China is imposing a $160bn municipal-bonds-for-debt swap on banks in a bid to shift some of the financing costs of cash-strapped local governments back to lenders, local media reported on Wednesday.

Ballooning debts at municipalities — estimated at $2.9bn by mid-2013 as local governments engaged in a frenzy of debt-fuelled infrastructure building — have emerged as one of the fault lines in China’s economy as growth slows and property prices dip.

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Beijing is seeking to limit debt servicing costs for municipalities by obliging banks to switch out loans, which frequently carry interest rates over 7 per cent, in return for municipal bonds with a capped coupon.

The swap will crimp banks’ income, but the central bank will cushion the blow by accepting municipal bonds as collateral for key lending facilities through which it provides liquidity to commercial lenders.

The debt swap will also avoid public bond auctions that had threatened to drain Rmb1tn ($160bn) in liquidity from the financial system and expose lacklustre demand for municipal paper.

Instead, the swap will occur through bilateral negotiations between localities and individual creditors, the central bank, finance ministry, and bank regulator said in jointly issued guidelines obtained by Sina Finance.

The reduction in credit risk will mitigate the negative impact on banks’ bottom lines, analysts said.

“Although banks’ earnings will be hurt by the lower yields of bonds (relative to higher interest on loans), we believe the market will value banks’ gain in risk reduction and liquidity over their loss in interest revenue,” wrote Tao Wang, chief China economist at UBS.

China’s finance ministry in March revealed a plan for provincial governments to refinance Rmb1tn in debt due to mature this year by issuing municipal bonds. The goal is to lower debt-servicing costs and extend maturities by converting short-term loans to long-term bonds.

But the plan hit a snag last month when two provincial governments were forced to postpone bond auctions in the face of weak demand from banks, who balked at the low yields.

The latest rules say that the new local bonds must not carry yields of more than 30 per cent above prevailing yields on Chinese central government bonds with matching maturities. Chinese treasuries yield 3.2 to 3.5 per cent for maturities of one to 10 years.

The yield cap will not apply to the Rmb600bn in new local bonds that will be auctioned this year outside the debt swap program.

Beyond the issue of yields, market watchers were also concerned that Rmb1tn in new bonds, if sold in the open market, would suck liquidity out of China’s financial system, choking off the flow of funds to other borrowers.

Under the latest guidelines local governments will negotiate directly with individual creditors to swap maturing loans for newly issued bonds. As such, no cash payments will change hands so liquidity will be unaffected.

Private placements will be used to refinance bank loans as well as maturing debt from non-bank financial institutions like trust companies, securities brokerages and insurers, the guidance said.