Subnational Borrowing Research Articles

Subnational borrowing and bailouts: When the federal government looks at the votes (differently) and its borrowing matters

AbstractSometimes it is difficult to find a rationale for episodes of bailouts in which the political motivations of the federal government are not clear cut. In other cases, the soft‐budget constraint of subnational governments (SNGs) seems to be based on unlimited federal resources. This paper aims to shed some light on both issues taking as a reference the workhorse model developed by Goodspeed. The principal change in its basic assumptions lies in allowing the federal government to borrow to finance its grants to SNGs. The results indicate that the way in which the federal government translates voters' preferences into electoral probabilities is crucial to determine grants. Moreover, the SNGs do not borrow excessively. When the model is extended to consider risk premium spreads in the SNGs debt and the option of transferring part of their borrowing to the upper level, the main outcomes remain.

Decentralization and intra-country transfers in the Great Recession: the case of the European Union

ABSTRACT Empirical evidence is found supporting the assignment of the redistribution function to the central government. Viewing the Great Recession, or recessions in general, as a shock, it is found that after the shock, more decentralized economies show a more negative response of subnational government social protection expenditures than more centralized ones. Results for the vertical fiscal imbalance are consistent with the theory of soft budget constraints: economies with a greater vertical fiscal imbalance show larger increases in subnational government social protection expenditures after the shock and greater prior subnational government borrowing. Caution should be used in extending the argument to the European Union level.

Fiscal stability during the Great Recession: putting decentralization design to the test

ABSTRACT This paper provides an empirical analysis aimed at disentangling the roles played by decentralization level and design as well as the extended decentralized framework provided by subnational borrowing rules and fiscal responsibility laws on a country’s fiscal stability. Using Organisation for Economic Co-operation and Development (OECD) countries’ data from the period 1995–2014, strong regularities are found regarding the effects of decentralization, even during the recent Great Recession. Higher levels of fiscal decentralization have a beneficiary effect on fiscal performance, but the positive impact erodes rapidly with the level of vertical fiscal imbalance. Other fiscal institutions shaping decentralization design, such as borrowing and other fiscal rules, can also contribute to foster fiscal stability.

Improving Subnational Government Development Finance in Emerging and Developing Economies: Toward a Strategic Approach

Considerable attention has been given to enhancing subnational development finance in response to the 2008 global financial crisis and recent global development agendas, including the Sustainable Development Goals, Financing for Development, and Habitat III/New Urban Agenda. Much work on this topic is fragmented, focusing on specific elements of development finance: fiscal transfers, capital market access, public-sector lending agencies, or public–private partnerships. Most countries, however, have a range of subnational governments with varying needs and capacities that require different and evolving mixes of development finance mechanisms. Enabling greater subnational borrowing is often desirable but requires adoption of other reform policies to improve the fiscal capacity and creditworthiness of subnational governments over time. We review the rationale and potential for improving subnational development finance, outline the overall landscape of institutional arrangements available for this purpose, and consider broad challenges involved. Based on a review of global practice and experience in selected Asian developing countries with a range of special entities and innovations to enhance subnational investment, we propose a more integrated, strategic approach to building subnational development finance.

Intergovernmental Fiscal Reform in China

China is the most decentralized country in the world in terms of expenditures shares, with subnational governments responsible for 85 percent of government spending. Limited revenue autonomy and insufficient intergovernmental transfers have led to large unfunded mandates and a build-up of debt outside the budget. The government has recently announced an ambitious intergovernmental fiscal reform, which will increase the role of the central government. Comprehensive reform is needed to improve public service delivery, increase overall social spending levels and reduce regional disparities. Revenue reforms are also necessary to improve efficiency and reduce vulnerabilities from excessive subnational borrowing. These reforms are challenging, but are crucial so that the government can support China’s continued development and prosperity.

