Sovereign Aid Across 24 Countries Varied Widely

Many governments have pursued expansionary fiscal policy to mitigate the pandemic-induced economic shock to businesses and households. Job protection programs, greater health care spending, and cash handouts to households have been the most common types of support during the pandemic. Most sovereigns also provided direct fiscal aid to LRGs. (For an explanation of the 24 countries that we included in our analysis, please see the last section of the article.)

While not all central governments had preestablished mechanisms to disburse aid once the pandemic started, most were able to promptly deploy funding in some form, such as extraordinary transfers or loans. However, the magnitude and type of stimulus and its effectiveness in alleviating financial stress among subnational governments varied widely across the 24 countries.

In some cases, sovereigns' generous stimulus packages, coupled with LRGs' cautious spending, have resulted in an unexpected improvement of their finances in 2020 versus the pre-pandemic levels. In others, sovereign aid focused on mitigating the shock to the economy, leaving local administrations to deal with the direct budgetary impacts from tax revenue erosion and higher spending. LRGs' strategies also differed--some fiscally strong entities decided to significantly increase spending in support of sovereign countercyclical policy, while others only raised spending moderately. Conversely, speculative-grade LRGs were forced to trim their budgets amid the high uncertainty caused by the pandemic.

Chart 1

This article focuses on central governments' direct support to LRGs, although we recognize that their revenue also largely benefited from sovereigns' overall countercyclical policy. We measure the size of the fiscal aid by looking at sovereign transfers in relation to the "shock" to LRGs' budgetary balances after capex in 2020, or the "excess deficit." We estimate the excess deficit by calculating the balance after capex, excluding extraordinary transfers, and comparing that balance to the LRGs' pre-pandemic three-year average, which we will refer to as the baseline. (We note that under this methodology, other factors or events that could have influenced fiscal results in 2020 are not differentiated.)

Financial Assistance Mostly Consisted Of Direct Transfers

In more than half of the 24 countries we analyzed, extraordinary transfers covered over 50% of the COVID-19 impact on LRGs' budgets. In several countries, massive transfers, combined with limited spending at the local level, offset the pandemic-triggered budgetary squeeze in 2020.

Transfers were the preferred form of central government fiscal support by far. Some of these were earmarked for health care spending, which is usually executed at the local level, while others compensated for tax revenue losses. Six sovereigns (see the Appendix table) also supported their LRGs through new loans to cover financing needs, thus lowering the subnational governments' need to tap the debt markets. This was especially important in cases in which access to external funding was uncertain. The third form of fiscal aid, which four of the countries in our analysis provided, was debt relief measures. These included suspending and extending payments of debt owed to the central governments and their financial arms, and to commercial banks as part of a broader initiative (see the note at the end of the article).

Our analysis indicates that the level of support wasn't always correlated with sovereign credit quality. Investment-grade sovereigns opted for various, sometimes multi-pronged, approaches. Some used their considerable financial power to prevent fiscal erosion at the LRG level by providing direct support. This was the case in Sweden and the U.K., which provided massive stimulus. On the other hand, some developed economies encouraged LRGs to use their ample balance sheets for countercyclical spending, leading to wider deficits than the baseline.

Speculative-grade sovereigns provided more support than we expected, partly due to limited financing options and budgetary constraints among LRGs in those countries. However, we believe pressures could emerge starting in 2022, because these sovereigns are now focusing on fiscal tightening.

We classify the 24 countries into four groups through the following dimensions:

• The pandemic's impact on LRGs' budgetary performance, measured by the "excess deficit" over a baseline average of the prior three years; and
• The adequacy of fiscal aid, measured by the coverage of the excess deficit through cash transfers.

The four groups are arranged in the following manner:

• Minor impact, adequate support;
• Minor impact, minor support;
• Large impact, adequate support; and
• Large impact, minor support.

The pandemic dealt a tough blow to LRGs' budgets as tax revenue collapsed, but spending decisions also exacerbated the trend. We consider impact as minor if LRGs' excess deficit relative to total revenues (excluding sovereign support) was below 5 percentage points. We consider sovereign support was adequate if extraordinary transfers covered more than 50% of the excess deficit.

