Global Finance Crisis Structural Challenges Sub-sovereign ...

1. Global Finance Crisis & Structural Challenges Sub-sovereign Finance November 5, 2010 Lili Liu Lead Economist & Cluster Leader for Subnational Finance Co-Chair of Decentralization and Subnational Thematic Group Economic Policy and Debt � 2010 by The International Bank for Reconstruction and Development/The World Bank

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3. Importance of Subnational Debt in Developing Countries Contributing factors Worldwide decentralization has given subnational governments spending responsibilities, revenue raising power, and capacity to incur debt Rapid urbanization => Immense infrastructure financing needs in developing countries, urbanization Globalization, capital mobility, and more competitive financial markets 3

4. Impact of Global Financial Crisis The global financial crisis has had a profound impact on subnational finance across countries Reduced economic growth rates => reduced fiscal transfers and own revenues Deteriorating fiscal balance driven by declining revenues combined with expenditure rigidity or continuing expenditures. 10/2008-1/2010: Moody�s rating actions affected 72 SNGs or 24 percent of the rated universe outside the United States. 96% of the actions were in a downward direction. For example, 31% of the actions were downward for Western Europe and Commonwealth of Independent States/Central and Eastern Europe countries, and 13% were downward in Asia Pacific. 4

5. Fiscal Balance as Share of GDP for Subnational Governments in BRIC Countries 5

6. Fiscal Balance as Share of GDP for Subnational Governments in Selected Developed Countries 6

7. Impact of Global Financial Crisis Cost of borrowing through increased spread and shorten maturity Exchange rate. Even though subnationals are not allowed to borrow externally without sovereign guarantees, the interaction of currency and interest rates could affect subnational debt service structure 7

8. Yield Spread and Maturity for Subnational Bonds Issuance Quarterly2007-2010 (Excluding US) 8

9. Yield Spread of 10-year US Municipal General Obligation Bonds 2007-2010 Q1 9

10. Long term structural pressure: urbanization and infrastructure Developing countries invest 3-4% of GDP in infrastructure, far short of what is viewed as required 7-8% of GDP Rapid Urbanization requires large scale infrastructure investments Each year, over 60 million people move into cities. By 2030, 1.8 billion more people will become urban, most of these in developing countries This will requires large scale infrastructure investments in transport, subway systems, rail/air/sea links, tunnels, water supply and sewage systems, waste treatment facilities, power generation and distribution, etc Characteristics of infrastructure investment Debt financing, if properly regulated, is a sound public policy 10

11. Long term structural issues: infrastructure (cont) 11

12. Factors Critical to Sustainable Subnational Borrowing Macroeconomic stability Regulatory frameworks Ex ante fiscal rules Ex post insolvency system Subnational debt management Competitive and diversified subnational credit markets 12

13. Macroeconomic Fundamentals The sovereign�s macroeconomic fundamentals will continue to be vital to the fiscal sustainability of SNGs Sovereign rating as a binding constraint for sub-sovereign ratings (Fitch, Moody�s, S&P) Macroeconomic cycles and subnational credit market development Recent global financial crisis and subnational credit market With the gradual withdrawal of fiscal stimulus packages and the ending of monetary easing, pressures on SNGs� fiscal space could increase through various channels, such as reduced fiscal transfers and higher borrowing costs Risks from unregulated subnational borrowing in unstable macroeconomic environment 13

14. Macroeconomic Fundamentals (cont) 14

15. Developing competitive subnational credit markets Ensure the lowest cost and the sustainable availability of credit Provide more choices of investment instruments for institutions (such as insurance companies and mutual funds), and individual investors Two major models of subnational credit markets (Peterson 2002) Western European: bank lending dominates, though bond market developing over the last 10 years US: capital market Though bank loans still dominates SNG borrowing in many developing countries, various countries have been moving toward more diversified instruments including bonds China leading in this direction. being the largest and dominant issuer On aggregate, size of bond market small in developing countries. 15

16. Developing competitive subnational credit markets Private capital has emerged as important, though public institutions still dominate subnational lending in some countries Subnational bond market volatile (outside US) Subnational debt crises in 1990s (e.g., Argentina, Brazil, Mexico, and Russia) contribute to the volatility Crisis has produced reform opportunities 16

17. Developing competitive subnational credit markets 17

18. Developing competitive subnational credit markets 18

19. Developing competitive subnational credit markets Require securities regulations largely similar to those for sovereign and corporate bonds. Market infrastructure includes regulations on credit rating agencies, broker-dealers, underwriters, and auditors, etc Securities laws cannot replace rules for prudent fiscal management of SNGs and for corporate governance of SPVs. Importance of self-regulation and a �buyer beware� approach. Many U.S. regulations were developed by market players themselves Accessing financial markets can be a challenge for smaller SNGs or those in less-developed regions. 19

20. Developing Regulatory FrameworksAddressing/preventing subnational debt crisis Subnational debt crisis occurs when a large number of subnational governments become insolvent Crisis can be widespread and default systemic Subnational insolvency is a reoccurring event in development: US examples Subnational debt crises: Brazil, Mexico, Russia, etc Potential risks in newly decentralized countries: Hungary, Russia, Peru, etc Subnational fiscal stress 1990s: India, Hungary, Colombia As measured by Revenue Deficit/Subnational GDP, debt service capacity (e.g., Debt Service/Revenue) 20