Intergovernmental Fiscal Reform in China

China is the most decentralized country in the world in terms of expenditures shares, with subnational governments responsible for 85 percent of government spending. Limited revenue autonomy and insufficient intergovernmental transfers have led to large unfunded mandates and a build-up of debt outside the budget. The government has recently announced an ambitious intergovernmental fiscal reform, which will increase the role of the central government. Comprehensive reform is needed to improve public service delivery, increase overall social spending levels and reduce regional disparities. Revenue reforms are also necessary to improve efficiency and reduce vulnerabilities from excessive subnational borrowing. These reforms are challenging, but are crucial so that the government can support China’s continued development and prosperity.

Economic Openness and Subnational Borrowing

Using a panel dataset of 206 non‐U.S. subnational governments from 31 countries between 2004 and 2010, this study investigates the relationship between economic openness and sub‐sovereign borrowings. We find that financial openness generates a positive impact on the size of subnational obligations in developing countries but a negative effect in developed countries. It also improves the credit ratings of subnational jurisdictions regardless of the country's development status. However, trade openness does not show any effects on subnational borrowings. To account for these findings that cannot be fully explained by existing theories, we propose a new efficiency hypothesis.

How Well Do Subnational Borrowing Regulations Work?

There are many positive things associated with subnational borrowing, including additional funding or promoting intergenerational equity. But it may also endanger fiscal sustainability and macro stability due to moral hazard and soft budget constraints. Thus borrowing controls are justified and also common. In this paper we review the different types of ex-ante and ex-post regulations used the international experience based on a large panel of developed and developing countries. Effectiveness or borrowing regulations in this paper is defined relative to the ability to preserve primary balances at the general government and subnational levels. There is a wide variety of both ex-ante and ex-post sub-national borrowing regulations that countries implement. Each has both advantages and disadvantages, with different suitability countries’ circumstances. For example, depth of financial markets is important when choosing market-based regulations. The presence of subnational tax autonomy contributes to an increase in the general government primary balance, but not significantly for subnational primary balances. A history of subnational bailouts is associated with lower primary balances on average at all levels. The “golden rule” (borrowing is only for capital investment purposes) and limits on debt and borrowing appear effective at all levels of government. However, we find that none of the broad types of sub-national borrowing regulations seem to have a distinct significant direct effect on the narrow definition of fiscal sustainability at the subnational level.

How Well Do Subnational Borrowing Regulations Work?

There are many positive aspects associated with subnational borrowing, including additional funding and promoting intergenerational equity. However, it may also endanger fiscal sustainability and macro stability due to moral hazard and soft budget constraints, making borrowing controls justified and common. This chapter reviews the different types of ex ante and ex post subnational borrowing regulations used in the international experience based on a large panel of developed and developing countries. Each type of regulation has advantages and disadvantages, with varying suitability to a country’s circumstances. It is found that the presence of subnational tax autonomy contributes to an increase in the general government primary balance but not significantly for subnational primary balances. A history of subnational bailouts is associated with lower primary balances, on average, at all levels. The ‘golden rule’ and limits on debt and borrowing appear effective at all levels of government. However, none of the broad types of subnational borrowing regulations seem to have a distinct significant direct effect on the narrow definition of fiscal sustainability at the subnational level.

Fiscal Equalization Schemes and Subcentral Government Borrowing

Examining the cases of Canada, Germany, and Spain, the role played by fiscal equalization schemes in determining subnational borrowing was analyzed, and the link between regional governments’ primary fiscal balances and gross domestic product per capita was tested econometrically. The study results show that either poor or rich regions can display higher regional public borrowing on average, and these results can be linked to the institutional design of regional equalization systems in place. Particular elements, such as tax efforts and fiscal capacities, also play relevant roles in this regard. Reforms of these schemes can therefore prove instrumental in reducing regional heterogeneity in public borrowing.

