Air pollution and local government financing costs: Evidence from the Chinese municipal corporate bond spread

Using a sample of Chinese municipal corporate bonds from 2011 to 2019, this paper investigates the effect of city-level air pollution on local government financing costs. We find that cities with severe air pollution tend to have higher municipal corporate bond spreads, indicating that air pollution leads to higher local government financing costs. Moreover, air pollution is associated with lower economic growth, decreased population, and worse fiscal conditions, supporting the “implicit guarantee channel” that air pollution curtails implicit guarantees for municipal corporate bonds and thus increases bond spreads. Furthermore, the detrimental effect of air pollution is more salient for municipal corporate bonds without explicit guarantees, implicitly guaranteed by governments at lower administrative levels, and issued by local government financing vehicles located in regions with less marketization. Our study enhances understanding on the effect of air pollution on agents’ behaviors and provides guidance for reducing local government financing costs.