Beijing issued 10.5 billion yuan (1.7 billion U.S. dollars) in municipal government debt on Thursday, becoming the eighth Chinese region to issue their own local government bonds among 10 scheduled to do so.

The move is part of a trial launched by the Ministry of Finance in May to allow the 10 local governments to issue and repay bonds on their own in a bid to tackle a looming crisis in public finances and rein in the shadow banking sector that municipal authorities rely on for funding.

Beijing's fixed-rate municipal bonds were issued in three tranches on five, seven and 10-year terms.

The returns range from 4.00 to 4.24 percent, below market expectation of higher costs associated with loans local governments have secured in the past through financing vehicles or state-owned firms.

The funds raised will be used for affordable housing, transport infrastructure and environmental projects, according to Li Yingjin, head of the municipal finance bureau.

Authorities are now looking to build a municipal bond market for local governments to raise funds for infrastructure as the back-door financing widely used by local governments over the years has stoked fears that such unregulated activity may cause systemic risk for China's financial system.

Since the national budget law was issued in 1994, Chinese provincial and municipal governments have been forbidden to borrow any money, except through a separate pilot scheme launched in 2009 under which the central government issues bonds on their behalf and takes responsibility for repayment.

For years, local governments have circumvented this ban by setting up companies known as local government finance vehicles (LGFVs) that issue bonds or takes loans on behalf of the local authority.

A national audit released late last year showed that Chinese local governments had a debt obligation of 10.88 trillion yuan as of the end of June 2013. About 40 percent of the debt was raised through LGFVs.

The central government has tried to shut down bond sales and bank borrowing by LGFVs in recent years but that has only encouraged many of them to turn to the high-interest, short-maturity shadow banking sector to remain solvent.

Issuing bonds directly will allow local authorities to better manage their finances and borrow legitimately, said Ye Bingnan, an analyst with the Bank of China International (China) Limited.P Unlike in the past when the Ministry of Finance has repayed local governments' debts, Beijing not only issued the bonds itself but will also pay back the debts by itself.

"With the bond issuance, transparent information disclosure and strict market discipline are conducive to restricting overexpansion of financing activities from local governments," said Ye.

Independent bond issuance will be a major financing channel in the future for local governments, which will gradually reduce their reliance on LGFVs, he added.

Zhong Liang, an analyst with Standard & Poor's, predicted that the pilot bond issuance program will significantly change the way local governments borrow in the next three years.

CHALLENGES TO CREDIBILITY

As a burgeoning business, the local government bond issuance still faces many challenges.

The introduction of credit ratings is a distinctive feature of the bond issuance this time, but the eight regions that issued bonds in the past three months all got AAA ratings, the highest grade assigned to a debt product, regardless of their economic development level.

The rating is higher than the AA and AA+ normally assigned to the majority of bonds issued by the LGFVs, suggesting the issuer's strong ability to repay.

The underdeveloped northwestern Ningxia Hui Autonomous Region and the eastern Jiangxi Province were rated the same as booming Guangdong Province and Shanghai, which stirred doubts among investors as to the credibility of the ratings system, which is meant to allow investors to gauge risk.

"It's hard to judge the credibility of the rating as basic data, including the balance sheets of local governments, has not been released," said Zheng Chunrong, professor with the Shanghai University of Finance and Economics.

The ratings for the eight regions were offered by three independent ratings agencies: Shanghai Brilliance Credit Rating and Investors Service Co. Ltd, China Credit Rating Co. Ltd and Dagong Global Credit Rating Co. Ltd.

Meanwhile, repaying funds raised through municipal bonds will put local government budgets to the test. Without imposing proper fiscal discipline, it will be a challenge to put the issuer's fiscal strength in perspective, according to Lu Zhengwei, chief economist with Industrial Bank Co., Ltd.

Having proper budgetary constraints will be a determining factor when reviewing a local government's eligibility to issue municipal bonds, he added.

Minister of Finance Lou Jiwei said in early July that the Chinese government will expand the pilot bond issuance program.

At the same time, Lou called for local governments to make public their balance sheets and for a mechanism to be established to ensure local governments are held accountable for their debts.

The eight regions to have issued their own local government bonds so far are Guangdong, Shandong, Jiangsu, Jiangxi, Ningxia, Qingdao, Zhejiang and Beijing. Shenzhen and Shanghai are scheduled to make the move before the end of 2014.