Local Government Debt in China: Implications for Reform

Since the 1994 fiscal reforms, China's national public finances have been in a strong position, but public finances of local governments (including provincial, city and county governments) have been always under stress. This is because local governments in China are responsible for financing the provision of basic economic and social services, as well as for urban infrastructure, but they have limited access to tax revenues, have no power to introduce new taxes or to increase rates of existing taxes, and are prohibited under the 1994 Budget Law from borrowing. Consequently, local governments are heavily dependent on non-tax revenues and fiscal transfers from the central government. In spite of the prohibition on borrowing, most local governments have been borrowing informally for many years and the central government has ignored this breach of the Budget Law. Now the size of local government borrowing has reached levels that are causing concerns for the sustainability of local public finances and the stability of the Chinese banking system. This situation raises many policy issues, some requiring urgent policy interventions and other requiring medium-term policy responses. Thus, there is a need for broadening provincial powers over taxation, reforming intergovernmental fiscal transfers, and formally recognizing provincial borrowing powers. However, the focus of this paper is on the incidence of local debt on provincial and sub-provincial public finances, an aspect of local debt that has not attracted sufficient attention in the literature. The concentration of local debt and contingent liabilities at sub-provincial levels and the new annual limit imposed by the State Council on local debt in 2015 are discussed. Lessons learned from Australia's experience in relation to the management of subnational borrowing are also discussed, as these appear to be highly relevant to China's current situation.

Vertical debt spillovers in EMU countries

This article examines the extent to which subnational governments may drive sovereign risk premiums. Is subnational fiscal policy affecting the interest rates on central government bonds? Furthermore, we focus on a number of causal mechanisms that may mitigate or reinforce these upstream vertical spillovers, i.e. the presence of bailout expectations and subnational borrowing autonomy. Our findings indicate that debt accumulation by subnational governments (SNG) spills over onto sovereign risk premiums when the restrictions on SNG borrowing are weak and when investors believe that subsovereign debts are backed by the center. The results suggest that spillovers may be reduced through a proper design of a country's fiscal and institutional framework; countries should either bolster the sovereignty of subnational governments by increasing SNG fiscal autonomy, or tightening up SNG borrowing constraints.

Local Government Borrowing in Europe – Lessons for Croatia

The paper surveys models of local public borrowing across Europe. It begins by discussing some theoretical issues on local deficit financing. Positive and negative sides of local public borrowing are analysed. Legal framework for local borrowing in EU members and the relation between the sub-national government fiscal discipline and rigidity of constraints on borrowing is also examined. At the end, Croatian model of local borrowing is presented. Some lessons are drawn from experience of EU countries. Finally, according to theoretical and empirical finding, some proposals for improving the Croatian model of sub-national borrowing are stipulated.

Soft budget constraints and strategic interactions in subnational borrowing: Evidence from the German States, 1975–2005

Cooperative federations are usually characterized by the existence of bailout guarantees and intergovernmental transfer schemes. This paper explores whether such features of cooperative federations lead to subnational soft budget constraints using panel data from the German States covering the 1975–2005 period. The methodology is based on the premise that subnational governments’ borrowing will exhibit vertical and horizontal strategic interactions if they operate under soft budget constraints. Therefore, a test for strategic interactions in subnational borrowing can be used to infer whether a cooperative federation like Germany is susceptible to soft budget constraints. The results suggest that state borrowing in Germany exhibited horizontal but not vertical interactions during the time-frame of the analysis. This indicates (i) that German States faced soft budget constraints and (ii) that they were more concerned about the likelihood of a bailout than about its volume.

Fiscal institutions of Brazilian municipal borrowing

AbstractIn an effort to understand subnational borrowing, this article explores how three Brazilian institutions—the 1988 Constitution which mandates revenue and expenditure assignments among the levels of the federation; the national Law of Fiscal Responsibility, which imposes expenditure and debt limitations on all levels and branches of government; and various borrowing arrangements—affect the municipal borrowing environment. These institutions are examined in light of de Mello's (2001) policy recommendations for strengthening efficiency and fiscal discipline in subnational borrowing. The institutions of Brazilian borrowing were found to have some of de Mello's recommendations, with the new Constitution and the Law of Fiscal Responsibility making progress towards increased fiscal responsibility, but the current borrowing arrangements serving to maintain a controlled system that is not conducive to responsible municipal borrowing. Several recommendations are made to improve the borrowing environment and foster fiscal discipline and efficiency Copyright © 2008 John Wiley & Sons, Ltd.

