Subnational Government Debt Governance:

Lessons from Non-Asian Emerging

Economies
Jorge Martinez-Vazquez
and
Yasin Civelek
International Center for Public Policy
Andrew Young School of Public Studies
Georgia State University

The views expressed in this presentation are the views of the author and do not necessarily reflect the views or policies of the Asian Development Bank Institute (ADBI), the Asian
Development Bank (ADB), its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for
any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms.
Introduction

• Local borrowing is one of the fundamental pillars of fiscally decentralized

system together with the assignment of functional expenditure
responsibilities, revenue assignments and transfers.

• This presentation addresses the practice with subnational debt governance

of Non-Asian Emerging Economies (NAEE) over last several decades with
the main objective of extracting lessons (both positive and negative) for
the development of best practice around the world.
Introduction: Local Borrowing

• Subnational government borrowing to finance local infrastructure projects

is:
• Efficient, solving hard liquidity issues

• Intergenerational equitable

• However, there are risks with undisciplined borrowing behavior leading to:
• disruptions in public service delivery at the subnational level

• negative externalities on macroeconomic stability at the national level

 Why do local governments over-borrow? (1)
• Faulty asymmetric design of the fiscal decentralization system:
• Common to observe significant expenditure authority but much less revenue authority,
which leads to large Vertical Fiscal Imbalances (VFIs)
• Large VFIs => excessive local spending, lower tax effort, deficits (all induced by the presence
of common pool problem & moral hazard)

• Political economy reasons--- but even with a good fiscal decentralization design
• Local officials seeking local votes may see additional borrowing and spending as an expedite
way to get that support, while the (political) costs are shifted as responsibilities for other
officials in future years (e.g. the cutting of ribbons for infrastructure projects)
 Why do local governments over-borrow? (2)

• Therefore, ensuring disciplined and responsible subnational

borrowing behavior requires explicit rules, monitoring and oversight
regarding local government debt.

• The question is how to provide a legal framework and practice that

allows subnational governments flexibility to pursue optimal service
delivery while preventing undisciplined or irresponsible behavior (in
good times or in times of economic crisis.)
 Literature (1)
• Over the last four plus decades, there has been intensive study of what may be
the potential causes of fiscal indiscipline at the subnational level and the role of
fiscal institution and fiscal rules.
• Lack of tax autonomy and large VFIs as one of the leading factors for the
subnational fiscal indiscipline (Rodden et al. 2003; and Oates 2008)
• Large VFIs enhances de “common pool problems” and can lead to moral hazard
and bailout expectations (Rodden 2002, Eyraud and Lusinyan 2013, Asartyan et
al. 2015).
 Literature (2)
• A considerable empirical literature has not found evidence that decentralization is associated with
higher macroeconomic instability (Martinez-Vazquez and McNab 2003; Schaltegger and Feld
2009; Baskaran 2010; Neyapti 2010).

• A number of additional papers have also explored the role of borrowing and other fiscal rules at
subnational level (Jin and Zou, 2002; Rodden, 2002; Plekhanov and Singh, 2007; Martinez-Vazquez
and Vulovic, 2017).

• However, these studies still fall short of providing robust results about the effectiveness of the
different institutional arrangements that may lead subnational governments to the most
desirable fiscal outcomes.
 Beyond FD design and borrowing rules:
Other Instruments
• Fiscal Responsibility Laws
• More complex and comprehensive than borrowing rules— involving budgeting procedures etc.
• Role of FRLs on fiscal outcomes appears to be mixed so far but an indication that they can be helpful.

• Fiscal Councils
• A more or less independent authority to monitor and help enforce fiscal rules
• Key aspect, whether it is a truly independent authority --similar to the role played by central banks regarding
monetary policy

• Rainy-day Funds
• Set aside savings in good times to protect budgets and spending against unexpected economic shocks and so
to minimize disruptions caused by economic fluctuations and sharp declines in revenues.
 Importance of having an all inclusive definition
and quantification of subnational debt
• Debt is defined as a liability that consists of the payment of interest and principle by a
debtor to a creditor at a date(s) in the future ((IMF 2001) .

• In reality, subnational governments can bypass controls and even prohibitions by

adapting less visible or less formal forms of debt.
• It is important to be clear what constitutes debt and that we are able to measure it.

