* Local bank suing local govt funding vehicle over bad debt
* Bank, financing vehicle based in same city; LGFV owns bank shares
* Could be first official admission of an LGFV default-Nomura
* Highlights divergence of interests between banks, LGFVs
By Pete Sweeney
SHANGHAI, July 1 (Reuters) - A Chinese bank is suing a local government financing vehicle over a bad loan in a rare public display of a deepening rift between lenders and borrowers in China's murky $3 trillion local debt market.
The unusual step also highlights growing strains in the market confronted by slowing economic growth and a property sector that has started to cool off after decades of runaway expansion.
Qilu Bank, based in the city of Jinan in the coastal province of Shandong, announced in its 2013 annual report -- published online in Chinese and English -- that it was suing a local government financing vehicle (LGFV) over unpaid debt.
The bank said the Urban Construction and Comprehensive Development Company of Licheng District failed to make payments on a 35.4 million yuan ($5.71 million) outstanding loan, along with 6.1 million yuan in unpaid interest.
"To the best of our knowledge, this is the first official disclosure of a LGFV default on a bank loan," wrote Nomura analysts in a research note distributed to clients on Monday.
Neither Qilu Bank nor the company in question answered phone calls requesting comment.
Much of China's massive debt overhang and its accompanying industrial overcapacity was incurred by local governments using such vehicles, known as LGFVs, to get around laws prohibiting local governments from borrowing directly. These entities, financed by local banks, were linked to the local governments and conducted investment activities on their behalf, dabbling in real estate, battening on subsidies to strategic industries like solar power, and otherwise helping contribute to China's industrial overcapacity and its real estate asset price bubble.
Until recently banks have been willing to roll over LGFVs' debts indefinitely, avoiding write-downs and keeping reported non-performing loan (NPL) ratios at levels well below what analysts considered realistic -- a strategy analysts say worked fine so long as China maintained double-digit economic growth.
Chinese banking sources agreed that while de-facto defaults by LGFVs are common, the public nature of the disclosure was unusual given the fraternal relationship between the two entities. Both are headquartered in Jinan, and according to the Qilu report the Licheng District LGFV is one of its shareholders, holding 0.08 percent of its shares.
"LGFV defaults are to be expected and are inevitable," said a loan officer at a Shanghai-based Chinese bank, who spoke on condition of anonymity, but said in most cases the defaults were hidden from public view using accounting methods.
However, pressured by regulators to clean up their books, banks have grown less willing to roll over the loans and more sceptical about local governments' readiness to bail out failed their financing arms.
A senior bond trader at a major Chinese state-owned bank in Shanghai noted that while investors still largely considered debt issued by provincial-level financing vehicles to be effectively guaranteed, that no longer held true for lower level entities.
"Bonds issued by provincial LGFVs are privately guaranteed by related local governments, but I don't think lower-level LGFVs' debt is guaranteed in a similar way."
Beijing has said it is trying to move away from the investment-intensive economic model that spurred the development of local financing vehicles, and the central bank announced in January that it would move to eliminate those with "unclear functions" and unsustainable finances.
The local government financing vehicle bond market has yet to experience a public default. Beijing did allow China's first default of a publicly traded bond in March, and since then other firms have also defaulted, but none of them have been operating under presumed government guarantees the way LGFVs do. ($1 = 6.2000 Chinese Yuan Renminbi) (Additional reporting by Lu Jianxin and the Shanghai Newsroom; Editing by Tomasz Janowski)