The macroeconomic effects of local government debt structure in China

China’s local government debt consists mainly of local government bonds (LGBs) and local government financing vehicle (LGFV) debt. Although existing studies have documented the less favourable risk profile of LGFV debt compared with local government bonds, it remains unclear whether and how local government debt structure affects macroeconomic outcomes, including financial stability, through the banking channel for a given aggregate local government debt burden. We develop a modified DSGE model with financial frictions and bank balance-sheet constraints that distinguishes LGBs from LGFV debt in terms of financing costs, maturity structures, and asset-specific financial frictions. The results show that, under fiscal and monetary policy shocks, LGFV debt causes larger declines in bank net worth and tighter liquidity constraints than LGBs, resulting in larger contractions in credit supply, investment, and output and a greater weakening of policy effectiveness. Increasing the share of LGBs mitigates these adverse effects by lowering financing costs, extending debt maturities, and easing pressure on bank balance sheets and liquidity conditions. Higher aggregate debt burden amplifies these structure -dependent effects. A sustainable resolution of local government debt risks also requires improving the fiscal revenue structure and reducing excessive reliance on debt financing.