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Contributor: World Bank
Author: Decentralization Thematic Team
Contact: Jennie Litvack

Should Borrowing by the Public Sector Be Decentralized?

Should Borrowing by the Public Sector Be Decentralized?

The debt crisis of subnational governments in Brazil, the inflationary impact of subnational financing in Argentina, and city-level bankruptcies in the United States have often been used to illustrate the possible macroeconomic implications of decentralizing borrowing powers. The moral hazard problem-the proposition that access to financial markets by subnational governments may create unplanned fiscal liabilities for central government-is the core of the argument. The academic literature and country experiences, however, do not suggest an a priori adverse link between decentralizing borrowing powers and the central government's ability to maintain fiscal discipline and macroeconomic stability. Rather, the key seems to be the design of fiscal decentralization, particularly the design of the regulatory framework under which borrowing powers are decentralized.

Why Is Access to Financial Markets Important?

There are three primary reasons why access to financial markets is considered important for subnational governments:

  • Financing capital expenditure: Subnational governments often have responsibility for public investments that are lumpy in nature. Financing such capital investment through increases in current taxes would be inefficient. In addition, because the benefits of such public investments often last several decades, equity considerations would suggest that future generations participate in the financing. Capital markets provide this intertemporal link.
  • Matching expenditure and tax flows: Within a particular fiscal year, expenditures incurred and tax intake may not be fully in synchrony. Access to financial markets offers an opportunity to smooth out such mismatches.
  • Fostering political accountability: The pricing of capital by markets may provide an independent mechanism for fostering political accountability. Markets may signal the poor performance of subnational governments through increases in interest rates or simply by blocking access.

What Are the Mechanisms for Accessing Capital Markets by Subnational Tiers?

At least four channels exist for access to capital markets by subnational governments:

  • Direct borrowing by central government and on-lending to subnational tiers
  • Through a public intermediary, a state-owned financial institution
  • Direct borrowing from capital markets
  • Through market decentralization of public services, where possible (see below).

In ascertaining the relative merits of each channel, policymakers will need to consider several factors. The channel selected should minimize or eliminate the inefficient political allocation of credit. Any implicit liability by an upper-tier government should be explicitly recognized and reduced or eliminated. And selection should be made with a view toward strengthening capital markets. Additional complications may occur when multiple channels are used. For example, in South Africa, government has created a public infrastructure bank that operates alongside a well developed private capital market. In this case, the regulatory framework will need to address the extent to which a complementary relationship can be established between the public and private financial systems, whether competition between the two is necessary and whether fair competition can be enabled, and the extent to which one channel displaces the other.

Evolution of Local Capital Markets

Of particular interest in assessing the merits of different channels is the linkage between access to capital markets by subnational governments and the evolution of local capital markets. In countries where local capital markets are weak, central government borrowing abroad may be the primary mechanism through which subnational governments access long-term finance. The challenge for policymakers would be to ensure a transition strategy for phasing out central government on-lending as capital markets emerge. In countries with more developed capital markets, however, the use of public intermediaries or central government on-lending will require careful attention to avoid displacing private capital.

Market decentralization-involving the private sector in the financing and delivery of government services-corporatization, and the unbundling of the delivery of services may also increase access to financing. For example, organizing the delivery of water or electricity in a company structure-private or public corporation-may improve access to capital markets if such organizations have a greater ability to shield themselves from political interference than do subnational governments. In countries with limited local capital markets, market decentralization may enable access to international capital markets directly by the service provider thereby facilitating the deepening of capital markets.

In addition, in relatively more developed capital markets, the use of private credit rating agencies and bond insurance agencies offers a market-based mechanism to monitor and regulate subnational borrowing. But these institutions also need to be monitored and regulated by the public sector.

Finally, one lesson from worldwide experiences is clear: subnational public financial institutions are undesirable. The incentives for subnational governments to abuse their relationship with their own financial institutions at the expense of macroeconomic stability is too great. Argentina stands out as a classic example of this situation.

How Should the Regulatory Framework for Subnational Governments Be Designed?

A well-designed regulatory framework is necessary to ensure that the decentralization of borrowing does not provide perverse incentives for excessive lending by markets and excessive borrowing by subnational governments-excesses that may eventually end up as liabilities of central authorities.

Such a framework requires transparency, preferably through information systems with standardized accounting systems for subnational governments and better public information on their liabilities. However, more public information will not by itself curb moral hazard problems. Penalties would need to be associated with excessive borrowing. One method is to legislate debt thresholds and penalties for crossing them and to establish transparent mechanisms for enforcing public bankruptcies. Examples of the latter include the U.S. type of financial control boards or the New Zealand system of court-appointed receiverships.

Ensuring that subnational governments have access to funds of their own (tax bases and unconditional grants) that can be pledged into the market as collateral is also necessary to reduce moral hazard tendencies. Without such direct fiscal backing, markets might view any capital market borrowing by subnational governments as being implicitly backed by the central government. Having their own fiscal base is therefore an important prerequisite for subnational governments' access to finance and for limiting moral hazard problems.

Market decentralization may also offer an interesting mechanism for reducing the moral hazard problem. Privatization of public infrastructure could expose the firms to private sector bankruptcy laws and allow other private companies to bid for the assets in case of financial difficulties-an option unavailable with public ownership. (To implement this option, however, governments will need to ensure multiple deliverers in any one sector.) Private participation also creates options for accessing financial equity as well as debt, creating an incentive for equity to monitor debt that is not available in public financing systems. In addition, unbundling services may reduce the size of the entities involved, thus avoiding the "too big to fail" syndrome that often motivates bail-outs.

Finally, the back-door channels to creating financial liabilities need to be monitored and, where possible, closed. In particular, legislation must ensure that dipping into pension funds or using subnational corporations to borrow on behalf of subnational governments is not permitted or is explicitly included in debt limits. In addition, balanced budget requirements for subnational governments may ensure that current accounts are balanced by the end of each fiscal year so that borrowing to match expenditures and revenue streams does not lead to the financing of current account deficits over time.

Ultimately, the combined use of information systems, access to subnational governments' own fiscal base, public legislation, bankruptcy laws, and market decentralization offers an institutional setting, creates an incentive to stick to a hard budget constraint at all tiers of government, and permits borrowing to be decentralized.

Should Foreign Borrowing Be Allowed?

Direct access to international capital markets by subnational governments is further complicated by issues of general capital controls, capital account liberalization, and the nature of the foreign exchange regime adopted by the government. This overall context of the exchange rate regime should determine whether direct borrowing by subnational governments in international markets should be permitted. Because this decision is further influenced by the depth of local capital markets, a sequencing issue may arise as well. Sometimes it may be preferable to allow direct access to local capital markets prior to opening access to international markets.

Given the limited consensus on this issue, there seems to be a bias toward not granting direct access to international markets by subnational governments. In any case, the issues raised in this note about the regulatory framework for decentralizing borrowing apply equally to local and foreign borrowing.