The Shadow of Government: Government Debt and Extralegal Shadow Banking in China

• In Event: State Capacity and Taxation

Abstract

Since China's four-trillion-Yuan stimulus program in 2008, local government debt has attracted extensive scholarly attention, especially regarding its impact on capital markets. Utilizing a novel dataset on illegal public fundraising in Chinese cities from 2012 to 2021-- an integral but understudied extralegal form of shadow banking-- the present study offers a rigorous empirical analysis of how Local Government Financing Vehicles (LGFV) debt impact financial risks. Our findings indicate a crowding-out mechanism where substantial issuances of government debt led to an increase in illegal fundraising, primarily due to the governmental overuse of formal financial channels. This dynamic is pronounced in scenarios where local fiscal conditions are constrained, evidenced by higher special transfer payments and interest rates of LGFV debt. Additionally, the study uncovers a mechanism of strategic sanction, where local fiscal constraints are linked to the intensified criminalization of extralegal fundraising, suggesting a deliberate policy maneuver to direct private capital towards local government financing instruments. These mechanisms collectively illuminate the complex relationship between government debt and local capital markets.

Authors

• Chao Ma, University of International Business and Economics

• Qiang Ruan

• Zhaoyang Sun, Tsinghua University

• Xiaohong Yu