Polluting Local Government Bond: The Effect of Air Pollution on Public Financing Costs in China

ABSTRACT This paper examines the effect of air pollution on public financing costs in China. Using 2752 general obligation bonds issued by provincial governments and five prefecture‐level cities from 2015 to 2020, we find that air pollution significantly raises the costs of public financing. Specifically, a 10% rise in the air quality index leads to a 0.30–1.11 basis points increase in the local government bond issue yield spread. To address possible endogeneity issues, the instrumental variable approach is employed. Mechanism analysis suggests that this effect likely operates through fiscal channels: Air pollution implies fiscal allocations for pollution‐related expenditures, and these ongoing expenditures place pressure on local budgets and widen the fiscal gap. As a result, investors demand higher yields to compensate for the anticipated fiscal risks. Heterogeneity analysis reveals a stronger effect for long‐term bonds. These findings offer practical policy implications: (1) Environmental risks should be considered when evaluating debt issuance and fiscal health; (2) the maturity structure of new issuances could be optimized to help mitigate fiscal vulnerability induced by environmental risks; and (3) the positive fiscal externalities associated with cleaner air should be fully acknowledged in the enforcement of environmental regulations.