Fiscal Decentralization, Local Government Behaviors and Polarization of Corporate Leverage Ratios, a paper co-authored by our school’s Professor Tan Xiaofen, and Zhang Wenjing, from the Hanqing Advanced Institute of Economics and Finance, Renmin University of China, was published in the 2021 6th Issue of Economic Research Journal.
Preventing and eliminating major risks, esp. financial risks, is one of the three uphill battles advanced emphatically by our government now. Deleveraging in a steady and orderly manner is an important approach to achieve this goal, and can help to promote the high-quality development of the Chinese economy. Since 2015, “deleveraging” has always been one of the core contents of supply-side structural reform. The priority of deleveraging has gradually shifted from macro and aggregate control to specific control targets by sector and debt type since 2018. In comparison with other countries, the leverage ratio of the Chinese government and households is relatively low, but that of enterprises is far higher than the average level in developed and other emerging economies during the same period. However, the asset-liability ratio of individual enterprises is falling overall, but the macro leverage ratio of enterprises is on the rise. In the meantime, there is a structural polarization in corporate leverage ratios. Especially after 2008, the leverage ratio of state-owned enterprises (SOEs) rose obviously, but that of their private peers fell. This paper seeks to investigate the causes of these phenomena from a fiscal perspective, and come up with corresponding policy implications.
Employing China’s industrial enterprise database in the period of 1998-2013, this paper investigates the effect of fiscal decentralization degree on the leverage ratio of enterprises and the heterogeneity thereof shown in different sectors, as well as the channel through which fiscal decentralization affects corporate leverage ratios to clarify the central government --> local government --> enterprise transmission chain and the influence path. The authors find that fiscal decentralization is notably correlated with the polarization of corporate leverage ratios. The more decentralized the local fiscal expenditures, the higher leverage ratio of SOEs, and the lower leverage ratio of non-SOEs. This conclusion still stands after a series of robustness tests. Furthermore, this paper proves that local government behaviors and changes in incentive direction constitute the mechanism by which fiscal decentralization influences the polarization of corporate leverage ratios. On the one hand, given a specific total amount of financial resources nationwide, local governments will exert influence of a certain degree on the financial system by various means so as to secure more financial resources for themselves, which in turn will affect the allocation of regional financial resources. On the other hand, local governments can also change the financing capability and environment of enterprises in different sectors by direct or indirect means such as affecting enterprises’ investment and financing decisions and distorting the prices of land for industrial use, which results in the polarization of corporate leverage ratios.
Based on the heterogeneity analysis of enterprises’ characteristics, the authors also find that: (1) In terms of political ties, the crowding out effect of fiscal decentralization is shown relatively lightly in non-SOEs which maintain relatively close political ties with local governments; (2) In terms of financing constraints, non-SOEs with lower dependence on external financing will be subject to less negative impact of fiscal decentralization on their leverage ratio. The way such decentralization polarizes the leverage ratio of enterprises of different ownership systems cannot be simply attributed to ownership system bias. We consider that this is probably owing more to the fact that local governments exploit the autonomy brought by fiscal decentralization and change the external financing environment and capability of enterprises by providing implicit guarantees and taking other actions, which reflects the issue of financialization of public finance. Based on further analysis of the economic consequences, given the differentiated behaviors of local governments, the efficiency of credit fund allocation is not improved effectively; enterprises with stronger profitability fail to obtain funds at a relatively low credit price, whereas those with weaker profitability obtain credit resources more easily. This leads to increasingly low added value brought by credit expansion of the same scale, and a rising macro leverage ratio of enterprises.
In comparison with existing literature, this paper contributes in the following three aspects:
Firstly, providing a new explanation for the structural characteristics of current leverage ratios of enterprises from a fiscal perspective. Existing literature may omit the endogenous factor of local government behaviors in explaining the polarization of corporate leverage ratios. But this paper approaches the issue from this angle to analyze the motifs behind local government behaviors, and finds that fiscal decentralization is a key incentive for such behaviors. Fiscal decentralization influences the financing capability and environment of individual enterprises through local government behaviors, and finally results in the crowding out of non-SOEs in terms of leverage ratio. This also provides another macro-level influencing factor for the theory of capital structure determination for enterprises.
