Understanding the local government debt in China

Abstract

The alarmingly high level of local government debt (LGD) in China threatens the financial stability, fiscal system, and sustainability of China's economic success. This study provides a comprehensive and in-depth understanding of the evolution and causes of LGD expansion by investigating institutional details, developing conceptual frameworks through economic and institutional lenses, and conducting empirical analyses. Under the economic framework, we find that the demand-side (issuing LGD to fill the widening fiscal deficits) driver explains little about the rapid expansion of LGD in China except in the Northeastern region, while the supply-side driver (banks' and the public's asset needs) and investments in real estate and local employment are positively associated with LGD. Under the institutional framework, rent-seeking behaviors (capitalizing on executive power and institutional frictions), instead of resolving institutional frictions (connecting agents of different political and economic natures to achieve state goals through market mechanisms) is a significant determinant of LGD. These findings suggest that anti-corruption and system design (or supervision and incentives) in addressing the boundary between local government officials and businesses is critical for financial stability and economic sustainability in China.