Managing Government Default Risk in Federal States

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.