OREANDA-NEWS. A new draft law that would see the German Federal government extend funds to financially weak municipalities, underlines the strong support mechanism between Germany's Federal government and its local and regional governments, Fitch Ratings says.

The draft law, agreed by the Federal Cabinet last month, would earmark EUR5bn of federal funds for the municipalities in 2015-2018. Most (EUR3.5bn) would be designated for infrastructure investment in 2015-2018 while EUR1.5bn would be provided in 2017 for other investments. Municipalities will also receive EUR500m in 2015-2016 to help meet the cost of supporting refugees.

Looking further ahead, municipalities will receive EUR5bn in 2018 and 2019 to help pay for social programmes from the federal government under its medium-term financial plan.

It is not clear what budgetary impact these programmes could have on the German municipalities. If the draft law comes into force, the municipalities might use the newly available funds to increase total spending, instead of sticking to planned spending targets and using the Federal money as an alternative to existing funding sources (such as borrowing). An increase in spending cannot be discounted given the municipalities' high spending commitments in the relevant areas (such as infrastructure).

This may limit the draft law's contribution to the reduction of municipal debt. Combined with other initiatives, it should constrain further debt increases after a period when German municipal debt has grown sharply (in particular via the issuance of short-term debt, or Kassenkredite) to cover the mismatch between expenditure and available funds.

A large number of municipalities still face deficits (the latest available data estimates their end-3Q14 aggregate deficit at EUR2.6bn), and continued reliance on equalisation payments between municipalities or support from higher tiers of German government indicates that while the pace of debt accumulation may slow, any repayment of debt may take time.

The amount of Kassenkredite outstanding increased from EUR24bn in 2005 to EUR50bn in 3Q14, exposing the municipalities to considerable refinancing and interest-rate change risk. The new law follows other measures to reduce fiscal and financing risks to the municipalities by both the German Federal government and the Laender. Some Laender have established programmes to put municipalities' funding on a more sustainable basis and allow them to replace short-term funding with long-term debt, while obliging the municipalities to consolidate their budgets.

For example, the state of Rhineland-Palatinate (AAA/F1+) has created a fund, one-third funded by the participating municipalities through higher local taxes or cost-cutting, one-third by transfers between municipalities under financial equalisation schemes, and one-third by the state. Participating municipalities will receive the proceeds after they achieve agreed consolidation measures.

The federal government has already taken over the net cost of the basic subsistence income for the elderly and people with reduced earning capacity. This has so far saved the municipalities about EUR11bn in 2012-2014, of an estimated total saving of EUR30bn by end-2017.
These developments suggest that upper levels of government are prepared to use the increased budgetary flexibility from economic recovery and increasing tax revenues to help local governments carry out a greater range of administrative functions without creating additional funding imbalances.

This supports the municipalities' creditworthiness. The absence of explicit constitutional support, and the lack of a liquid market for municipality debt, means we do not have a rating floor of the type we use when rating German Laender, but the individual creditworthiness of a single municipality should profit from the increasing support.