Promoting Effective Decentralization: the Role of Central Finance Agencies

1. Promoting Effective Decentralization: the Role of Central Finance Agencies Presentation by Teresa Ter-Minassian at the Asia-Pacific and Latin American Interregional Forum on Managing for Results Manila, 11/28/2012

2. Outline of presentation • Presentation will cover five key questions • Why decentralize? • Why is a hard budget constraint for sub-national governments (SNGs) needed to minimize the risks and maximize the results of decentralization? • How to ensure hard budget constraints? • What if the crisis prevention approach doesn’t work? What are best practices in resolving sub-national fiscal crises? • What should central financing agencies do and not do to promote fiscally responsible and effective decentralization?

3. Why decentralize? • Traditional normative argument • To promote efficiency in resource allocation, preference matching • Underlying assumptions: benevolent government; citizen mobility • Second-generation positive federalism theories • Emphasize political economy objectives of decentralization • Discard assumption of benevolent government • Focus on how incentives and institutions (e.g. electoral systems, legal frameworks, sub-national capacity constraints) shape decentralization and its results in terms of efficiency and citizens’ welfare • Concerns about risks posed by decentralization for macro-economic management • Reduced central government control of fiscal stabilization instruments • Risks of unsustainable sub-national (SN) fiscal behavior

4. Why is a sub-national hard budget constraint necessary for successful decentralization? • Poorly designed and implemented decentralization can lead to the emergence of SN soft budget constraints (SBC) • A SBC occurs when a SN entity expects to be able to increase spending without carrying its full cost • This creates incentives to overspend (run deficits and accumulate debt). It also discourages efforts to mobilize own revenues and to be efficient in spending • Therefore, SN SBCs can lead to: • Macro-economic instability and debt crises; and • Poor value for money in the delivery of SN goods and services

5. Which are the main causes of SN SBCs? • Flaws in the design of intergovernmental fiscal arrangements likely to result in SN SBCs • Reliance on market discipline when pre-conditions for its effectiveness are lacking • Ineffective “cooperative federalism” arrangements • Weaknesses in more hierarchical control mechanisms • Significant discretion in direct central control of SN borrowing • Inappropriate design and/or inadequate enforcement of SN fiscal rules • Substantial discretion in intergovernmental transfers • Little or no revenue autonomy for SN governments (SNGs) • Unclear expenditure assignments or unfunded mandates

6. Conditions for effective market discipline • A consistent record of no bailouts of SNGs in financial difficulty • Well-developed, competitive financial markets • No privileged access of SNGs to credit • Adequate transparency of SN accounts • Adequate responsiveness of SN politicians to market signals

7. Political economy influences on negotiated arrangements • Both “cooperative federalism” and administrative control mechanisms on SN borrowing can give rise to SBC, because of : • Scope for discretion and thus political bargaining, especially in countries where the executive is relatively weak, and SNGs wield substantial powers in the legislative branch • Likely expectations by SNGs and markets of a more accommodating CG attitude towards jurisdictions politically aligned with the ruling party or coalition • Difficulty for a CG to refuse bailouts to a SN experiencing debt servicing difficulties, if it (or a previous government) had authorized a significant portion of that debt

8. Sub-national fiscal rules • The demanding pre-conditions for effective reliance on market discipline and the weaknesses of negotiated arrangements explain the growing popularity of SN fiscal rules • Rapid growth of SN fiscal rules in recent decades • An increasing share of countries uses more than one rule. Most popular combination: budget balance and gross debt. • SN expenditure rules also on the rise. • But, fiscal rules are no magic bullet for ensuring adequate SN fiscal discipline. Effectiveness of SN fiscal rules depends on: • Extent of political and social support • Robustness of legal basis • Soundness of design • State of SN PFM systems; and • Firmness of enforcement

