Academic journal article The Innovation Journal

Financial Innovation in Local Governments as a Response to the Deterioration of Their Risk Profile and Legislative Changes: The Case of Poland

Academic journal article The Innovation Journal

Financial Innovation in Local Governments as a Response to the Deterioration of Their Risk Profile and Legislative Changes: The Case of Poland

Article excerpt

Introduction

The financial crisis which broke out in 2008 had a profound impact on public sector finances. During the crisis, local governments undertook vast investment efforts, which created strong countercyclical and pro-growth stimuli for the economy. Local government investments amounted to 9.2% of total investment in the EU countries. In the case of Poland, the local government sector had an even bigger influence on the domestic economy as it generated over 14% of total country investment. Several pieces of research show that local governments' spendings have relatively high productivity (Blöchliger, 2013), (Blöchliger and Égert, 2013), (Fredriksen, 2013) and thus effectively support economic growth. However, on the other hand they resulted in growing debt burdens. In the European Union, the debt of local governments grew from 5.5% of GDP in 2008 to 7.7% of GDP in 2013. In Poland local government debt nearly doubled - from 2.3% to 4.2% of GDP in this period.

Consequently, the economic slowdown worsened the risk profile of local governments and hindered the execution of public policies (Vammalle and Hulbert, 2013). Since 2010, the local government sector in the European Union countries has experienced an overall decrease of its productivity, accompanied by a relative deterioration of its financial standing (Kluza, 2014). The debate on the design of the fiscal consolidation process in local governments as well as flaws of the fiscal austerity model for municipalities as a response to the crisis are shown inter alia in Peck (2014) and Donald et al. (2014).

The deteriorated financial standing of local governments triggered financial innovation efforts in the local government sector. This process is extensively described in Pérignon and Vallée (2014) based on data for local governments in France. Among others, the authors show the political behavior factors leading to demand for innovative financing products, which are often a sort of toxic instruments which increase the credit risk of local governments in the future. Additionally, the authors show that such behavior is more frequent in highly indebted, and thus, more risky entities. The dynamics behind the innovation process in the financial sector as well as the mechanisms leading from higher financial innovation to higher probability of financial crises is presented in Thakor (2012). The risks for taxpayers, investors as well as for the financial system, which may be generated by financial innovations in the local governments, are analyzed in Whitaker (2014). Whitaker's analysis concentrates on innovation in municipal bond issuance.

In this paper, we focus on innovative financial products in Poland such as the sale and leaseback of property and the reversed tenancy, outlining both the rationale and benefits of their implementation by local governments as well as the risks arising from them. These innovations must be clearly distinguished from the public sector innovation processes aiming at achieving social and economic development through freeing a creative potential, which are widely described in Gow (2014). They are more related to creative accounting instruments, although their primary goal is to sustain local governments' investments in the real economy.

The current wave of financial innovation in Polish local governments was caused by two main factors: the worsened financial standing of local governments in Poland during the economic slowdown period and legislative changes regarding statutory debt limits. This created a framework similar to that described in Pérignon and Vallée (2014), in which the demand for innovative products is mainly driven by entities with the worst financial standing.

The investment efforts of local governments in Poland were associated with a deep deterioration of their risk profile compared to the pre-crisis year, 2008. On average, local governments had the worst financial standing in 2011. Since 2011, the average situation has improved modestly, but there is a group of local governments with strongly worsening financial indicators. …

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