Chart 2

According to our analysis, the deepest decline of fiscal and debt profiles occurred among LRGs in group 4 (large impact, minor support), resulting in several downgrades. However, downgrades and defaults also occurred in Argentina (group 1) despite limited excess deficit and relative adequacy of fiscal support, given idiosyncratic factors such as very weak liquidity coverage and no access to credit markets amid the sovereign's default.

Below, we provide an in-depth analysis of financial assistance to LRGs in each of the four groups of countries.

Group 1: Minor Impact, Adequate Support

In this group of countries, the excess deficit stemming from the pandemic was minor and largely covered by extraordinary transfers, leading to fiscal results that were similar to or even better than those prior to the pandemic.

In Nordic countries--Denmark, Norway, and Sweden--local government revenues (excluding sovereign support) were largely unscathed by the pandemic in 2020, partly due to economic stimulus measures at the national level. At the same time, these countries engaged in moderate countercyclical spending that led to low excess deficits. The story is quite different in Latin American countries, given that local revenues dropped at a steeper pace and low excess deficits were largely due to a contraction in LRG spending. Subnational governments resorted to capex cuts and curbs in operating expenditures such as public-sector wage freezes (Argentina and Brazil) to navigate the uncertainty amid limited access to debt markets.

Some countries, such as Denmark and Mexico, deployed funds from pre-established support mechanisms. Fiscal relief measures in other countries were on ad-hoc basis, while some countries required legislative approval for fiscal relief. In Brazil and Sweden, massive support for LRGs stemmed from grim projections of revenue collapse at the pandemic's onset.

Most of the support in all countries was in the form of extraordinary transfers, some of which was slated for health care expenditures, and others to spend with discretion. Brazil also provided debt relief through the suspension of LRGs' payments of loans from public lenders, which was part of a broader scheme to prop up the economy.

Fiscal strains are likely to emerge as sovereigns phase out ample support starting in 2021. While in some cases, fiscal results are likely to erode following extraordinary adjustments in 2020, our base-case scenario assumes that fiscal performance of LRGs in this group of countries will remain broadly in line with the pre-pandemic baseline.

Group 2: Minor Impact, Minor Support

Extraordinary transfers in this group weren't as sizable as in the group 1: they covered less than 20% of the pandemic's fiscal impact in 2020. However, the amount was adequate, and LRGs' deficits differed little from their baseline. LRGs' less expansionary fiscal strategy and resiliency of their revenue base helped contain fiscal imbalances.

France set up its aid package primarily for those departments that were suffering the most in terms of revenue erosion. However, property tax revenue outperformed expectations, and LRGs' consolidated revenue hasn't weakened. Extraordinary funding was directed to big urban areas or tourism-dependent cities. Meanwhile, the peculiarities of the Swiss tax system delayed a major portion of the pandemic's impact into 2021. (The 2020 tax payments were based on 2019 income levels and had to be paid over the course of the year through a number of installments, while settlement of 2020 actual incomes occurs in 2021.) This, coupled with the Swiss National Bank's higher profit distribution to the governments, resulted in strong local revenues and the limited need for extraordinary support in 2020. However, we expect sovereign fiscal assistance to increase this year, given that revenue losses could be more pronounced than last year.

Group 3: Large Impact, Adequate Support

In all countries in this group, local governments provided countercyclical spending amid COVID-19, which mostly explains excess deficits in 2020. Nonetheless, support broadly covered the pandemic' hit on LRGs' budgets, and in some countries, results improved from the pre-pandemic baseline.

Fiscal aid compensated for revenue shortfalls and covered higher operating expenditures stemming from the pandemic. About half of the LRGs in this group prioritized spending to counter the pandemic-related economic damage and opted to delay capital spending (the U.K., Japan, and Israel), while others pursued countercyclical policy by maintaining or increasing capital spending (Spain, Italy, Finland, Russia, and China).

For LRGs in this group, we expected financial assistance from the central governments given their track record of support under extraordinary circumstances, such as natural disasters. At the same time, fiscal rules prompted support in some countries, such as Italy. In general, fiscal relief wasn't channeled through pre-established mechanisms, while budget amendments to support LRGs were announced throughout 2020 and 2021, following the pandemic's trajectory.

The bulk of stimulus in this group was in the form of extraordinary transfers. Only Italy and Russia provided debt relief on loans from the central government and state lending arms, while Russia's central government also granted new loans. China relaxed the bond issuance quota, and LRG bonds were accepted by the sovereign-controlled banks at exceptionally low spreads.

