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The long shadow of a fiscal expansion

Chang-Tai Hsieh, Chong-En Bai, and Zheng (Michael) Song


In 2009 and 2010, China undertook a 4 trillion Yuan fiscal stimulus, roughly equivalent to 12 percent of annual GDP. The "fiscal" stimulus was largely financed by off-balance sheet companies (local financing vehicles) that borrowed and spent on behalf of local governments. The off-balance sheet financial institutions continued to grow after the stimulus program ended at the end of 2010. After the end of the stimulus program, spending by these off balance sheet companies accounted for roughly 5% of annual GDP. The off-balance spending by local governments is likely responsible for a 5 percentage point increase in the aggregate investment rate and part of the 7 to 8 percentage point decline in current account surplus. Finally, we provide suggestive evidence that local governments used their new access to financial resources to facilitate access to capital to favored private firms, which potentially worsens the overall efficiency of capital allocation. The long run effect of off-balance sheet spending by local governments may be a permanent decline in the growth rate of aggregate productivity and GDP.

In “The Long Shadow of Fiscal Expansion,” Chong-En Bai of Tsinghua University, Chang-Tai Hsieh of the University of Chicago, and Zheng (Michael) Song of the Chinese University of Hong Kong find that China’s large recent 4 trillion Yuan fiscal stimulus, equivalent to 11 percent of its GDP, was funded by removing financial constraints over local governments, which allowed them to create new financial institutions that were exploited to channel resources towards favored private firms—resulting in a permanent decline in aggregate productivity and GDP growth.

Because of the way the stimulus was financed, it caused a sea-change in China’s economy, even 6 years later: a permanent increase in the investment rate, a decline in the current account surplus, a worsened allocation of resources, and a permanent decline in the aggregate growth rate.

Bai, Hsieh and Song note that the stimulus program was implemented by local governments and mostly financed by the relaxation of financial constraints facing local governments.  Specifically, local governments were legally prohibited from borrowing or running deficits.  To circumvent these rules, local governments were allowed to create off-balance sheet companies known as local financial vehicles in 2009 and 2010 to fund the stimulus spending.  A typical arrangement would be that local governments would transfer ownership of land to the local financing vehicle, and the land would be used as collateral to borrow from banks and shadow banks (trust products) as well as to issue bonds.

This financing choice appears to have had long lasting effects, even 6 years after the end of the stimulus program.  The authors show that after the end of the program, the off-balance sheet financial institutions continued to grow as local governments found themselves with powerful new tools to circumvent the financial controls on their budgets.   By 2014, Bai, Hsieh and Song estimate that the off-balance sheet spending by local governments account for about 11 percent of GDP, with 4.6 percent of GDP spent on local infrastructure projects and 6.4 percent of GDP on essentially private commercial projects.  The aggregate effect is an increase in the investment rate to what is probably the highest of any country in the world today, a worse allocation of financial resources, and a decline in the growth rate of aggregate GDP.

This paper is part of the Fall 2016 edition of the Brookings Papers on Economic Activity, the leading conference series and journal in economics for timely, cutting-edge research about real-world policy issues. Research findings are presented in a clear and accessible style to maximize their impact on economic understanding and policymaking. The editors are Brookings Nonresident Senior Fellow and Northwestern University Economics Professor Janice Eberly and James Stock, Brookings Nonresident Senior Fellow and Harvard University economics professor.


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