Subnational Borrowing Framework

1. Subnational Borrowing Framework Lili Liu Lead Economist PRMED PREM Learning Week Washington DC, May 10 2006

2. Outline • Rise of Subnational Debt Market • Subnational Borrowing: Key Fiscal Concepts • Subnational Debt Crisis • Regulatory Framework for Subnational Borrowing: Ex-ante and Ex-post Regulation • Subnational Fiscal Adjustment: critical for access to borrowing, but adjustment process differs from that for national government • Conclusions

3. Rise of Subnational Debt Market • Factors contributing to the rise of subnational debt market in MICs • Decentralization of significant spending responsibilities to subnational governments. • Globalization (capital mobile, financial sector liberalization). • Large and growing infrastructure financing needs.

4. Benefits of Subnational Borrowing • Infrastructure financing demands capital market development. • Intertemporal financing nature of infrastructure. • Exposing subnational government to market discipline, reporting requirements, and fiscal transparency => promoting good governance. • Facilitating financial market reforms.

5. Size of Subnational Debt Market • United States has the most dynamic and largest subnational debt market. • About US$400 billion subnational bonds are issued per year on average. • Subnational bonds outstanding US$1.12 trillion (December 2005), accounting for about 10 percent of US domestic bond market, and 26 percent of US public sector bonds.

6. Subnational Bond Market in MIC Small but Developing • Development Uneven Across MICs • Russia: Subnational bond market most rapidly growing segment of subnational debt, having grown six fold since 2001 to $5.1 billion. • Colombia: domestic capital market small and shrinking. • Romania: 50:50 bank financing and bonds. • Mexico post-crisis adjustment.

7. Differentiated Subnational Entities in Client Countries

8. Subnational Financing: Basic Concepts • Expenditure • Recurrent expenditure • Capital expenditure • Revenues • Own Revenues • Transfers • Financing Gap • Borrowing

9. Subnational Financing: Basic Concepts • Three basic concepts of fiscal balance • Fiscal balance • Primary balance • Consolidated balance (to include off-budget liabilities)

10. Key Fiscal Aggregates • Subnational fiscal sustainability: Refers to the ability of the subnational government to sustain its fiscal policies in the long-run while remaining solvent • Solvency is defined as the ability to service debt • Four key indicators: • Recurrent Expenditure/Total Revenue • Fiscal Deficit/GSDP • Debt/GSDP • Debt Service Ratio

11. Subnational Debt Crisis: Overview • Subnational debt crisis occurs when a large number of subnational governments become insolvent. • Subnational debt crisis: Argentina, Brazil, Mexico, Russia, etc. • Crisis can be widespread and defaults systemic • US: history. Modern defaults exceptions. • Potential risks in newly decentralized countries (e.g., Mexico, Hungary). • Is absent of crisis good thing?

12. Subnational Fiscal Stress: India

13. Subnational Fiscal Stress: India Caveats: • While Debt/GSDP of Indian states not high (25% in 2001/02), compared to 65% for the center, the states’ ability to meet debt service obligations was eroding. • Debt stress: interest payments/revenues > ? • The reported deficits underestimate real liabilities due to arrears.

14. Subnational Fiscal Stress: India • Rapid increase in expenditures on salaries, retirement benefits, and pensions • Rapid increase in subsidies • For some states, their share in central tax devolution declined further following the Finance Commission’s award. • Increased borrowing to support the growing revenue deficit. • Growth in contingent liabilities associated with fiscal support to the public sector units, cooperatives, and the statutory boards.

15. Subnational Debt Crisis: Mexico • The 1994-1995 Tequila crisis (financial crisis) exposed the vulnerability of subnational debt profile: • High ratio of debt over the shared revenues received by the states, particularly for the four largest subnational borrowers. • Short debt maturity which lead to higher share of principal payment over subnational’s annual shared revenues; and • Nearly all debt carried floating interest rates. Adverse developments in the late 1994 that persisted through 1997 (rapid currency depreciation, sharp rise in interest rates, sharp contract in pool of shared revenues, and inflation) made debt payment unsustainable.

16. Impact of Subnational Debt Crisis • Jeopardize public services. • Risks to financial system. • Country’s own creditworthiness. • Overall macroeconomic stability.

17. Regulatory Framework for Managing Subnational Borrowing Risks • Regulatory framework for ex-ante control • Regulatory framework for ex-post insolvency • These two are not exclusive, they re-enforce each other.

18. Purpose of Regulatory Framework • Commitment drive for fiscal discipline • Improve accountability for use of taxes • Intergovernmental coordination: reduce free rider problems • Induce subnational governments to undertake fiscal adjustment • Improve subnationals access to capital market • Transparent debt restructuring

19. Regulatory Channels for Controlling Subnational Debt Crisis Source: Steven Webb, “Fiscal Responsibility Laws for Subnational Discipline: the Latin American Experience” July 2004

20. Ex-Ante Regulatory ControlFiscal Responsibility Law • What is Fiscal Responsibility Law? • Limits on fiscal aggregates • Procedural requirements (MTFP, etc) • Fiscal transparency (audit, contingent liabilities, etc) • Sanctions

21. Fiscal Responsibility Law National law, National Law Subnational own All levels of gov’t central gov’t only FRL Argentina Y Some opted in Brazil Y Canada N Most Colombia Y India Y 5 states have FRL. All states now required to have FRL Russia Y Peru Y UK Y

22. Ex-ante Regulation: Case of India • State-level Fiscal Responsibility Legislation • Before the 12th Finance Commission, five states (as well as the Government of India) passed fiscal responsibility legislation. • After 12th Finance Commission, fiscal responsibility legislation has become mandatory for states. Incentive have been offered to states to pass fiscal responsibility legislation, and all states are in the process of putting the required legislation in place. • FRL needs to meet minimum standards - eliminating revenue deficit by fiscal year 2008/09, reducing fiscal deficit to 3% of GSDP by the same year, annual intermediate deficit reduction targets, and annual reporting requirements.

