May 24, 2012

Currently, there are increasing suggestions that the lower levels of governments should issue joint bonds in cooperation with the central government. In Spain, so-called “hispanobonos” have been discussed for quite some time. Representatives of some – mainly fiscally weaker – German federal states have lately suggested so-called “Deutschlandbonds”. What is the main idea behind them?

The two concepts have two elements in common: on the one hand, the lower levels of government of the Federation (Germany: Länder, Spain: regions) are to be jointly liable for their debt (i.e.: jointly issued bonds). On the other, the superior government level (Germany: federal government, Spain: central government) would additionally cover this liability with explicit guarantees or even issue the total volumes of the bonds themselves. On the basis of this concept, Deutschlandbonds must therefore not be mixed up with joint Länder bonds (Jumbos): here, a number of federal states join forces and issue a joint bond with liability on a pro rata basis and one federal state functioning as paying agent.

The arguments put forward are ultimately based on the consideration that the central government may usually borrow money at lower costs (interest rates) in the capital market: the credit standing of central government is better, and the marketability should increase due to higher market liquidity. It is foreseeable that the explicit credit guarantee on bonds of subordinate levels of government would also reduce the risk premium on these bonds required by investors. An interest saving for subordinate levels of government and ultimately also the entire government thus seems possible.

The motivation for such joint borrowing in the examples available varies, however: while in Germany individual federal states are promoting the idea, central government is the decisive driver in Spain. It hopes to get better control of the budgets of subordinate levels of government, as central bank borrowing is to be linked with conditions for the regions and more influence of the central government on the budget policy of the regions.

The idea of “Deutschlandbonds” and “Hispanobonos” is often compared with the concept of eurobonds. However, this comparison holds true only at first sight. Euroland is not a fiscal federation (yet). There is no superior political governance level which by analogy to the central government could interfere in the policy and budgetary sovereignty of the Euroland countries. This is not changed by the latest bills from the European Commission (“Two Pack”), which allow closer scrutiny but no direct interference, though. Irrespective of this, it cannot be ruled out that advocates of euro bonds disregard this specification and interpret “Deutschlandbonds” as a precedent in their interest.

How is the suggestion of joint bonds and especially “Deutschlandbonds” to be assessed?

Indeed there is a lot to suggest that a pool would make possible higher issue volumes. Germany’s Länder and Spain’s regions would probably no longer have to contend with liquidity premiums (currently up to 100 bp for the German federal states and several hundred basis points in Spain). At the same time, (remaining or new) bonds without assumptions of liability would only be traded at a premium. In an environment where investors show a risk-averse attitude such a market segmentation could have the effect that bonds with assumed liability could crowd out other bonds. This would have the side effect that the possibility for subordinate levels of government to borrow on their own would be severely restricted. The influence of the central government would be increased successfully – but the budgetary autonomy of the subordinate government level would be reduced. Especially this restriction would call into question the legal admissability of Länder borrowing in Germany. For this reason, at best a voluntary participation in the model would be a solution. Due to the mentioned crowding-out effect of fiscally weaker federal states, this would automatically have the consequence that federal states under market pressure as a result of weak economic governance would have no alternative but to choose the “Deutschlandbond“ model. Their financial independence would be reduced.

A low level of interest rates for central government cannot be taken for granted, though. An explicit liability does not necessarily bring more certainty from the investor point of view. A bailout of lower levels of government – especially in Germany – was often implicitly assumed by investors, with the consequence of quite low yield premiums.

Structural problems as the reason for the debt of lower levels of government would not be solved via an assumption of liability, however: the key to the solution of structural budget problems at lower government levels would probably be the potential conditionality which could be set in the framework of an explicit assumption of liability by the central government. But it is not as simple as that: the argument that the central government, securing the financing of the Länder, controls the Länders’ finances is not totally convincing. In the federal system, superior and lower levels of government are interdependent not only in the field of fiscal policy. They depend on each other in other fields as well; for example when a central government bill requires the support of the Bundesrat. This could result in horsetrading and dampens the optimism that the greater scope for central government control will also be perceived and exercised. The German Bundesrat provides a clear demonstration of the conflicts between the central government and lower levels of government that does not stop at party boundaries.

Irrespective of this, there are funding options for the Länder and the Spanish regions besides the capital market. They may also borrow via loans of their Landesbanks or financial institutions. Currently, loans (still) account for roughly 50% of the borrowing of the Länder. This compares to roughly 55% in Spain.

These arguments suggest that “Deutschlandbonds” and “hispanobonos” are not a lasting solution to the problem of ballooning debt for sub-national levels of government but – depending on their structure – may even have a negative effect on budget discipline. For the more reliable the joint liability system, the fewer the incentives that the lower level of government has to economise. At least in this respect, the German Länder and the Spanish regions are more European than quite a few people would like.