Rising interest rates may take some local and regional governments (LRGs) for a hike, while others should be able to hunker down around low cost of debt and strong budgetary performance. Despite the mixed bag of potential outcomes, S&P Global Ratings assumes global LRGs are unlikely to undergo material changes to their credit qualities because of interest rate volatility in 2023-2025. This general stability follows a prolonged period of historically favorable market conditions. Overall, only sustained scenarios of high interest rates would have meaningful impacts on budgetary deficits and tax-supported debt ratios.

No One-Size-Fits-All Approach For Analyzing LRGs' Interest Rate Sensitivity

Our study captures the LRG sectors of 12 countries as well as rated municipalities in Central and Eastern Europe. We analyzed the sensitivity of these different LRGs under three hypothetical scenarios of interest rate levels: Low stress (4%); moderate stress (6%); and high stress (8%). This is a simplification, of course, since differences in the current cost of funding mean that a similar scenario of interest rates represents a different departure from the current expectations for each country. That said, we have identified three key parameters that impact interest rate sensitivity: Starting position of indebtedness and cost of outstanding debt; speed of debt repricing; and expected net new borrowing (see chart 1).

This stress test focuses on the first-order effects of higher interest rates. It does not consider the second-order effects that these higher interest rates may have on depressing economic activity and consequently tax revenue, nor an inflationary impact on expenditures. The stress test is meant only to highlight differences in sensitivity to interest rate increases across LRG tiers, all else being equal. As such, we do not factor in any fiscal policy reaction, such as governments' decision to raise taxes or reduce non-financial expenditures.

Also, while our findings reflect the overall assessment for each LRG tier, some individual entities within countries and government levels are more exposed than others, to the extent that their own variables deviate from the norms for their respective sectors.

Our analysis is based on these parameters, and it modelled the impact that various levels of interest rates for new debt would have on LRGs' key budgetary and debt metrics, enabling us to compare their resilience to such scenarios. Ultimately, we measure interest rate sensitivity by the relative impact that rising rates would have on LRGs' budgets, measured as interest expenditure as a percentage of operating revenue.

Chart 1

Australian States, Canadian Provinces, And Spanish Regions Are The Most Vulnerable

In our view, increased interest expenditures in a stress scenario would place the greatest pressure on operating budgets for Canadian provinces and Australian states. For the latter, the immediate pressure stems mostly from our expectation of high deficits over the coming three years (see chart 2). Canadian provinces' high debt burdens, as well as expected wide deficits, make them vulnerable. But the large proportion of debt denominated at fixed rates is a mitigant.

Chart 2

Spanish regions, however, currently benefit from very low average financing costs, despite their high indebtedness. This is thanks to the favorable interest rate environment in the euro area over the past several years, as well as to the availability of central government funding at interest rates comparable with those of the sovereign. That said, comparatively large expected deficits and high debt stocks would strain budgets in a scenario of materially higher rates.

French regions appear stronger than their Spanish peers, mostly owing to much lower debt levels, a longer average maturity of debt, lower average cost of debt, and our projection of much smaller deficits. Still, French regions are comparatively less protected, according to our estimates, due to their reliance on fixed-rate debt.

Japanese LRGs, German States, And Mexican States Should Manage, Despite Their Specific Weaknesses

Japanese LRGs are sensitive to interest rate increases, mostly due to their very high levels of debt (see chart 3). However, all other parameters appear very favorable, with extremely low funding costs (in line with the prevailing interest rate environment in Japan), expected surpluses, and almost all debt denominated at fixed rates.

Chart 3

The key vulnerability of German states lies in relatively high levels of debt in a global context, albeit with pronounced variations across individual entities. Nevertheless, funding costs are very low, and we expect generally balanced budgets in the years ahead. We therefore view German states as very resilient to potential interest rate shocks, which would only have a meaningful impact on their budgetary performance and flexibility at elevated rates.

We have defined the stress cases for Mexican states at 12%, 14%, and 16% interest rates for new debt, meaning the results reflect the particular funding conditions and are not perfectly comparable with other countries. However, we observe that Mexican states would generally be able to withstand the pressure of higher rates thanks to minimal indebtedness and expected low deficits. Nonetheless, and unlike the rest of the peer group, almost all of Mexican states' debt is issued at variable rates. As such, the repricing of debt would be almost immediate at all levels of stress.

The Budgets Of Swiss Cantons, Austrian States, And Swedish LRGs Would Withstand The Strain

Swiss cantons enjoy low levels of debt and cheap funding, leading to overall low interest rate pressure on their budgets. Moreover, most of their debt is set at fixed rates. However, over the coming few years, some deficits will likely emerge, spurring an increase in debt that has potential to heighten the pressure on additional interest expenditures amid otherwise strong credit metrics.

Austrian states' budgetary metrics appear very balanced. We observe strength across all parameters, with moderate debt, low funding costs, expected small deficits or balanced budgets, and just the slight vulnerability of a comparatively high refinancing rate, with about 11% of their total debt stock being rolled over each year, according to our estimates.

