Chinese authorities have removed the last hurdles on a massive local government debt swap that should also jump start the growth of a market-driven municipal bond market.
"It's an important step forward for China," RiverFront Investment Group's director of international portfolio management Chris Konstantinos told CNBC. "It's proof the authorities are willing to take pro-active steps to try to deal with the problem of municipal debt," he said.
China's economy may be slowing, but the country is making progress on tackling a ticking fiscal time bomb by restructuring part of local municipalities' bank debts into bonds.
After a government audit last year uncovered a massive web of municipal debt in the shadow banking system, Chinese authorities have been preparing to bring some of that borrowing, officially of 10.8 trillion yuan ($1.74 trillion), back into the formal system.
The first step was to roll over one trillion yuan of local government debt owed to banks into municipal bonds. Having run into some resistance from the banks, the central government has now sweetened the terms of what is effectively a restructuring of the loans.
The implied yield, based on the band imposed by the authorities, will be juicy: between 0.80 to one percent over Chinese Government Bonds of the same maturity, according to a Moody's report published on Wednesday.
The higher yields on the municipal bonds remove the difference between what investors felt they should be paid and what municipalities wanted to pay, ANZ China rates strategist David Qu said in a note on Wednesday. "The arrangement allays the market's concerns regarding the debt swap," he said.
Now that the last hurdles have been cleared, the debt swap process is expected to kick into high gear.
The authorities are planning to complete the one trillion yuan bank loan for muni bond exchange by the end of August, according to an ANZ report citing the state-owned Xinhua news agency.
To avoid any potential glitches that could arise from public auctions, the authorities have decreed that municipalities will negotiate directly with their creditor banks to replace existing loans with private placement bonds.
In addition, the new municipal bonds will be eligible to be used as collateral by the banks to borrow from the central bank, the People's Bank of China (PBOC).
The scheme will be similar to European Central Bank's long-term refinancing operations (LTROs) and allow banks to take out cheap loans from the PBOC.
"It's very similar to Europe's LTRO program, basically creating a purchaser of last resort for troubled municipal loans," RiverFront Investment Group's Konstantinos said.
More to come
At the same time, slowing economic growth has prompted the central bank to aggressively cut interest rates. With the banks awash in liquidity, they should have no problem absorbing the wave of new issuance, analysts said.
Including new debt issuance of 600 billion yuan not included in the debt swap, local government bond issuance is expected to rise to 1.6 trillion yuan in 2015, according to ANZ's Qu. 2014, total issuance by government related entities came to just 2.2 trillion yuan.
The PBOC's rates cuts will also make the higher yield on municipal debt "relatively more attractive," said Qu.