China's Shandong province will issue a total of 13.7 billion yuan ($2.21 billion) of five-, seven- and 10-year municipal bonds on July 11.

The proceeds will be used to support public projects such as rebuilding of shanty housing and construction of new roads, the Shandong government said in its bond prospectus published late on Friday on the website for China major bond issues (www.chinabond.com.cn).

Shandong province is the second local government to issue municipal bonds after Guangdong.

The Mini stry of Finance said in late May that 10 local governments had been given quotas to issue a combined 109.2 billion yuan ($17.52 billion) worth of municipal bonds this year.

Earlier, the finance ministry announced China's watershed move of allowing the 10 local governments issue and redeem their own bonds in an experiment to straighten out messy state budgets, and start the clean-up of its $3 trillion public debt problem.

Governments in Shanghai, Zhejiang, Guangdong, Shenzhen, Jiangsu, Shandong, Beijing , Qingdao , Ningxia and Jiangxi will be part of a pilot plan that effectively creates China's first-ever municipal bond market.

Guangdong leads China's municipal bond issuing pilot

South China's Guangdong province has issued the first municipal bond in China, kicking off a more transparent pilot program designed to curb growing debt risks.

Guangdong became the first among 10 regions approved by the State Council, or China's cabinet, to issue their own local government bonds totaling 109.2 billion yuan ($17.7 billion).

Guangdong on Monday raised 14.8 billion yuan through the issue, with 40, 30 and another 30 percent maturing in five, seven and 10 years respectively.

The returns range from 3.84 to 4.05 percent, below market expectation of higher costs associated with loans local governments have secured in the past through financing vehicles or State-owned firms.

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 unregulated financing activities may cause systemic risk for China's financial system.

Chinese law has prohibited local governments from borrowing directly from any party. Under a small pilot in operation since 2009, the Mini stry of Finance has issued bonds on their behalf and pledged to use fiscal revenues to repay the debts.

Some analysts have argued that for municipal bonds to really become the mainstream source of funding for local governments, authorities should expedite the process of revising the current legislation banning local government from borrowing.

"The central government cannot, even if it wants to, grant local governments the freedom to issue muni bonds at their own discretion until the new Budget Law is passed by parliament," said three strategists with Bank of America Merrill Lynch in a recent research note.

The move to gradually allow local governments to raise funds from the bond market on their own is part of an effort to deflate risks stemming from reckless financing in the shadow banking sector, where local governments have borrowed through entities created for financing purposes to fund projects that may not generate enough cash flow to pay back interest.

The growing amount of obligations local governments have taken on in the years after the global financial crisis are deemed as one of the major risks facing the world's second-largest economy. A national audi t released late last year showed that local governments in China had a debt obligation of 10.88 trillion yuan by the end of June 2013.

The funds local governments have indirectly borrowed through other proxies tend to have short maturities and analysts fear that such reckless borrowing will be unsustainable in the long run as short-term loans are used to fund long-term projects.

At 1.02 trillion yuan as of the end of June 2013, Guangdong has the second-largest debt obligation among all provinces and municipalities in China.

The bond issued on Monday will be traded on the interbank market and the country's securities exchanges in Shanghai and Shenzhen. It has also received a rating of AAA -- the highest grade assigned to a debt product -- from domestic credit agency Shanghai Brilliance Credit Rating & Investors Service Co Ltd.

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

Yet traders have advised caution over the quality of upcoming issuance by other provinces under the pilot. "The top rating assigned to Guangdong doesn't mean others in the pilot will enjoy the same rating," said a Shanghai-based trader.

"Now the central government's implicit guarantee to repay has diminished, the rating will depend largely on local government's finances."

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.

In the face of rising debt load, some local authorities in China have imposed limits on the amount of debt they can take since last year. East China's Anhui province said it cannot expand its debt outstanding if its current debt level exceeds the province's fiscal revenue and the amount of debt due accounts for 20 percent of its fiscal revenue in the following year.

Ma Jun, an economist with the People's Bank of China, the central bank, said local governments have to take concrete steps to get their own fiscal house in order.

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