In Germany, local government is entrusted with key tasks, especially those pertaining to social benefits, day care for small children, schools, public administration, and local transport and recreational infrastructure. Within the scope provided by law, local authorities act independently. Responsibility for overseeing compliance with the strict budgetary rules rests with state government. Although only a small share of general government debt is attributable to local government, there exists a major gulf between the budgets of individual local authorities. Some are very heavily indebted and are struggling with persistent structural budget imbalances.

Financial support from central government in the pipeline

The Bundesbank expects local government finances to deteriorate overall this year. It cites refugee migration as one of the reasons for this, as spending relating to this has, up to now, been only partly refunded. However, according to the Monthly Report, the longer-term outlook is significantly more favourable now that central government plans to provide additional funds to relieve the strain. This move should provide local authorities with further scope to expand their investment activities. Following a long-term decline over many years, these had recently stagnated at a low level in relation to economic output – as a result, net non-financial investment fell overall. While the Bundesbank recognises that there is catching-up to be done in some areas, it opposes the massive increase in government investment expenditure that some have been calling for. In its opinion, planning assistance from central government with a view to implementing targeted investment measures is the more promising strategy.

Financing terms opening the door to trouble ahead

Under state government budgetary rules, local authorities are generally only permitted to borrow for the purpose of investment. However, in recent years, many local authorities have been given tacit approval to take recourse to cash advances to cover current expenditure rather than using them for their intended purpose, which is solely to bridge short-term liquidity shortfalls. The Monthly Report describes how, in fact, levels of cash advances have been rising almost constantly for many years. It further remarks that, given the difficult situation in some quarters, it is permitted in several federal states to take out cash advances with long maturities.

In addition, local authorities that find themselves in a tense budgetary position can obtain financing on the financial markets with next to no risk premiums. This opens the door to trouble ahead and leads Bundesbank economists to the following conclusion: lenders evidently assume that, in the event of local government running into payment difficulties, state government will step in to service the debt. However, state government is not on the hook for local government debt. Consequently, the possibility that loans granted to local authorities will not be serviced on time cannot be ruled out altogether.

Tension masked by low interest rates

While the current low interest rates have partly masked the strain placed by high debt on many local authorities, the situation could be expected to intensify considerably if interest rates were to rise. In addition to strict budgetary oversight and adequate funding by state government, the Bundesbank therefore advocates a framework under which local authorities are only permitted to take out from state government cash advances for which repayment is not envisaged within one fiscal year. This would lay significantly greater responsibility at the feet of state government and provide it with an incentive to intervene at an early stage to avert local authorities' financial distress.