How can states benefit from the equity premium puzzle? Debt as revenue source for Swiss cantons

Ramon Christen,Nils C Soguel

doi:10.1186/s41937-019-0030-x

Abstract

This paper addresses the question of the optimal debt level of a state (canton) that issues new bonds and subsequently invests the borrowed capital. For that purpose, we first estimate the effect of the debt level on the interest rate and then we contrast the predicted interest rate with potential revenue from the capital markets. The estimation is based on panel data from the 26 Swiss cantons between 1980 and 2015. The median performance of Swiss pension funds serves as a reference value for the revenue achieved in the capital market. The results show an exponential relationship between the debt and its interest rate; raising indebtedness by 1000 Swiss francs per capita makes the spread between the risk-free rate and the interest rate on the debt increase by 5%. Given this small effect, the inherent optimal debt level equals more than twice the initial levels and the reinvested uncommitted funds provide a return potential of nearly 5% of the total cantonal receipts, on average.

Highlights

IntroductionWhen the price of the borrowed capital falls below the return rate in the capital markets, the government can issue bonds and invest the raised capital on the capital market
This paper argues that governments can benefit from higher indebtedness
The equity premium is the discount on the interest rates of public bonds in comparison to other asset classes that remain after deducting the risk premium

Summary

Introduction

When the price of the borrowed capital falls below the return rate in the capital markets, the government can issue bonds and invest the raised capital on the capital market. These leveraged investments yield a net profit to the government, which is reinforced when taking the equity premium puzzle into account. The equity premium is the discount on the interest rates of public bonds in comparison to other asset classes that remain after deducting the risk premium. Such a practice has its limits, because an ascending debt level amplifies the default risk, leading lenders to ask for higher yields. If the government stretches it out, the costs of borrowing exceed the return rate and the leveraged investments become unprofitable

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Results

Conclusion