Social Debt Overhang and Under-Consumption

Abstract

Debt owed to family and friends (DOFF) is a major component of household and entrepreneurial finance, particularly in developing countries. However, such informal finance carries with it an implicit covenant that can cause households to forgo durable-good consumption. This is because durable-good consumption can be perceived by the lender as a mis-use of funds and can result in social sanctions or debt recall. This paper uses China's Vehicle Scrappage Program (VSP) as a laboratory in which to study the causal link between DOFF and consumption. Merging survey data on Chinese household balance sheets with bid prices from China's online used-car markets, I find that DOFF on the balance sheet significantly reduces the probability that eligible households participate in the VSP and trade in their clunkers for new cars. Further, I find that this negative effect of DOFF on consumption is significantly mitigated by the presence of formal features such as a written contract, pre-determined debt repayment schedule, or positive interest rate. Together these results suggest that developing more formal channels for household finance can lead to increases in consumption. This is particularly important for developing countries such as China, where low consumption rates impede economic growth.