Weakest link will determine success of muni reform

China's push for a municipal bond market could raise the pressure on provinces that are already struggling to fund massive debt, effectively creating a two-tier market dominated by the nation's major cities and financially strong regions.

The challenge for investors will be how to assess risks of different provinces in the world's third-largest bond market as the central government tries to withdraw its implicit guarantee of their debts and introduce market discipline.

Guangdong helps kick off new era

Local governments 'need to refinance debt'

The central government has decided to allow 10 cities and provinces to sell municipal bonds, an expansion of a pilot program with one significant change: The issuers will be responsible for repayments.

Those areas that have been given permission "don't need to raise money. The idea is for them to get their own rating, unlike loans where it is the sovereign's backing," said Daiwa Capital Markets Hong Kong Ltd economist Kevin Lai.

The governments that really need to raise money are those "in the red and in fiscally bad shape", he said.

The bonds would have to be rated and benchmarked against central government bonds. That is something the local ratings industry has not previously had to do.

"In the United States, leading up to the subprime (crisis) there was ratings inflation even though there were just three agencies. Imagine if all six local agencies in China were to compete for market share," said David Cui, an analyst with Bank of America-Merrill Lynch in the Hong Kong Special Administrative Region.

Currently, the Ministry of Finance sells bonds on behalf of local governments, an arrangement that left it responsible for repayments and gives even the weakest provinces an effective sovereign guarantee on their borrowing.

"In China, not only do you need to see reform allowing bonds as well as loans, you will also need to find investors other than banks to provide that funding. Those are the true reforms," said Viktor Hjort, head of the Hong Kong-based Asia fixed-income research at Morgan Stanley.