• Therefore, subnational government debt should be inclusive of all forms of all liabilities
either explicitly contracted (e.g., bank loans, bond issues or central government loans) or
otherwise created by sub-central governments (e.g. external borrowing vehicles, accruals
or arrears in payments to suppliers or providers).
 Subnational Government Debt Trends
in NAEEs (as percent of GDP)
• Latin America: high levels but declining
25

20

15
% of GDP

10

0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Years

Argentina Brazil Colombia Mexico

 Subnational Government Debt Trends
in NAEEs (as percent of GDP)
• Eastern Europe: low levels but rising
6

4
% of GDP

0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Bulgaria Czech Republic Hungary Poland Romania Slovenia

 Regional Comparison for SNG Debts in NAEEs( as
percent of GDP)
• South Africa shows rapidly increasing levels
14

12

10
% of GDP

0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

L.A. Average E.EU. Average Russian Federation

South Africa Nigeria Turkey
 Subnational Borrowing Regulations

• In the analysis, we follow Ter-Minassian and Craig (1997) who first

classified subnational borrowing regulations and debt supervision into four
categories:
• i) Administrative

• ii) Rule-based

• iii) Cooperative

• iv) Market-based
Borrowing Regulations Across Years in NAEEs
1990 2000 2010
Bulgaria Chile Chile
Chile
Prohibited
Poland
Romania
Brazil Mexico Mexico
Mexico Nigeria Nigeria
Administrative Russia Russia Slovenia
Slovenia Slovenia Turkey
Turkey Turkey
Colombia Brazil Brazil
Colombia Bulgaria
Hungary Colombia
Centrally-imposed rule Poland Czech Republic
Hungary
Poland
Romania
Russia
Self-imposed rule Argentina Argentina (None)
South Africa Romania Argentina
Cooperative
South Africa South Africa
Czech republic Bulgaria (None)
Market-based
Hungary Czech Republic
 Subnational Borrowing Regulations in NAEEs
9
Number of Non-Asian Emerging Countries

Prohibited Administrative Centrally imposed Self Imposed Cooperative Market-based

Borrowing Rules

1990 2000 2010

 Cross-Cutting Rules for Debt Regulations
in NAEEs
14
Number of Non-Asian Emerging Countries

12

10

Limit on debt Golden rule Foreign allowed Foreign prohibited Foreign approval
1990 2000 2010
 Performance of Borrowing Regulations

• What do we know about which approach to borrowing regulations

works best?

• One may suggest that the rule-based approach is superior to the

administrative approach from the viewpoint of budget transparency
and certainty or that the cooperative approach has the advantage of
directly involving subnational governments into the pursue of fiscal
stability.
Performance of Borrowing Regulations
• In the case of high vertical fiscal imbalances, centrally-imposed rules seem to lead
to better fiscal outcomes than self-imposed rule-based approach among
emerging economies (Plekhanov and Singh 2007).
• Moreover, the cooperative approach has a positive impact on general
government fiscal discipline, even with high levels of subnational debt and high
vertical fiscal imbalance (Martinez-Vazquez and Vulovic 2017).
• However, each approach encompasses multiple dimensions, and clearly none of
the approaches a priory dominates all those dimensions.
 A Different Approach?
Borrowing Autonomy Index
• Even though, the categorization of the four types of borrowing regulations clearly
provides useful information for policy makers, more detailed study is still needed
for precisely understanding the effectiveness of the different approaches.

• The index captures a variety of relevant fiscal regulations into a scalar taking
values between 0 and 3. Specifically, the borrowing autonomy index takes into
account whether an approval by higher-level government is required, whether
debt limits are in force, whether the “golden rule” is in place, and whether
foreign borrowing is allowed.
Subnational Borrowing Autonomy in NAEEs
9
Number of Non-Asian Emerging Countries

0 0.9 1 1.2 1.9 2 2.8 3

Borrowing Index, ( 0 - 3 )

1990 2000 2010

 Fiscal Responsibility Laws (FRLs):
Response to Systemic Subnational Debt Crises
in Latin America
• The FLRs have attempted to address fiscal coordination failures between the central and
subnational governments, which resulted in significant macroeconomic crises starting in
the 1980s.

• FRLs are designed to address wider fiscal governance issues, including short time
planning horizons, moral hazard and common pool problems.

• They are framed within medium-term fiscal horizons, emphasizing budget transparency
and accountability, the monitoring of fiscal targets, the inclusion of enforcement
measures, and often carefully specified escape clauses (Liu and Webb 2016).
 Fiscal Responsibility Laws (FRLs):
Response to Systemic Subnational Debt Crises
in Latin America
• Overall, the introduction of FRLs appear to have brought better coordination of fiscal
policies at the different levels of government and to have contributed to enhanced fiscal
sustainability, especially where they have been supported by other fiscal rules.