Secondly, providing micro evidence for the spillover effect of Chinese-style decentralization. Existing literature mostly focuses on discussing the effect of fiscal decentralization on macroeconomic variables such as economic growth, government debt and fiscal expenditure structure. Very little looks into its effect on micro variables and transmission channel. Using the database about Chinese industrial enterprises above the designated scale (with the widest enterprise coverage by far) as the sample, this paper investigates the spillover effect of fiscal decentralization from a micro perspective, and clarifies the transmission path from macro variables to micro ones. As far as the scope of literature is concerned, this paper links Chinese-style decentralization with corporate leverage ratios for the first time, filling in the blank left by existing literature.
Thirdly, offering strong policy implications for the ongoing “structural deleveraging”, prevention and elimination of major financial risks in China. The conclusion reached herein shows that a structural imbalance in the leverage ratio of Chinese enterprises is a micro manifestation of the financialization of fiscal risks, and the close ties between public finance and financing have aggravated and complicated such an imbalance to a certain degree. Therefore, we shall take the approach of structural deleveraging, implement varied policies for different sectors, regulate central and local fiscal and taxation relationships, deepen the financial system reform, strengthen uniform financial regulation, reinforce the incentive & constraint mechanism for local governments, improve the corporate governance structure, and put in place rules and provisions for stabilizing macro leverage ratios, preventing and eliminating financial risks, and promoting coordination between fiscal and monetary policies.
The policy implications provided herein include: Firstly, improve and optimize the fiscal system. It is essential to straighten out the fiscal relationship between the central and local governments, and enhance the fiscal fund allocation efficiency. Secondly, establish a market-oriented local government debt management framework. It is important to grant local government certain room for proactive actions, and also establish a rigid constraint mechanism to prevent irregularities or excessive actions by local governments. Relevant measures include: improving the governance system, and enhancing the transparency of debt information; give play to the supervisory and constraining role of local people’s congresses; and establish a bankruptcy system for local governments. Thirdly, continuously optimize uniform financial regulation and macro-prudential management. It is necessary to maintain the independence of monetary policy, and avoid finance assuming fiscal functions. Moreover, it is advisable to increase rather than reduce good levers, continue to advance the market-driven reform of financial intermediaries, deepen the development of capital markets and boost fund allocation efficiency. Fourthly, improve the corporate governance structure, and intensify rigid constraints over corporate budgeting. High leverages of Chinese enterprises, especially SOEs, are interwoven with the faulty modern corporate governance structure. Therefore, it is essential to optimize the market-oriented incentive & constraint mechanism, continuously advance the SOE reform, improve the risk monitoring and early warning mechanism for corporate debts, scrap rigid payments and correct structural imbalances in accordance with the Guiding Opinions on Strengthening Asset-Liability Constraints on State-owned Enterprises.
The conclusion stated herein shall not be over-interpreted as a negation of the Chinese-style decentralization system, as we do not deny that a rising degree of local fiscal decentralization has positive incentives on and facilitates local economic and social development. However, we focus on whether such incentives have negative effects on micro-level economic participants, when transmitted to local governments but somehow distorted to a certain degree. This paper places emphasis on analyzing certain undesirable “moral hazards” or “rent-seeking” behaviors of local governments and officials after they gain economic autonomy brought by fiscal decentralization, such as influencing the operation of the financial market and behaviors of micro enterprises by multiple means. Therefore, during the implementation of fiscal decentralization, the Chinese-style decentralization system will play a more effective role in promoting the high-quality development of the Chinese economy and vitalizing micro economic participants, if the independence of the financial system’s operation can be maintained more strictly, uniform financial regulation strengthened, supervision and constraint of local governments stepped up to attenuate the financialization of public finance.
