The Crowding-In Effects of Local Government Debt in China

Abstract:We study how changes in the composition of Chinese local government debt influenced bank risk taking, credit allocation, and local productivity. Using confidential loan-level data and a difference-in-difference identification approach, we show that a debt-to-bond swap program for local governments implemented in 2015 significantly increasedbank risk taking through a risk-weighting channel under Basel III capital regulations.The debt swap program converted bank holdings of municipal corporate debt to local government bonds, reducing banks’ risk-weighted assets. Banks responded by lowering credit spreads on loans to privately owned firms (POEs) relative to state-owned enter-prises (SOEs), with significantly larger reductions in POE credit spreads in provinces with more outstanding government debt. Furthermore, the credit reallocation toward moreproductive private firms—a crowding-in effect of the debt swap—significantly raised local productivity.