Abstract: Many believe that, due to the soft budget constraint, the borrowing costs of local government financial vehicles (LGFVs) do not reflect credit risks, and their borrowing decisions are not sensitive to interest rates. In the presence of such borrowers, therefore, it would be difficult for a policy-rate based monetary policy framework to achieve its goals. This paper, using data on 3280 bonds issued by LGFVs during 1997-2014, attempts to quantify the impact of budget constraints on borrowing costs and borrowing decisions by LGFVs. Our results suggest that the budget constraint on LGFVs may be harder than perceived: (1) the coupon rates of LGFV bonds do reflect their financial strengths and credit risks; (2) the amounts of borrowing by LGFVs are sensitive to changes in the risk-free rate, though not yet to credit risk premiums. We believe that the on-going fiscal reforms and the development of the local government bond market will help further improve harden the budget constraint on local governments and LGFVs in the future.

Full report ： LGTV Bonds, Soft Budget Constraint and Interest Rate Liberalization.pdf