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Sub-nationals' risk premia in fiscal federations: Fiscal performance and institutional design

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  • Sola, Sergio
  • Palomba, Geremia

Abstract

The recent debt crisis in Europe highlighted the importance of institutional design and, in particular, bail-out clauses in determining States' risk premia in fiscal or quasi-fiscal federations. This paper examines the determinants of sub-national governments' risk premia in fiscal federations using secondary market data for the USA, Canada, Australia and Germany. It finds that, as for central governments, fiscal fundamentals matter in the pricing of risk, and sub-national governments with higher public debt and larger deficits pay higher premia. However, this relationship is not uniform across federations and it differs with institutional arrangements. In particular, market pricing mechanisms are less effective in presence of explicit or implicit guarantees from the central government. We show that when sub-national governments depend on high transfers from the central government (i.e., when there is some form of implicit guarantee from the center), markets are less responsive to sub-national governments' fiscal fundamentals. Using primary market data, the paper also shows that high transfer dependency lowers the probability of sub-national governments to borrow on capital markets.

Suggested Citation

  • Sola, Sergio & Palomba, Geremia, 2016. "Sub-nationals' risk premia in fiscal federations: Fiscal performance and institutional design," Journal of International Money and Finance, Elsevier, vol. 63(C), pages 165-187.
  • Handle: RePEc:eee:jimfin:v:63:y:2016:i:c:p:165-187
    DOI: 10.1016/j.jimonfin.2016.01.009
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    1. repec:eee:jimfin:v:79:y:2017:i:c:p:72-98 is not listed on IDEAS
    2. Beck, Roland & Ferrucci, Gianluigi & Hantzsche, Arno & Rau-Göhring, Matthias, 2017. "Determinants of sub-sovereign bond yield spreads – The role of fiscal fundamentals and federal bailout expectations," Journal of International Money and Finance, Elsevier, vol. 79(C), pages 72-98.

    More about this item

    Keywords

    Sub-national governments; Fiscal policy; Interest rates; Risk premia; Government debt; Fiscal federations;

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • H6 - Public Economics - - National Budget, Deficit, and Debt
    • H7 - Public Economics - - State and Local Government; Intergovernmental Relations

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