Subnational Borrowing Framework

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Subnational Borrowing Framework

• Lili Liu
• Lead Economist
• PRMED
• PREM Learning Week
• Washington DC, May 10 2006

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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

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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.

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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 gt promoting good governance.
• Facilitating financial market reforms.

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Size of Subnational Debt Market

• United States has the most dynamic and largest
  subnational debt market.
• About US400 billion subnational bonds are issued
  per year on average.
• Subnational bonds outstanding US1.12 trillion
  (December 2005), accounting for about 10 percent
  of US domestic bond market, and 26 percent of US
  public sector bonds.

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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 5050 bank financing and bonds.
• Mexico post-crisis adjustment.

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Differentiated Subnational Entities in Client
Countries
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Subnational Financing Basic Concepts

• Expenditure
• Recurrent expenditure
• Capital expenditure
• Revenues
• Own Revenues
• Transfers
• Financing Gap
• Borrowing

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Subnational Financing Basic Concepts

• Three basic concepts of fiscal balance
• Fiscal balance
• Primary balance
• Consolidated balance (to include off-budget
  liabilities)

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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

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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?

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Subnational Fiscal Stress India
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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 gt ?
• The reported deficits underestimate real
  liabilities due to arrears.

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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
  Commissions 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.

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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 subnationals 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.

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Impact of Subnational Debt Crisis

• Jeopardize public services.
• Risks to financial system.
• Countrys own creditworthiness.
• Overall macroeconomic stability.

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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.

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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

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

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Fiscal Responsibility Law

• National law, National Law Subnational own
• All levels of govt central govt 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

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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.

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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)

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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
  govts. 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 gt 60 debt
  stock/current revenues gt 80. Prohibited from
  borrowing.
• Autonomous indebtedness (green light)
  Interest/operational savings lt 40, debt
  stock/current revenue lt 80. Allowed to borrow.

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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.

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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.

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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?

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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

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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

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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
  governments 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

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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.

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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

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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.

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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.