The Implicit Government Guarantee as a Spillover Channel: Evidence from Chinese Local SOE Bond Markets

We demonstrate that the implicit government guarantee (IGG) can produce a spillover effect, transforming an idiosyncratic shock into a systemic shock. A model has been developed to illustrate the mechanism. The pivotal channel is that, when investors are unable to distinguish between an idiosyncratic default and a policy regime shift, they will revise their beliefs regarding the IGG for all default cases. We provide empirical evidence for the model by examining the unforeseen default event of Yongcheng Coal Group in November 2020. This event is regarded as an exogenous shock that eroded investors’ confidence in the IGG, particularly that of local governments in precarious financial positions. Employing difference-in-differences regression analysis, we observe a 50-basis-point increase in the credit spread for SOE bonds in a weak financial condition relative to those in a strong financial condition, which represents a significant 30% of the average credit spread. Further analysis indicates that the shifts in IGG-related beliefs prompted by the Yongcheng default are more pronounced for bonds with lower ratings, aligning with our model’s predictions. Our results echo the great effort made by the Chinese central government to reduce the IGG provided by local governments.