Bond issue could save local governments billions in interest

First, debt swap could enhance banks' capital adequacy by reducing the size of risk assets. Current local government debts are mainly in the form of bank loans to LGFVs, which have 100 percent risk weighting, but new provincial bonds will carry explicit provincial government guarantees and likely have 20 percent risk weighting. It is estimated that every 5 trillion yuan swapped from bank loans to local government bonds could boost banks' capital adequacy ratio by 0.6-0.7 percent.

Second, while the existing local government debts are loans and trust loans, new local government bonds are securities that can be more easily transacted at the market.

Furthermore, as bonds are considered investments and not included in the loan-to-deposit (LDR) ratio, unlike loans, holding bonds rather than loans will effectively lower banks' LDR, freeing more liquidity for lending. It is estimated that every 5 trillion yuan swapped could cut banking system LDR by around 4 percentage points.

Last but not least, as debt swap will increase local government debt sustainability, it will also reduce credit risk and the pace of NPL formation, improving overall asset quality of the banking system. This will be taken positively by investors who have been predominantly concerned about banks' asset quality and tail risk rather than their earnings.

In sum, local government debt swap can not only reduce local financing pressure and make lower local government debt more sustainable, but also benefit the banking system through multiple channels. Therefore, such debt swaps may be carried out in greater scale than the currently announced 1 trillion yuan, and to avoid pushing up yields, may be carried out through direct placement in negotiation with current debt holders such as banks.

The author is UBS chief economist. The views do not necessarily reflect those of China Daily.