Borrowing By Subnational Governments

This paper presents various models of control with advantages and disadvantages, the balance of which would make it more or less suitable to a particular country's circumstances. As these circumstances evolve—as fiscal and macro imbalances improve or worsen—the preferable model may change over time. Although appealing in principle, sole reliance on market discipline for government borrowing is unlikely to be appropriate in many circumstances. This is so, because one or more of the conditions for its effective working frequently are not realized in each particular country. The increasing worldwide trend toward devolution of spending and revenue-raising responsibilities to subnational governments seems likely to come into growing conflict with systems of administrative controls by the central government on subnational borrowing. Rules-based approaches to debt control would appear preferable, in terms of transparency and certainty, to administrative controls and also to statutory limits defined in the context of the annual budget process, the outcome of which may be unduly influenced by short-term political bargaining.

Countries have adopted various institutional responses to subnational government borrowing. Using a sample of 44 countries 1982-2000, this paper provides a panel data analysis to determine the most effective borrowing constraints for containing local fiscal deficits. The results suggest that no single institutional arrangement is superior under all circumstances. The appropriateness of specific arrangements depends upon other institutional characteristics, particularly the degree of vertical fiscal imbalance, the existence of any bailout precedent, and the quality of fiscal reporting.

To bring fiscal discipline to state and municipal governments, Mexico's federal government has established a two-pillar framework that explicitly renounces federal bail-outs and establishes a Basel - consistent link between the capital-risk weighting of bank loans to subnational governments and the borrower's credit rating. Whether the framework succeeds will depend partly on market assessments of the government's commitment to enforce bank capital rules and refrain from bailing out defaulting subnational governments.

This Technical Assistance report on Brazil highlights strengthening the framework for substantial borrowing. A significant change in the institutional framework is needed to impose hard budget constraints and promote stable and sustainable policies. The approach proposed in this report is based on demanding greater transparency and accountability by subnational governments, while also making the framework more flexible. If adopted, the framework is expected to introduce risk sharing among states, within an enhanced insolvency framework, and tighten fiscal rules. The proposed changes would also put more emphasis in market incentives. The changes in the framework will also need to be accompanied by progress in addressing fiscal pressures from rising budget rigidities (including pensions) and excessive tax incentives (the so-called tax wars). It is recommended to create an independent fiscal council that monitors fiscal performance and compliance of fiscal rules by subnational governments. One possibility is to add this mandate to the Independent Fiscal Institution, while strengthening its independence and provide enough resources.

With decentralization and urbanization, the debts of state and local governments and of quasi-public agencies have grown in importance. Rapid urbanization in developing countries requires large-scale infrastructure financing to help absorb influxes of rural populations. Borrowing enables state and local governments to capture the benefits of major capital investments immediately and to finance infrastructure more equitably across multiple generations of service users. With debt comes the risk of insolvency. Subnational debt crises have reoccurred in both developed and developing countries. Restructuring debt and ensuring its sustainability confront moral hazard and fiscal incentives in a multilevel government system; individual subnational governments might free-ride common resources, and public officials at all levels might shift the cost of excessive borrowing to future generations. This book brings together the reform experiences of emerging economies and developed countries. Written by leading practitioners and experts in public finance in the context of multilevel government systems, the book examines the interaction of markets, regulators, subnational borrowers, creditors, national governments, taxpayers, ex-ante rules, and ex-post insolvency systems in the quest for subnational fiscal discipline. Such a quest is intertwined with a country’s historical, political, and economic context. The formal legal framework interacts with political reality to influence the dynamics of and incentives for reform. Often, the resolution of a subnational debt crisis unfolds in the context of macroeconomic stabilization and structural reforms. The book includes reforms that have not been covered by previous literature, such as those of China, Colombia, France, Hungary, Mexico, and South Africa. The book also presents a comprehensive review of how the United States developed its debt market for state and local governments, through a series of reforms that are path dependent, including the reforms and lessons learned following state defaults in the 1840s and the debates that shaped the enactment of Chapter 9 of the Bankruptcy Code in 1937. Looking forward, pressures on subnational finance are likely to continue—from the fragility of global recovery, the potentially higher cost of capital, refinancing risks, and sovereign risks. This book is essential reading for anyone wanting to know the challenges and reform options in debt restructuring, insolvency frameworks, and public debt market development.

