The signaling effect of local government debt: Evidence from China

We conduct an empirical analysis of the influence of local government debt on the deleveraging behavior of listed firms in China between 2015 and 2021. In contrast to the findings in existing literature, we discover that the expansion of local government debt positively affects the growth of firm leverage ratios, which we term the signaling effect. The signaling effect is more pronounced in regions with high fiscal transparency, in firms that are not state-owned, not over-leveraged, less financially constrained, and non-real estate industry. We further explore the economic consequences of signaling effect on both firm performance and the local economy. We observe that in the short run, the signaling effect improves firm value and stimulates economic growth, but over the long term, its impact turns negative. Our main results are robust after addressing potential concerns related to endogeneity.