OREANDA-NEWS. Fitch Ratings says the Chinese central government's move to allow local governments to convert maturing bonds to municipal or provincial bonds with lower rates, and the granting of a new quota for local authorities to issue debt directly will mitigate the immediate risks related to their heavy debt burdens.

China's Ministry of Finance on 8 March 2015 gave approval to allow local governments to convert some of their maturing bonds with high borrowing costs to municipal or provincial bonds, which tend to have lower costs. The amount of debt that will be swapped is CNY1trn. Fitch expects the amount to increase in the near to medium term as the list of cities and provinces allowed to issue municipal bonds directly expands from the current 10.

Fitch expects the debt swap to lower the financing costs for local governments and extend their debt maturities, which will significantly reduce their liquidity risks. While the measure reduces immediate risks around the refinancing of the debt falling due in 2015, the impact on longer-term sustainability remains to be addressed. If the refinancing succeeds in achieving a materially lower cost of funding then local governments' overall financial profiles could be strengthened. The new measure will also introduce more oversight, transparency and discipline over debt issuance by local governments. Fitch notes that scale of local government indebtedness remains to be fully acknowledged.

The main beneficiaries of the debt swap are likely to be local government financing vehicles (LGFV), which have been used to skirt the ban on local governments issuing debt directly. Fitch expects the finance ministry to allocate the initial CNY1trn swap amount to regions where debt ratios are above the national average and pose risks to the broader economy. The swap from LGFV debt to municipal or provincial debt will also make it clearer who has ultimate responsibility for the debt. However, it remains unclear to what extent the new debt will carry an explicit or implicit sovereign guarantee.

The debt swap is part of the "close the back door, open the front door" approach that China's finance ministry has adopted. The "back door" is debt accumulated by local governments while the "front door" refers to new debt quotas granted to local governments. This year's quota, according to the Draft General Budget 2015 released on 5 March 2015, is CNY600bn. The quotas will encourage local governments to bring some of the debt held at LGFVs into their annual budgets and shift responsibility of servicing the debt to the local governments.