How do financial variables impact public debt growth in China? An empirical study based on Markov regime-switching model

TL;DR

This study uses a Markov regime-switching model to analyze how financial variables like credit, house prices, and stock prices influence China's public debt growth, revealing regime-dependent effects and implications for fiscal policy.

Contribution

It introduces a TVTP-Markov regime-switching model to examine regime-specific impacts of financial variables on China's public debt growth, highlighting the importance of regime-aware policy adjustments.

Findings

Two regimes of public debt identified: surge and steady.

Financial variables impact debt growth differently across regimes.

Higher financial growth rates increase the likelihood of stable debt regimes.

Abstract

The deep financial turmoil in China caused by the COVID-19 pandemic has exacerbated fiscal shocks and soaring public debt levels, which raises concerns about the stability and sustainability of China's public debt growth in the future. This paper employs the Markov regime-switching model with time-varying transition probability (TVTP-MS) to investigate the growth pattern of China's public debt and the impact of financial variables such as credit, house prices and stock prices on the growth of public debt. We identify two distinct regimes of China's public debt, i.e., the surge regime with high growth rate and high volatility and the steady regime with low growth rate and low volatility. The main results are twofold. On the one hand, an increase in the growth rate of the financial variables helps to moderate the growth rate of public debt, whereas the effects differ between the two regimes. More specifically, the impacts of credit and house prices are significant in the surge regime, whereas stock prices affect public debt growth significantly in the steady regime. On the other hand, a higher growth rate of financial variables also increases the probability of public debt either staying in or switching to the steady regime. These findings highlight the necessity of aligning financial adjustments with the prevailing public debt regime when developing sustainable fiscal policies.