• The experience with FRLs of four emerging countries in Latin America

• Brazil,
• Argentina,
• Colombia and
• Peru.
 Major Features of FRLs
in Four Latin American Emerging Countries
• Measures on budget transparency
• Prepare & Publish budget plans-medium term framework

• Fiscal Targets
• Limits on spending

• Sanctions
• Restrict borrowing autonomy & cut unconditional grants
The difficult part: Enforcement of Borrowing
and Fiscal Rules…..
Non-Asian Emerging Economy Subnational Bailout History
Country Bailout Country Bailout
Argentina Yes Nigeria Yes
Brazil Yes Peru No
Bulgaria No Poland No
Chile Yes Romania No
Colombia Yes Russia Yes
Czech Republic No Slovenia No
Hungary Yes South Africa No
Mexico Yes Turkey No
 Effective Borrowing:
Monitoring Compliance and Enforcement
• Effective successful practices require to go beyond subnational borrowing and fiscal rules (Rodden
and Eskeland 2003; Kumar et. al. 2009; Ter-Minassian 2015; Kotia and Lledo 2016).
• Preventive measures
• Monitoring
• Enforcement
• Sanctions, if needed

• Clearly, the strength with which the rules are applied, comprising the monitoring and
enforcement mechanisms, can be more important than the rules themselves on the fiscal
performance at the subnational level.
 Prevention Measures
• The design and strength of the rest of the fiscal decentralization system plays an important role
(reduction of VFIs, etc.).

• Limiting the extent of “off-budget” spending or borrowing.

• eed to make sure that borrowing rules and monitoring have the widest scope possible.

• Credit risk mitigation measures should not work against prudent and responsible subnational
borrowing.
• This can be achieved through accepting and enhancing the role of private credit rating agencies or
alternatively, an independent public authority (for example, an autonomous fiscal council).
• Some forms of central government loan guarantees, as in the case of on-lending
 Monitoring and Enforcement of
Borrowing and Fiscal Rules
• Governments can rely on a strong market discipline if it is available.
• But as we have seen in most emerging economies the lack of financial market development can
significantly reduce the effectiveness of this approach.

• What makes the rule stronger is the capacity of monitoring.

• Monitoring is typically charged to the Ministry of Finance at the central level.
• However, it is preferable to have an independent institution to monitor the implementation of the
borrowing rules.
• Media visibility of fiscal rules

• Fiscal Councils
 Fiscal Councils in NAEEs
Monitoring of
Country Name Name of Fiscal Council Established in Coverage Fiscal Rules

Chile Advisory Fiscal Council 2014 Central Government Yes

Colombia Comite Consultivo para la Regla Fiscal 2012 Central Government Yes

Hungary Fiscal Council 2009 General Government Yes

Mexico Centre for Public Finance Studies 1998 Central Ggovernment No

Nigeria Fiscal Responsibility Commission 2007 General Government Yes

Peru Consejo Fiscal 2015 General Ggovernment Yes

Romania Fiscal Council 2010 General Government Yes

Serbia Fiscal Council 2011 General Ggovernment Yes

Slovak Republic Council for Budget Responsibility 2011 General Ggovernment Yes

South Africa Parliamentary Budget Office 2014 General Government No

Enforcement of Borrowing and Fiscal Rules
• Consolidated Debt Ceilings can also help with enforcement
• imposed by supranational government agreements

• imposed by the country own national legislatures

Debt Rule, Consolidated Government
6

5
Number of countries

0
1990 1995 2000 2005 2010 2015
 What are the lessons from those
experiences?
• First, good outcomes on debt governance are not only about borrowing rules and
other controls.

• Second, there is a need for inclusive definitions and accounting of debt.

• Subnational governments can bypass controls and even prohibitions by adapting less visible
or formal forms of debt.

• Third, regarding subnational borrowing rules, among the different options

available, non-Asian emerging countries have shown a definite predilection for
centrally imposed rules.
 What are the lessons from those
experiences?
• Fourth, the recent introduction of Fiscal Councils in a good number of developed
countries and some developing countries points to their effectiveness in achieving overall
improved fiscal discipline at the national level.

• Fifth, adopting Fiscal Responsibility Laws (FRLs) early and wide scope including the
national and subnational governments significantly reinforces the legal framework
behind borrowing rules and will help prevent fiscal indiscipline and national fiscal crises.

• Sixth, besides fiscal rules and borrowing regulations, enforcement and monitoring
mechanisms are vital for the rule strength.
 Conclusion
• Subnational borrowing is both efficient and inter-generationally equitable.
However, subnational borrowing also poses clear dangers to the
macroeconomic stability of fiscally decentralized countries.

• Because of these dangers, the temptation may be just to prohibit it. But
that will not the optimal solution.

• The best way out of this dilemma is to allow subnational governments to

borrow but also regulate, monitor and enforce compliance with the rules.