44896 The World Bank J UNE PREMnotes 2008 N U M B E R 117 ECONOMIC POLICY & DEBT Subnational Fiscal Sustainability Analysis Elena Ianchovichina and Lili Liu, PRMED Why does Subnational Fiscal is the fundamental building block for study- Sustainability Analysis Matter? ing subnational debt dynamics both in a Subnational fiscal sustainability is important historical and forward-looking mode. In because an insolvent government cannot equation (1), Bt is the outstanding public provide public services. Although the ba- state debt measured at the end of period t, sic sustainability framework applies to any Xt is primary fiscal balance in period t, and nt government, subnational fiscal adjustment is the average interest rate payable in year t qualitatively differs from the national one, on the debt stock accumulated by the close of reflecting the interplay of subnational and year t–1.1 For the budget constraint to hold, national policies. Decentralization has given the primary balance should include all flows subnational governments significant spend- that affect the debt level. ing, taxation, and borrowing power, and For the purpose of policy analysis, it is subnational fiscal stress and debt crisis in useful to represent debt and the subnational emerging economies highlight the impor- government budget constraint (1) in percent- tance of subnational fiscal adjustment and ages of gross state domestic product (GSDP) sustainability. Examples include the 1997 and disentangle the growth and inflation debt restructuring agreements between states effects on indebtedness: and the federal government and the Fiscal gt Responsibility Law in Brazil, the recommen- bt − bt −1 = it − xt − bt −1 (1 + gt )(1 + π t ) (2) dations of the 12th Finance Commission in India mandating states’ fiscal responsibility πt − bt −1 legislation, a new borrowing framework in (1 + π t ) Mexico, and fiscal legislation in Colombia and Peru. Subnational sustainability analysis where bt,, it, and xt are respectively the out- should therefore be a centerpiece of Bank’s standing public state debt, interest payments, subnational AAA work. and primary balance as a share of GSDP in period t, gt is the real annual growth rate, and πt is the annual inflation rate. The terms on Basic Framework of Subnational the right-hand side of equation (2), in order, Fiscal Sustainability Analysis are the interest rate, the primary balance (as The inter-temporal financing constraint of a share of GSDP), the growth, and inflation the subnational government: effects on domestic debt.2 With a consistent set of projections for Bt − Bt −1 = nt Bt −1 − Xt (1) interest rates, primary balance, growth, and FROM THE POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK inflation rates, we can assess debt sustain- and debate over feasible parameters for ex- ability under different scenarios using: penditure adjustment, tax reform, quasi-fis- cal adjustment, and reform of the borrowing (1 + rt ) (3) framework. bt = bt −1 − xt (1 + gt ) The MTFP needs to go beyond published fiscal accounts. Hidden and contingent li- where rt is the real interest rate defined as abilities can lead to the sudden onset of a fiscal crisis without warning. Potential sources rt = [( nt + 1) /(π t + 1)] − 1 . of liabilities include off-budget liabilities of special-purpose vehicles and subnational Why do Subnational and National enterprises, government guarantees, civil Fiscal Adjustments Differ? servant pensions, nonperforming assets of Although national and subnational debt subnational banks, arrears under the cash dynamics are alike, subnational fiscal sustain- accounting system, and liabilities associated ability analysis differs from the national one. with judiciary decisions. Subnational debt sustainability is compli- cated by the legislative mandates of central Subnational Fiscal Sustainability vis-à-vis subnational governments and the Analysis: Base Case intergovernmental finance system. Unable We use the Indian state of Tamil Nadu as to issue their own currency, subnationals an illustration.3 The baseline simulation cannot use seigniorage finance. Subnationals follows the fiscal adjustment proposed in cannot freely adjust their primary balance Tamil Nadu’s MTFP (2005–09). Beyond the due to potential legal constraints on raising MTFP timeframe, the baseline assumption own revenue, varying dependence on central on real interest rate and the subnational government transfers, and central govern- primary balance and GDP growth are based ment’s influence on key expenditures such on projection in AAA (e.g., CEMs, DPRs, as wages and pensions. When public banks subnational AAA). dominate the supply of subnational credit, lending rates could be subsidized and credit Sensitivity Analysis risk could be compromised. Many policies Sensitivity analysis helps address the failure affecting the subnational economy and its of simple analytical models to take into ac- fiscal health can be largely set by the central count uncertainty. It analyzes fiscal risks and government. the probability of insolvency. Recent studies Market participants may tolerate unsus- propose different methods for analyzing tainable subnational fiscal policy if they per- uncertainty. In the cases where historical ceive that the central government implicitly time series data are available, one can apply guarantees subnational debt service. When a econometric techniques. Without historical soft budget constraint prevails, subnational time series data, as in the case of Tamil Nadu, governments may live beyond their means, we rely on the set of stress tests, complement- negating competitive incentives and foster- ed by an in-depth discussion of key