Fiscal Federalism, Sovereign Risk, and Subnational Credit

Booms, Busts, and Bailouts: Fiscal Federalism, Sovereign Risk, and Subnational Credit By Kyle D. Hanniman A dissertation submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy (Political Science) at the UNIVERSITY OF WISCONSIN-MADISON 2012 Date of final oral examination: 10/4/12 This dissertation is approved by the following members of the Final Oral Committee: Nils Ringe, Associate Professor, Political Science Mark Copelovitch, Assistant Professor, Political Science, La Follette School of Public Affairs Lisa Martin, Professor, Political Science Scott Gehlbach, Associate Professor, Political Science David Weimer, Professor, Political Science, La Follette School of Public Affairs ii For Karla iii Booms, Busts, and Bailouts: Fiscal Federalism, Sovereign Risk, and Subnational Credit Kyle Hanniman, Ph.D. University of Wisconsin-Madison, 2012 This dissertation examines the constraints credit markets impose on subnational fiscal policies, focusing on the role and limits of fiscal federal structures in mediating this relationship. The conventional wisdom claims credit markets do not constrain the policies of governments that rely heavily on central transfers. Co-financing is believed to limit market discipline by signaling a national incentive in bailing out fiscally distressed units. I argue that the effects of transfer dependence are overstated and that if anything, dependence hardens market constraints. Dependence not only fails to send compelling bailout signals, but it also harms subnational creditworthiness by restricting governments' autonomy to raise additional revenues during periods of fiscal distress. I find clear links between market participants' bailout expectations and other aspects of the fiscal federal environment, including subnational responsibility for politically sensitive social services, formal national commitments to redistributing risk and wealth across territorial units, and heavy concentrations of national population, output, and debt in a limited number of territorial jurisdictions. However, I caution against overstating the importance of transfer dependence and other fiscal federal factors. Most variation in market constraints is driven by national-level factors in general and investors’ relative expectations of sovereign default in particular. Extreme movements in sovereign risk can induce booms and busts in subnational lending, outcomes that intergovernmental institutions only weakly mediate. iv I substantiate these claims using a range of quantitative and qualitative data and methods, including cross-national statistical analyses of credit ratings and bailout probabilities assigned by major credit rating agencies; case studies of subnational credit conditions in Canada and Germany; and interviews with regional treasurers, underwriters, and investors in regional bonds in these same countries. The findings have implications for the relationship between financial markets and government policy autonomy and the macroeconomic stability of multi-tiered systems of government. v ACKNOWLEDGEMENTS A dissertation is a collective effort. There may only be one author, but the final product embodies the insights and support of friends, family, academic advisors, and many others. I want to thank my dissertation committee - Nils Ringe, Mark Copelovitch, Lisa Martin, Scott Gehlbach, and David Weimer - for being at the forefront of that effort. I am especially grateful to Nils Ringe and Mark Copelovitch, the two advisors who have contributed the most to this project and my development as a scholar. Several others have also helped along the way, either by reading drafts, providing informal advice, keeping my statistical analysis honest, or helping me get my mind off work and research for a while. I want to thank Marc Ratkovic, Doug Brown, Adrienne Pagac, Brian Gould, Keith Banting, Yujin Kim, Bob Ascah, Enid Slack, Alex Tahk, Paul Hutchcroft, and Barry Burden as well members of my cohort. I want to extend a special thanks to two Madison colleagues. Ilia Murtazashvili was the senior graduate student colleague who readily availed himself as my informal academic advisor. I will admit his advice was not always welcomed, at first, but in the end, I would have gladly invited him to sit on my dissertation committee. Adam Auerbach was my housemate and best friend in the program from day one. I already miss our long hours poring over readings and stats problems in computer labs, libraries, and coffee shops. Madison would have been a much lonelier, unproductive and boring place without Adam's friendship, inspiring work ethic, and sense of humour. I also received tremendous support from the department's administrative staff. It is difficult to imagine how I would have found my way around campus, let alone an expense report, vi