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Managing Government Default Risk in Federal States

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  • Jan J.G. Lemmen

Abstract

Federal governments typically apply fiscal rules to impose fiscal discipline on lower levels of government. Analogously, by trading in government debt, government bond markets impose fiscal discipline on lower levels of governments. this paper finds new evidence for Australia, Canada and Germany showing that whether these rules or markets matter, or not, may be a function of the worlds appetite for credit risk. Rules and markets only tend to bite during periods when there is a low appetite for credit risk in world financial markets. Therefore, this paper proposes an alternative more incentive-based framework of fiscal discipline. this incentive-based framework should increase the sensitivity of government borrowing costs with respect to debt levels, increase the geographical diversification of investors portfolios with respect to government bonds, and prevent government financing from fuelling private sector bailout expectations.

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  • Jan J.G. Lemmen, 1999. "Managing Government Default Risk in Federal States," FMG Special Papers sp116, Financial Markets Group.
    • Handle: RePEc:fmg:fmgsps:sp116
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    File URL: http://www.lse.ac.uk/fmg/documents/specialPapers/1990s/sp116.pdf
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    1. Robert N McCauley, 1999. "The Euro and the Liquidity of European Fixed Income Markets," CGFS Papers chapters,in: Bank for International Settlements (ed.), Market Liquidity: Research Findings and Selected Policy Implications, volume 11, pages 1-26 Bank for International Settlements.
    2. Bishop, Graham, 1998. "The European Central Bank and the Prudential Regulation of the Financial System," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 3(1), pages 13-20, January.
    3. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, January.
    4. Toni Gravelle, 1999. "Liquidity of the Government of Canada Securities Market: Stylised Facts and Some Market Microstructure Comparisons to the United States Treasury Market," CGFS Papers chapters,in: Bank for International Settlements (ed.), Market Liquidity: Research Findings and Selected Policy Implications, volume 11, pages 1-37 Bank for International Settlements.
    5. Morris Goldstein & Geoffrey Woglom, 1991. "Market-Based Fiscal Discipline in Monetary Unions; Evidence From the U.S. Municipal Bond Market," IMF Working Papers 91/89, International Monetary Fund.
    6. von Hagen, Jurgen, 1991. "A note on the empirical effectiveness of formal fiscal restraints," Journal of Public Economics, Elsevier, vol. 44(2), pages 199-210, March.
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    Cited by:

    1. 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.
    2. repec:kap:decono:v:165:y:2017:i:3:d:10.1007_s10645-017-9299-2 is not listed on IDEAS
    3. Schuknecht, Ludger & von Hagen, Jürgen & Wolswijk, Guido, 2009. "Government risk premiums in the bond market: EMU and Canada," European Journal of Political Economy, Elsevier, vol. 25(3), pages 371-384, September.
    4. repec:eee:jimfin:v:79:y:2017:i:c:p:72-98 is not listed on IDEAS
    5. Schulz Alexander & Wolff Guntram B., 2009. "The German Sub-national Government Bond Market: Structure, Determinants of Yield Spreads and Berlin’s Forgone Bail-out," Journal of Economics and Statistics (Jahrbuecher fuer Nationaloekonomie und Statistik), De Gruyter, vol. 229(1), pages 61-83, February.
    6. Ohls, Jana, 2017. "Moral suasion in regional government bond markets," Discussion Papers 33/2017, Deutsche Bundesbank.
    7. Guiseppe Pisauro, 2001. "Intergovernmental Relations and Fiscal Discipline; Between Commons and Soft Budget Constraints," IMF Working Papers 01/65, International Monetary Fund.
    8. Agustín Molina-Parra & Diego Martínez-López, 2015. "Do federal deficits motivate regional fiscal (im)balances? Evidence from the Spanish case," Working Papers. Collection A: Public economics, governance and decentralization 1503, Universidade de Vigo, GEN - Governance and Economics research Network.
    9. Landon, Stuart & Smith, Constance E., 2007. "Government debt spillovers in a monetary union," The North American Journal of Economics and Finance, Elsevier, vol. 18(2), pages 135-154, August.
    10. Rangarajan , C. & Prasad, Abha, 2012. "Managing state debt and ensuring solvency : the Indian experience," Policy Research Working Paper Series 6039, The World Bank.
    11. Arnold, Ivo & Lemmen, Jan, 2001. "The Vulnerability of Banks to Government Default Risk in the EMU," International Finance, Wiley Blackwell, vol. 4(1), pages 101-125, Spring.
    12. Ondřej Schneider & Petr Hedbávný & Jan Zápal, 2007. "A Fiscal Rule that Has Teeth: A Suggestion for a “Fiscal Sustainability Council” Underpinned by the Financial Markets," Czech Economic Review, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, vol. 1(1), pages 32-53, March.
    13. 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.
    14. Kirsten H. Heppke-Falk & Guntram B. Wolff, 2008. "Moral Hazard and Bail-Out in Fiscal Federations: Evidence for the German Länder," Kyklos, Wiley Blackwell, vol. 61(3), pages 425-446, August.
    15. Bernoth, Kerstin & von Hagen, Jürgen & Schuknecht, Ludger, 2012. "Sovereign risk premiums in the European government bond market," Journal of International Money and Finance, Elsevier, vol. 31(5), pages 975-995.
    16. Laurence Copeland & Sally-Anne Jones, 2001. "Default probabilities of European sovereign debt: market-based estimates," Applied Economics Letters, Taylor & Francis Journals, vol. 8(5), pages 321-324.
    17. Dhritidyuti Bose & Rajeev Jain & Lakshmanan L, 2011. "Determinants of Primary Yield Spreads of States in India: An Econometric Analysis," Working Papers id:4370, eSocialSciences.
    18. Van Hecke, Annelore, 2013. "Vertical debt spillovers in EMU countries," Journal of International Money and Finance, Elsevier, vol. 37(C), pages 468-492.
    19. Petr Hedbávný & Ondrej Schneider & Jan Zápal, 2005. "A Fiscal Rule that has Teeth: A Suggestion for a ‘Fiscal Sustainability Council’ underpinned by the Financial Markets," CESifo Working Paper Series 1499, CESifo Group Munich.

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