1 Lex localis - Journal of Local Self-Government, Volume 14, Issue 1, January 2016, pp. 115-132. Sustainability of local government sector debt. Evidence from Monte-Carlo simulations Krzysztof Kluza Abstract The financial standing of local governments across the European Union was strongly affected by the economic crisis. The local government sector conducted vast investment policies reaching 10.2% of all investments in the EU countries in 2010. However, at the same time its indebtedness expanded significantly. The current low interest rate environment makes the sector vulnerable to future interest rate increases. The presented research analyses the impact of several scenarios of interest rate changes in Poland on the local governments’ ability to service their current debt burdens. Simulations are conducted with the Monte Carlo method. Some scenarios indicate a high vulnerability of local governments to adverse changes in market interest rates, but only if they are combined with a reduction of sector’s operating surplus. Such an economic setup may give rise to systemic problems for the whole public sector. JEL: C53, E62, H72, H74, R50 Keywords: local governments, debt sustainability, interest rate increase, Monte Carlo method 1. INTRODUCTION The methods of financial risk assessment and scenario testing have been employed in finance and economics for a long time. Initially, they were mostly used by banking and insurance sector supervisory bodies as well as the individual market players. They aimed to monitor the financial position of single entities and whole sectors in order identify vulnerabilities to different types of risks and plot future scenarios so as to mitigate adverse consequences. They evolved into stress testing methods, whose significance has additionally grown since the outbreak of the financial crisis in 2008. A comprehensive description of the methodologies used in the testing is presented, i.a. in (Vasilopoulos, 2013), and guidelines are in (BIS 2011, 2013). Simultaneously, numerous analyses devoted to fiscal sustainability of individual countries have been made. Research in this area has intensified since 2008, when several Mediterranean European Union (EU) members experienced serious fiscal troubles. For example, the sustainability of sovereign debt for Greece is analyzed in (Cline, 2013) and (IMF, 2013). Debt projections for numerous alternative scenarios for Italy and Spain are presented in (Cline, 2012b), confirming future debt stability in these countries. The impact of interest rate shock on Italy’s Sovereign Debt is presented in (Cline, 2012a), showing both the maximum sustainable interest rate level as well as contingent risks from such scenarios as liquidity squeeze. (Eller, Urvova, 2012) conduct a thorough analysis of public debt sustainability in Central and Eastern European Countries, based on the stochastic debt sustainability analysis. This research in general confirms the debt stability of these countries in the medium term, although they also show that the primary balance is not responsive enough to fiscal and macroeconomic shocks. Analyses of country sustainable debt levels are conducted by (Ghosh et al., 2013). Using stochastic models authors derive the areas of fiscal solvency failures for individual countries. They also show that the marginal response of the primary balance to lagged debt (ie. fiscal multipliers) is non-linear. It remains positive at moderate debt levels but starts to decline when debt reaches around 90–100% of GDP. Similar conclusions for the EU countries are delivered by stochastic simulations of