Local Government Bonds, Land Finance and Systematic Financial Risk

Li Yulong

doi:doi:10.16538/j.cnki.jfe.2019.09.008

Summary

Local government debt plays an important role in promoting economic development, but with the continuous expansion of the scale of local government debt, coupled with the opacity of financial and debt information, local debt risk may be directly transformed into financial risk. Therefore, the potential mechanism of local government debt risk inducing systemic financial risk is studied to strictly control local government debt and prevent it at present. It is of great practical significance to mitigate systemic financial risk.　　At present, the research on local government debt mainly focuses on the mechanism of local government debt to amplify economic fluctuations, while the potential mechanism of local government debt risk to induce systemic financial risk is relatively few. From the perspective of local government bonds and land finance, the innovation of this paper is to depict the Chinese elements such as the maturity of local government bonds, the opacity of debt and financial information, and to integrate local government debt, land finance and financial intermediaries into the framework of general equilibrium to analyze the potential mechanism of systemic financial risk induced by local debt risk.　　This study finds that when the economy is facing negative productivity shocks, the decline in total output will inhibit the land demand of households and enterprises, and the decline in land prices caused by the decline in demand will reduce the land-related fiscal revenue of local governments. On the one hand, the decline of land-related fiscal revenue will reduce government expenditure; on the other hand, it will increase the pressure on local governments to repay debt and the risk of debt, which will lead to the rise of bond interest rates and the decline of bond prices. Lower bond prices will affect the balance sheet of financial intermediaries, resulting in increased leverage and risk premium of financial intermediaries. Under the balance sheet constraints, financial intermediaries will shrink corporate credit, resulting in an increase in systemic financial risk. Rising interest rates and tightening credit will restrain enterprises’ investment and land demand, further reduce total output and land prices, increase the debt risk of local governments, and form a financial accelerator mechanism in the economy, which will lead to the mutual reinforcement of the debt risk and financial risk of local governments and form a vicious circle. In addition, when financial risk rises, the default risk of local government debt is lower. Based on the trade-off between risk and return, financial intermediaries will hold more local government bonds. Credit squeeze brought by asset allocation changes will further strengthen the financial accelerator mechanism and strengthen the interaction between debt risk and financial risk. Meanwhile, although extending the bond maturity can reduce the pressure of local governments to repay their debt in the short term, the longer the bond maturity is, the greater the financial shock and economic volatility caused by local government debt risk are.　　The paper indicates that: for resolving local government debt risk and reducing the probability of systemic risk, we firstly need to improve the local government bond market, diversify local government bond investors, and change the current situation dominated by commercial banks; secondly, we should strengthen budget constraints and control the scale of local government debt; thirdly, we should rationally design the maturity structure of local government bonds, strengthen the transparency of local government finance and debt information, and play the role of market constraints; finally, when financial risk rises, the central bank can adopt non-traditional monetary policy to intervene in the market, which can reduce financial risk and social welfare losses.