Local Government Debt and Corporate Investment Behavior in China: Real versus Financial Investment

Abstract

The ongoing expansion of local government debt (LGD) in China constitutes a significant impediment to economic development, while the existing literature predominantly concentrates on macro-level investigations, neglecting the repercussions of government debt expansion on firms. Firms serve as fundamental constituents of the real economy, and the suitability of their investment structure is a pivotal determinant of their robust development. Therefore, it is of great significance to investigate whether the investment structure of non-financial firms will undergo deviations attributable to the expansion of local government debt. This paper uses a two-way fixed-effects model to examine the causal effect of local government debt on firms’ investment structures. The quasi-natural experiment using the DID model with “Document 43” issued by China on local government debt governance as a policy shock can be a good endogeneity test. It is found that local government debt exacerbates the trend of “exit from real to virtual” of enterprises, leading to a bias towards financial investment in the investment structure of enterprises, and this result is still robust after a series of robustness tests. A heterogeneity analysis shows that the impact of LGD on the investment structure of firms mainly exists in non-state-owned firms, small-scale firms, and firms with high financing constraints. Overall, this study provides new evidence on how the government influences the investment structure of Chinese firms through the perspective of LGD, which helps firms to prevent and cope with the risks associated with LGD. Furthermore, it offers practical references and policy insights for government initiatives in the realm of local debt governance.