without the help of Deb McFarlane, Diane Morauske, Debbie Bakke, Beth Shipman, Mary Hurley, and other staff in the political science department. I would also like to take the opportunity to thank my former professors at St. Thomas University. It was at St. Thomas where I first decided to become a political scientist and it was here, in many respects, where this project began. I extend my deepest appreciation to Shaun Narine, Richard Myers, Patrick Malcolmson, Tom Bateman, Mikhail Molchanov, Gerald Baier, and the late John McKendy. Support for this dissertation extended well beyond academic circles. I would like to thank the many credit analysts, investors, underwriters, and treasury officials who patiently explained the world of finance to an uninitiated political scientist. It is with regret that I cannot, for reasons of confidentiality or fear of omissions, list all of you. But I would be remiss if I did not acknowledge the support of a few. I would like to thank Mike Richter of DZ Bank, Thomas Fuchs of UniCredit, and Thomas Stoffer of Barclays, the three German underwriters who organized my interviews with institutional investors in that country. I would also like to acknowledge Edgar Kresin, head of treasury for Saxony-Anhalt, who introduced me to these and other market participants. The bulk of my Canadian interviews were arranged by Gary Smith at the University of Alberta and the debt capital markets teams at the Bank of Montreal, National Bank of Canada, and the Canadian Imperial Bank of Commerce. Here, I extend a special thanks to Grant Williams (BMO), Jason Stewart (NBC), and Doug Bartlett (CIBC). Finally, none of the Canadian interviews would have been possible without introductions to underwriters by Gadi Mayman and Lynsey Wynberg of the Ontario Financing Authority. vii A number of individuals and organizations also provided me with data. I want to thank Warren Lovely of CIBC for providing spread data for Canadian provinces and Dave Rubinoff and his Moody's colleagues (Jennifer Wong, Aaron Wong, Colleen Tock, and Don Carter) for supplying the data analyzed in chapters 4 and 5. Dave Rubinoff deserves special credit, not only for organizing multiple data-collecting trips to the Moody's office in Toronto, but also for the countless email exchanges and phone conversations, in which he helped me sift through what I had collected. I would like to acknowledge financial support from the National Science Foundation, the European Union Center of Excellence at the University of Colorado-Boulder, and the Department of Political Science, the Graduate School, and the European Union Center of Excellence at the University of Wisconsin-Madison. Thanks also to my hosts at the European University Institute, where I spent a semester as a visiting researcher. Finally, thank you to Nicole Kalupa for providing invaluable research assistance and to Ryan Biava for referring her. This dissertation never would have been possible without the support of family. I want to thank my sister Jenny for a lifetime of encouragement and comic relief and my brother Brent for his unwavering support and example of hard work and achievement. Thanks also to Brent's new life partner, Steffi, for the generous hospitality she and her family showed me during my fieldwork in Germany. If there is one debt of gratitude I can never repay, it is the debt to my parents. Both have insisted on a first-rate education from day one and I have never wanted for their moral or financial support. Although I cannot share with them the title of Dr., I wish I could, because it is as much their accomplishment as mine. viii I will close by thanking my new family: my wife Karla, her brother Jeff, and her parents Lynn and Mike. I will always regret not finishing these acknowledgements before Mike had a chance to read them. He and Lynn always encouraged my scholarly pursuits, even when they must have wondered when I planned on getting a 'real' job. No doubt their confidence in me came from their daughter, who has been my greatest supporter since our first date 11 years ago. I will never forget the sacrifices she has made and unlike the debt to my parents, this is one I can and fully intend to repay. Let me begin with the smallest of gestures, dedicating this dissertation to her. ix TABLE OF CONTENTS ACKNOWLEDGEMENTS ............................................................................................................ v 1 INTRODUCTION ................................................................................................................... 1 1.1 RESEARCH QUESTION ................................................................................................ 1 1.2 EXISTING RESEARCH.................................................................................................

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