Will Political Connections Be Accounted for in the Interest Rates of Chinese Urban Development Investment Bonds?

ABSTRACT

A special political connection, i.e., the implicit guarantee of the government on the debts of borrowers, is considered in this article to explore the mechanism through which the implicit guarantee of government will affect the interest rate of bonds issued by borrowers. Theoretical analysis shows that if the implicit guarantee from the government is less convincing, only investment income will play an important role in the determination of interest rate while explicit credence will not affect interest rate. If the implicit guarantee is persuasive, both explicit credence and investment income will affect the interest rate of bonds. Empirical analysis of Chinese urban investment bonds and U.S. municipal bonds during 2006–11 supports our theoretical predictions.

KEY WORDS:

• default risk
• implicit guarantee
• urban investment bond

Notes

1. Audit report by National Audit Office of the People’s Republic of China, No. 24 of 2013 (general serial no. 166).

2. Although studies such as Butler and Fauver (2006), Butler et al. (2009), and Khwaja et al. (2005) also look at political connection, they do not give a theoretical analysis of the mechanism through which this connection would affect the interest rate of bonds.

3. As pointed out by Bonilla et al. (2014), Clare and Gang (2010), and Peyton and Belasen (2012), political factors are important considerations in the study of emerging and developing economies.

4. For example, municipal urban investment bonds in China are usually guaranteed by banks or other UDICs.

5. Since a promising local economy is usually related to a good government performance, we can assume here to be a variable reflecting the state of the economy as well.

6. For the proof of Propositions 1–4 are available upon request from the corresponding author.

7. In our article, the idea that one project is better than another means the cumulative probability distribution function of this project is first-order stochastic dominant.

8. Maybe you will feel confused about this prediction. Why do we predict that investment-related variables may have no effect on the interest rate of bonds? From Proposition 4, we know that for the bonds with AAA credit level or explicit guarantee, investment income willnot affect expected default risk and interest rate. Only the bonds with worse credit and no explicit guarantee are influenced by the distribution of investment income. In our empirical part, since we cannot get enough sample size to distinguish between these two types of bonds—bonds with or without good explicit credence—we just examine the determinants of interest rate using all the observations from the eastern region, which will result in some uncertainty in our empirical work.

9. We test the robustness by including explanatory variables such as fiscal revenue, GDP growth, and stock return into our regression model one by one. We only report part of the results here because of limited space.

10. One possible explanation for the failure of robustness of guarantee is that in China, many UDIBs are guaranteed by other UDICs, which makes guarantee less attractive. However, we indeed find a negative relationship between guarantee and interest rate in the eastern region.

11. The reason for us to divide the United States into three regions (e.g. middle, eastern, and western) is as follows: As shown in our theoretical model, economic development is an important factor that influences investors’ expectations about government implicit guarantee and default risks. Thus, when we decide how to divide the United States, we should consider the heterogeneity in economic development. As we know, many less developed states lie in the middle of United States, while more-developed states mainly lie in the coastal areas of the eastern and western regions. Drawing on our data sample, we can also find significant differences in GDP between the middle region and other regions. Thus, it will be more convenient to capture the sharp differences in economic development if we divide the United States into three regions.

Additional information

Funding

Shiyi Chen acknowledges the support from Chang Jiang Scholars Program, National Social Science Foundation (14ZDB144 and 12AZD047), National Natural Science Foundation (71173048), Shanghai Leading Talent Project and Fudan Zhuo-Shi Talent Plan. Li Wang thanks the Sate Scholarship Fund provided by China Scholarship Council (CSC).