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The German federal institutional framework is highly integrated, closely tying Länder credit quality to the federal government’s AAA-rating. This close connection is evident in the federal government’s financing of the costliest measures related to the energy crisis in the aftermath of Russia’s full-scale invasion of Ukraine.

After an aggregate budget deficit of around 1% of GDP in 2020 due to the Covid-19 pandemic and significant borrowing under emergency debt-brake rules, the Länder saw moderate surpluses of around 0.1% of GDP on average in 2021/22, supported by a recovery in tax collection.

“Revenue should continue to be robust, though rising interest and operating costs, as well as high investment spending, will place structural pressure on the Länder’s budgets,” says Julian Zimmermann, senior analyst at Scope Ratings. “Still, we project the Länder to broadly maintain balanced budgets over 2023/24, as most Länder return to strict deficit limitations of the debt brakes,” Zimmermann says.

Summary of main trends for Germany’s Länder in 2023

Debt burden to stay broadly stable after recent increase; debt affordability still strong

Länder governments took advantage of the low-interest environment, issuing record-high amounts of debt in the years 2020/21.

“The aggregate debt burden will stay broadly stable in coming years, due to the Länder’s debt brakes, but the states have limited budgetary room to reduce nominal debt levels. Rising interest rates complicate consolidation efforts of highly indebted issuers, but dedicated federal transfers and a low implicit interest rate of 1.4% in 2022 support the sector’s debt affordability,” says Zimmermann.

Market watch: Moderate bond issuance set to continue

Länder bond issuance has slowed over recent months. As monetary policy normalisation progresses, Länder’s bond yield spreads to the federal government have widened, but remain in line with long-term averages, anchored by close institutional ties.

“Issuance will remain moderate this year, partly because borrowing needs can be fulfilled via reserves, some of which reflect unused funds from the Covid-19 pandemic,” says Zimmermann.

ESG issuance will continue to grow in relevance, but at a measured pace. The Land of Berlin (AAA/Stable) recently issued its first sustainable bond in early 2023, extending the list of Länder with ESG-linked securities to four. The volume of such bonds remains limited, however.