The World Bank JANUARY 1999 NUMBER 15 PUBLIC SECTOR Decentralizing borrowing powers With sound intergovernmental fiscal relations and proper regulation, subnational borrowing is both feasible and desirable. Where these conditions are not in place, subnational borrowing may lead to unplanned liabilities for central govern- ment and thus should be restricted while enabling institutions are developed. The debt crisis among subnational govern- ing. It would be inefficient to finance such ments in Brazil, the inflationary impact of capital investment by increasing taxes. In subnational financing in Argentina, and city addition, because the benefits of such bankruptcies in the United States are often investments often span several decades, used to illustrate the potential macroeco- equity considerations suggest that future How can nomic hazards of decentralizing borrow- generations should participate in the ing powers. The argument focuses on the financing. Capital markets provide this subnationat impact of a possible moral hazard problem- intertemporal link. namely, that access to financial markets by Second, access to financial markets can governments access subnational governments may generate foster political accountability. The pricing of unplanned liabilities for central government. capital by markets can signal the poor per- financial markets Yet the academic literature and country formance of subnational governments by rais- experiences do not suggest an inevitable ing interest rates or simply blocking access. without creating adverse link between decentralized bor- rowing powers and central government's Subnationat mechanisms for unplanned liabilities ability to maintain fiscal discipline and macro- accessing capital markets economic stability. Rather, the key seems to Subnational government can access capital for central lie in the design of fiscal decentralization, markets through: particularly the regulatory framework under * Direct borrowing by central government government? which borrowing powers are decentralized. that is onlent to subnational tiers. (For a literature review and discussion see * A public financial intermediary. Litvack, Ahmad, and Bird 1998.) Designing * Direct borrowing. and implementing this framework are no easy * Market decentralization of public services. task. Still, where the necessary conditions are Policymakers should consider several in place, subnational borrowing is both fea- objectives when weighing the merits of each sible and desirable. Where these conditions channel, including minimizing the political are not in place, subnational borrowing allocation ofcredit, reducing or eliminating should be restricted and institutions devel- implicit liabilities for an upper-tier govern- oped to enable it in the long run. ment, and strengthening capital markets. Although borrowing through the cen- Why is access to financial tral government ensures access by subna- markets important? tional governments to long-term finance, Subnational governments require access credit allocated in this manner may get to financial markets for two main reasons. embroiled in a political process, leading The first is to finance lumpy capital spend- to inefficient investments. Intermediation FROM THE DEVELOPMENT ECONOMICS VICE PRESIDENCY AND POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK by a public financial intermediary can also provide public information on their liabil- have this shortcoming (depending on its ities and repayment capacity design), with the additional disadvantage that the debt of public financial interme- Bankruptcy laws diaries is an implicit obligation of central By itself, better disclosure will not curb moral government. hazard-penalties are also needed. In par- Additional complications can occur when ticular, explicit bankruptcy procedures (such multiple channels are used. For example, South as the financial control boards in the United Africa's central government has created a pub- States or system of court-appointed receiver- lic infrastructure bank that operates alongside ships in New Zealand) may need to be legis- Regultato ry design awell-developed private capital market (Ahmad lated. (Central government can also legislate 1996). Unless the regulatory framework for intermediate steps with an associated penalty issues start with the municipal borrowing clearly delineates a com- schedule-for example, setting debt thresh- plementary role for the public and private olds that, if overstepped, then require central question of financial systems, the public system may dis- approval for future borrowing or even cause place the private system, or the public system the loss of borrowing powers altogether. Too transparency, initially may get saddled with high-risk clients. many central controls may, however, make Direct access to capital markets, where central authorities implicitly liable for sub- through possible, offers potential for a more trans- national borrowing. Thus it may be prefer- parent, market-based relationship to develop able to require full disclosure and legislate better information and for a better chance of enforcing a hard bankruptcy procedures without introduc- budget constraint between levels of gov- ing intermediate controls.) Such mechanisms systems ernment. Macroeconomic concerns about mustensure that the deliveryof basic services moral hazard-based on the assumption by is allowed to continue, even if at a reduced capital markets that borrowing by subna- level,while management and financial restruc- tional governments is ultimately backed turing proceed. Otherwise there will be enor- by central government-may arise with mous pressure for central bailouts. direct borrowing from private financial mar- kets. Managing such risks through an appro- Tax bases priate regulatory framework-while allowing Moral hazard can also be eased by ensur- market discipline to guide the allocation ing that subnational governments have of capital-is probably the most efficient access to own taxes (within a predictable sys- way to allow subnational access to finan- tem of intergovernmental finance), which cial markets. can be pledged as collateral. Without such direct fiscal backing, markets may view any Designing the regulatory borrowing by subnational governments as framework for subnational implicitly backed by the central government. borrowing Thus own taxes are an important prereq- Better information systems, bankruptcy laws, uisite for subnational access to finance and and access to tax bases, separate fiscal and for limiting moral hazard. financial systems, market decentralization, and supervision and legislation help impose Separatefiscal andfinancial systems budget discipline at all tiers of government Equally important is keeping fiscal and finan- and enable borrowing to be decentralized. cial systems separate when designing inter- governmental systems. Indeed, the lack of Information systems separation between fiscal and financial sys- Regulatory design issues start with the ques- tems-rather than decentralization-may tion of transparency, initially through bet- have led to macroeconomic instability in ter information systems. These systems some countries, as the web of implicit oblig- should include standardized accounting pro- ations suddenly appeared as explicit bud- cedures for subnational governments and get commitments. In Argentina, for example, provincial gov- ings and loan debacle and recent East Asian ernment deficits have been partly financed