9. How to promote the effectiveness of fiscal rules? • Design issues • Self or centrally imposed rules? • Coverage • Nature of targets/limits • Degree of flexibility • Implementation issues • The state of SN PFM systems • Monitoring of compliance, including by independent fiscal watchdogs • Enforcement tools • Sanctions • Correction mechanisms

10. Other prerequisites to minimize the risk of SN SBCs • Clarity about respective spending responsibilities of different levels of government • Avoidance of unfunded mandates • Significant revenue-raising autonomy at the state and local levels • An appropriate design of inter-governmental transfers • Formula-based • Formulas based on factors that cannot be manipulated by SNGs • Adequately redistributive • Not pro-cyclical • Adequate SN capacity in the administration of own revenues, and in public expenditure management

11. What if efforts to ensure SN fiscal discipline don’t work? • Ensuring adequate SN fiscal discipline and preventing SN fiscal crises is a difficult endeavor • The specific mix of borrowing controls that is likely to be most effective depends on country-specific circumstances, but in most cases involves a combination of : • Soundly designed and firmly enforced rules, with an appropriate degree of flexibility • Minimal discretion in the CG’s support to SNGs, and • Institutional reforms to increase the effectiveness of market discipline • Unfortunately, however, efforts to prevent excessive SN indebtedness do not always work. • Extensive international experience with SN debt crises

12. Bailouts • Consequencesof SN debt crises • Disruption of provision of public goods and services for the affected population • Possible adverse financial, social, and political spillovers on other SNGs, and possibly the whole nation • The threat of such consequences frequently leads to bailouts by higher-level governments, in the form of: • gap-filling transfers, • debt assumption and restructuring • debt forgiveness • The degree of moral hazard created by bailouts depends on: • their frequency • the severity of the conditions (political, as well as financial) attached to them • whether or not they are accompanied by strengthened preventive measures • Few examples (US, and in recent decades Canada) of a consistent record of no bailouts. Also, few examples of successful bailouts (not leading to moral hazard and thereby not increasing SBCs)

13. SN insolvency frameworks • Limited but growing international experience with formal frameworks for SN debt resolution, setting out pre-specified rules for allocation of default risks • Benefits: • Reduce disruption of provision of public services and attendant political pressures for bailouts • Facilitate orderly workouts, minimizing holdout problems • May help prevent both SNGs’ and lenders’ expectations of bailouts • Design of insolvency frameworks should: • Balance the protection of creditor rights with that of core functions of SNG involved • Entail significant political costs for leaders of defaulting jurisdiction, to minimize moral hazard. • Design of insolvency frameworks requires definition of many complex issues, including • Triggering procedures • Role of the judiciary • Creditors’ majority required to bail-in holdouts • Conditionality • Order of priority of claims • Design must take into account, among other things: • Relevant characteristics of a country’s legal system • The state of the judicial system • The size and capacity of the jurisdiction involved • Country examples: US (for local governments only); Hungary; South Africa

14. What can central finance agencies do to Avoid SN SBCs? • Mistakes to be avoided • Seeking to maintain significant discretion in various forms of support to SNGs (transfers; borrowing controls; definition of budget targets) • Resisting a clear (albeit asymmetric or evolving over time) delineation of respective spending responsibilities, especially in concurrent functions • Devolving spending responsibilities but trying to keep control of most budgetary resources, thereby giving rise to unfunded mandates or excessive vertical imbalances • Relying on market discipline when preconditions for its effective functioning are not in place • Unconditional bailouts in case of SN debt crises • Proactive actions • Promoting the adoption of sound SN fiscal rules • Supporting their enforcement through budgetary transparency requirements, timely monitoring, and non-discretionary application of sanctions when needed • Taking appropriate steps to strengthen market discipline on SN borrowing • Supporting the design and adoption of appropriate SN insolvency frameworks • Supporting the development of sound SN PFM systems, and effective SN tax administrations (through e.g. modernization of local property cadastres and IT systems; and exchange of taxpayer information)

15. Thank you for your attention!