European Cities on the Edge of a Debt Crisis

As European capitals look to fund ballooning deficits, local and regional borrowing is set to reach record levels

Venice: Rialto Bridge and Grand Canal
In a bid to shore up the city’s finances, Venice has put three historic sties, including the Grand Canal, up for sale. Photograph: Sergio Pitamitz/Corbis

While relaxing on the back of a gondola, the millions of tourists who drift by the Palazzo Diedo, Gradenigo or San Casciano in Venice don’t generally know that what they’re looking at are the roots of another European debt crisis. For in a desperate move by the Italian city to shore up its books, these three historic Venetian sites have been put up for sale.

A quarter of Venice’s income comes from the City-owned casino near the famous Rialto bridge, where thousands of tourists gamble, unaware that they’re funding the city’s battle against rising lagoon levels, or paying for its world-renowned carnival. But a credit crunch-led drop in tourism has starved the municipal coffers, and forced the city into new fundraising ventures. Venice recently created an 18-property fund, valued at €82m (£71.3m), expected to be sold within three to five years.

“The lower income from the casino has decreased our expense capacity, so the fund structure gave us half of the value, €40m in cash, ahead of the sales,” said Paolo Di Prima, director of financial investment at Comune di Venezia – the city hall. Downgraded by Moody’s earlier this month but still within investment grade status, Venice is “not desperate, as before we had an excellent position, and now we’re in a good one”, Di Prima says.

The crisis in the eurozone is making headlines at the moment, but at a lower level another debt storm is slowly brewing. European cities and regions are expected to flood the market this year, all anxious to fund ballooning deficits. Local and regional government borrowing is expected to reach a historical peak of nearly €1.3 trillion, according to credit ratings agency Standard & Poor’s (S&P). The bulk will come from the highly decentralised German Länder (states) and from the deficit-ridden Spanish regions, which face severe central government transfer cuts. Regions also face higher borrowing costs and, most likely, further credit downgrades.

“We expect a significant increase in [debt] issuance in Germany; German borrowers have huge refinancing needs and they’re running deficits,” said Myriam Fernandez, head of European local and regional government ratings at S&P. “And in Spain, where there is a need to roll over debt, and there are high deficits in 2010, we could see further downgrades for local and regional governments.”

S&P recently cut the rating of Madrid, whose debt is expected to remain between 155%-170% of expected revenues until 2012. Madrid went through a spending spree during the boom years, investing millions in infrastructure projects, such as covering up the ring road around the capital. Valencia also spent huge sums in international attention-grabbing events such as the America’s Cup or a Formula One grand prix.

“These events don’t have any capacity to generate economic growth and now they will have to rush to issue debt,” said Andres Rodriguez-Pose, a professor of economic geography at the London School of Economics. “They will have fewer transfers from the central government and will need to cut their budgets brutally.”

Catalonia also suffered the S&P axe, as the credit ratings agency said the region’s “high debt burden is likely to persist in the long term”. But the downgrade won’t affect the government’s ability to tap international markets, claims Ferran Sicart, general director for financial policy at the Catalan government. As with other senior civil servants, he faces a possible 15% salary cut as the region tries to shrink its deficit. Catalonia needs to raise €9.4bn this year, almost twice as much as last year, and plans to use its industrial and tourism base, as well as the strong Barcelona brand to attract investors. Catalan officials have now added Japan to the usual roadshow spots of London, Paris and Frankfurt.

“The weight of international investors in our public debt has slightly diminished – there’s also more competition, so we have to reach out to investors, through meetings and roadshows,” Sicart says. “We need to raise more money because of a fall in tax-intake, mostly linked to the construction sector.”

But as much admiration as Catalan officials receive for Barcelona – and its successful football team – Catalonia still needs to pay higher interest rates than it did before financial turbulence hit the markets earlier this month.

In contrast, the German state of North Rhine-Westphalia can get away with forking out just 0.35% above the sovereign German bund rate. The biggest local borrower in Europe, it plans to raise €27bn this year – one third of it through bonds. “We take advantage as German bonds are seen as a safe haven – and we offer a bit more than German sovereign bonds,” says Eckhard Helms, the state’s treasurer, in his office in Dusseldorf. “We tell investors we’re reliable. I don’t compare myself to Spanish regions, but the market seems to make differences.”

Germany’s richest and most populous state isn’t immune to the global recession, though: North Rhine-Westphalia needs to raise €3bn more than last year, “because we have lower tax income, and because we had to issue short-term bonds following the collapse of Lehman Brothers two years ago”, Helms says.

An established player in international markets, the state plans to issue more than €1bn worth of securities soon, and to do so it will send representatives around around Europe, Asia and the Middle East. The US is not a target market as regulatory costs are too expensive, Helms says.

