If big State issuers squeeze LGFVs out of the primary bond market, it could also hit capital spending at a time when growth in China is already at quarter-century lows.

ANZ estimated that the total impact of proposed changes to the fiscal system would force local governments to deal with a funding gap worth 4.2 percent of China's $10 trillion economy.

Beijing says it has plans to deal with such problems.

"We have to steadily deleverage, but must also prevent the economy from falling off a cliff," said Finance Minister Lou Jiwei on Friday, adding local governments had an estimated 100 billion yuan of maturing debt this year.

He said local government funding would move from the LGFVs toward a municipal bond market, as in the United States.

But that does not help with existing debts, particularly those linked to projects without a steady income stream, and the municipal bond market is currently limited to a few top-tier regions and a quota of only 500 billion yuan for all of 2015.

To address this problem, the Ministry of Finance announced on Sunday that local governments would be permitted to swap up to 1 trillion yuan of high interest, maturing debt for low interest municipal or provincial bonds.

In the meantime, LGFVs like Anhui Bozhou Jianan Investment Holding Co Ltd, the financing vehicle for the Bozhou city government in Anhui province, one of China's poorest regions, will continue to struggle to service per capita debt that stood at about 3,100 yuan in 2013 from per capita revenue of just 1,635 yuan.

As a partial solution, the government is also pushing a public-private partnership model for local governments that would convert existing debt into corporate bonds.

But local governments fear they will get stuck with the debt raised for projects that might have been necessary but are not financially attractive, while the private sector cherry-picks the best.

"The construction projects were meant for us, but now the central government says it is not giving them to us," said a sceptical official at an LGFV in Bozhou, who declined to be named.

"The projects have been given to private investors, and you still want us to represent the government and manage the PPP?"