The Value and Real Effects of Implicit Guarantees

Exploiting the first default by a large state-owned enterprise (SOE) in China’s onshore bond market for identification, we find that implicit government guarantees account for 1.45 - 1.77% of bond values, or 39 basis points - 48 basis points in yield spread, given an average bond duration of 3.64. This translates into a total value of more than 93 billion CNY (15 billion USD) in China’s domestic bond markets for the corporate sector. Implicit guarantees account for a greater value for firms in sectors operating at overcapacity and with high default risk but a smaller value for firms that receive direct government subsidy and firms that rely primarily on banks for financing. We further document that implicit guarantees have real effects on corporate investment and financing policies. The reduction of implicit guarantees leads to a decline in investment and net debt issuance, an increase in cash holdings, and an improvement in investment efficiency for SOEs compared to non-SOEs.