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Moral hazard and bail-out in fiscal federations: evidence for the German Länder

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

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. Quantitatively, the effects are, however, quite small. 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. --

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Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 1: Economic Studies with number 2007,07.

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Date of creation: 2007
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Handle: RePEc:zbw:bubdp1:5561

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Keywords: moral hazard; bail-out; sovereign bond spreads; fiscal federalism; Germany;

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Cited by:
  1. 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.
  2. Dhritidyuti Bose & Rajeev Jain & Lakshmanan L, 2011. "Determinants of Primary Yield Spreads of States in India: An Econometric Analysis," Working Papers id:4370, eSocialSciences.
  3. Van Hecke, Annelore, 2013. "Vertical debt spillovers in EMU countries," Journal of International Money and Finance, Elsevier, vol. 37(C), pages 468-492.
  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. 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.
  6. Salvador Barrios & Diego Martínez, 2014. "Fiscal equalisation schemes and sub-central government borrowing," Working Papers 1401, Universidade de Vigo, GEN - Governance and Economics research Network.
  7. Sven Jari Stehn & Annalisa Fedelino, 2009. "Fiscal Incentive Effects of the German Equalization System," IMF Working Papers 09/124, International Monetary Fund.
  8. E. Jenkner & Zhongjin Lu, 2014. "Sub-National Credit Risk and Sovereign Bailouts: Who Pays the Premium?," IMF Working Papers 14/20, International Monetary Fund.
  9. 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.
  10. 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.

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