Investing like conglomerates: is diversification a blessing or curse for China's local governments?

Summary

Focus

China's local government financing vehicles (LGFVs) are often viewed as platforms that are used to evade borrowing constraints and make inefficient investments. They are even accused of harbouring potential fiscal and financial risks. By contrast, anecdotal evidence suggests that some LGFVs contribute to local economic growth through successful investments.

Contribution

We provide new insights on LGFVs, especially in terms of how they invest. Using data for 4,432 LGFVs from 1,225 counties across China between 2005 and 2018, we show that since 2014 the function of LGFVs has changed from financing conduits to conglomerate platforms with more diversified investments. By combining LGFV-level micro data and county-level macroeconomic data, we evaluate the investment style of LGFVs and their impact on local economies in a novel way.

Findings

The degree of LGFV diversification has an inverted U-shaped relationship with local economic growth. Diversification up to a certain level accelerates growth, while over-diversified investment hinders growth. Moreover, the effect of diversification on economic growth has become much more prominent since 2014, and also depends on the condition of a local economy. The finding that some diversification is a blessing but too much is a curse might be explained by debt build-ups and the crowding-out effect on private firms.

Abstract

This paper examines how China's local governments make investment via financing vehicles (LGFVs) and provides new insights on often-criticised LGFVs from a different perspective. Using data for 4,432 LGFVs from 1,225 counties across China between 2005 and 2018, we show that since 2014, the function of LGFVs has changed from financing conduits to conglomerate platforms with more diversified investments. While a certain level of diversification can be a blessing for local economic growth, over-diversification is a curse. Such an inverted U-shaped relationship depends on the condition of the local economy. Over-diversification may lead to rising local debt and crowding-out effects on private investment.

JEL Codes: E61, G21, H72, O17

Keywords: local government financing vehicle, diversified investment, government debt, conglomerate