financial crisis suggest, private banks must by provincial banks, many ofwhich have gone be supervised with a clear prudential reg- bankrupt. The Central Bank's policy of man- ulatory framework that monitors the level aging these banks and absorbing their losses and nature of their aggregate liabilities. provided provincial governments with a cir- Finally, if central authorities grant subsidies cuitous mechanism of inflationary finance. to subnational governments, the subsidies It also weakened incentives for fiscal disci- should be provided explicitly through the pline at the provincial level. In Brazil evi- fiscal transfer system rather than implicitly dence suggests that a soft budget constraint through the financial sector. between tiers of government can exist Central subsidies through the banking system despite a sound Market decentralization intergovernmental fiscal system (Dillinger Marketdecentralizationmayalsoreducemoral should be provided 1997). Similarly, in China the weak revenue hazard. Privatization of public infrastructure base of the center has put political pres- may enable the application of private sector explicitly through sure on the People's Bank of China to offer bankruptcy laws and allow other private com- credit to lower-level governments. Such pol- panies to bid for the assets in case of finan- the fiscal transfer icy-based lending can have a negative impact cial difficulties-not a viable option under on macroeconomic price stability and, pre- public ownership. To implement such an system rather than sumably, fiscal discipline at the subnational option, however, governments must ensure level (Lall and Hofman 1995). that a sector contalns multiple service deiiv- implicitly through Several mechanisms can be used to sep- erers. Private participation creates options for arate fiscal and financial systems. First, an accessing financial equityaswell as debt, cre- the financial sector independent central bank is a key element ating an incentive for "equity to monitor debt" of a hard budget constraint. Second, where that is not available in public financing Sys- possible, the public sector must get out of tems. In addition, unbundiing may shrink the the financial system (box 1). (At the very entity involved, thus avoiding the "too big to least, as Argentina suggests, subnational pub- fall" syndrome often associated with bailouts. lic financial institutions should be closed.) Although this move includes privatizing the Supervision and legislation banking system, privatization is insufficient Finally, the backdoor channels that lead to enforce the separation. As the U.S. say- to financial liabilities should be monitored Box i Evolution of capital markets and decentralization of borrowing powers In countries without a domestic capital mar- lending, thus preserving the separation of ket, it may be preferable to have central fis- risks between the public and private sectors. cal transfers-from central borrowing from Colombia offers lessons for designing dis- international sources-provide resources to count facilities. subnational governments while policy efforts The need for discount facilities will disap- focus on developing a private commercial pear as capital markets emerge with finan- banking system. This approach avoids the cre- cial instruments offering long-term finance. ation of public financial intermediaries, keeps And as long as the fiscal system is well designed, the fiscal and financial sectors separate, and subnational governments will be able to secure can offer a better starting point for a munic- longer maturities. Still, for fiscally weak munic- ipal finance system. ipalities the fiscal transfer system will remain As the private banking system establishes an important vehicle for accessing funds. In itself, long-term finance can be provided more developed capital markets, private credit through centrally funded discount facilities, rating agencies and bond insurance agencies These facilities stretch the terms of com- offer a market-based mechanism for moni- mercial bank lending to municipalities but toring and regulating subnational borrowing. take on only the maturity risk. Commercial These institutions, however, require public sec- banks retain the credit risk for their retail tor regulation. and, where possible, closed. In particular, centers (which usually have strong fiscal legislation must ensure that subnational gov- resources and management capacity) quicker ernments are not allowed to dip into pen- access to financial markets and perhaps even sion funds or use subnational corporations foreign markets; implementing market to borrow, or must explicitly include such decentralization as a first step; and replac- borrowing in subnational debt. In addition, ing implicit resource transfers through pub- balanced budget requirements for subna- lic financial institutions with explicit fiscal tional governments can ensure that current transfers. The challenge is to design the accounts are balanced by the end of each regulatory framework for financial decen- fiscal year, so that borrowing to match expen- tralization; debating whether financial decen- diture and revenue streams does not lead tralizationisgoodorbadmaybeamootpoint Financial to the financing of current account deficits. given emerging local capital markets and a strong political push in many countries to decentralization can Foreign borrowing decentralize powers to subnational govern- The question of direct access to interna- ments. be implemented tional capital markets by subnational gov- ernments is further complicated by issues using a phased, of capital market liberalization and for- AhmadJunaid. 1996. "Structure of Urban eign exchange regimes. This overall context Governance in South African Cities." asymmetric will determine whether direct borrowing by International Taxation and Public Finance subnational governments in international 3(2): 193-213. approach markets should be permitted. Although this Dillinger, William. 1997. "Brazil's State Debt note is focused on decentralizing borrow- Crisis: Lessons Learned." World Bank, ing powers in the domestic market, the reg- Latin America and the Caribbean Region, ulatory framework suggested here applies Poverty Reduction and Economic Man- equally to local and foreign borrowing. agement Unit, Washington, D.C. Lall, Rajiv, and Bert Hofman. 1995. "Decen- Next steps tralization and Government Deficits in Financial decentralization-allowing sub- China." Injayanta Roy, ed., Macroeconomic national governments direct access to cap- Management and Fiscal Decentralization. ital markets-is an important complement Washington, D.C.: World Bank. to the devolution of fiscal powers to regional Litvack,Jennie,JunaidAhmad, and Richard and local authorities. If properly designed, Bird. 1998. "Rethinking Decentraliza- decentralization of borrowing powers can tion in Developing Countries." Sector add to the gains in efficiency and governance Studies Series. World Bank, Poverty expected from fiscal decentralization. But Reduction and Economic Management effective financial decentralization requires Network, Washington, D.C. a well-designed regulatory framework. This is not to imply an all or nothing sce- This note was written byJunaid Ahmad (Prin- nario: financial decentralization can be cipalEconomist, SouthAfrica ResidentMission). implemented using a phased, asymmetric Ifyou are interested in similar topics, consider approach. 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