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| Local Government Debt, Corporate Default Risk, and Financial Market Stability |
| LIU Qiongzhi, LIAO Yunqi
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| Economics and Management School, Wuhan University |
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Abstract This paper studies how the expansion of Chinese local government debt affects corporate default risk and how this risk transmits to financial stability. The rapid accumulation of local government liabilities has raised concerns not only about fiscal sustainability but also about the interaction between local public balance sheets and corporate financing conditions. Local debt expansion can alter firms' borrowing costs and access to credit through higher market interest rates, credit crowding-out, weakened expectations about local fiscal capacity, and heterogeneous debt structures. Against this background, the paper addresses three questions: whether local government debt and default risk are linked in a non-linear manner; through which channels this relationship is transmitted and how it affects financial stability; and whether policy adjustments alter this relationship.
The theoretical framework integrates local government debt, corporate default risk, financial stability, and central regulatory intensity into a unified dynamic system. In a deterministic setting, the model allows for threshold switching, so that key parameters change across debt regimes. The stochastic extension adds diffusion terms and Poisson jumps to capture both continuous macro-financial disturbances and discrete institutional or policy events. Under optimal-control conditions, the paper derives state-contingent policy responses and expresses them as estimable reaction functions, yielding testable sign restrictions and interpretable thresholds.
The empirical analysis is based on a 2014–2022 firm–year panel. The data are compiled from WIND, CSMAR, the Bank of China Database (CBD), and official statistics from the National Bureau of Statistics and the Ministry of Finance. Local government debt is measured using publicly available indicators of explicit debt. Corporate default risk is measured using a Merton-type structural approach and further combined with liquidity, profitability (ROE), leverage, and market risk in a multi-factor specification to obtain a composite default risk score.Financial stability is measured from the banking side, the market side, and a PCA-based composite index. From the banking perspective, we use the loan-to-deposit ratio (LDR) to proxy liquidity resilience and reliance on funding sources. On the market side, a market instability index (MSI) is built from high-frequency returns in CSMAR by aggregating tail-risk indicators. The analysis also constructs a firm-level proxy for shadow-banking activity.
The baseline identification uses two-way fixed effects and explicitly tests for quadratic non-linearity between local government debt and corporate default risk. The paper reports a statistically significant quadratic relationship: at relatively low debt levels, higher local debt is associated with lower measured default risk, whereas as debt rises the marginal effect increases and eventually turns risk-increasing. To address potential endogeneity, the paper further implements a two-step fitted-value regression and a stepwise TWFE set-up. Regarding policy effects, it employs a multi-period DID design with multiple policy nodes to assess the stage-wise impact of different governance milestones.To study transmission to financial stability, the empirical strategy decomposes total effects into direct and indirect channels and conducts mediation analyses that incorporate both corporate default risk and shadow banking as parallel mechanisms.
The results indicate that both mediation paths are statistically significant. Extending the mechanism tests, the paper examines banking-side instability, market-side instability, and the PCA composite. Within the sample, local government debt is in general statistically negatively associated with the instability measures, but corporate default risk is positively and significantly related to banking-side instability, highlighting that the credit channel is most clearly reflected in bank liquidity vulnerability. Evidence on non-linearity is stronger for the banking-side measure.The results suggest that the effect of local government debt on corporate default risk is non-linear and exhibits threshold behavior. At relatively low debt levels, fiscal resources may help buffer risk, whereas beyond a critical level, rising financing costs, crowding-out effects, and worsening expectations are associated with higher default risk. Corporate default risk further acts as an important channel linking local government debt to financial instability. The multi-node DID evaluation further shows that average treatment effects differ across governance nodes. Taken together, these results imply that debt-risk assessment and policy design should take account of regime heterogeneity and coordinate actions across the debt, corporate and financial-system dimensions.
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Received: 04 June 2025
Published: 02 June 2026
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