We expect overall fiscal performance of subnational governments in this group to remain moderately weaker in 2021 than the pre-pandemic baseline. Deficits are likely to remain at similar levels to those in 2020 among Chinese and Russian LRGs, stemming from ambitious infrastructure plans. We expect the Israeli and U.K. LRG budgets to return to the pre-pandemic baseline by 2021.

Group 4: Large Impact, Minor Support

Steep revenue losses, very limited direct sovereign support, and a substantial countercyclical spending response--especially among Canadian provinces and in Australia--resulted in considerable budgetary impact.

Relief packages for LRGs were present in some countries in this group, but their scope was modest. Therefore, LRGs' fiscal deficits widened considerably and are raising public debt. In some cases, central governments prioritized the mitigation of the economic shock over fiscal discipline, and prompted LRGs to do the same, which eroded their finances in the short term. For example, LRGs' higher spending was viewed positively by Australia's federal government, while India's central government relaxed borrowing ceilings for LRGs, following a sharp decline in revenues and a rise in pandemic-related spending.

Australian LRGs used their strong balance sheets to soften the pandemic's harsh impact on business and households (see "Why We Downgraded the Australian States Of New South Wales And Victoria," published Dec. 7, 2020). New Zealand's early success at containing the public health crisis mitigated the damage to the economy. However, many councils are ramping up capital spending as a form of economic stimulus, with some support from the central government. The sharp rise in spending dealt a blow to finances among LRGs in Germany, Bulgaria, and to lower extent Belgium, in 2020. However, the impact was more contained thanks to a less severe hit to tax revenue. The German states played a key role, together with the federal government, in providing support to municipalities through extraordinary transfers, which compensated for tax revenue losses and higher expenditures stemming from COVID-19.

Even though transfers were lower in this group than those in other groups of countries, some sovereigns provided funding to cover part of rising expenditures amid the pandemic. Austria's Federal Financing Agency increased loans to states, which besides drawing on cash and raising debt in capital markets, covered about half of their financing needs. India's central government lent part of its borrowing to states, which was key at containing their debt interest burden. The central banks of India, Canada, and New Zealand stepped in to support the liquidity and efficiency of LRG bond markets through participation in the secondary markets or changes to liquidity regulations for banks.

Excess Deficit Continues To Weigh On LRGs In 2021

We estimate that in 17 out of the 24 countries, local governments will face budget gaps, which could lead to increased borrowings. The speed of a return to the baseline will depend mainly on the magnitude of sovereign support throughout the pandemic, pace of economic recovery, and local administrations' decisions on countercyclical spending and budget containment measures (see "Local And Regional Governments Midyear Outlook 2021: Sovereign Support And Market Access Anchor Credit Quality," published July 15, 2021).

Chart 5

Countries Covered In This Report

Our analysis encompasses 24 countries: Argentina, Australia, Austria, Belgium, Brazil, Bulgaria, Canada, China, Denmark, Finland, France, Germany, India, Israel, Italy, Japan, Mexico, New Zealand, Norway, Russia, Spain, Sweden, Switzerland and the U.K. We consider this sample as representative of our ratings on non-U.S. LRGs. The 2021-2022 figures are our estimates and don't necessarily reflect the LRGs' own projections.

Notes

As per our methodology for rating non-U.S. LRGs, we treat loans extended by a central government to LRGs differently from commercial debt, given that the former is provided on a concessionary basis as an integral part of intergovernmental relationships. Therefore, we don't view nonpayment of intergovernmental debt as a default. We consider it so when an LRG fails to pay an obligation it owes to a municipal funding agency, a higher tier of government's financial arm, or a development or export bank, unless the debt benefits--or is expected to benefit--from an ongoing or extraordinary support from a higher tier of government. None of the debt relief programs extended to local governments that we rate resulted in a default under our rating definitions.

Appendix

Related Research

• Credit FAQ: How Central Government Support Will Limit COVID-19's Impact On Spanish Regions' Finances, June 24, 2020
• China Local Governments: More Breathing Space For Recovery, June 17, 2021
• Mexican Local Governments' Economic Recovery Prospects After Largest-Ever Election, June 9, 2021
• Institutional Framework Assessments For International Local And Regional Governments, June 4, 2021
• Latin American Local Governments Face Financial Strains Despite Sovereign Aid, June 2, 2021