Decentralization, Supervision, and Chinese Local Government Debt

• Published date: 01 July 2024
• Author: Chunfei Yang,Yongyou Li,Yu Qi,Yanzhe Xu
• Date: 01 July 2024
• DOI: http://doi.org/10.1111/cwe.12545

©2024 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 229–262, Vol. 32, No. 4, 2024 229

Decentralization, Supervision,

and Chinese Local Government Debt

Chunfei Yang, Yongyou Li, Yu Qi, Yanzhe Xu*

Abstract

Decentralization can alter the incentive structure of local governments and one outcome

of this is debt accumulation. Based on the “Province-Managing-County” pilot policy, a

fiscal decentralization reform devolving fiscal power from the prefecture-level city to the

county level, we assess the impact of fiscal decentralization on local government debt

using a difference-in-differences model with a unique county-level dataset from 2011 to

2019. According to the study findings, the “Province-Managing-County” reform resulted

in an average increase of 5.758 percent in the local government debt ratio across the

pilot counties. Mechanism analyses suggest that this may have arisen from changes

in the incentive structure, including external pressures from government assessments

and internal developmental needs for promotion, leading to a rise in expenditure

pressures on local governments. The role of supervision in mitigating the impact of fiscal

decentralization on debt growth was also demonstrated, indicating that an appropriate

supervision mechanism must be in place in conjunction with a decentralization policy.

Keywords: fiscal decentralization, incentive structure, local government debt, supervision

JEL codes: H63, H71, H72

I. Introduction

It is important to balance economic growth and debt expansion in macroeconomic policy.

Research on the scale of local government debt is relatively limited in comparison with

research on central government debt. Local government debt represents a crucial and

distinctive category of fiscal revenue and expenditure. It serves as a significant tool for

*Chunfei Yang, PhD Candidate, School of Economics and Management, Wuhan University, China. Email:

yangcf@whu.edu.cn; Yongyou Li, Professor, School of Economics, Shandong University, China. Email:

202376000009@sdu.edu.cn; Yu Qi (corresponding author), Professor, School of Public Finance and Taxation,

Zhongnan University of Economics and Law, China. Email: Z0004447@zuel.edu.cn; Yanzhe Xu, PhD

Candidate, School of Economics and Management, Wuhan University, China. Email: 15890189591@qq.com.

The authors are grateful for support from the National Natural Science Foundation of China (Nos. 71973118,

72173136, and 72103208), National Social Science Foundation of China (No. 20&ZD080), and the Fundamental

Research Funds for the Central Universities of Zhongnan University of Economics and Law (No. 2722024AK004).

Chunfei Yang et al. / 229–262, Vol. 32, No. 4, 2024

©2024 Institute of World Economics and Politics, Chinese Academy of Social Sciences

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fiscal resource allocation, exerting macroeconomic impacts on economic growth and

microeconomic influences on the consumption and investment behaviors of consumers

and businesses (Huang et al., 2020). However, it often involves soft budget constraints

and public pool issues that distort the behavior of local governments (Kornai, 1986;

Ostrom, 1990). In federal or fiscally decentralized countries, local government debt is

an important source of regional and even national fiscal and economic risk (Musgrave,

1983). According to data published by the OECD, as it stands, the debt of local

governments has exceeded that of the central government in some countries, including

Canada and Switzerland. China is another country with high local government debt.

Additionally, the COVID-19 crisis further increased local government debt. This raises

two important questions: what factors drive the increase in local government debt in a

country, and what policies can mitigate the unreasonable portions of this debt growth?

Local government debt occurs mostly in fiscally decentralized countries (Jiang and

Hu, 2016). The first and second generations of decentralization theories emphasized the

importance of giving local governments moderate fiscal power from the perspectives of

local government information advantages and the incentive effects of decentralization.

Some empirical studies have pointed out that decentralization can lead to changes in

local government fiscal expenditures and revenues (Ding et al., 2019; Yang, 2019),

aggravate fiscal burden on the economy (He, 2008; Wang et al., 2023), and increase

corruption (Malesky et al., 2014). This may bring about changes in the financing

structure of local governments, including their propensity to incur debt, which is related

to the incentives created by decentralization and the ability and willingness of local

governments to acquire debt. Several papers have discussed how decentralization affects

government debt and reached different conclusions. Shi et al. (2018) found that fiscal

decentralization was beneficial for increasing the capacity of local governments to

service debt, using US data as the sample. Baskaran (2010) argued that a high degree

of fiscal decentralization tended to significantly reduce public indebtedness in OECD

countries by improving government efficiency. But Guo et al. (2018, 2022) used Spanish

data and found that the anticipation of transfers under the institutional framework of

fiscal decentralization led to overborrowing ex ante. Are these situations present in

developing countries ? Some studies have used soft budget constraints to explain the

increased size and risk of debt in developing countries, especially those in transition

(Kornai, 1986; Boadway and Tremblay, 2006). However, soft budget constraints cannot

be the only explanation. In countries like China, local government debt continues

to grow even as budget constraint mechanisms improve. To understand the reasons

behind the increasing local government debt against the backdrop of decentralization,

it is therefore necessary to reveal the various channels through which decentralization

©2024 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Decentralization, Supervision, and Chinese Local Government Debt 231

influences local governments’ borrowing behavior. However, the existing literature is

insufficient in this aspect, particularly in addressing the endogenous problems in the

identification process and in identifying the influencing mechanisms.

There is an important question related to this. If decentralization leads to increased

local government debt, can improving supervision curb such excessive growth?

Answering this question requires a link between supervision and the debt resulting

from decentralization. In other words, whether supervision can mitigate the impact of

decentralization on local government debt is an empirical question requiring further

investigation.

We consider the fiscal decentralization reform implemented by Chinese provincial

governments, known as the “Province-Managing-County” (PMC) reform, as an

exogenous impact that created an opportunity to investigate the relationship between

decentralization and the size of local government debt.1 This paper also makes the

following contributions to the study of government debt.

First, this study focuses on the largest developing country, China, and examines

the impact of fiscal decentralization on grassroots government debt at the county level.

Most of the literature on fiscal decentralization focuses on federal economies, neglecting

countries undergoing decentralization reforms. It also often emphasizes the power

alignment between the central (or federal) government and the provincial (or state)

governments while neglecting the alignment between the provincial and grassroots

governments. In China, county governments are shouldering most of the expenditure

responsibility, and their debts have already exceeded those at the province and city

levels and have been increasing at an alarming rate. As a result, paying attention to

county-level government debt enables us to identify the mechanism of local government

debt expansion more precisely. Yet, owing to data limitations, articles investigating

county-level debt have often been based on estimated data (Huang et al., 2020). In this

paper, a set of accurate county-level government debt data is collected by applying to

the government, which mitigates the bias of the results based on the estimated data and

enhances the reliability of the findings.

Second, this paper includes supervision in the analysis framework of the

relationship between decentralization and government debt, which enriches the

literature on government supervision. Existing literature has mainly offered qualitative

discussions and lacks hard evidence on the effectiveness of supervision in addressing

1The reform of Province-Managing-County in China has two aspects: one is an administrative reform called

“County-Power-Expansion,” and the other is fiscal decentralization (Li et al., 2016). The PMC reform

described in this paper refers only to the fiscal reform, not the administrative reform.