The financialization of local government debt in China and its risk transmission to commercial banks

Abstract

China's local government debt has risen sharply due to fiscal stimulus and decentralized financing. This debt expansion increases systemic risk as default risk is transmitted to banks, the primary holders of local debt. Using a Dynamic Stochastic General Equilibrium model incorporating local governments and banks, we show that local debt expansion increases banks' nonperforming loans and crowds out private credit, increasing bank risk-taking. We empirically examine 2010–2019 data on 350 Chinese banks and find that the level of local debt positively impacts bank risk-taking, especially low-capital, nonstate, and unlisted banks. The mechanisms operate through an increase in nonperforming loans due to default risk and a reduced regional repayment capacity due to crowded-out private credit. Our study reveals the impact of local debt on bank risk and financial stability in China. Policy implications include strengthening bank regulation and pursuing diversified government financing.