* Local bank suing local govt-controlled property firm over bad debt
* Bank, property firm based in same city; Borrower owns bank shares
* Bank denies the firm is a LGFV, contradicts media, analyst report
* Highlights divergence of interests between banks, local govt companies (Updates with additional detail about the sued company)
By Pete Sweeney
SHANGHAI, July 2 A Chinese bank is suing a local government-controlled property investment firm 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 as local governments confront 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 the Urban Construction and Comprehensive Development Company of Licheng District over unpaid debt.
The bank said the company had failed to make payments on a 35.4 million yuan ($5.71 million) outstanding loan, along with 6.1 million yuan in unpaid interest. The Commonwealth Bank of Australia currently owns 20 percent of Qilu Bank's total shares.
"To the best of our knowledge, this is the first official disclosure of a LGFV (local government financing vehicle) default on a bank loan," wrote Nomura analysts in a research note distributed to clients on Monday.
The Licheng District company could not be reached for comment, while Qilu Bank said on its website on Wednesday that the entity was not a financing vehicle as Nomura and domestic media had reported, but rather a property development company established by the local government.
"They are totally independent and should be responsible for their own profits and losses," the statement said, adding that the company had begun rolling over its loans when it got in trouble in 2008.
LGFVs in China are usually defined as vehicles created exclusively for the purpose of fundraising on the behalf of local governments, which are legally prevented from raising money on their own behalf. A company controlled by a local government, on the other hand, is considered a commercial entity in its own right.
The distinction, however, can be a technical one and in reality lines can be blurred.
While LGFVs are considered to be implicitly guaranteed by the government by many investors, they are not formally guaranteed. At the same time, local government-connected commercial entities -- such as solar power companies -- have operated without fear of bankruptcy for years, seeing their debts rolled over repeatedly.
Much of China's massive debt overhang and its accompanying industrial overcapacity was incurred by local governments using entities under their direct or indirect control to borrow heavily from the banking system at low rates. Such corporations were able to conduct investment and business activities on behalf of local governments, not all in the public interest, on the tacit assumption that the taxpayer was ultimately on the hook. Many dabbled in real estate, battened on subsidies to incubate strategic industries, and otherwise helped contribute to China's industrial overcapacity and its real estate asset price bubble.
Until recently domestic banks were willing to roll over their debts indefinitely -- a strategy analysts say worked fine so long as China maintained double-digit economic growth -- but the Qilu case is an example of a bank becoming less accommodating.
Chinese banking sources agreed that while de-facto defaults by such companies 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 company is still 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 loans and more sceptical about local governments' readiness to bail out their failing financing arms. ($1 = 6.2000 Chinese Yuan Renminbi) (Additional reporting by Lu Jianxin and the Shanghai Newsroom; Editing by Tomasz Janowski)