There were also at least two waves of explicit bailouts of local governments in Spain. The first wave was in 1983 when the central government assumed part of the local government debt, as documented in PedrejaChaparro et al. (2006). The second wave took place in 2012. In response to the crisis and mounting regional government debt, two regional liquidity funds were set up by the central government to provide cheaper loans to regional governments: the Fund for Financing Payments to Suppliers (“FFPP” in Spanish) that lent to local governments to pay for arrears owed to local suppliers; and the Autonomous Liquidity Fund (“FLA” in Spanish) designed to help with regional governments’ difficulties in debt refinancing. In essence, local governments that were facing surging interest rates or even losing access to the financial market can borrow cheap loans from the FFPP and FLA funded by the central government.<sup>46</sup>

# **B. Empirical evidence**

Empirical studies on the causal link between central government transfer and local governments’ debt burden mainly follow two approaches. The first approach uses econometric methods to estimate or test whether higher debt burden (or higher deficits in the past) indeed results in higher transfers. Solé-Ollé and SorribasNavarro (2012) use the municipal level panel data in Catalonia region during 1988-2006 to study how municipal governments respond to shocks to revenue, expenditure and grants. They find that a positive expenditure shock to municipal government is followed by an increase in grants from upper level governments. As stated by the authors, these grants are usually discretionary grants, and they “might have generated a moral-hazard problem, with municipalities having the incentive to undertake excessive expansion since additional capital spending will always be financed (at least in the long run) by higher tiers of government.” Sorribas-Navarro (2011) uses regional fiscal data in Spain during 1986-2006 to document that regions with larger debt burden tend to receive more federal transfers. The potential endogeneity problem is addressed by (1) adding cyclical economic indicators as control variables, such as unemployment, GDP, and population net flows; and (2) using the share of debt at a variable interest rate interacted with changes in interbank interest rates as an instrumental variable.<sup>47</sup> The second approach follows Rodden (2005a) to see if the financial market distinguishes regional governments based on their debt service abilities. If regions’ debt service abilities do not affect their debt ratings, it implies that the financial market believes that the central government will eventually help indebted regional governments with their debt burden, either through emergency bailout or periodic transfers in normal times. Rodden (2005a) compares the dispersion of regional debt ratings in countries where regional governments face “harder” budget constraints (Canada and the U.S.) and “softer” constraints (Germany and Spain) in the late 1990s. He finds that in Canada and the U.S., regional debt ratings are more dispersed, and the cross-region rating difference can be largely explained by the heterogeneity in regional debt burden (proxied by regional debt-to-own revenue ratio). To the contrary, the debt ratings of German Landers and Spanish regions are much less dispersed and closely follow their sovereign ratings, and debt-to-own revenue ratio is a weak factor

> 46There are two reasons why the FFPP and FLA can provide cheap loans to regions. The first is that the FFPP and FLA can borrow from banks under the central government’s guarantee, which lowered the funding cost of the FFPP and FLA. The second is that the central government also made direct budgetary contributions to the two funds. For example, the initial budgetary contribution to the FFPP announced in 2012 was €6 billion (Minguez et al. 2012).

> 47The main concern about endogeneity is that a negative shock to a region (e.g., flood in a region) can increase the region’s debt (due to higher expenditure) while trigger additional federal transfers through insurance channels. This may create an upward bias to the estimated impact of regional debt on federal transfers. The ideal instrumental variable should be correlated with debt burden but uncorrelated with other shocks that affect transfers. As discussed in SorribasNavarro (2011), the accumulation of debt comes from two parts: primary deficits and interest payment. The instrument adopted (share of debt at a variable interest rate interacted with interbank interest rates) would be correlated with interest payment (and hence debt burden), but plausibly uncorrelated with other regional shocks such as regional flood.

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