Swedish LRGs are somewhat vulnerable to rising rates due to their reliance on short-dated debt (see chart 3). They issue a considerable amount of 12-month dated commercial paper to finance their spending. In recent years, Swedish entities have taken advantage of extremely benign market conditions to fund expenditure needs with short-term debt at negative costs. This means, however, that their debt portfolio is currently more exposed to a rapid repricing compared with peers. However, low overall levels debt and our expectation of only small deficits for the coming years mitigate this risk.

Also, a majority of Swedish LRGs' debt is typically on-lent to public companies (such as social housing entities or utilities). These companies, in case of interest rate stress, could pass on at least part of the costs to their customers, thereby helping to absorb some of the impact. Nevertheless, we do not expect Swedish LRGs to change their financing policies--by either moving toward fixed rate debt or lengthening their maturities--since they have communicated confidence in their ability to absorb the impact of higher rates without jeopardizing their budgetary performance.

Chart 4

In all three cases, although an increase in rates would materially increase the weight of interests on the budget, the starting points are strong enough to absorb the impact.

French Departments, U.K. Local Authorities, And Italian Regions Would Emerge Relatively Unscathed

French departments benefit from extremely low levels of indebtedness and our assumption of balanced accounts during 2023-2025. Although about 10% of their debt stock is rolled over each year, and they lean on fixed-rate debt less than their European peers, we believe their budgets would not bend much under higher interest rates. Moreover, French departments have structurally high operating balances that, in our view, enable them to comfortably absorb such impacts.

Although interest payments represent a higher burden for U.K. local authorities than for French departments, we do not see the former as particularly exposed to further monetary policy tightening. This mainly owes to s their very long dated debt (influenced by Transport for London) and a sizable proportion of fixed-rate debt. Their key relative weakness lies with moderately high deficits in the coming years, according to our estimates.

Italian regions are sheltered from a potential increase in interest rates. This is mostly thanks to their overall low indebtedness and our expectation of balanced budgets over 2023-2025, with stable or decreasing debt levels. Although their average interest costs are somewhat higher than those of other LRG government tiers in Western Europe--since Italian bonds usually display a higher premium--the generally low debt stock helps protect the regions from material damage on the debt-stock side.

The Interest Rate Impact Would Vary Across Central And Eastern European Municipalities

Funding costs for rated central and Eastern Europe municipalities are generally higher than those for Western European ones, and their use of fixed rate debt is comparatively smaller. However, there's a mixed bag of hypothetical outcomes in this group, which includes LRGs in the Czech Republic, Poland, Croatia, Bulgaria, North Macedonia, and Bosnia and Herzegovina.

The budgetary metrics of rated municipalities in the Czech Republic appear very strong, with generally low debt, and balanced budgets, although low proportions of fixed rate debt. Municipalities in Bulgaria also benefit from low debt, but there are relevant differences in terms of their shares of fixed-rate debt. Nevertheless, on balance they appear relatively well protected. Rated Polish municipalities have moderately high debt levels. But, at the same time, their very moderate deficits make them more resilient, under our base case.

The most vulnerable LRGs in this group appear to be those in Latvia, Bosnia and Herzegovina, and, to a lesser extent, Croatia and North Macedonia. Latvian LRGs have high average interest rates on outstanding debt and low prevalence of variable rates. LRGs in Bosnia and Herzegovina carry high debt. Meanwhile, in Croatia and North Macedonia, almost all LRG debt is at variable rates.

Chart 5

Only The Most Acute Stress Scenarios Would Hurt Budgetary Balances And Tax-Supported Debt

Overall, our stress test for 2023-2025 suggests strain from rising interest rates alone would not be sufficient to fundamentally change the debt trajectory of the analyzed LRGs. Australian states and Canadian provinces would see the most pronounced deterioration in budgetary performance, absent any corrective measures, more so than Spanish regions given the latter's much lower deficits in our base-case scenario. Most other LRGs would see a more moderate deterioration. Interest rates would have to soar way past 8%, for example, to push German states, Japanese LRGs, or Austrian states into meaningful deficits.

Chart 6

We do not expect interest rate increases to have material, country-wide rating implications for the LRGs we have analyzed, all else being equal. This could change if interest rate pressure intensified alongside broader economic disruption, particularly at the high levels of stress. That said, LRGs, or their respective sovereigns, could counter some of the ramifications of such stress with policy measures.

Nevertheless, those individual entities that deviate from the norm within each country--whether due to higher debt; greater proportion of variable or short-dated debt; or larger-than-average expected deficits--would be comparatively more at risk.

Chart 7

Related Research

• Subnational Debt 2023: An Easing Burden In Germany, Austria, And Switzerland, March 2, 2023
• Subnational Debt 2023: Australian States Navigate Crosscurrents Of COVID, Coal, And Capex, Feb. 26, 2023
• The Clock Is Ticking For The Debt-Led Growth Of China Local Governments, Feb. 21, 2023
• Canadian Local And Regional Government Debt: Economic Headwinds Will Slow Debt Sustainability Efforts In Fiscal 2024, Feb. 14, 2023