This note discusses how to design subnational fiscal rules, including how to select them and calibrate them. It expands on the guidance provided at the national level on rule selection and calibration in IMF (2018a) and IMF (2018b). Thinking on subnational fiscal rules is still evolving, including their effectiveness (for example, Heinemann, Moessinger, and Yeter 2018; Kotia and Lledó 2016; Foremny 2014), and this note only provides a first analysis based on international experiences and the technical assistance provided by the IMF. Main findings are summarized in Box 1. The note is divided into five sections. The first section defines fiscal rules. The second section discusses the rationale for subnational rules. The third section provides some guidance on how to select the appropriate rule(s) and whether they should differ across individual jurisdictions. The fourth section explores the issue of flexibility by looking at how rules should adjust to shocks. Finally, the last section focuses on the “calibration” of the rules.

To bring fiscal discipline to state and municipal governments, Mexico's federal government has established a two-pillar framework that explicitly renounces federal bail-outs and establishes a Basel-consistent link between the capital-risk weighting of bank loans to subnational governments and the borrower`s credit rating. Whether the framework succeeds will depend partly on market assessments of the government's commitment to enforce bank capital rules and refrain from bailing out defaulting subnational governments.Faced with weak subnational finances that pose a risk to macroeconomic stability, Mexico's federal government in April 2000 established an innovative incentive framework to bring fiscal discipline to state and municipal governments.That framework is based on two pillars: an explicit renunciation of federal bail-outs and a Basel-consistent link between the capital-risk weighting of bank loans to subnational governments and the borrower`s credit rating.In theory, this new regulatory arrangement should reduce moral hazard among banks and their state and municipal clients; differentiate interest rates on the basis of the borrowers' creditworthiness; and elicit a strong demand for institutional development at the subnational level.But its success will depend on three factors critical to implementation:middot; Whether markets find the federal commitment not to bail out defaulting subnational governments credible.middot; Whether subnational governments have access to financing other than bank loans.middot; How well bank capital rules are enforced.This paper - a product of the Mexico - Country Department and Poverty Reduction and Economic Management Sector Unit, Latin America and the Caribbean Region - is part of a larger effort in the region to understand the subnational underpinnings of sustainable, national economic framework. The authors may be contacted at [email protected], [email protected], or [email protected].

A comprehensive explanation of information institutions as they relate to the success of subnational capital markets Global trends in decentralization and the growing role of world cities have increased the importance of infrastructure development. But with competing incentives of suppliers and borrowers of capital in the web of institutional governance arrangements, information problems are inevitable. Understanding how local choices affect these larger trends can help national and city actors not just avoid being paralyzed by information problems, but actually improve information resolution. In this book Christine R. Martell, Tima Moldogaziev, Salvador Espinosa argue that capital markets are a viable financing alternative for subnational borrowers. They explain how subnational governments can manage their fiscal and debt choices to leverage capital markets to finance efficient, effective, and equitable infrastructure provision. The book builds on previous work by exploring the role of information institutions as they relate to the success of subnational capital markets and by advancing options for subnational government to gain agency as active market participants. With broad geographic coverage, Information Resolution and Subnational Capital Markets answers core questions: How does information permeate the landscape and outcomes of subnational government borrowing, both at the aggregate national level and at the city level? What measures and mechanisms can national and subnational governments take to resolve information problems? And, what can cities do to enhance their agency vis-à-vis central governments and capital market actors, so that they can command a voice in managing internal and external sources of capital financing?