subnational borrowing framework lili liu lead economist prmed prem learning week washington dc, may...
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Subnational Borrowing Framework
Lili Liu
Lead Economist
PRMED PREM Learning Week
Washington DC, May 10 2006
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
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.
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.
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.
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.
Differentiated Subnational Entities in Client Countries
Market Access with Credit Support
Market Access on Own Credit
Limited Financial Transparency
Audited Financials
Subnational Financing: Basic Concepts
Expenditure Recurrent expenditure Capital expenditure
Revenues Own Revenues Transfers
Financing Gap Borrowing
Subnational Financing: Basic Concepts
Three basic concepts of fiscal balance Fiscal balance Primary balance Consolidated balance (to include off-budget
liabilities)
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
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?
Subnational Fiscal Stress: India
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Debt/GDP Fiscal deficit/GDP
Figure 2: State deficits and debt levels
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.
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.
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.
Impact of Subnational Debt Crisis
Jeopardize public services. Risks to financial system. Country’s own creditworthiness. Overall macroeconomic stability.
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.
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
Regulatory Channels for Controlling Subnational Debt Crisis
Source: Steven Webb, “Fiscal Responsibility Laws for Subnational Discipline: the Latin American Experience” July 2004
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
Fiscal Responsibility Law
National law, National Law Subnational ownAll levels of gov’t central gov’t only FRL
Argentina Y Some opted inBrazil YCanada N MostColombia YIndia Y 5 states have FRL.
All states now required to have FRL
Russia YPeru YUK Y
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.
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)
Ex-ante Regulation: Colombia
Traffic Light Law (Law 358, modified by Law 795) 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.
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.
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.
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?
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
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
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
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.
Fiscal Sustainability
How 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
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.
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 macroeconomic stability.