Debt Centralization and Soft Budget Constraint

Abstract

We show that debt centralization could result in soft budget constraint (SBC) of local governments by building and analyzing a stylized model that might be new to the literature. Our work first contributes to the theoretical literature on the causes of SBC of local governments. Our work also suggests that debt decentralization could help to harden the budget constraint of local governments because it eliminates the origin that gives rise to the SBC of local governments in our model. Finally, our work implies that the recent “debt decentralization” reform adopted by the central government of China to give the authorization to the local governments of Shanghai, GuangDong, ShenZhen, and ZheJiang to issue local government bonds by themselves is in the right direction to harden the budget constraint of Chinese local governments.