Rating agency Moody’s, on Tuesday, warned that China’s local government debt may have been understated by auditors by 3.5 trillion yuan ($540 billion), putting Chinese banks at risk for huge losses that could potentially threaten their credit ratings.

China presented the results of its first-ever nationwide audit of local governments last week in which the government claimed that the debt level of cities and counties stood at 1.6 trillion yuan. Analysts said that it was the most reliable detailing of local debts to date.

Some even praised the government for keeping debt at manageable levels at 44 percent of annual economic output, which is far lower compared to other major economies such as Germany (75 percent), the US (93 percent), and Japan (225 percent).

The rating agency Moody’s which upgraded China’s sovereign rating in 2010, however, believed that the audit may have missed a huge part of the problem. They were referring to problematic loans that were not properly underwritten, hence cannot be officially classified as government obligations.

Last year, lending by Chinese banks to local government reached 8.5 trillion yuan ($1.3 trillion) in an effort to propel economic growth. Many state-owned banks were urged by Beijing to bolster credit when the global financial crisis started to threaten the rapid Chinese economic growth. The surge in lending, which was largely pointed to infrastructure projects, became the fuel that led to the country’s economic recovery.

For some time, investors have viewed China’s massive local government debt problem to be a source of major risk. Worries persist about widespread loan defaults in the event that the world’s second largest economy will slow down in growth, essentially hobbling its banking system overall.

Moreover, Moody’s warned that bad debt could be in the range of 8 to 10 percent of the total loans. Given the scale of their bad debt, Moody’s warned that credit outlook for Chinese banks could turn negative. They also urged China to come up with a “clear master plan” to solve the problem.

Moody’s found that after cross-examining the results of the National Audit Office (NAO) report, which was submitted to the Chinese parliament last week, with the reports from China’s banking regulators, that NAO may have understated the banks’ exposures to local governments. Moody’s added that these loans were not covered by the NAO since they were not regarded as real claims on local governments, an indication that those loans were a result of poor documentation.

Nevertheless, given the economy’s strong growth and the fact that banks appear to have started to get a handle on the debt problem, Ms Zhang told the Financial Times that she did not anticipate a downgrading of Moody’s stable outlook for Chinese lenders.