matures.
Traditionally, most BAs are discounted, but the ratio has fallen in recent years.
Banks issued 503 billion yuan in new, undiscounted bills in the last four months of 2012, while discounted bills declined by 518 billion yuan in the same period. That suggests that banks merely shifted discounted bills off-balance-sheet.
Regulators have taken repeated steps in recent years to crack down on deceptive use of BAs, including requiring margin deposits to be counted towards banks' required reserve ratio and tightening rules for the endorsement transfer of BAs.
But the surge in undiscounted bills in recent months suggests the cat-and-mouse game is continuing.
($1 = 6.2262 Chinese yuan) (Reporting by Gabriel Wildau; Editing by Kim Coghill)