Reform takes back seat as China drives muni debt swap

* New debt to be mostly by private placement with rates capped

* Strategy may undermine reforms to capital markets

By Nathaniel Taplin and Pete Sweeney

SHANGHAI, May 21 (Reuters) - China's plan to help local governments swap their debt for bonds might avert a funding crunch for the provinces and help its slowing economy, but it risks suspending reform of its dysfunctional credit markets just to push the debt problem down the road.

The swap is a response to a problem partly of Beijing's own making.

Concerned about explosive growth in the murky shadow banking sector, regulators cracked down on unconventional forms of financing, which many local government financing vehicles (LGFV) relied on to run up debts of more than $3 trillion dollars, much of it on ill-advised or vanity projects.

Beijing launched a new U.S.-style municipal bond market to supplant LGFV financing, a reform it hoped would bring market discipline to local borrowing and allocate capital to better effect, a perennial problem in China, where too much lending finds its way to inefficient state projects and entities.

But Chinese banks, already under pressure to clear up their bad loans, were reluctant to buy the bonds, which effectively would saddle them with poor local government assets at low rates of return.

To resolve the issue, Beijing agreed last week to let banks count the new municipal bonds as guaranteed collateral with the central bank, a circumvention of market mechanisms that makes the bonds less risky and increases the cash banks have available for lending.

That intervention appeared to break the logjam.

After a one-month delay to the first public auction under an initial 1 trillion yuan ($161 billion) debt-replacement programme, on Tuesday the heavily indebted Jiangsu province managed to sell 52 billion yuan of bonds at a price not much higher than the yields China pays on its sovereign bonds.

The Xinjiang Autonomous region conducted a similar auction on Thursday at similar prices, and its bonds were oversubscribed by nearly three times.

Some say letting local governments replace their debt in this fashion amounts to a back-door bailout, and that delaying reform of the credit markets risks crimping long-term growth, but economists say there are few attractive alternatives to the debt swap.

Local governments, as providers of key social services and investors in infrastructure, are drivers of domestic demand and investor confidence.

FISCAL SHOCK

Beijing has acknowledged the need for accelerated fiscal spending, but local governments struggling with debt payments have held off on investment.

Total government spending in the first quarter of 2015 fell 0.2 percent year on year, compared with 6.4 percent growth in 2014, Deutsche Bank analysts say.

"China's weak economic performance in 2015 is to a large extent driven by a fiscal shock," wrote Zhiwei Zhang, Chief China Economist at Deutsche Bank on Wednesday.

"LGFVs are responsible for most of the infrastructure investments, which account for 20 percent of the total investment in China. The crackdown on LGFV financing contributed to a fiscal contraction in Q1."

Propping up the local government debt market might avert an abrupt slowdown, but it undermines the effort to improve the efficiency and transparency of capital allocation.

After initial claims that the debt would be issued according to "market principles", new rules released on Friday will ensure that most of the swap is via private placements, with creditors and debtors directly negotiating prices away from prying eyes.

Following the new debt swap rules - and an additional document urging banks not to cut off financing for local government projects - yields on Chinese five-year sovereign debt also jumped sharply, suggesting investors may already be pricing in more stimulus from Beijing and a shifting of risk from the periphery to the centre as Beijing ramps up the central deficit.

"The central bank's easing policies will mainly push down one or two year rates," said Frances Cheung, Head of Rates Strategy Asia Ex-Japan at Societe Generale.

"If the market is expecting the government to do more stimulus, we could see the yield curve steepen slightly. Uncertainty around the five year is higher because that is the same duration as much of the local government debt, and there is indeed a lot of supply coming online."

Despite the government's aggressive steps to ensure the debt swap runs smoothly, many market participants still think more is needed - and that the government is walking a tightrope.

"The Jiangsu result has smoothed the way for other provinces, but the current 1 trillion yuan size of the swap is definitely too small to resolve the local government debt problem," said an official at a municipal finance bureau.

"We are still very cautious." ($1 = 6.2046 Chinese yuan renminbi) (Additional reporting by the Shanghai Newsroom and Kevin Yao in BEIJING; Editing by Will Waterman)