Local Crowding‐Out in China

• Published date: 01 December 2020
• DOI: http://doi.org/10.1111/jofi.12966
• Date: 01 December 2020

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 6 •DECEMBER 2020

Local Crowding-Out in China

YI HUANG, MARCO PAGANO, and UGO PANIZZA∗

ABSTRACT

In China, between 2006 and 2013, local public debt crowded out the investment of

private firms by tightening their funding constraints while leaving state-owned firms’

investment unaffected. We establish this result using a purpose-built data set for

Chinese local public debt. Private firms invest less in cities with more public debt,

with the reduction in investment larger for firms located farther from banks in other

cities or more dependent on external funding. Moreover,in cities where public debt is

high, private firms’ investment is more sensitive to internal cash flow.

INCHINA,LOCAL GOVERNMENT DEBT almost quadrupled from 5.8% to 22% of

GDP over the 2006 to 2013 period. This increase in local public debt was due

largely to the fiscal stimulus program carried out after 2008, worth US$590

billion, together with much-reduced reliance on central government debt and

transfers to local governments. Based on a novel, purpose-built database on

the public debt of prefecture-level Chinese cities from 2006 to 2013, we show

that the increase in local public debt crowded out private investment in the

∗Yi Huang is with the Graduate Institute Geneva and CEPR. Marco Pagano is with the Uni-

versity of Naples Federico II, CSEF, EIEF, CEPR, and ECGI. Ugo Panizza is with the Graduate

Institute Geneva and CEPR. We are grateful to Philippe Bacchetta; Chong-En Bai; Agnès Bé-

nassy Quéré; Markus Brunnermeier; Lin Chen; William Cong; Fabrizio Coricelli; Sudipto Das-

gupta; Peter Egger; Hanming Fang; Mariassunta Giannetti; Luigi Guiso; Harald Hau; Haizhou

Huang; Zhiguo He; Mathias Hoffmann; Bengt Holmström;Tullio Jappelli; Olivier Jeanne; Alessan-

dro Missale; Maury Obstfeld; Hélène Rey; Hong Ru; Hyun Shin; Zheng Michael Song; Paolo Surico;

Dragon Tang; Jaume Ventura; Paolo Volpin; Ernst-Ludwig von Thadden; Pengfei Wang; Fabrizio

Zilibotti; two anonimous referees; the Editor Wei Xiong; participants at the 2014 CEPR Interna-

tional Conference on Financial Market Reform and Regulation in China, the 2017 ABFER Confer-

ence in Singapore, the 9th EBC Network Conference on Financial Regulation, Bank Credit and Fi-

nancial Stability, the 13thCSEF-IGIER Symposium on Economics and Institutions, and the 2017

EFA Meeting; and seminar participants at the American University, Bank of England, Bank for In-

ternational Settlements, Beijing University,Chinese University of Hong Kong, Hong Kong Univer-

sity,International Monetary Fund, London Business School, Paris School of Economics, Princeton

University, Tinbergen Institute, Tsinghua University, University of California, San Diego, Uni-

versity of Lausanne, University of Milan, University of Pennsylvania, and University of Zurich

for insightful comments and suggestions. We thank Chong-En Bai, Haoyu Gao, Sibo Liu, Zhang

Qiong, Gewei Wang, Xueting Wen, Jianwei Xu, Li Zhang, and Ye Zhang for sharing their data

with us. We have read The Journal of Finance disclosure policy and have no conflicts of interest

to disclose.

Correspondence: Marco Pagano, Department of Economics and Statistics, University of Naples

Federico II, Via Cintia, 80126 Napoli, Italy; email: pagano56@gmail.com.

DOI: 10.1111/jofi.12966

© 2020 the American Finance Association

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2856 The Journal of Finance®

corresponding cities by inducing banks to tighten credit supply to local firms,

which led to a reallocation of capital from private firms to the local public

sector. We also show that the credit crunch spared state-owned enterprises

(SOEs). As private firms are the most dynamic component of the Chinese

economy, such reallocation of credit is likely to exacerbate the detrimental

effects of crowding-out on growth, with public debt issuance reducing not only

firm investment, but also its efficient allocation.

