OREANDA-NEWS. The Chinese central bank's recent landmark move to open the interbank bond market to certain foreign institutional investors will diversify the investor base and is likely to boost aggregate demand for local government bonds, says Fitch Ratings. As a result, the ongoing local government debt-for-bonds swap programme will benefit, and this will have potentially significant positive implications for local government credit.

The central bank on 14 July granted certain foreign institutional investors - including central banks, international financial institutions and sovereign wealth funds - the ability to invest in China's onshore interbank bond market. The onshore market is estimated at around CNY35.3trn (USD5.7trn) as of end-May 2015, according to the latest data from the central bank, with government bonds accounting for approximately 30% of the total outstanding.

Fitch believes these reforms will help facilitate the Ministry of Finance's (MoF) local government debt-for-bonds swap programme, which aims to lower the financing costs of local governments by converting high-cost debt into municipal bonds. The swap is significant for local government credit, and will significantly reduce liquidity risk by extending debt maturities and lowering financing costs. The MoF has initiated two rounds of swaps thus far, of CNY1trn apiece. Fitch expects another CNY1trn debt swap in 2015, bringing the total to CNY3trn.

The scale of the debt swap is such that demand from onshore investors may not be sufficient to meet the substantial increase in government bond supply. It is notable that a large proportion of local government bonds thus far are held by big commercial banks, and the take-up from other onshore investors has been relatively limited. Therefore, opening the interbank bond market to foreign investors will help to diversify the investor base for the local government bond market at a time when significant new supply is coming.

Investing in local government bonds on the onshore interbank market will allow for foreign institutional investors to gain quasi-sovereign mainland China exposure. Fitch maintains that Chinese local government bonds will continue to have an implicit sovereign guarantee.

The agency maintains though, that the process of increasing aggregate demand through foreign investment is likely to be gradual, and the market for local government bonds will continue to be dominated by onshore investors for the short to medium term.