The Policy Paradox: Government Debt Servicing and Local Bank Risk Growth

TL;DR

This paper examines how government debt servicing policies in China shift debt from explicit to implicit forms, increasing risks for local banks, especially rural and high-concentration banks, with implications for systemic financial stability.

Contribution

It provides empirical evidence on the risk effects of debt servicing policies using a DID model on Chinese local banks from 2010 to 2023.

Findings

Government debt shifts from explicit to implicit forms under policies.

Local banks' risks increase, especially in rural and high-concentration banks.

Debt crowding out private credit weakens regional repayment capacity.

Abstract

The issue of local government debt is widely recognized as one of the "gray rhinos" affecting the stable development of China's economy. Government debt can transmit risks to local banks, which are among the primary holders of local debt, thereby triggering systemic financial risks. Consequently, exploring debt resolution pathways and evaluating the systematic effects of debt servicing policies has become critically important. This study employs panel data from 348 local commercial banks across 29 provincial-level administrative regions in China from 2010 to 2023, and constructs a difference-in-differences (DID) model to investigate the impact of the State Council's special supervision of debt servicing on local bank risks. The findings indicate that the government's debt servicing policy essentially represents a shift of government debt from explicit to implicit forms, significantly increasing the risks faced by local banks and producing outcomes contrary to the policy's original intent. This effect is particularly pronounced for rural commercial banks and banks with high customer concentration and fewer branches. Mechanism analysis reveals two key insights. First, local banks are heavily influenced by local government control; the government's debt servicing requires banks to support the government by purchasing government bonds and other financial instruments, which leads to a deterioration in asset quality and an expansion of risk exposure. Second, government debt crowds out private credit from local banks, weakening the region's repayment capacity and ultimately increasing bank risk. Our research uncovers the counterintuitive effects of government debt servicing and offers corresponding policy recommendations.