Lenders encouraged to buy more local government bonds

China's 1 trillion yuan ($161 billion) local government bond plan is likely to get a new lease of life.

Designated State-owned banks may soon be able to swap loans for bonds issued by local governments in the debt exchange plan, the Economic Information Daily reported, citing sources close to the Ministry of Finance.

If this is the case, it would be a substantial change in the way the system operates. As it stands, local governments sell low-yield bonds to whatever banks who are interested in the bonds and then use the money raised to repay legacy debt to creditors, mainly banks.

The link established between a bank's previous holding of government debt and the new bonds it is required to purchase made the swap plan much easier to realize.

"The central bank could encourage commercial banks to buy bonds by pumping low-cost liquidity into them, and policy banks," said Huang Wentao, chief economist with China Securities Co Ltd. "The central bank could also include the bonds as collateral that the bank can use to secure re-lending from the central bank. Whatever the name you want to give the operation, it is in essence targeted re-lending."

The Finance Ministry in March announced a 1 trillion yuan debt-for-bonds swap plan that would save local governments up to 50 billion yuan in interest payments a year. But Jiangsu province delayed a 64.8 billion yuan bond issuance on April 23 after failing to agree with banks on the issuance price. This scenario could be repeated in other parts of China because banks stand to lose money on low-yielding government debt.

As the main providers of credit to local governments, State-owned banks hold 50.8 percent of the 10.88 trillion yuan debt as of June 2013, according to National Audit Office's data. These loans usually have an interest rate of between 7 to 8 percent－a premium asset for banks. Other loans are mainly owned by trusts, securities firms and insurers.

The report further said that the debts owned by non-bank financial institutions will not be included in the new plan. This means their debts will be repaid by money raised through local government loans issued on the open bond market.

Huang said the main issue remained the issuance price local governments would like to offer.