21. Developing Regulatory FrameworksAddressing/preventing subnational debt crisis Unregulated borrowing grew rapidly. Subnationals borrowed heavily to finance substantial operating deficits and subsidies Increased subsidies Imprudent lending based on implicit guarantees from the central government Unregulated foreign borrowing Risky debt profile: short maturity, high debt service ratio, variable interest rate Imprudent lending by public banks and failure to subject subnationals to the discipline of capital market Hidden and contingent liabilities (guarantees, pensions, SOEs, banking sector, arrears) Currency and macroeconomic crisis as triggers, exposing the vulnerability of fiscal position of subnationals 21

22. Developing Regulatory FrameworksAddressing/preventing subnational debt crisis Soft budget constraints, a key aspect of fiscal incentives, allow subnational governments to live beyond their means, negating competitive incentives and fostering corruption and rent-seeking. Market participants may tolerate unsustainable fiscal policy of a subnational government if the history backs their perception that the central government implicitly guarantees the debt service of the subnational government Unconditional bailouts of financially-troubled subnational entities by the national government create moral hazard and the implication of a sovereign guaranty and encourage fiscal irresponsibility and imprudent lending Khemani (2002) found that in 15 major states of India over the period 1972-1995, states have substantially higher spending and deficits (higher by about 10 percent of the sample average) when their government belongs to the same party as that governing at the center; and that intergovernmental grants tend to have a counter-intuitive negative effect on spending and deficits 22

23. Developing Regulatory FrameworksAddressing/preventing subnational debt crisis Regulatory framework for subnational debt since the late 1990s in Developing Countries is still evolving They aim at: more sustainable subnational financing structure so that subnational governments (including public utilities and special purpose vehicles) can access financial markets on a sustainable basis Hard budget constraints to minimize moral hazard With growing political independence of subnational government, the informal mechanisms no longer sufficed. Formal coordination mechanisms were needed A comprehensive regulatory framework has two parts: Ex-ante control on types, purpose and procedures of debt issuing Ex-post insolvency mechanism: increase the pain of circumventing ex-ante rules, thus enhancing the effectiveness of rules 23

24. 24 Regulatory Frameworks: Ex Ante Fiscal Rules Country Examples Brazil: Fiscal Responsibility Law Colombia: Law 358; Law 617; Fiscal Transparency and Responsibility Law France: borrowing regulations and balanced budget rules India: States Fiscal Responsibility and Budget Management Acts, following 12th Finance Commission Mexico: Subnational borrowing framework Peru: Fiscal Responsibility and Transparency Law, General Debt Law Poland: Public Finance Law South Africa: Municipal Finance Management Act Turkey: Various regulations US: states regulations (e.g., Maryland)

25. Regulatory Frameworks: Ex Ante Fiscal Rules Basic Elements Limits on fiscal aggregates (consolidated fiscal concept, balanced budget rule, debt service ratio, guarantees, etc) Golden rule: borrowing only for capital investment Ending guarantees of subnational debt service Procedural requirements (medium-term fiscal framework, budgetary process, etc) Fiscal transparency (independent audit, periodic public disclosure of key fiscal data, making hidden liabilities explicit, making off-budget liabilities on budget, monitor all liabilities, etc) Sanctions for violation of regulations (transfer intercepts for borrowers, invalidate lending for lenders, etc) Caution: relying on central government control on individual loan approval can limit the role of market 25

26. Regulatory Frameworks: Ex Post InsolvencyObjectives Debt restructuring and fiscal adjustment to restore subnational fiscal sustainability to Maintain essential public services & improve creditworthiness to re-access capital market Protect creditor rights to Nurture embryonic capital markets Lower cost of borrowing Extend lending maturity Enforce hard budget constraint Pressures for political ad-hoc intervention decrease, as restructurings become institutionalized 26

27. Regulatory Frameworks: Ex Post InsolvencyObjectives Collective Enforcement and Efficient Debt Restructuring Voluntary negotiations or unilateral adjustments unpredictable Holdout creditors threaten debt restructuring Creditors� contractual remedies effective to enforce discrete unpaid obligations, but individual lawsuits ineffective if there is inability to pay In systemic crisis, impracticable, costly and potentially harmful to the interests of a majority of creditors Pre-determined rules allocating default risks and anchoring expectations: debtor and creditors share the pain 27

28. 28 Regulatory Frameworks: Ex Post Insolvency Selected country models United States: US Bankruptcy Code, Chapter 9 (1937). United States: State intervention on municipal fiscal and debt adjustment. Examples: NYC bankruptcy crisis 1975, Ohio state early warning system (1976) France: state intervention in subnational fiscal and debt adjustment Hungary: Law on Municipal Debt Adjustment (1996) South Africa: Municipal Financial Management Act, Chapter 13 Brazil: Federal government and states debt restructuring program (1997)

