Debt overhang, risk accumulation and institutional reform: beyond the developmental state


ZHANG Xiaojing;LIU Xueliang;WANG Jia


Macroeconomic Stability Research Group, Institute of Economics, Chinese Academy of Social Sciences;Macroeconomic Stability Research Group, Institute of Economics, Chinese Academy of Social Sciences;Macroeconomic Stability Research Group, Institute of Economics, Chinese Academy of Social Sciences


In the 40 years of reform and opening up, the Chinese economy has achieved great transformation and created a growth miracle. At the same time, it has accumulated many institutional and structural problems which are gradually turning into various types of risks. The debt overhang is an embodiment of these risks. This paper investigates China’s debt formation mechanism and argues that institutional factors are the root causes of the debt overhang. These institutional factors are the typical features of the developmental state, which can be summarized as the “structural advantage” of state-owned enterprises (SOEs), the development responsibility and soft budget constraints of local governments, the institutional preferences of financial institutions, and the “last resort” of the central government. On the one hand, this is the know-how for China’s growth catch-up; and on the other hand, it has negative impacts, especially the current debt overhang and risk accumulation. Based on a BGG model (Bernanke et al., 1999), we change the subject of selecting the optimal debt contract to maximize the profit from enterprise to bank, and introduce fiscal subsidies to state-owned enterprises to describe the institutional distortion. The model reveals the phenomenon as follows. When fiscal subsidies are introduced, optimal bank behavior is to allocate more credit to SOEs, increase the leverage ratio of SOEs and reduce the leverage ratio of private enterprises (PEs) at the steady state. Further simulation results show that: (1) the positive impact of fiscal subsidies (for example, increased subsidies to SOEs) increases the SOE leverage ratio, reduces the POE leverage ratio, and raises the total leverage ratio; (2) the banks’ subsidy delusions result in a higher SOE leverage ratio and total leverage ratio; and (3) the deleveraging policy can reduce the total leverage ratio, but more so for POEs than SOEs, thus exacerbating the credit misallocation. By integrating the newly published IMF Global Debt Database (Mbaye et al., 2018), World Bank Open Data, , the International Financial Statistics of the International Monetary Fund (IMF-IFS), credit to the non-financial sector dataset of the Bank for International Settlements (BIS) and other data, we construct a cross-border panel data of overall non-financial sector debt, namely, the debt of the government, private sector and SOE sector, and add other economic indicators such as growth and total factor productivity (TFP). The econometric results can be seen as follows. (1) Although many factors contribute to the macro leverage ratio in the economy, institutional factors measured by the proportion of government debt in total debt are more fundamental. (2) Cumulative debt generally has a negative effect on growth and TFP, and SOE debt has a more significantly negative effect on efficiency. (3) At the low-income stage, public sector debt, especially the government debt, has a relatively small negative impact on growth, yet at the high-income stage, there is a significant increase in the negative impact of public sector debt represented by the government and SOE leverage ratios. This indicates that it benefits the economy to allocate more credit resources to the private sector at the high-income stage. This fresh perspective indicates that as China enters the high-income stage, the developmental state featuring government intervention to facilitate growth catch-up requires urgent transformation. In the context of this paper, this transformation should be promoted as follows. (1) We should steadily push forward bankruptcy and restructuring, especially the exit mechanism of zombie enterprises, allow the market clearing mechanism play a decisive and mandatory role. (2) We should break the government bailout, harden budget constraints on SOEs and local governments, build a normative behavior pattern and incentive-constraint mechanism under a modern enterprise system and modern governance framework, and weaken the impulse to expand or catch-up. (3) We should establish the competitive neutrality rule in credit allocation to eliminate institutional discrimination of financial institutions. In short, we must move beyond the developmental state to establish a restricted and service-oriented government.


macro leverage ratio;debt risk;developmental state;institutional reform


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