International Experience on Regulatory Framework for Subnational Borrowing Lili Liu

1. Turkey Treasury’s Forum onFiscal Management and Borrowing of Local AdministrationMay 22-23, 2008, Ankara International Experience on Regulatory Framework for Subnational Borrowing Lili Liu Lead Economist Economic Policy and Debt Department World Bank

2. Subnational Finance in Consolidated Fiscal Accounts • Subnational governments account for a significant share of consolidated public finance in many developing countries (e.g., Brazil, China, India, Indonesia) • Managing subnational finance is an important part of public finance management, for efficient public spending, service delivery, and the stability of macroeconomic and financial system • Three sources of subnational finance: • Borrowing from financial market • Taxation and non-tax revenues such as user fees • Transfers from higher levels of government • Subnational borrowing has become important • Increase fiscal space for infrastructure financing • Globalization, capital mobility, financial sector liberalization, and diversification of financial instruments • Potential for financial market to be part of fiscal monitoring

3. Regulatory Framework for Subnational Borrowing • A regulatory framework for subnational borrowing is evolving at varying paces across countries • A regulatory framework has two parts: • Ex-ante regulation of types, purpose and procedures of debt issuing • Ex-post insolvency mechanism: what to do when a subnational government has debt stress or becomes insolvent? • The ex-post mechanism helps enforce ex-ante rules • The regulatory framework aims at: • A more sustainable subnational financing structure so that subnational governments (including public utilities and special purpose vehicles) can access financial markets on a sustainable basis • A more diversified and competitive financing structure • Hard budget constraints to minimize moral hazard

4. What motivates the regulatory framework? • Subnational fiscal stress in countries such as India, South Africa, Hungary (as measured by Revenue Deficit/Subnational GDP, debt service capacity (e.g., Debt Service/Revenue) has motivated reforms • Subnational debt crises in countries such as Brazil (1980s, 1990s), Mexico (mid-1990s), Russia (late 1990s) have motivated reforms • Countries such as Peru, Indonesia, Romania, newly decentralizing countries, want to manage risks upfront

5. What causes subnational fiscal risks? • Main causes include: • Lack of transparent fiscal and regulatory framework particularly in the process of decentralization • Imprudent lending (including from public banks) based on implicit or assumed guarantees from the central government • Risky debt profile of subnational government: short maturity, high debt service ratio, variable interest rates • Currency and macroeconomic crises as triggers • Contingent liabilities from multiple sources • Fiscal mismanagement of a subnational government

6. Regulatory Framework for Subnational BorrowingEx-ante framework • Selected Country Examples • Brazil: Fiscal Responsibility Law, 2000 • Colombia: Law 358 (1997); Law 617(2000); Fiscal Transparency and Responsibility Law 819 (2003) • India: 12th Finance Commission recommendations • Mexico: Subnational borrowing framework (2000) • Peru: Fiscal Responsibility and Transparency Law (2003), General Debt Law (2005) • South Africa: Municipal Finance Management Act (2003)

7. Regulatory Framework for Subnational BorrowingEx-ante Framework • Managing fiscal aggregates (consolidated fiscal concept, balanced budget rule, debt service ratio, guarantee ceiling, etc) • Colombia example (Law 358 “Traffic Light Law” (1997), and Law 819 (2003) sought to limit subnational debt to payment capacity. • Red light (prohibited from borrowing): interest/operational savings greater than 40%; debt stock/current revenues greater than 80% • Green light (allow to borrow): interest/operational savings less than 40%; debt/current revenue less than 80%. • India (12th Finance Commission) • Fiscal responsibility legislation mandatory for states • States to eliminate current deficit by 2008/09, fiscal deficit to 3% of GSDP by the same year • Annual intermediate deficit reduction targets • Caution: persistent relying on central government control on individual loan approval can limit the role of market