Clientelism and Ethiopia's post-1991 decentralisation

ABSTRACTThis article addresses the question of why Ethiopia's post-1991 decentralisation reform is not taking the desired direction of matching diverse needs with available resources and creating accountable, responsive and autonomous regional governments. Given regional governments' relatively diverse socio-economic positions, the intention of the reform to create autonomous regions with devolved administrative, fiscal and political power is appropriate. Nonetheless, the implementation of the elements of the reform – expenditure assignment, revenue assignment, intergovernmental fiscal transfer and sub-national borrowing – is flawed. Existing studies that question the effectiveness of Ethiopia's devolution focus on political or fiscal aspects, and fail to link the de facto centre-region political power relationship with intergovernmental fiscal relations. This article, based on detailed field research in three regional governments, argues that the flawed intergovernmental fiscal relations reform is best explained by the clientelistic relationship between central and regional political parties.

Market-Based Fiscal Discipline Under Evolving Decentralisation: The Case of Russian Regions

Subnational governments' access to credit is essential for smoothing out shocks to their revenue and expenditures, including those associated with large infrastructure projects. However, governments might pursue an unsustainable borrowing path unless they face appropriate incentives. Theoretically, credit markets can discourage excessive borrowing by charging risk premia rising with the level of indebtedness. We examine the robustness of this market mechanism under the evolving institutions of decentralised governance in a transitional country. Russia presents a perfect case for such analysis, for the market discipline was the only constraint on subnational borrowing there throughout the 1990s.

ON-LENDING IN INDONESIA: PAST PERFORMANCE AND FUTURE PROSPECTS

On-lending to sub-national governments in Indonesia has a long and generally disappointing history. Among other noteworthy problems, an insufficient amount of funds has been channelled through the system vis-à-vis capital fi nancing needs, and loan repayments have proved poor. Aid agencies and government have recently invested substantial resources in attempts to improve the on-lending system; the resultant newly installed regulatory framework for sub-national borrowing is, however, unlikely to improve outcomes substantially. Developing sub-national government access to private capital markets would appear to constitute the way forward, although this will not come quickly or easily. A positive step in the right direction would be for government and aid agencies to embrace the anticipated change and work together to make the transition a successful one, rather than continue to tinker with reforms at the margin of a moribund system.

How Should Subnational Government Borrowing Be Regulated? Some Cross-Country Empirical Evidence

Countries have adopted various institutional responses to subnational government borrowing. Using a sample of 44 countries 1982-2000, this paper provides a panel data analysis to determine the most effective borrowing constraints for containing local fiscal deficits. The results suggest that no single institutional arrangement is superior under all circumstances. The appropriateness of specific arrangements depends upon other institutional characteristics, particularly the degree of vertical fiscal imbalance, the existence of any bailout precedent, and the quality of fiscal reporting.

Fiscal Decentralization and Borrowing Costs: The Case of Local Governments

Borrowing costs vary across different levels of government. Local governments often face costlier borrowing than their higher level counterparts. This article shows that the decentralization of expenditure functions and revenue sources to lower tiers of government has a bearing on local government borrowing costs. Empirical evidence is provided for a sample of industrial and developing economies in the period 1970 to 1995, using three different fiscal decentralization indicators and two different borrowing cost indices. The findings are robust to the inclusion of controls for additional determinants of subnational borrowing costs. An important implication of these results is that policies aimed at disciplining subnational finances in the process of fiscal decentralization also tend to reduce subnational borrowing costs.