Vertical debt spillovers in EMU countries

Abstract

This article examines the extent to which subnational governments may drive sovereign risk premiums. Is subnational fiscal policy affecting the interest rates on central government bonds? Furthermore, we focus on a number of causal mechanisms that may mitigate or reinforce these upstream vertical spillovers, i.e. the presence of bailout expectations and subnational borrowing autonomy. Our findings indicate that debt accumulation by subnational governments (SNG) spills over onto sovereign risk premiums when the restrictions on SNG borrowing are weak and when investors believe that subsovereign debts are backed by the center. The results suggest that spillovers may be reduced through a proper design of a country's fiscal and institutional framework; countries should either bolster the sovereignty of subnational governments by increasing SNG fiscal autonomy, or tightening up SNG borrowing constraints.