'Eurozone Disease' in China: Regional Currency Overvaluation and Local Government Debt

Abstract

China and the eurozone are alike in terms of unbalanced regional growth and having a common currency. Inland China, with growth much slower than that of coastal China, calls for a weak currency. However, RMB, the common currency for all of China, cannot depreciate to match inland China’s weak fundamentals and is thus overvalued from the perspective of inland China. Without monetary autonomy to devalue its overvalued currency, inland China has to turn to debt issuance, leading to higher indebtedness in inland China. This study, therefore, establishes a link between regional currency overvaluation and local government indebtedness. We show that city-level currency overvaluation is positively associated with higher local government debt. Our findings suggest that a 1% increase in regional currency overvaluation prompts the new issuance of local government debt by approximately 0.2%. This effect can be magnified by a higher degree of labor market immobility and spatial disequilibrium.

Keywords: F1, G2