29. Regulatory Frameworks: Ex Post Insolvency Selected country models United States Federal municipal insolvency law adopted in 1937, after default wave during the Great Depression Primary aim: deal with the holdout problem Requirement of State consent, rooted in strong federalist tradition Apart from federal bankruptcy proceeding, many states have their own procedures, for example, NY: 1975 Emergency Financial Control Board Ohio: Fiscal Watch Program 29

30. Regulatory Frameworks: Ex Post InsolvencyKey design issues Balance interests of different players Judicial approach vis-�-vis administrative approach Respective role of legislature, executives and judicial Differences between public and private insolvency Country context Developing insolvency mechanisms takes time Immediate practical steps can be taken to assure investors of return to their investment. Options 30

31. Regulatory Frameworks Ex Post Insolvency Three basic elements Insolvency triggers Debt restructuring and discharge Fiscal Adjustment 31

32. Regulatory Frameworks: Ex Post InsolvencyElement 1: Insolvency Triggers �Financial distress� & �Insolvency�: Defined by specific insolvency mechanism Courts may dismiss petitions filed in bad faith Generic definition: Inability to pay debts as they fall due US Debtor generally not paying due debts Unable to pay debts as they become due Hungary Invoice not disputed or paid within 60 days Not paid a recognized debt within 60 days South Africa A set of triggers for serious financial problems and another set of triggers for persistent material breach of financial commitments 32

33. Regulatory Frameworks: Ex Post InsolvencyElement 2: Debt Restructuring Debt restructuring is fundamental to any insolvency mechanisms Contribution required by creditors, given feasible fiscal adjustment Adjustment plan reconciles contractual commitments with payment capacity, preference to voluntary restructurings Restructuring binding on non-consenting creditors major departure from principle that contracts ought to be fulfilled Thus, courts better placed to ensure equitable discharge South Africa and US: Only courts have power to discharge debt Brazil: Refinancing did not involve discharge Creditors could stop lending if debt discharge perceived as �unfair� 33

34. Regulatory Frameworks: Ex Post InsolvencyElement 2: Debt Restructuring Hungary Example Debt Committee is chaired by a count-appointed financial trustee and charged with preparing a reorganization plan and debt settlement proposal. Fiscal and debt restructuring proposals are decided by a majority vote of the Committee A debt settlement is reached if at least half of creditors whose claims account for at least two-thirds of total undisputed claims agree to the proposal. Creditors within the same group must be treated equally. The Act stipulates the priority of asset distributions. If disagreements arise on distribution, the court makes the final decision which cannot be appealed. 34

35. Regulatory Frameworks: Ex Post InsolvencyElement 3: Fiscal Adjustment Medium-term fiscal framework for adjustment Address root causes of fiscal imbalances Indispensable element in any insolvency mechanism Short- to medium term fiscal measures to enhance long-term debt sustainability Medium-term fiscal adjustment plan essential (Examples: US NYC, Orange County) Administrative mechanism typically more intrusive Chapter 9 (US): municipality retains control over fiscal management State intervention (US): State has broad power over its municipalities Fiscal Sustainability Framework Analyze how key components of fiscal accounts respond to differing reform parameters, shocks, uncertainties and the interplay of national and subnational policies. 35

36. This presentation draws from the following references Canuto and Liu. 2010. �Subnational Debt Financing and the Global Financial Crisis.� Premise Note, Poverty Reduction and Economic Management Network. Washington, D.C: World Bank. Canuto and Liu. 2010. �Subnational Debt Finance: Make it Sustainable� in The Day After Tomorrow: A Handbook on the Future of Economic Policy in the Developing World, ed. Otaviano Canuto and Marcelo Giugale. Washington, DC: World Bank.� Liu. 2010. �Strengthening Subnational Debt Finance and Managing Risks� in ???????46F-9. ??????????. Liu. 2008. �Creating a Regulatory Framework for Managing Subnational Borrowing.� In Public Finance in China: Reform and Growth for a Harmonious Society, ed. Jiwei Lou and Shuilin Wang. Liu and Waibel. 2010. �Managing Subnational Credit and Default Risks� World Bank Policy Research Working Paper #5362, and chapter 11 in in Braga and Vincelette ed. "Sovereign Debt and the Financial Crisis." World Bank. 36

37. Liu and Waibel. 2009. �Subnational Insolvency: Cross-Country Experiences.� in Does Decentralization Enhance Service Delivery and Poverty Reduction? ed. by Ehtisham Ahmad and Giorgio Brosio. Liu and Waibel. 2008. �Subnational Borrowing, Insolvency and Regulations,� in Macro Federalism and Local Finance, ed. by Anwar Shah, World Bank, 2009 Liu and Tan. 2008. �Subnational Credit Ratings:A Comparative Review,� World Bank Policy Research Working Paper #5013 Ianchovichina, Elena, Lili Liu, and Mohan Nagarajan. 2007. �Subnational Fiscal Sustainability Analysis: What Can We Learn from Tamil Nadu?� Economic and Political Weekly, Vol XLII, No.52, December. 37

38. Thank you 38