fiscal risks ing corruption and rent seeking. and constraints to fiscal adjustment. The first sensitivity test sets the real ef- Developing a Medium- fective interest rate, the real growth rate, and Term Fiscal Framework the primary balance after 2006/07 at their A medium-term fiscal framework (MTFP) historic averages of the 1990s. The test il- serves as the baseline for sustainability lustrates the ambitiousness of the adjustment analysis. Often, the MTFP is driven by a fiscal envisaged in the baseline projection relative crisis. The MTFP involves political tradeoffs to historical experience. The Government 2 PREMNOTE JUNE 2008 Table 1. Baseline Simulation as Proposed in Tamil Nadu’s MTFP Assumptions 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Real interest rate (r) 5.5 5.5 5.5 5.5 5.0 5.0 5.0 5.0 5.0 5.0 5.0 Real growth rate (g) 8.5 6.5 6.0 6.0 6.0 6.0 6.0 6.0 6.0 5.8 5.7 Primary surplus (x) –0.3 –0.5 –0.1 0.5 0.8 0.5 0.5 0.5 0.5 0.5 0.5 Debt dynamics* Debt (% of GSDP) (b) 27.8 27.3 27.5 27.5 26.9 25.8 25.1 24.4 23.7 23.0 22.3 21.7 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 Real interest rate (r) 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 Real growth rate (g) 5.5 5.3 5.2 5.0 4.8 4.7 4.5 4.5 4.5 4.5 4.5 4.5 Primary surplus (x) 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 Debt dynamics* Debt (% of GSDP) (b) 21.1 20.5 20.0 19.5 19.0 18.6 18.2 17.8 17.4 17.0 16.6 16.2 * Authors’ simulation based on equation (3). of India started to liberalize interest rates in ratio will gradually climb from 27 percent in the mid-1990s, thus the historic real interest 2008/09 to 39 percent by 2026/27, but its debt rate average does not provide an appropriate service payments will increase to 16 percent benchmark. Therefore, the second sensitivity of revenue over the same period—below the test leaves the interest rate as in the baseline debt stress ratio of 20 percent (Figure 1). This and sets only the real growth rate and the suggests that there is “fiscal space” for an primary balance after 2006 at their historic increase in capital investment through ad- averages of the 1990s. This test reveals the ditional borrowing without jeopardizing the costs of loose fiscal policy. state’s debt service capacity. Tamil Nadu may One may conduct a number of stress even avoid the increase in the debt burden tests changing the key variables, separately if its annual real economic growth increases or jointly, by one or more standard deviations by 1.6 percentage points from its expected from their means, over a period of time. Our growth rate in 2008/09. Research has shown tests show that it is the unexpected, adverse such an increase may occur as a result of combined shock of a more permanent nature improvements in investment climate. (low growth, high real interest rates, and large primary deficits over a period of 5 to Figure 1. Impact of Increased Infrastructure 10 years) that will have grave consequences Investment in Tamil Nadu and require a major fiscal adjustment. 45 Debt as a % of GSDP 40 Can Fiscal Space for 35 Infrastructure be Expanded 30 during Fiscal Adjustment? 25 We simulate the impact of an increase in Tam- 20 il Nadu’s capital expenditure after 2007/08 to 15 3 percent of GSDP—the average for Indian 10 states. We assume that real economic growth 5 and interest rates will remain as in the base- 0 06 08 10 12 14 16 18 20 22 24 26 line, and there will be no effect on the state’s 20 20 20 20 20 20 20 20 20 20 20 revenue. We abstract from questions about the efficiency and effectiveness of public Capital expenditure increase Baseline expenditure on infrastructure investment. Source: Authors’ simulation based on equation (3). Under these assumptions, the debt-to-GSDP JUNE 2008 PREMNOTE 3 Risks to Fiscal Adjustment disaggregate data on states’ debt maturity It is important to appreciate how the sub- are unavailable, but the rollover risks are low national debt crisis got started and how due to fixed interest rates and in many cases the interaction of national and subnational medium- to long-term debt maturity. policies may evolve. In the case of India’s Adjustment in the primary balance also states, key fiscal risks include increases in faces constraints. On the expenditure side, real interest rates and constraints to primary political impulse could push up the number balance adjustment. of civil servants and backtrack on progress In Tamil Nadu, increases in borrowing with wage and pension reform. Large pen- and interest rates in the 1990s led to ris- sion liabilities are a major concern for Indian ing interest expenditure. From 2000/01 to states due to the long-term nature of pen- 2004/05 declining interest rates helped stabi- sion policies, the acquired rights of existing lize interest expenditure, but the risk of rising employees, the aging civil service force, and interest rates due to increased demand for the need for the government to contribute to credit and an upturn in international inter- a newly defined contribution scheme. More- est rates is real. A hypothetical 3 percentage over, pressures to increase utility subsidies point increase in the real average borrowing could intensify. cost after 2007/08 will double Tamil Nadu’s On the revenue side, the potential for debt burden in 2026 compared to the base- increasing the state’s tax revenue is limited. line (Figure 2) and lift debt service as a share The central government reserves the right of revenue to the stress level of 20 percent. to tax the service sector, which is the fastest The debt maturity structure impacts roll- growing sector in Tamil Nadu. Successive over risks. One trigger of the Mexican debt central finance commissions have reduced crisis in the mid-1990s was the short maturity Tamil Nadu’s share in the pool of net share- of subnational debt and variable interest able central taxes. rates. Rapid currency depreciation, a sharp The 12th Finance Commission has rise in interest rates, and a sharp contraction increased incentives for responsible subna- in the pool of shared revenues eventually tional fiscal behavior, with debt consolidation triggered a subnational debt crisis. In India, and a waiver scheme linked to reduction in states’ fiscal and revenue deficits. However, the enforcement mechanism is lacking. It is Figure 2. Policy Risks in Tamil Nadu also unclear if the incentives offset the nega- 90 tive effect of the deficit grant distribution. 