The Chinese credit market provides an ideal setting to test this local

crowding-out hypothesis because of its geographical segmentation. In an in-

tegrated, nationwide market, there would be no reason to expect local govern-

ment debt to affect local investment—its issuance would trigger an increase in

local interest rates, drawing capital from the rest of the country and possibly

increasing local saving, but eventually, the greater stock of local public debt

would be held by investors throughout the country and hence any crowding-

out of private investment would occur at the national level. If the credit market

is geographically segmented, however, the imbalance and its impact on invest-

ment would be localized. In China, debt issuance by local governments ends

up being absorbed by local banks and, owing to interest rate ceilings, does not

trigger an increase in local interest rates and thus a local savings response.

Not all borrowers are expected to be affected equally, however. If banks max-

imize profits, they will tighten credit more to riskier borrowers, such as those

with less collateral to pledge and higher monitoring costs. If, in contrast, banks

allocate credit preferentially to politically connected borrowers, such as state-

owned firms, then firms with no political ins will be rationed more strongly. In

China, these two scenarios may well coincide, as state-owned firms are often

assisted by implicit or explicit government guarantees.

We provide complementary firm-level evidence on this local crowding-out

hypothesis. We start by showing that the investment of private manufacturing

firms is negatively correlated with local government debt, while this is not the

case for the investment of state-owned manufacturers. We next employ three

different approaches to assess whether this relationship is causal and to iden-

tify the mechanism through which local government debt affects investment.

Importantly, each of these approaches exploits a source of within-city firm het-

erogeneity, which allows us to control for city-year-level correlations between

investment and public debt and thereby mitigate concerns about spurious cor-

relation and reverse causality between these variables.

The first of these three approaches exploits variation in the location of firms

within their respective cities. Firms close to neighboring cities—and to banks

located in those cities—should be able to access credit outside their local mar-

ket and hence should be less exposed to crowding-out due to debt issuance

in their own city. Consistent with this view, we find that the investment of

these firms drops less in response to government debt issuance in their city.

Moreover, what appears to drive this result is firms’ distance from the clos-

est banks in nearby cities, rather than their distance from neighboring cities’

borders. This finding suggests that crowding-out is due specifically to financ-

ing, rather than more generally to firms’ access to other inputs available in

Local Crowding-Out in China 2857

nearby cities. As these regressions include city-year fixed effects, they rule out

the most obvious problems related to omitted variables and reverse causality

between city-level investment and public debt issuance.

The second approach exploits firm-level variation in firms’ funding needs due

to technological differences between industries. Specifically, we test whether

local government debt has a disproportionate effect on the investment of firms

whose technology requires more external funding. This approach, akin to that

of Rajan and Zingales (1998), allows us to investigate whether government

debt affects investment by tightening credit constraints. It also further miti-

gates endogeneity problems by permitting the inclusion of city-year, industry-

year, and industry-city fixed effects. We find that local government debt is as-

sociated with lower investment by more financially dependent private firms

but not by state-owned firms.

Our third approach tests whether local government debt affects the sensi-

tivity of firms’ investment to internally generated funds, which is taken to be

an indicator of the severity of firms’ financing constraints. This approach re-

quires no assumptions about the external financing requirements of firms in

different industries. We find that local government debt increases the sensi-

tivity of investment to internally generated funds for private firms but not

for state-owned firms, and for small firms but not large firms. To address the

weaknesses of exogenous sample separation rules based on firm characteris-

tics, we also rely on a switching regression model with endogenous sample

separation, where firms’ investment sensitivities are estimated jointly with

their likelihood of being credit-constrained. Consistent with the previous re-

sults, local government debt affects cash-flow investment sensitivity for credit-

constrained firms but not for unconstrained firms, with credit constraints be-

ing significantly more likely to bind for private than for state-owned firms and

for small than for large firms.

This paper is related to the vast literature on the effect of government debt

on investment and growth. While there is evidence of a negative correlation

between public debt and growth (see Reinhart and Rogoff (2011)), establishing

causality has been more difficult, as international comparisons are plagued

by problems of reverse causality, omitted variables, and limited degrees of

freedom.1As noted above, the geographical segmentation and interest rate

ceilings of China’s credit market enable us to identify a local crowding-out

channel whereby government debt reduces investment by tightening financing

constraints on private firms. As such, our work also relates to the corporate

finance literature on investment and credit constraints.

We also contribute to research on the effects of the Chinese fiscal stimulus in

the wake of the global financial crisis (see Deng et al. (2014), Ouyang and Peng

(2015), and Wen and Wu (2019), among others). The stimulus plan appears to

have exacerbated the fact that in China, high-productivity private firms tend

to fund their investment mainly out of internal savings, while low-productivity

1Panizza and Presbitero (2014) survey the literature on debt and growth with particular em-

phasis on causality and measurement issues.