China's push for a municipal bond market could raise the pressure on provinces that are already struggling to fund massive debt, effectively creating a two-tier market dominated by the nation's major cities and financially strong regions.

The challenge for investors will be how to assess risks of different provinces in the world's third-largest bond market as the central government tries to withdraw its implicit guarantee of their debts and introduce market discipline.

The central government has decided to allow 10 cities and provinces to sell municipal bonds, an expansion of a pilot program with one significant change: The issuers will be responsible for repayments.

Those areas that have been given permission "don't need to raise money. The idea is for them to get their own rating, unlike loans where it is the sovereign's backing," said Daiwa Capital Markets Hong Kong Ltd economist Kevin Lai.

The governments that really need to raise money are those "in the red and in fiscally bad shape", he said.

The bonds would have to be rated and benchmarked against central government bonds. That is something the local ratings industry has not previously had to do.

"In the United States, leading up to the subprime (crisis) there was ratings inflation even though there were just three agencies. Imagine if all six local agencies in China were to compete for market share," said David Cui, an analyst with Bank of America-Merrill Lynch in the Hong Kong Special Administrative Region.

Currently, the Ministry of Finance sells bonds on behalf of local governments, an arrangement that left it responsible for repayments and gives even the weakest provinces an effective sovereign guarantee on their borrowing.

"In China, not only do you need to see reform allowing bonds as well as loans, you will also need to find investors other than banks to provide that funding. Those are the true reforms," said Viktor Hjort, head of the Hong Kong-based Asia fixed-income research at Morgan Stanley.

Official estimates put local government debt at about $3 trillion, equivalent to one-third of China's annual output, and private sector estimates are even higher.

Analysts welcomed the move to develop a domestic government bond market as the start of a long-term reform that will improve financing through the economy.

"Such a market is vital to reducing the risks to China's sovereign creditworthiness stemming from local governments' use of off-balance-sheet debt," Standard & Poor's Financial Services LLC analysts said in a report.

Guangdong and Shandong provinces are taking part in the pilot program and, with debt-to-GDP ratios in the teens, are unlikely to be worried about the need for disclosures. The test of the market will come when those with weaker positions have to tap the market on their own.

"The problem is whether the local governments will fully disclose their financial positions, particularly those with weak metrics. The higher the debt-to-GDP ratio, the greater the urgency for them to raise money," said Cui.

Much of that existing debt has been raised through local government financing vehicles, opaque entities that help regional authorities skirt the ban on municipal bonds. Beijing has tried to curtail the LGFVs, but the debt still needs to be serviced.

"As the central government has sought to limit bank loans to LGFVs, local governments have turned to issuing riskier, more expensive forms of debt," Debra Roane, a senior credit officer at Moody's Investors Service, said in a report.

"For example, about 8 percent of local related government debt is in trust products that are very short term and typically at interest rates higher than 9 percent."

Many local governments take out bank loans with terms shorter than the projects they are financing, resulting in a mismatch of maturities and income. The pilot tries to address that by requiring 10-year bonds to account for 30 percent of bond issues.