Credit Misallocation and Disintermediation in China's Infrastructure Financing

Abstract

This paper investigates how the institutional arrangement in China's financial market increase the cost of capital for underdeveloped areas. I show that fiscal capacity results in higher leverage but not superior profitability for local government financing vehicles. Infrastructure in fiscally strapped cities is more growth-enhancing, however, they can hardly access the low-interest bond market, and instead largely reckon on expensive bank loans. To raise a given amount of debt, a disadvantaged city would fork over anywhere from zero to five times more interest of what would cost a city with bond instruments. Such credit redlining spawns a vicious circle that results in a salient and persistent interregional inequality.