Debt Management and Strategic Interactions in Top-down Bureaucracy: Evidence from China

Strategic interactions between political agents shape the allocation of public resources in various economies. Based on a comprehensive dataset, we empirically investigate how the ceiling on local government debt is allocated to prefectural cities in China after its debt management reform. We show that the distributional outcome of the debt ceiling relies on the bilateral interactions of local and their superior governments. In particular, besides fundamental factors, political connections with provincial leaders and local applications induced by regional competition significantly raise the newly increased debt ceiling for prefectural cities. We establish the robustness through various econometric specifications. Moreover, we find that the effects of local application are more pronounced for distributing the ceiling of special debt that is used to finance public projects with certain returns. We further evaluate the real consequences of the debt ceiling distribution. An increase in the debt ceiling leads to higher economic growth but dampens total factor productivity (TFP), and regions with tighter debt ceilings tend to obtain external finance by accumulating more implicit debt through the local government financing vehicle. Our paper offers new evidence for distributive politics in a top-down bureaucracy and its economic consequences.