The Double Role of Regulatory Regimes: How Low Borrowing Costs Increase Financial Risks in English and German Local Government

This paper investigates the relationship between local government (LG) debt and LG borrowing costs. Research on US LGs indicates that financial indicators of individual LGs significantly affect their borrowing costs (Capeci,... [ view full abstract ]

This paper investigates the relationship between local government (LG) debt and LG borrowing costs. Research on US LGs indicates that financial indicators of individual LGs significantly affect their borrowing costs (Capeci, 1994; Robbins & Simonsen, 2012). Due to limited empirical research, little is known about the relevance of the US findings outside the US context. This paper starts from the assumption that constitutional structures critically affect the relationship between LG borrowing costs and LG debt. The paper analyses the impact of constitutional structures by comparing the relationship between LG debt and LG borrowing costs across three European systems – England, Germany and the Netherlands.
The paper demonstrates that the English and German intergovernmental regulatory regimes contribute to high investor confidence in the creditworthiness of LGs. This confidence is expressed through low interest rates applied by credit providers when borrowing to local authorities, including highly indebted LGs. The empirical analysis demonstrates that borrowing costs significantly affect debt policies at the local level, with low borrowing costs enhancing local debt accumulation. The debt enhancing effect of borrowing costs is found to be particularly strong for large LGs.
The paper applies a mixed method strategy. The quantitative research draws upon a unique dataset of Dutch, English and German LG finances. Statistical results are combined with a comparison of relevant legislation regulating LG borrowing, and elite interviews conducted among Dutch, English and German intergovernmental financial regulators and local treasurers.
The findings demonstrate the importance of analysing LG financial stress from multiple time horizons. While low borrowing costs may reduce LG financial stress in the short term, it increases financial risk exposure for LGs, and the overall intergovernmental systems, in the long term. Strategies are discussed to minimise financial risks of current LG debt practices, including applying higher interest rates to LGs with weak finances.

References:
Capeci, J. (1994). Local fiscal policies, default risk, and municipal borrowing costs. Journal of Public Economics, 53(1), 73-89.
Robbins, M. D., & Simonsen, B. (2012). Do Debt Levels Influence State Borrowing Costs? Public Administration Review, 72(4), 498-505.