Regional Decentralization and the Soft Budget Constraint: The Case of China

The majority of enterprises in China are controlled by local governments at the provincial, city, county, township and village levels. We study the effect of regional decentralization on soft budget constraints in these enterprises. We show that fiscal competition under (foreign) capital mobility may be effective in hardening enterprises' budget constraints. Decentralization of monetary authority leads to a softening of local governments' budget constraints, however, as well as those of enterprises. Fiscal decentralization combined with monetary centralization (i.e. fiscal federalism) may achieve not only hard budget constraint but also the objective of monetary restraint. We also examine the effect of labour and product market conditions on soft budget constraints. We apply our model to explain harder budget constraints of the enterprises controlled by lower-level governments of townships and villages in China.