80 The 12th Finance Commission has departed from its tradition of greater weight to eq- Debt as a % of GSDP 70 60 uity than economic performance. For Tamil 50 Nadu, this implies reversing the past trend of 40 diminishing states’ share in the pool of shar- 30 able tax revenue. Nonetheless, it is unclear how future finance commissions will decide 20 on the distribution of revenues given growing 10 disparities among Indian states. 0 Individually, the above risks may not 05 07 09 13 15 17 19 21 23 25 11 threaten fiscal sustainability, but their com- 20 20 20 20 20 20 20 20 20 20 20 bined effect may derail debt sustainability. Baseline Interest rate increase A 3 percentage point increase in the real Wage increase Combined policy risks borrowing cost, a percentage point decline Other expenditure increases in the GSDP growth, and a worsened primary Source: Authors’ simulation based on equation (3). balance reflecting revenue stagnation, de- 4 PREMNOTE JUNE 2008 crease in central devolution, subsidy increase, Burnside, Craig. 2005. “Some Tools for Fis- and the wage shock after 2008/09 4 will dra- cal Sustainability Analysis.” Chapter 3 in matically worsen debt dynamics. Under this Fiscal Sustainability in Theory and Practice. hypothetical scenario in 2026/27 the debt Washington, DC: World Bank. services are expected to be 51 percent of revenue—much higher than the debt stress This PREM Note, one in a series of PREM threshold of 20 percent,5 while the debt Notes on subnational finance, is based on Ian- burden is expected to be nearly 80 percent chovichina, Liu, and Nagarajan, “Subnational of GSDP (Figure 2). Fiscal Sustainability Analysis: What Can We Learn from Tamil Nadu?” World Bank Policy Concluding Remarks Research Working Paper, No. 3947, 2006 and Assessing fiscal sustainability is a complex Economic and Political Weekly, Vol. XLII, No. task as it requires one to form a view about 52, December 2007. how much fiscal adjustment is politically and socially feasible, and how various com- About the authors ponents of subnational fiscal accounts re- Elena Ianchovichina is a Senior Economist with spond to policy reform and shocks. At the the Economic Policy and Debt Department of the subnational level, of particular concern are PREM Vice Presidency. the respective legislative mandates of central vis-à-vis subnational governments and the Lili Liu is a Lead Economist with the Economic intergovernmental finance system, which Policy and Debt Department of the PREM Vice make subnational fiscal adjustment differ- Presidency. ent from the national one. The possibility that such mandates may change is real and Endnotes particularly relevant for many developing 1. Time is discrete, debt matures in one period, countries where intergovernmental system and financing and interest payments take place and the structure of financial markets are evenly throughout the year. Debt should be net of continuously evolving. Thus, country context comparable assets, while interest payments should matters. Finally, the analysis is subject to all be net of any receipts. the caveats pertaining to fiscal sustainability 2. For countries allowing subnational govern- analysis at the national level. ments to access external financing, equation (2) must be amended to include the exchange rate References effect. Ianchovichina, Liu, and Nagarajan. 2007. 3. Tamil Nadu was the first Indian state where “Subnational Fiscal Sustainability Analy- the World Bank worked with the state govern- sis: What Can We Learn from Tamil ment to apply the fiscal sustainability framework Nadu?” Economic and Political Weekly presented in this PREM Note. XLII(52), December. (Also available as 4. The decision of the fifth pay commission World Bank Policy Research Working of the central government, emulated by many Paper, No. 3947, 2006, World Bank, states, contributed to the rapid increase in wages Washington, DC.) and pensions without accompanying reduction in Burnside, Craig. 2005. “Theoretical Pre- civil service employment. One cannot rule out the requisites for Fiscal Sustainability Analy- recurrence of such an event. sis.” Chapter. 2 in Fiscal Sustainability 5. The government of India defines 20 percent in Theory and Practice. Washington, DC: or above of debt service over revenue as a thresh- World Bank. old of “debt distress.” JUNE 2008 PREMNOTE 5 This note series is intended to summarize good practices and key policy findings on PREM-related topics. The views expressed in the notes are those of the authors and do not necessarily reflect those of the World Bank. PREMnotes are widely distributed to Bank staff and are also available on the PREM Web site (http://www.worldbank.org/prem). If you are interested in writing a PREMnote, email your idea to Madjiguene Seck at mseck@worldbank.org. For additional copies of this PREMnote please contact the PREM Advisory Service at x87736. PREMnotes are edited and laid out by Grammarians, Inc. Prepared for World Bank staff