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      German Länder to increase borrowing by end-2024 for investment but continued focus on consolidation
      WEDNESDAY, 31/07/2024 - Scope Ratings GmbH
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      German Länder to increase borrowing by end-2024 for investment but continued focus on consolidation

      Germany’s Länder are likely to borrow around EUR 10bn more than originally planned this year as they face weak domestic economic growth and federal budgetary constraints.

      Julian Zimmermann, Sovereign and Public Sector

      We estimate that aggregate funding needs for 2024 are now around EUR 60bn, up from EUR 45bn in 2023, as the Länder take advantage of the limited flexibility under the so-called debt brake for additional borrowing even though overall fiscal consolidation this year will likely amount to 2% of total spending.

      The German Länder which have widened their funding targets, mainly in response to weaker-than-expected economic growth and continued high investment spending, include North Rhine-Westphalia (AAA/Stable), planning to use the cyclical component of the debt brake (EUR 2bn), and Hesse (AAA/Stable), extending borrowing under the cyclical component and for (net) spending on financial transactions (EUR 2.8bn).

      Berlin (AAA/Stable) is another example. The Land includes EUR 1.7bn in (net) spending on financial transactions. Finally, Baden-Württemberg (AAA/Stable) plans to use the cyclical component in 2025 for up to EUR 774m (together with reduced redemptions). This resembles the federal government’s (AAA/Stable) approach, which plans to borrow around EUR 44bn, or 1% of GDP, in its 2025 draft budget, while remaining compliant with constitutional borrowing limits.

      Figure 1: German Länder: expected deficits in 2024-25 will lead to higher borrowing
      % of operating revenue

      Source: Destatis, issuers, Scope Ratings

      Modest financing needs due to expected deficits
      More broadly, this year’s funding shows that the federal and Länder governments retain some flexibility to address budgetary realities. This is even after the ruling by the German Constitutional Court in November 2023, which restricted use of the debt brake’s emergency clause for potentially very large borrowings to fund multi-year spending, a practice common in 2020-23.

      Using the debt brake more flexibly under existing rules helps to ease the pressure on the Länder to consolidate their public finances, but ultimately unlocks only modest sums to tackle rising structural challenges, including costs and investments associated Germany’s ageing population and the green and digital transitions.

      Funding needs arise for the Länder due to expected deficits of around 2.5-3.0% of operating revenue in 2024 and 2025 (see Figure 1). These will only be partly financed with remaining budgetary reserves, which we expect will be largely exhausted by end-2025. Deficits are driven by a narrowing operating balance at around 8% of operating revenue, as higher spending on personnel and transfers outpace growth in tax revenue. In addition, net interest expenditure will increase to around 2.5% of operating revenue, up from 1.7% in 2023. Finally, (net) capital expenditure is projected to remain high, standing at around 8% of operating revenue.

      Fiscal consolidation key priority, but rigid expenditures and diverging revenue impact from census
      In the context of moderate growth, which we estimate at around 1% over coming years, the focus remains on consolidation programmes of around 2% on average of total spending each year. Länder’s expenditure flexibility is relatively limited, and spending on personnel will keep rising, partly due to pay rises negotiated in December 2023, which led to personnel expenditure rising by 8.8% YoY up to May 2024.

      While consolidation targets are ambitious, we ultimately view them as broadly achievable due to Länder’s commitment and strong budgetary management. The debt brake, allowing for its more flexible provisions, supports a declining trend in the system-wide debt-to-operating-revenue ratio.

      The Länder will still have to prioritise what capital expenditure they undertake, but overall investment spending will remain high, with a focus on the green and digital transformation and education, security, healthcare, and social housing. Conversely, voluntary transfers to budgetary reserves, such as for coverage of pension liabilities for civil servants, will likely be paused to create some headroom in the near term.

      Finally, the Länder’s individual consolidation efforts will also depend on the financial impact of the 2022 German census, which was finalised in early 2024. Re-estimated population figures are a key input for distribution of shared taxes among the Länder.

      The largest relative winners of the census exercise are Saarland and Bremen (both financially relatively weaker), which will receive an additional 2-3% of operating revenue a year from 2024. Conversely, Berlin and Mecklenburg-Western Pomerania are the two states that will receive the largest deductions to their tax shares, at 1.7% and 1.4% of operating revenue per year, respectively. To smooth the impact, the retroactive corrections for 2022 (2023) will be reduced to 1/3 (2/3). Berlin had already created a dedicated budgetary reserve to partially absorb the census impact.

      Scope recently expanded its public rating coverage of German Länder, and rates the remaining issuers, as well as Länderjumbos, on a subscription basis, available via ScopeOne.
       

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