How Local Government Debt Reduces the Ability of Chinese Urban Commercial Banks to Create Liquidity

What is it about?

This study examines how China’s rising local government debt (LGD) affects the liquidity creation of urban commercial banks using bank-level panel data from 2016–2022. Liquidity creation is measured at the bank level and modeled with fixed effects to net out time-invariant bank heterogeneity. To uncover the channel, a mediation effect model evaluates whether LGD influences banks’ liquidity creation by altering their business structure, especially the shift toward interbank business. Results show that continuous growth in LGD significantly inhibits the liquidity creation capacity of urban commercial banks. The primary mechanism is a credit crowding-out effect: as LGD expands, scarce credit resources are absorbed by government-related financing needs, leaving fewer resources for liquidity-creating activities linked to the real economy. Mechanism tests further indicate that higher LGD promotes banks’ expansion into interbank operations, which, while balance-sheet enhancing, reduces net liquidity creation relative to traditional loan activities. The inhibitory effect is heterogeneous. It is particularly pronounced in banks with government institutions as major shareholders and in non-listed urban commercial banks, suggesting that ownership structures and market discipline shape banks’ responses to LGD pressures. The policy implication is clear: to safeguard and enhance banks’ liquidity creation, LGD should be more tightly regulated to mitigate crowding-out and to curb incentives that reallocate activity toward interbank business at the expense of services to the real sector.

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Photo by Jerry Wang on Unsplash

Photo by Jerry Wang on Unsplash

Why is it important?

Liquidity creation is a core social function of banks, transforming illiquid assets into claims that fund households and firms. When LGD rises and crowds out credit, banks’ capacity to create liquidity for the real economy weakens, with potential implications for investment, employment, and growth. This paper provides micro-evidence that connects fiscal dynamics (LGD) to banking sector behavior, showing a systematic, adverse effect on liquidity creation and clarifying a behavioral channel (interbank expansion). The findings matter for macro-prudential policy and fiscal-financial coordination. They indicate that debt management cannot be evaluated solely on government financing needs; it must also account for spillovers to bank balance sheets and the composition of bank activities. The documented heterogeneity highlights where risks may concentrate—banks with government majority ownership and non-listed banks—thus helping regulators target surveillance and buffers. By quantifying how LGD influences liquidity creation, the study supplies evidence for designing debt ceilings, transparency rules, and supervisory guidance that preserve banks’ capacity to serve the real economy.

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