Chinese Shadow Banking's Debt Pricing for Local Government Financing Vehicles
SHAO Xinjian, DONG Dingding, HONG Junjie
School of International Trade and Economics, University of International Business and Economics; Center for Quantitative Economics/School of Business, Jilin University
Summary:
Since the outbreak of the 2008 global financial crisis, Chinese local governments' debt and unique shadow banking practices have grown explosively. In contrast to the numerous studies that have explored the systematic macroeconomic risk introduced by these practices, this paper focuses on shadow banking pricing mechanisms for local government financing vehicles (LGFVs) from a micro perspective. Based on the detailed information about trust products issued by trust companies (i.e., a typical shadow banking practice in China), which were used to raise money for the LGFVs controlled by 178 Chinese city governments from 2010 to 2017, this paper demonstrates that the booming land market and investors' rigid payment expectations are two important cornerstones of Chinese shadow banking pricing references. More specifically, the findings include the following. (1) Prices are higher for city land and the credit spread for LGFVs' debt is lower; however, land auction failures will increase the cities' LGFV debt costs. (2) If the local governments' expenditure depends heavily on their land leases, which signals a high default risk for LGFVs, then shadow banking tends to require that these LGFVs pay a higher risk premium. (3) The shadow banking institutions' capacity for maintaining rigid payments to investors can help to reduce the LGVFs' financing costs. The relevant proxies for this capacity include capital adequacy ratios, leverage, and the trust asset scale. Furthermore, the governments' ownership of shadow banking institutions, especially the central government's controlling rights, can reinforce the expected rigid payments to investors. However, the introduction of a new budget act in 2014 weakened the positive relationship between investors' rigid payment expectations and local governments' property rights significantly. (4) Local governments control about half of the trust companies in China; however, this affiliation does not seem to intensify the adverse selection and moral hazard problems experienced by shadow banking institutions when the LGFVs select these linked banks to help raise money. In contrast, some evidence shows that affiliated shadow banking practices can help the LGFVs to decrease their credit spreads by mitigating the information asymmetry between the LGFVs and investors. This paper makes two potential contributions to the literature. First, we discuss the pricing mechanism of Chinese shadow banking for LGFVs' debt. The related literature can be divided into two strands: shadow banking and LGFVs' debt pricing. The first strand in the shadow banking literature focuses on the driving forces behind the rapid development of shadow banks and their consequences for monetary policies and systemic financial risk. The second strand of the shadow banking literature analyzes the determinants of Chinese municipal investment bonds' credit spread; however, these bonds are issued and traded in the public capital market. Municipal investment bonds have transparent offering procedures and strict information-disclosure obligations, which attract sophisticated institutional investors instead of retail investors. In contrast, shadow banks are inclined to seek regulatory arbitrage and escape regulation. In addition, shadow banking products attract more retail investors than institutional investors. Therefore, research on the impact of shadow banking prices on LGFVs' debt should be conducted. Second, this paper constructs a new framework for the analysis of LGFVs' debt pricing that includes three relevant factors and can provide a new extension to the literature. Many studies focus on the role of local governments' implicit guarantees; however, this paper is concerned with the implicit guarantee from shadow banks and their large shareholders (i.e., governments, especially the central government). The literature has ignored the role of land prices and the local governments' reliance on land sales in the LGFVs' debt pricing. This paper sheds light on these three factors' effects on debt pricing. Finally, the literature ignored local governments' special control rights for shadow banks. Local governments control about 44% of trust companies. We analyze the special relationship between local governments and shadow banks and its effect on the LGFVs' debt pricing. Our findings will extend the literature on shadow banking's operation mechanisms.
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