Qing Yang, Professor, School of Economics, Fudan University

Director, Research Center for Assets Evaluation of Fudan University

Abstract:

China’s local gov debt and the rise of shadow banking have gained worldwide attention since 2008 financial crisis. With the non-bank financial system expanding, it’s believed that large part of China’s shadow banking came into Local Gov Financing Vehicles (LGFVs) and industries where bank loan was limited, for example, the real estate industry; or circulated within the financial system for arbitrage.

At the same time, China’s local governments were confronted with the dilemma of repaying the soon-to-expire debt while investing to promote economic growth after 4 Trillion Fiscal Stimulus, however, they can’t directly borrow from banks or issue municipal bonds according to China’s Budget Act since 1994. The expanding and different forms of shadow banking provide new financing channels for them. 

How did China’s local gov debt facilitate the rise of shadow banking? Studying the links and mechanisms between local gov debt and shadow banking helps to understand these problems, and provide new evidence on how financial development affect economic growth and financing constraints in an emerging market dominated by gov.

The study identifies the local gov debt’s positive effect on shadow banking, varied with regions, time and different forms of shadow banking. It finds that the effects are more significant in western provinces, and that there appears to be a substitution effect between WMP and trust loan with the evolution of regulatory policy.

It also evidences two main explanations about the origin of China’s shadow banking, namely, the explanation of Local Gov’s Pressure to Repay Debt from the demand side, and the explanation of Regulatory Arbitrage from the supply side. What’s more, the study explores the link between shadow banking and local gov debt from the perspective of financial constraint.