More importantly, provincial bonds are meant to be used strictly for repaying maturing bank loans or other similar debt stock, which means no additional debt will be created, hence no extra liquidity will be needed from the central bank.

Given the limited size of the bond market (gross issuance of local government and enterprise bonds totalled 4 trillion yuan in 2014 and net issuance amounted to 556 billion yuan), issuance of another 1 trillion yuan in local bonds in the market may push up yields across the board.

The central bank may need to provide sufficient liquidity to keep interbank market rates low at the time of bond issuance and avoid an unnecessary spike in interest rates, and adjust controls on bank lending accordingly after the debt swap to prevent unintended over-expansion of credit. This would require close cooperation and coordination between the central bank and other relevant parties.

Local debt swap is the right step in restructuring local debt and this should be done on a much larger scale. It is estimated that total local government debt reached 21 trillion yuan by the end of last year, of which at least 11 trillion yuan will be deemed direct responsibility of local governments (the rest could be classified as corporate debt), with average interest rates of 6.5-7 percent.

Current interest rates of LGFV bonds are around 4.7 percent for 3-year and 5-year durations. Therefore, replacing 10 trillion yuan old debt with new bonds could save annual interest payments by up to 300 billion yuan. In addition, extending the maturity from 3-5 years to 7.15 years could reduce current principal payment by 800-1,000 billion yuan per year.

Given that local governments are facing increasing pressure to service debt due to the ongoing property downturn and slowdown in tax revenue, lowering debt service costs by replacing old and high cost debt with new bonds at lower interest cost and longer maturity at a large scale would bring much needed relief to local finance, improve debt sustainability, and reduce the pace of NPL formation.

Banks to benefit from debt swap

Large scale debt swap will benefit banks in more than one way. At the moment there is much concern among investors on whether banks and other current local government debt holders will be pressured to accept lower-yielding bonds and lose on interest revenue. Despite such a likely loss in interest revenue, banks will benefit from the debt swap through the lowering of risk assets, increasing capital adequacy ratio, improving loanable liquidity and improving asset quality.