The Transition of Local Government Financing Platforms in China: Risks, Incentives, and Regulations

Changlin Luo ()

Annals of Economics and Finance, 2019, vol. 20, issue 1, 221-245

Abstract: In this paper, we build on the Dewatripont-Tirole (2012) model and argue that leverage caps can be used as an instrument to regulate the deeply indebted local government financing platforms in China. The key incentive scheme places different leverage caps on different types of platforms, and the control right shifts from the government to the debt holder if the cap is exceeded. We also propose different means to tackle a moderate macroeconomic shock, including ex ante adjustment of the cap, ex post debt rollover, and debt-toequity conversion. Direct governmental bailout is necessary when the shock is sufficiently large. In this case, we calculate the upper bound of the bailout that the central government is willing to provide, and show that it increases with the long-term prospect for the economy after the shock.

Date: 2019
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