Soft budget constraints: The case of municipal bonds in Italy

This paper discusses a novel approach to identify soft budget constraint expectations, exploiting the idea that financial investors rationally incorporate in sub-national bond prices also expectations of future bailouts by the central government. We consider as a testing ground the municipal bond market in Italy. We first build an original dataset of all the 1 388 bond issuances from 1996 (the year when the national legislation provided an organic discipline for municipal bonds) to 2011, involving 529 cities out of about 8 000. We then regress bond yields at issuance on bond characteristics, central government bond yields, and three proxies for bailout expectations on soft budget constraints (an index of vertical fiscal imbalance and of central government budget tightness, plus a dummy for the city being subject to the Domestic Stability Pact). Our results suggest that soft budget constraint problems arise frequently, especially in small cities and those located in the poorer South.