Chinese banks will see their profit shrink under the 2 trillion renminbi (US$320 billion) debt swap plan with the local governments, but the central bank will cushion the blow by dangling a few perks, industry experts say.

Under the swap plan, provincial governments can refinance up to 2 trillion renminbi of debt due this year by issuing municipal bonds. This will reduce cost of servicing the debt and extend payment deadlines by converting debt into long-term bonds. Every one trillion renminbi swapped will mean a loss of 50 billion renminbi for banks. 

But the program comes with perks for lenders. For one, the municipal bonds can be used as collateral for when they obtain financing from the central bank. Municipal bonds are exempted from taxes. Moreover, risks associated with these debts are dramatically reduced via the program. The so-called 'risk weights' on such assets is expected to fall 20% from up to 300% previously, says Fitch Ratings.

From May 18, 14 local governments have issued a combined 491.9 billion yuan of bonds to replace debts, of which 84% were sold publicly, while 16% through private placement, according to CICC's research report.

Fitch expects resolution of China's debt problem will ultimately involve a migration of debt on to the sovereign balance sheet, and this has begun with the local government debt swap plan to assist with debt restructuring.

"The central government may not explicitly guarantee the local government bonds, but will prevent any default from happening through various ways such as refinancing the bonds by issuing new sets of bonds and instruct banks or state-owned enterprises to buy them," says Jonathan Cornish, head of Bank Ratings North Asia, Fitch Ratings.

"[The debt swap program] is a good development. Doubling the quota in such a short time shows how proactive Chinese government is to tackle the debt problems," says Hayden Briscoe, director of Asia-Pacific Fixed Income, AllianceBernstein.