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High Local Debt and High Financing Costs Constraints to Growth, Write Economists at Shanghai University of Finance and Economics
Title: Financial System Efficiency and its Links to Local Government Debt (金融体系效率与地方政府债务的联动影响)
Journal: Economic Research (经济研究)
Authors: Tian Guoqiang, Shanghai University of Finance and Economics (田国强), Zhao Xuxia, Shanghai University of Finance and Economics (赵旭霞)
Publication Date: August 2019
China’s central government has identified two major constraints to economic growth: 1) high local government debt and 2) difficulty for private enterprises to obtain financing. Tian and Zhao write that these problems have largely been addressed by policymakers and academics as separate issues, but their research suggests the two are highly correlated.
A major contributing factor to both problems is that Chinese financial institutions routinely practice severe interbank lending discrimination, with large banks able to obtain much lower rates through interbank lending than small- and medium-sized banks, which are the primary lenders to the private sector.
(Note: Tian and Zhao cite literature to explain why small- and medium-sized banks cannot easily obtain the same interbank lending rates as large banks. Reasons include: perceptions that entities that receive loans from large banks, such as state-owned enterprises, are safer investments because they enjoy political protections and/or are considered too big to fail; corruption and political patronage, and; shadow banking. Many private-sector firms turn to unregulated, off-the-books markets to obtain financing, making them potentially more risky investments because they may have higher debt exposure than their small- and medium-sized banking lenders realize.)
Local government officials are under intense political pressure to promote economic growth. In the short term, this is easiest to do through debt financing by subsidizing large, inefficient state-owned enterprises.
This has a dangerous cyclical effect, however. When local officials and state-owned enterprises (SOEs) turn to large banks for financing, this crowds out capital that would have been available to small- and medium-sized banks via interbank lending, resulting in frequent liquidity issues for smaller banks (and contributing to the private sector’s higher cost-to-borrow). The authors write that, for every one percent decline in financial operations efficiency (taking into account degrees of interbank lending discrimination), there is a corresponding 2.01 percent increase in local government debt and a 0.52 percent welfare loss to the entire economy.
To address high government debt and to make it easier for the private sector to obtain financing, the authors argue that policymakers should consider changes to interbank lending policies and the evaluation and promotion system for local government officials.
Note: Tian Guoqiang is a recipient of the Sun Yefang award, one of the highest economics honors in China. He is honorary dean of the Shanghai University of Finance and Economics and also teaches at Texas A&M University and Hong Kong University of Science and Technology. The government-affiliated China Academy of Social Sciences (CASS) publishes the Economic Research Journal.