By Hongmei Zhao and Shengnan Zhang

China has clarified bad debt rules in a move that effectively segregates sour loans of deeply indebted regional governments from the nation's systemically vital big four banks, two sources with direct knowledge of the matter told Reuters on Monday.

The differing treatment of debt disposal at the national and local level is an important development for investors and analysts attempting to quantify the risk to China's state-directed financial system of 10.7 trillion yuan ($1.7 trillion) in bad debts racked up by local governments by the end of 2010.

The two sources cited a circular from the Ministry of Finance and the bank regulator stipulating that provincial asset management firms may only buy bad debt from regional financial institutions that do not have nationwide businesses, barring regional asset management firms from buying non-performing loans from giant state banks.

"Asset management firms established or authorized by provincial governments, autonomous regions and municipalities directly under the central government will be allowed to purchase non-performing assets of financial firms in the local area," one of the sources close to the finance ministry told Reuters.

"The four big assset management companies will buy non-performing assets of national financial institutions," he added, asking not to be identified as he was not authorized to speak to the media.

Chinese local governments borrowed heavily at Beijing's behest to fund massive infrastructure spending at the heart of a 4 trillion yuan economic stimulus plan unveiled at the depths of the global financial crisis in 2008.

China's four giant asset managers are Huarong, Cinda, Great Wall and Orient Asset Management Corp, which were set up by Beijing in 1999 to remove an estimated 1.4 trillion yuan's worth of bad loans from its top four lenders in one of the world's largest bank bailouts.

The move was regarded as vital for putting the Chinese financial system on a sound footing.

Those four asset management companies were backed by bonds issued by the Chinese government valid for 10 years, during which they were supposed to have sold all the non-performing loans. The terms were renewed in 2010 for another 10 years.

The separation of local from national debt disposal underlines Beijing's continual assertion that sour loans at local government level and the so-called "shadow banking sector" do not pose systemic risks.

The latest circular is a more detailed version of rules issued last February that allowed provincial governments to set up asset management firms to dispose of bad loans at a local level, but which did not distinguish whether the loans were made by nationwide lenders and local counterparts.

This move is the latest bid by Beijing to speed the clean-up of debt piles left by local government financing vehicles.

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