23. Ex-ante Regulation: Case of India • Introduction of Global Borrowing Limits • Incentives for Fiscal Prudence • Fiscal Reforms Facility, covering 1999-2004, established fiscal incentives for states to reduce revenue deficit. • The Debt Restructuring and Relief Facility, covering 2005-2009, rewards states for revenue deficit reduction with debt restructuring and relief. • Controlling hidden and contingent liabilities (power, civil service pension, guarantees)

24. Ex-ante Regulation: Colombia • Traffic Light Law (Law 358, modified by Law795) • Linked the borrowing of subnational governments to their capacity to pay the debt service. • Introduced a rating system for subnational gov’ts. Established Indebtedness Alert Signals. Two indicators for each new loan: a liquidity indicator (interest payment/operational savings) and a solvency indicator (debt/current revenue). • Critical indebtedness (red light): Interest/operational savings > 60%; debt stock/current revenues > 80%. Prohibited from borrowing. • Autonomous indebtedness (green light): Interest/operational savings < 40%, debt stock/current revenue < 80%. Allowed to borrow.

25. Ex-ante Regulation: Colombia • Law 617 • Established more fiscal rules for subnational governments. For example, a ceiling for the ratio of discretionary current expenditure over non-earmarked current revenues. • Fiscal responsibility law • Strengthening medium- and long-term fiscal management. • Both the central and subnational governments need to present a 10-year macroeconomic framework each year. • Both the central and decentralized budgets must also be in full compliance with the medium-term macroeconomic framework.

26. Ex-ante Regulation: Colombia • Supply side regulations • Prohibits lending by the national government to a subnational entity or guaranteeing its debt if the subnational is in violation of Law 617 or Law 358 or if they have debt service arrears to the national government. • Lending to subnationals by financial institutions and territorial development institutions must meet the conditions and limits of various regulations such as law 358, law 617, and law 817. • Otherwise the credit contract is invalid and borrowed funds must be restituted promptly without interest or any other charges.

27. Regulatory Framework: Insolvency • Why Insolvency Framework important • Country cases: US, Hungary, South Africa, Albania, Bulgaria, Macedonia and Romania • Principles • Core difference between subnational and corporate bankruptcy • Hard budget constraint for subnational entities • Clarity of rules to minimize corruption • Everyone shares the pain • Judicial or administrative approach?

28. Subnational Fiscal Adjustment • Subnational own creditworthiness important for accessing financial market • Both ex-ante and ex-post regulations induce subnational governments to undertake fiscal adjustment • Weak, corrupt and unstable central government undermines the ability of subnational governments to achieve good credit rating • Same is true for weak and corrupt subnational government

29. Fiscal SustainabilityHow Subnationals Differ from the National • Subnationals cannot issue their own currency, hence cannot use seigniorage finance • Foreign exchange risk may not directly affect sub-national finance • For example, in India, China and Peru sub-national governments’ external borrowing needs approval and guarantees from the national government which bears the foreign exchange rate risk • Currency risks can have an indirect impact on sub-national fiscal sustainability through real interest rate shocks

30. Fiscal SustainabilityHow Subnationals Differ from National • Monetary policy is at the purview of the central government • In a competitive bond market, a subnational government cannot set the interest rate at which it borrows. Its own actions however influence the spread it pays over or below the central government’s interest rate • Subnational lending markets are not competitive in many developing countries. • In India, interest rates on government bonds are the same for all states independent of their credit worthiness. Thus, better managed states cross-subsidize poorly managed ones, weakening incentives for prudent fiscal behavior

31. Fiscal SustainabilityHow Subnationals Differ from National • Legal constraints to the ability of sub-national governments in raising their own revenues, a key determinant of fiscal adjustment. • The legal constraints are set by the constitution and legislation • In India, the Constitution limits the power of states in setting tax policy. • The legal framework can change, due to evolving legal frameworks for fiscal decentralization in many countries. • In China, personal income tax was levied and retained by provinces prior to 2005. Now, personal income tax is shared between the center and provinces on a 50-50 basis.

32. Fiscal SustainabilityHow Subnationals Differ from National • Transfers from the central government are an important source of sub-national revenues. • Dependency on and predictability of fiscal transfers varies across countries. • In India, fiscal transfers are around 37% of states total revenue • In Mexico, fiscal transfers are 85%-95% of states total revenue

33. Fiscal SustainabilityHow Subnationals Differ from National • Central governments affect subnational fiscal finance and growth via: • national policies on wage and pensions (e.g., India, Brazil). • ceilings on debt service and debt stock (e.g., Colombia, Peru, Russia, India, and Mexico). • decisions on major infrastructure projects (e.g. ports, air markets, business exit policy), FDI policy, labor market regulations in India • Markets may tolerate unsustainable subnational fiscal policy if the center implicitly guarantees the debt services of subnationals.

34. Conclusions • Subnational borrowing critical to financing infrastructure and other services • Unregulated subnational borrowing can lead to widespread debt crisis, impact public services and threaten financial and macro stability • Subnational borrowing framework needs to think the incentives it can create for borrowers and lenders: moral hazard issues • Subnational borrowing framework needs to integrate infrastructure financing, capital market development, fiscal transparency, fiscal sustainability, decentralization, regulatory and governance reform, and macroeconomicstability.