8. Regulatory Framework for Subnational BorrowingEx-ante Framework • Borrowing only for long-term public capital investment (Golden Rule) • 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) • Managing multiple sources of contingent liabilities • Civil servants pension liabilities • Local government-owned banks and their non-performing assets • Guarantees issued to support the borrowing of loss-making public enterprises • Off-budget activities • Arrears not captured by cash-accounting system • Liabilities arise from PPP contracts

9. Regulatory Framework for Subnational BorrowingEx-ante Framework • Enforcing subnational fiscal discipline and hard budget constraint • Markets may tolerate unsustainable subnational fiscal policy if the central government implicitly guarantees the debt services of subnational governments • Hard budget constraint for subnational governments • Positive incentives for states to improve fiscal management • India: swap states high-cost debt with low-cost debt by national government • China: increased transfers from central government if a provincial government helps its lower tiers of government improve fiscal management • Ending guarantees of subnational debt service (South Africa, Russia) • Support fiscal discipline from regulating lenders (Mexico, Colombia) • Debt restructuring conditioned upon fiscal adjustment (Brazil)

10. Regulatory Framework for Subnational BorrowingEx-post Insolvency Mechanism • Ex-Post Insolvency Mechanism has Multiple Objectives • Deal with subnationals in fiscal stress or insolvency, owing to exogenous shocks or fiscal mismanagement • Debt restructuring and fiscal adjustment to enable subnational to maintain essential public services and improve creditworthiness to re-access capital market • Protect creditor rights to nurture embryonic capital markets, lower cost of borrowing, and extend lending maturity • Enforce hard budget constraint

11. Regulatory Framework for Subnational BorrowingEx-post Insolvency Mechanism: Country Examples • Hungary: Law on Municipal Debt Adjustment (1996) • South Africa: Municipal Financial Management Act (2003), Chapter 13 • Brazil: Federal government and states debt restructuring program (1997) • United States: US Bankruptcy Code, Chapter 9 • United States: State intervention on municipal fiscal and debt adjustment. Examples: • New York City bankruptcy crisis 1975 • Ohio state early warning system

12. Regulatory Framework for Subnational BorrowingEx-post Insolvency Mechanism: Country Examples • All insolvency mechanisms have three essential components • Triggers for insolvency or financial distress • Medium-Term Fiscal Framework for Adjustment • Address root causes of fiscal imbalances • Indispensable element in any insolvency mechanism • Medium-term fiscal adjustment plan essential: Brazil 1997 debt agreements between federal and states, India 12th Finance Commission, US NYC Bankruptcy case, Orange County case) • Debt restructuring • Administrative Approach: higher levels of government restructure the debt of lower tier government in financial trouble into longer-term debt instrument (e.g., Brazil, Mexico, US NY State) • Judicial approach: court implements a priority structure for debt restructuring/discharge (e.g., Hungary, US Orange County) • Mixed approach: South Africa

13. Subnational Borrowing and Debt Management • Subnational debt management is important, supporting regulatory frameworks • Capacity matters • Debt management has two components • Debt Sustainability Framework: • Analyze how key components of fiscal accounts respond to differing reform parameters, shocks, uncertainties and the interplay of national and subnational policies • Key to debt sustainability: interest rate, and subnational’s economic growth and primary balance • Debt portfolio management to address rollover risks and portfolio balance • Rollover risks arise from short maturity, high debt service ratio, variable interest rate, and currency risks (even if no foreign currency debt, risks can transmit through interest rate)

14. Managing Subnational BorrowingLinking with Other Reforms • Country-wide macroeconomic stability critical – international rating agencies puts the sovereign rating as a ceiling for sub-sovereign ratings, a pre-condition for subnational accessing financial market for borrowing • Three sources of subnational finance are inter-linked. Reforming intergovernmental fiscal system reform • To strengthen local revenue base, which helps access capital market and promote local economic growth • To reform grant distribution system to incentivize sound fiscal management • More competitive financial markets price and allocate risks more efficiently, and subnational bonds as alternative to bank lending can enhance competition • Cost recovery essential to match debt maturity with assets life for financing: a challenge in many developing countries