Summary:
Although government debt provides strong financial support for expanding government investments and responding to external economic shocks, it will also elevate the macro leverage ratio and pose potential financial and overall economic risks. Therefore, countries around the world prioritize the management of government debt. Specifically, China has made significant decisions and arrangements focusing on strengthening local government debt management and preventing and mitigating associated risks. Exploring the internal mechanism of local government debt formation is central to fending off and defusing local government debt risk. Historically, in the context of local government investment competition, local governments have leveraged their soft budget constraints to fuel a strong investment impulsion, but also lead to economic cycle fluctuations and impacting the stability of economic operation. Following the enactment of the Budget Law of the People's Republic of China in 1994, independent borrowing channels for local governments were restricted, effectively hardening their soft budget constraints and stabilizing local government investments. However, in response to the severe impact of the global financial crisis, the People's Bank of China and the former China Banking Regulation Commission issued the “Guiding Opinions on Further Strengthening Credit Structure Adjustment to Promote Stable and Rapid Economic Development” (No. 92 Document). This document relaxed credit regulations of local governments, allowing them to use local government financing vehicles (LGFVs) for off-budget borrowing, thereby rekindling local governments' investment impulse. Consequently, local governments could bypass institutional constraints, directly injecting their resources into LGFVs to improve their financial indicators or using their resources as guarantee to help these LGFVs finance, thereby rapidly expanding local government debt. By employing a difference-in-differences (DID) strategy and taking the sum of local state-owned industrial enterprise assets and land assets as the proxy variable of local government-controlled leverage resources, this paper builds a local government debt database and exploits the policy shock from credit deregulation of local governments in No. 92 Document in 2009 to study the impact of credit deregulation on local government debt. The results show that local governments with more resources used as leverage experienced more significant increases in government debt after the credit deregulation. On average, for every 1% increase in local government's leverage resources, the credit deregulation led to a 0.38% increase in local government debt. Mechanism analysis shows that, following credit deregulation, local governments supported LGFVs by providing equity and government subsidies, enhancing their financing capacity, helping them meet financial market requirements for financing and ultimately achieve the purpose of debt financing. From a debt structure perspective, credit deregulation allowed local governments to raise long-term debt with less rollover pressure and engage in bond financing activities. In terms of the usage of debt funds, relying on the credit deregulation, local governments not only repaid more existing debt but also increased new investments. Heterogeneity analysis finds that the effect of credit deregulation is more significant for local governments with more intervention on firms and economic growth pressure than others. Further findings suggest that credit deregulation enhanced the investment and financing functions of LGFVs and promoted transportation infrastructure construction. The contributions of this paper are as follows. First, this paper explores the internal mechanisms of local government debt expansion from a new perspective of credit deregulation. Existing research mainly focuses on fiscal and financial institutions, implicit government guarantees, and land finance, with few studies addressing the role of credit deregulation. This paper effectively supplements the literature on the causes of local government debt from this perspective. Second, existing literature has examined the impact of the four-trillion economic stimulus plan on the macroeconomy, local government behavior, corporate economic behavior, and credit allocation. This paper identifies an important but overlooked policy measure, No. 92 Document, in addition to the four-trillion economic stimulus plan, and examines its impact on local government debt, enriching the research in this field. Finally, this paper has important policy implication for local government debt risk management. The rapid expansion of local government debt is a significant source of systemic financial risk accumulation. However, the problem of local government debt has not yet been fundamentally governed. This paper, from the angle of credit deregulation, identifies a new budgetary soft constraint caused by off-budget credit deregulation. Therefore, managing local government debt requires attention to both on-budget and off-budget budgetary soft constraints.
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