Not in the Spread: Developer Defaults, Municipal Borrowing, and Bank Absorption in China

Abstract

How do subnational governments sustain debt expansions when their primary revenue base collapses and market discipline fails to bite? We answer this question by exploiting Chinese real estate developer bond defaults as plausibly exogenous shocks to local fiscal capacity. Using a staggered difference-in-differences design on a city–quarter panel of 263 cities from 2016 to 2022, we document a powerful fiscal substitution effect: cities exposed to a developer default replace lost land revenues by expanding off-budget local government financing vehicle (LGFV) bond issuance by 67.5%, or approximately CNY 170 billion annually. However, this borrowing expansion occurs without any widening of yield spreads, pointing to non-market debt absorption. We trace this pricing anomaly to locally affiliated city commercial banks (CCBs), which absorb these LGFV bonds under government influence and subsequently issue subordinated debt to relieve the resulting capital pressure. Our findings offer novel evidence on how the sovereign-bank nexus operates at the subnational level, demonstrating how non-market debt absorption suppresses price discovery, transfers fiscal risk into the banking system, and masks the buildup of systemic fragility.

Keywords: Local commercial bank, Local government debt, Implicit guarantees, Bank absorption, Systemic risk