Local Government Debt and Regional Competition in China

The GDP tournament among local governments plays a crucial role in supporting China's growth miracle. Investment-driven economic growth has led to a surge in local government debt in the past decade. To understand the relationship between local government debt and regional competition in GDP growth, we build a simple decision model of local governors based on prospect theory. Using a comprehensive data set of prefectural-level government debt, our empirical results confirm the theoretical prediction that regional competition in GDP growth does affect the dynamics of local government debt. The effect presents an asymmetric pattern, in the sense that a local government with GDP growth falling behind its competitors tends to issue debt more aggressively, while the effect is insignificant for local governments with GDP growth ahead of their competitors'. Furthermore, we find that the regulatory policy implemented at the end of 2015 that places a ceiling on local government debt effectively dampens the impact of regional competition on local government debt. However, local government investment remains strongly responsive to the regional GDP growth gap, probably because of alternative financial channels such as land financing. The above finding indicates that the debt regulatory policy cannot largely prevent local governments from implementing a pro-growth strategy induced by regional competition.