Cities don’t have the financial fuel of nations or global corporations, which pay multimillion-pound mandates to globetrotting investment bankers to find them investors. Also gone are the days when Wall Street firms took potential financiers bear-hunting in Poland to earn a stock market listing appointment. For cities and regions, a few tapas in Madrid or a book explaining the charms of Düsseldorf are what’s on offer.

They also face competition from newcomers such as Spain’s autonomous communities of Aragon or Galicia, and above all, they face anxious investors, who are even more risk-averse following the Greek debt meltdown. The Basque government, in northern Spain, has postponed a trip to market a bond issue of more than €1bn, a banker involved in the situation claims.

“The market is shut, nobody’s doing anything,” the banker says. “Money can’t be kept in a drawer but it was shut two weeks ago, and it will have to reopen.”

There are other more traditional problems, of course. S&P says the Italian city of Naples faces “structural problems in generating liquidity”. What does this mean? “Tax collection rates are very low. They raise taxes, but they don’t collect them – it’s not a problem of large indebtedness”, Fernandez says.

European regions had traditionally borrowed from public finance specialist banks such as Germany’s Depfa, or Dexia in Belgium. That has now changed. “That traditional base, the public sector banks, is not operational anymore,” says Philip Brown, Citigroup’s head of public sector origination. “And in this climate, investors are now very sensitive to countries with large debt.”

Despite the challenges, rating agencies don’t foresee any local financing catastrophe. According to S&P, most west European-rated cities and regions are still far from the lowest “junk” credit rating – giving them room and credibility to manoeuvre.

But the situation is rather different in eastern Europe. Cities such as Istanbul are rated as junk – as Turkey is still recovering from the severe financial crisis there 10 years ago.

“Most non-investment grade ratings are in eastern Europe, in countries such as Russia, as they have weak economies and have had liquidity problems in the past – they also lack the financial sophistication that comes with decades of experience in capital markets,” S&P’s Fernandez says.

Latvia’s capital city, Riga, is on the edge of a junk rating amid its “dependence on sharply diminishing revenue sources, the lack of authority over the city’s tax revenue and pressures arising from off-balance-sheet financing schemes,” Moody’s recently said.

In 2005, Riga borrowed €440m from Deutsche Bank to build a bridge over the Daugava river, which was recorded as a “trade payable,” instead of outright debt. The city changed the policy two years later, adding the sum to its debt pile.

But however bad it gets, Despite ballooning deficits, European regions and cities can expect the state to bail them it: hence they are not expected to follow counterparts in the US, where municipalities bear all of the financial responsibility.

In the US, Orange County and cities such as Vallejo, California, or Bridgeport, Connecticut, have gone bust over the past few years, and the entire state of California has been on the brink of collapse. “California has a political system where everything is based on referendums, so they always say they can’t raise taxes, so they don’t have resources for anything,” said Rodriguez-Pose. California’s governor Arnold Schwarzenegger last year stopped buying school textbooks, in a desperate move to cut costs.

In Europe, the explosion of local and regional funding may be putting cities and regions under intense strain, upsetting central governments and not generating enough fees for bankers. The fight between their politicians to attract funds will be “brutal,” Rodriguez-Pose warns.But for once, citizens seem to be the only winners: research shows the higher the level of local financial independence, the happier local residents are. Let’s hope the cities can stay above water.

A short history of European debt

Lenders have not always put pressure on borrowers. At some point, it was the other way around. According to Carmen Reinhart and Kenneth Rogoff, authors of This Time is Different: Eight Centuries of Financial Folly, a king’s promise to repay could often be removed as easily as the lender’s head. In the middle ages, whole families were slaughtered simply to seize their lands and wealth.

A few centuries later, after the 1400s, Italian city-states such as Venice, Genoa or Florence developed more sophisticated markets, where loans were traded after being issued. But this period also saw the first true international debt crisis.

By then, Italian merchants lent huge amounts to England, a less financially sophisticated country, which was only just starting to generate wealth through natural resources such as wool.

The Italian loans, which funded wars between England and France, were in trouble after Edward III of England defaulted in 1340, following a series of military failures. News of the default hit Florence, causing a bank run on the lenders’ doors, and ultimately leading to the collapse of the Peruzzi Bank.

England wasn’t able to fend off its serial defaulter tag until the 1688 revolution strengthened the powers of parliament. Italy, however, didn’t learn from its mistakes, and became a big lender to Spain’s worldwide exploratory forays and battles. Costly ventures such as the Invincible Armada led to a series of defaults, making Spain, with 13 failures, the country with the worst record in Europe. Germany and France follow with eight. Greece has just five.

Elena Moya
Sunday 23 May 2010

Source: The Observer

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