China's 12 trillion yuan debt swap program is set to pressure banks' net interest margins while helping lenders conserve capital.

China announced plans to raise the ceiling on local government debt by 6 trillion yuan and allocate 800 billion yuan annually in local government special bonds over the next five years, according to a Nov. 8 statement from the Standing Committee of the National People's Congress. The additional debt will refinance the "hidden" debt accumulated by local government financing vehicles, with Beijing also guaranteeing repayment of 2 trillion yuan of hidden debt from shantytown redevelopment.

"We think the news has little material impact on banks as we've factored in the debt swap program to pressure banks' net interest margin but will save banks capital as the special bond investment will lower risk weights to 20%, compared to the 75% to 100% range for bank loans," wrote Iris Tan, senior equity analyst at Morningstar, in a Nov. 11 note. "Besides, banks' earnings will benefit from lower provision expenses after the swap."

Chinese banks face margin pressures as the People's Bank of China maintains an easing stance to support the world's second-largest economy. GDP expanded by 4.6% in the September quarter, below the government's 2024 economic growth target of about 5%. The debt swap program aims to repair local governments' balance sheets and stabilize the economy.

"By 2028, the scale of local hidden debt would decline to 2.3 trillion yuan from 14.3 trillion yuan," China's finance minister, Lan Bo'an, said on Nov. 8. Beijing expects local governments to save a total of 600 billion yuan in interest payments over the next five years.

Credit risk

Swapping high-risk local debt with government bonds "could effectively prevent credit risk events," Ting Lu, Nomura's chief China economist, wrote in a Nov. 8 note, adding that the move reduces local governments' interest burdens and avoids asset liquidations.

"In the longer term, austerity measures are still required to impose stricter budget constraints on local governments," Lu wrote, cautioning that "with this new round of debt swap, local governments may accumulate some new hidden debt in the coming years."

The Chinese government aims to mitigate risks from the prolonged property sector downturn by addressing local government debt, much of which is repaid through land sales — a key revenue source for local governments.

While the short-term financial burden is reduced, local government financing vehicles' total debt remains high, estimated between 45 trillion and 55 trillion yuan, indicating persistent repayment pressures, according to Morningstar's Tan.

Real estate, local government debt and small and medium-sized financial institutions were highlighted as primary concerns in a report by Premier Li Qiang in March.

As of Nov. 8, US$1 was equivalent to 7.17 Chinese yuan.