The global economy has returned to growth, but that doesn’t mean the crisis is in the rearview mirror. A major legacy of the first stage of the crisis is the scar left on public finances. Public debt burdens in both emerging markets and advanced economies have soared in recent years, and they have already reached a boiling point in the euro zone periphery. Mark Horton of the IMF explores the reasons behind the fast build-up in public debt in the paper Fiscal Policy Issues after the Crisis.
Governments worldwide are now in belt-tightening mode. However, financial troubles at the local government level could undermine such efforts. More importantly, defaults by local governments could slow economic growth and/or threaten financial stability. Adding to the uncertainty, local government finances tend to be harder to track than those of central governments, but they are still important for gauging a country’s overall economic health.
Case of the United States
Local governments, like the federal government, suffered a contraction in tax revenue during the recession, and they are now having trouble slashing services fast enough to keep pace with the fall in revenue. This has led to wider budget deficits and higher debt levels. A major concern is that states – those most in trouble include California, New Jersey, Ohio – will cut aid to local governments.
A dangerous snowball effect could develop, whereby rising debt levels induce higher borrowing costs, which in turn makes it more challenging for local governments to service their debt. Inadequately funded pension liabilities are adding to their woes. Rather than raising taxes and irking voters, local governments may instead opt to default. So far, no major city has done so, but there are fears that this could soon change.
How worried should we be? Meredith Whitney, a prominent analyst known for looking beyond the Wall Street consensus, has predicted that dozens of US cities will default on their muni bonds. “Next to housing this is the single most important issue in the US and certainly the biggest threat to the US economy,” she said in a recent interview. Warren Buffett, the oracle of Omaha, has joined Ms. Whitney in expressing concern. See here.
Others say such fears are overblown. See Larry Swedroe of CBS MoneyWatch. Much of his counterpoint to Meredith Whitney seems to rely on looking at past defaults and extrapolating what happened to the future (eg. in previous defaults in Orange County and NYC, bondholders were made whole so they will be this time around too), which doesn’t seem like a particularly strong argument. Bloomberg columnist Joe Mysak also goes on the offensive against Whitney. Most of the column seems to be unsubstantiated vitriol against Whitney, except for the quotes he took from a Fitch report. “Debt service is generally less than 10 percent of a state or local government’s budget, and in many cases much less…. so not paying it does not do much to solve fiscal problems (particularly as compared to the costs of such an action).”
In response to fears of default, there were large net outflows from muni bond funds in late 2010/early 2011, as seen in the graph above. According to estimates from the Investment Company Institute, inflows returned to positive territory in May. Some have taken this as a sign that all’s well with muni bonds, but that remains to be seen.
The United States is not an isolated case. Financial troubles at the local level are one of the obstacles facing Hungary as it attempts to bolster public finances. Cutbacks by the central government have added to local governments’ fiscal burden. Hungary missed meeting its general government budget deficit target of 3.8% of GDP in 2010 owing to a higher-than-expected deficit at the local government level. By end-2010, local governments had accumulated debt amounting to over 5% of GDP.
Local government debt accounts for only a small share of Hungary’s total public debt, which topped 80% of GDP in 2010. However, it has some dangerous, potentially systemic implications. In the latest Financial Stability report, Hungary’s central bank warned that local government debt poses a risk not only to public finances, but to the health of the banking system as well.
By the end of 2010, banks’ exposure to municipalities exceeded HUF 1,000 billion (EUR3.7bn, US$5.4bn), accounting for 5% of total bank loans. As the central bank notes, “Credit risks are further aggravated by the fact that a large portion of municipality bonds were issued with a few years grace period, during which the borrower pays interest only, without servicing the principal. Once the grace periods expire, monthly installment burdens increase which, according to our estimates, may increase the expenditures of local governments by up to HUF 25-30 billion at the system level in the coming years.” The fact that 60% of local government debt (bonds and loans) is foreign currency-denominated (mostly Swiss francs) has added to solvency concerns.
In Hungary, there is not much data on local governments’ fiscal situations, which makes it challenging to evaluate. This is the case in many countries.
Case of China
Even before the global financial crisis, analysts worried that debt-laden local governments in China, if allowed to default, posed a risk to macroeconomic and financial stability. See this blog post from World Bank economist Louis Kuijs which details the issue: China’s local government debt—what is the problem?
A recent news report from Reuters suggests regulators are finally moving to address the problem. The central government is reportedly set to pay off some of local government loans, but banks would also take part of the hit. However, China expert Michael Pettis says that while it’s good that authorities are recognising and quantifying the problem, it doesn’t address who will ultimately foot the bill for the losses.