Weakest link will determine success of muni reform

Official estimates put local government debt at about $3 trillion, equivalent to one-third of China's annual output, and private sector estimates are even higher.

Analysts welcomed the move to develop a domestic government bond market as the start of a long-term reform that will improve financing through the economy.

"Such a market is vital to reducing the risks to China's sovereign creditworthiness stemming from local governments' use of off-balance-sheet debt," Standard & Poor's Financial Services LLC analysts said in a report.

Guangdong helps kick off new era

Local governments 'need to refinance debt'

Guangdong and Shandong provinces are taking part in the pilot program and, with debt-to-GDP ratios in the teens, are unlikely to be worried about the need for disclosures. The test of the market will come when those with weaker positions have to tap the market on their own.

"The problem is whether the local governments will fully disclose their financial positions, particularly those with weak metrics. The higher the debt-to-GDP ratio, the greater the urgency for them to raise money," said Cui.

Much of that existing debt has been raised through local government financing vehicles, opaque entities that help regional authorities skirt the ban on municipal bonds. Beijing has tried to curtail the LGFVs, but the debt still needs to be serviced.

"As the central government has sought to limit bank loans to LGFVs, local governments have turned to issuing riskier, more expensive forms of debt," Debra Roane, a senior credit officer at Moody's Investors Service, said in a report.

"For example, about 8 percent of local related government debt is in trust products that are very short term and typically at interest rates higher than 9 percent."

Many local governments take out bank loans with terms shorter than the projects they are financing, resulting in a mismatch of maturities and income. The pilot tries to address that by requiring 10-year bonds to account for 30 percent of bond issues.