By Jakob Suwalski, Director, Sovereign and Public Sector Ratings

For a full discussion, please join Scope Rating’s webinar on Thursday 17 February

Sub-sovereign borrowing in debt capital markets has benefited hugely from the European Central Bank’s still very accommodative pandemic monetary policy. The market for ESG-linked debt is also growing in importance for sub-sovereign issuers, offering regional and local governments access to a more diversified investor base.

Strong institutional frameworks shielded euro area sub-sovereigns from Covid-19, but the structural effects of the crisis challenge the return to ordinary budgeting. European sovereigns have broadly centralised the costs of the pandemic through elevated pandemic-related spending and additional transfers to sub-sovereigns to compensate for tax shortfalls and reduce their recourse to debt.

Now, in the context of an uneven economic recovery, sub-sovereign fiscal policy is set to gradually return to ordinary budgeting and may require adjusting to cope with pandemic’s after-effects. As crisis-related central government support diminishes, structural spending increases related to the pandemic will continue to weigh on sub-sovereign finances, coupled with likely reintroduction of limits on debt-financing while the recovery in tax revenues is likely to be  diverge within countries.

EU recovery funds could reduce economic divergence and investment gaps. The Covid-19 crisis marked a change of paradigm in Europe’s fiscal response to economic shocks, favouring emphasis on additional public investment – in contrast with fiscal austerity favoured in the aftermath of the financial crisis in 2008  – to avoid the further build-up of significant investment backlogs.

Sub-sovereigns play a central role in public investment and will bear significant responsibilities in the implementation of the Next Generation EU (NGEU) programme while also facing governance constraints which may limit  the degree to which the NGEU funds improve the euro area’s growth potential and economic and environmental resilience.

In terms of the impact of economic normalisation on sub-sovereign finances in 2022 and beyond, Spain’s autonomous communities will feel structural pressure on spending and lower central-government financial support.

Italy’s regions will receive extra resources for healthcare after the pandemic, which, together with legislation to gradually cancel a major regional tax, imply even higher future transfer-dependency in regions’ finances despite political efforts to promote their fiscal autonomy.

For Germany’s Länder, credit risk remains well-contained by a strong institutional framework, though they face economic recoveries at different speeds and varying debt-brake provisions.

Budgetary performance in France’s regions and municipalities is set to improve medium term as the economy recovers, while the longer-term outlook will be marked by local tax reform and central-government consolidation strategies.

For more information, download Scope’s Sub-Sovereign Outlook 2022.

Giulia Branz, Analyst, Sovereign and Public Sector Ratings, contributed to this commentary.