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Moral Hazard and Bail-Out in Fiscal Federations: Evidence for the German Länder

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  • Kirsten H. Heppke-Falk
  • Guntram B. Wolff

Abstract

We identify investor moral hazard in the German fiscal federation. Our identification strategy is based on a variable, which was used by the German Federal Constitutional Court as an indicator to determine eligibility of two German states (Länder) to a bail-out, the interest payments-to-revenue ratio. While risk premia measured in the German sub-national bond market react significantly to the relative debt level of a state (Land), we also find that a larger interest payments-to-revenue ratio counter-intuitively lowers risk premia significantly. Furthermore, with increasing values the risk premia decrease more strongly. This is evidence of investor moral hazard, because a larger indicator value increases the likelihood of receiving a bail-out payment. Our findings are robust to a variety of sample changes. In addition, we provide a case study of the recent Federal Constitutional Court ruling on the Land Berlin, which had filed for additional federal funds. The negative response of the court did not lead to a change in financial markets' bail-out expectations. In sum, our results indicate significant investor moral hazard in the sub-national German bond market. Copyright 2008 The Authors. Journal compilation 2008 Blackwell Publishing Ltd.

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Bibliographic Info

Article provided by Wiley Blackwell in its journal Kyklos.

Volume (Year): 61 (2008)
Issue (Month): 3 (08)
Pages: 425-446

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Handle: RePEc:bla:kyklos:v:61:y:2008:i:3:p:425-446

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Cited by:
  1. Peter Claeys & Raúl Ramos & Jordi Suriñach, 2007. "Fiscal sustainability across government tiers: an assessment of soft budget constraints," IREA Working Papers 200714, University of Barcelona, Research Institute of Applied Economics, revised Jul 2007.
  2. Diego Martínez López & Salvador Barrios, 2013. "Fiscal equalisation schemes and sub-central government borrowing," Working Papers. Serie EC 2013-03, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
  3. Sven Jari Stehn & Annalisa Fedelino, 2009. "Fiscal Incentive Effects of the German Equalization System," IMF Working Papers 09/124, International Monetary Fund.
  4. Schuknecht, Ludger & von Hagen, Jürgen & Wolswijk, Guido, 2008. "Government risk premiums in the bond market: EMU and Canada," Working Paper Series 0879, European Central Bank.
  5. Wolff, Guntram B, 2007. "Schuldenanstieg und Haftungsausschluss im deutschen Föderalstaat: Zur Rolle des Moral Hazard
    [Increasing debt and potential bail-out clauses in the German federation: on the role of moral hazard]
    ," MPRA Paper 11248, University Library of Munich, Germany.
  6. Van Hecke, Annelore, 2013. "Vertical debt spillovers in EMU countries," Journal of International Money and Finance, Elsevier, vol. 37(C), pages 468-492.
  7. Mark Hallerberg & Guntram Wolff, 2008. "Fiscal institutions, fiscal policy and sovereign risk premia in EMU," Public Choice, Springer, vol. 136(3), pages 379-396, September.
  8. Peter Claeys & Raúl Ramos & Jordi Suriñach, 2008. "Fiscal sustainability across government tiers," International Economics and Economic Policy, Springer, vol. 5(1), pages 139-163, July.
  9. E. Jenkner & Zhongjin Lu, 2014. "Sub-National Credit Risk and Sovereign Bailouts: Who Pays the Premium?," IMF Working Papers 14/20, International Monetary Fund.
  10. Dhritidyuti Bose & Rajeev Jain & Lakshmanan L, 2011. "Determinants of Primary Yield Spreads of States in India: An Econometric Analysis," Working Papers id:4370, eSocialSciences.

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