This study finds that reducing political influence over local courts weakens local government debt capacity. We establish this result by exploiting the staggered roll-out of a judicial centralization reform aimed at alleviating local court capture in China and find reduced judicial favoritism towards local governments post-reform. The majority of local government lawsuits are with contractors over government payment delays. The reform not only increases government lawsuit losses but also exposes their credit risk, as payment delays without court support signal government liquidity constraint. Investors respond by tightening lending and increasing interest rates, which curbs government spending.

An optimal tax and borrowing plan determines the marginal cost of servicing government debt, p', and makes the government’s debt risk-free. An option to default restricts debt capacity. Optimal debt-GDP ratio dynamics are driven by 1) a primary deficit, 2) interest payments, 3) GDP growth, and 4) hedging costs. Hedging influences debt capacity and debt transition dynamics. For plausible parameter values, we make comparative dynamic quantitative statements about debt-GDP ratio transition dynamics, debt capacity, and how long it would take our example economy to attain that calibrated equilibrium debt capacity.