From 2015 to 2018, China issued RMB 12.2 trillion in swap bonds, converting the outstanding debt of local government financing vehicles (LGFVs) into low-cost and long-maturity government bonds. Does this policy accelerate the market-oriented transformation of LGFVs, or does it hinder the reform by reinforcing bailout expectations?

This paper constructs a market-oriented transformation index across four dimensions (profitability, asset quality, debt risk, and government linkage) and measures the degree of marketization using the entropy-weighted TOPSIS method. The results show that debt swaps significantly promote the market-oriented transformation of LGFVs. Debt swaps entail two countervailing forces: a burden-reduction effect and a moral hazard effect. The burden-reduction effect lowers interest costs, improves the debt maturity structure, and eases liquidity constraints; these improvements, in turn, promote market-oriented transformation through the separation of government and enterprise credit and the mitigation of implicit debt risks. The moral hazard effect, by contrast, operates by fueling municipal construction investment, which in turn partially offsets the pro-transformation impact; strengthening audit oversight helps contain this channel. Comparing the two effects, the burden-reduction effect dominates the net outcome owing to its immediacy and directness, while the moral hazard effect has a limited adverse impact due to its lagged and indirect nature and the strengthening of central supervision. Heterogeneity analysis reveals that the swap effect is more pronounced among LGFVs with severer maturity mismatch, higher non-standard financing dependence, and lower credit ratings, as well as in cities with lower PPP financing dependence. These patterns delineate the boundary conditions under which the two mechanisms wax and wane.

The main implication of this paper is that whether the debt swap policy can accelerate LGFV reform and transformation hinges on constraining moral hazards while delivering burden-reduction gains. Looking ahead, the key to optimizing the debt swap policy lies in hardening budget constraints, so that debt swaps serve as a genuine catalyst for market-oriented LGFV operations rather than a trigger for renewed rounds of implicit debt expansion.