* State media report Zhejiang Xingrun owes 3.5 bln yuan
* Owner, son under arrest for illegal fundraising - official
* Report comes as Chinese property market softens, diversifies
* Housing prices falling in Wenzhou, Ningbo (Updates with housing market performance, background)
By Umesh Desai and Clare Jim
HONG KONG, March 18 (Reuters) - The looming bankruptcy of a Chinese developer owing billions of yuan to domestic banks has raised worries that a softening property market is heightening risks for the financial system.
But the localised focus of the firm, and the nuanced reaction of investors, shows that financial markets are not pricing in the bursting of a real-estate bubble just yet.
Government officials told Reuters on Tuesday that Zhejiang Xingrun Real Estate Co, based in the coastal city of Ningbo in Zhejiang province, is on the brink of bankruptcy. State media have estimated the company owes 15 domestic banks 2.4 billion yuan ($389 million) and individual investors another 1.1 billion, with only 3 billion yuan of assets on hand.
By raising that money from individual investors, Zhejiang Xingrun's owner also broke Chinese law, and local officials told Reuters that the company's owner and his son are in custody, accused of illegal fundraising.
Calls to Zhejiang Xingrun seeking comment were not answered.
The news of the expected bankruptcy came amid growing concerns about debt in China following the country's first domestic bond default earlier this month.
Yet analysts said they did not expect a domino effect following Tuesday's news, given that investors are aware of the distinctions in quality between different bond issuers, while Xingrun's property portfolio is highly localised.
"The offshore names are the higher quality names, so there isn't much panic reflected in bond prices," said Manjesh Verma, head of credit research and strategy at Credit Agricole in Hong Kong, referring to Chinese property bonds traded in the offshore market.
"But if (a company) is not localised in one city and the defaulter has a multiple province/city presence, it will be a big red flag," he added.
Property bonds in offshore markets underperformed on the day, but losses were contained.
Share price declines were more pronounced. The Shanghai property index was down 0.9 percent in afternoon trade, dragged lower by Beijing Capital Development Co Ltd, down 3.9 percent, Xingye Resources, down 3.2 percent, and Poly Real Estate, down 2.8 percent.
"While this news will definitely impact some property stocks, I don't think a domino effect is likely," said Du Changchun, an analyst at Northeast Securities in Shanghai.
China's government has been trying for years to tame surging home prices on concerns they were stoking an asset bubble.
But they worry that too sharp a fall could drag further on the world's second-largest economy, which slowed markedly in the first two months of the year.
Data released on Tuesday showed that Chinese home inflation slowed for a second straight month in February, due to government policy curbs and declining domestic demand. Some markets saw outright price declines, in particular the Zhejiang cities of Wenzhou and Ningbo, where Zhejiang Xingrun is based.
Some industry observers noted growing instability among a group of Chinese property developers, in particular those that overindulged in speculation financed by money borrowed at high rates in the shadow banking market.
"Underground private banks are very active in the Zhejiang and Jiangsu areas, and many companies have already gone bust because their owners personally borrowed a lot from these underground banks and then were not able to repay," said an executive at a real estate developer with projects in eastern China, who spoke on condition of anonymity.
"We have been hearing a lot of cases like this but this one is of a much larger size," he added. "I think by letting this news go public, the government wants to send a message to the market."
The true test of Beijing's commitment to risk reform will come when it confronts a potential default by one of the state-owned enterprises that dominate loan and bond markets.
"The X-factor here is (whether) the government will step in if some big guys start facing stress and big banks will be asked to provide more loans. If that doesn't happen and we start seeing medium scale defaults onshore, then we will see an easy 15-20 point drop in bond prices," said Credit Agricole's Verma. (Writing by Pete Sweeney; Additional reporting by Xiaoyi Shao, Koh Gui Qing and Kevin Yao in BEIJING, Tu Lianting in SINGAPORE and the Shanghai Newsroom; Editing by Chris Gallagher)