Instead, the swap will occur through bilateral negotiations between localities and individual creditors, the central bank, finance ministry, and bank regulator said in jointly issued guidelines obtained by Sina Finance.
The reduction in credit risk will mitigate the negative impact on banks' bottom lines, analysts said.
"Although banks' earnings will be hurt by the lower yields of bonds (relative to higher interest on loans), we believe the market will value banks' gain in risk reduction and liquidity over their loss in interest revenue," wrote Tao Wang, chief China economist at UBS.
China's finance ministry in March revealed a plan for provincial governments to refinance Rmb1tn in debt due to mature this year by issuing municipal bonds. The goal is to lower debt-servicing costs and extend maturities by converting short-term loans to long-term bonds.
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But the plan hit a snag last month when two provincial governments were forced to postpone bond auctions in the face of weak demand from banks, who balked at the low yields.
The latest rules say that the new local bonds must not carry yields of more than 30 per cent above prevailing yields on Chinese central government bonds with matching maturities. Chinese treasuries yield 3.2 to 3.5 per cent for maturities of one to 10 years.
The yield cap will not apply to the Rmb600bn in new local bonds that will be auctioned this year outside the debt swap program.
Beyond the issue of yields, market watchers were also concerned that Rmb1tn in new bonds, if sold in the open market, would suck liquidity out of China's financial system, choking off the flow of funds to other borrowers.
Under the latest guidelines local governments will negotiate directly with individual creditors to swap maturing loans for newly issued bonds. As such, no cash payments will change hands so liquidity will be unaffected.
Private placements will be used to refinance bank loans as well as maturing debt from non-bank financial institutions like trust companies, securities brokerages and insurers, the guidance said.
—Additional reporting by Ma Nan