The crowding out effect of local government debt on firm innovation : the moderating role of private banking

Abstract

I investigate the impact of local government debt (LGD) on firm innovation in China, where private firms contribute to 70% of the country’s technological innovations, bank loans are the primary source of financing for the real sectors, and the aggregate LGD shoots up from around 9.6% in 2008 to 15.8% in 2009 and to 20.6% of GDP in 2013. I posit that the upsurges in LGD crowd out firm innovation because LGD reduces the lending capacity of state-owned banks to private firms, and private banking moderates the negative effect of LGD. Consistently, I find a strong negative relationship between LGD and firm innovation using data covering 260 cities and 111,244 unique non-listed manufacturing firms from 2006 to 2013. My analysis shows that private firms’ financial constraint is one plausible channel through which the crowding out effect occurs. Furthermore, I find that the crowding out effect is less severe in cities where private banking plays a more significant role in the local credit market. My findings imply that LGD crowds out innovation of private firms in China and hampers capital market efficiency, and that private banking plays a positive role in mitigating the LGD’s crowding out effect and fosters innovation in China.