Chapter

7 Control of Subnational Government Borrowing

Editor(s):
Teresa Ter-Minassian
Published Date:
September 1997
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Author(s)
Teresa Ter-Minassian and Jon Craig

In the last two decades, public sector debt has shown a rising trend in relation to GDP in a wide range of countries, both federal and unitary. These increases have reflected high levels of real interest rates on the debt and, in a number of countries, a lack of fiscal discipline, as witnessed by primary deficits in the general government accounts. While these deficits have been recorded most frequently at the central government level—sometimes because of, inter alia, gap-filling transfers to subnational governments—in several countries, especially but not exclusively federations, deficits and debt have emerged and risen over time at the state or provincial and local levels as well.

The growth of subnational public debt is frequently a symptom of an inappropriate design of intergovernmental fiscal relations in the country in question, involving, for example, large vertical or horizontal imbalances or a system of intergovernmental transfers lacking transparent criteria and conducive to ad hoc bargaining or ex post gap filling. A question that arises in this context, and that this chapter attempts to shed some light on, is to what extent the growth of subnational debt may be promoted, or at least facilitated, by a lack of controls and limits on subnational government borrowing.

This chapter reviews a broad range of international experiences with such controls, drawing in particular on the case studies presented in Chapters 8 through 28. This survey of experiences shows considerable diversity in country approaches to these controls, ranging from virtually sole reliance on market discipline to direct controls by the central government on individual borrowing operations of subnational government entities. The different approaches reflect, among other things, constitutional provisions, the degree of political and administrative control of the central government over the subnational ones, the country’s overall tradition of financial discipline, the presence or absence of serious fiscal and macroeconomic imbalances, and the state of development of the country’s financial market. In general, central government controls over subnational governments’ borrowing tend to be looser, on the one hand, in countries with poor overall financial discipline and as yet unaddressed fiscal and macroeconomic disequilibria, and, on the other, in countries with well-developed and relatively transparent financial systems, which can rely more on the market to discipline the borrowing of subnational governments.

Country approaches to the control of subnational borrowing can be grouped into four broad categories, although most countries utilize a mix of them (Table 1). The four “stylized” categories are (1) sole or primary reliance on market discipline; (2) cooperation by different levels of government in the design and implementation of debt controls; (3) rules-based controls; and (4) administrative controls.

Table 1.Subnational Borrowing Controls in Selected Countries1
Market DisciplineCooperative ControlAdministrative ControlRules-Based ControlBorrowing Prohibited
OverseasDomesticOverseasDomesticOverseasDomesticOverseasDomesticOverseasDomestic
Industrial countries
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Japan
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
United Kingdom
United States
Developing countries
Argentina
Brazil
Bolivia
Chile
Colombia
Ethiopia
India
Indonesia
Korea
Mexico
Peru
South Africa
Thailand
Transition economies
Albania
Armenia
Azerbaijan
Belarus
Bulgaria
China
Estonia
Georgia
Hungary
Kazakhstan
Kyrgyz Republic
Latvia
Lithuania
Poland
Romania
Russia
Slovenia
Tajikistan
Ukraine
Uzbekistan

Classifications attempt to capture the predominant form of control, in some countries, the approach used may involve a combination of several Techniques. See also notes to table below.

Notes to Table

Industrial Countries

Australia. A cooperative approach is followed in setting annual debt ceilings with state governments within a National Loan Council established for that purpose. The limits set for each state government subsume loan limits for combined local government borrowing within the state concerned. In practice, the limits have been administered flexibly and market discipline plays a major role on final decisions on borrowing targets set by each state (see Chapter 8).

Austria. Domestic borrowing is subject to administrative controls. Länder have rules on the purposes for which loans can be raised, and local governments must seek the approval by the supervisional body for each Land, except for short-term loans and loans for public enterprises. Loans must be used to finance investment and are judged against the capacity to service debt as evidenced by the current budget balance. The Ministry of Finance must approve overseas loans.

Belgium. Substantial changes in fiscal federalism arrangements were introduced in 1989 with a number of functions devolved to the regions and communities (including local authorities). The arrangements envisage deficits at the subnational level in the early years of a transition period that are reversed toward the end of that period. Borrowing under these arrangements is supervised by a High Finance Council, which has mapped out a program of deficit sharing between the central and subnational governments. The Council subsequently monitors adherence to those targets and can initiate borrowing limitations if needed to meet commitments agreed to by both levels of government to stabilize debt service to revenue levels after 2000 (2010 for the Flemish communities). This debt-to- revenue target constitutes a crude method of capping the relative size of the overall debt burden and the distribution of that burden between central and subnational governments.

Canada. Each province in Canada is free to borrow overseas or domestically without limit. Market ratings have therefore played a crucial discipline on overall borrowing levels by provinces. By contrast, provinces impose strict limits on borrowing by local governments within their own jurisdiction (see Chapter 9).

Denmark. The central government engages in bilateral discussions with subnational governments leading up to the setting of limits on borrowing. Municipalities are allowed to borrow only for investments in certain items (such as water, electricity, urban renewal, housing for aged persons, and land acquisition). Borrowing for other purposes requires the permission of the Ministry of Interior. Strict controls are also set on the terms and conditions of loans. Limited access to overseas markets is permitted.

Finland. No administrative or legal restraints apply to domestic or foreign borrowing. Market discipline is therefore the main form of control.

France. Historically, deficits at subnational level have been small. Following the introduction of Decentralization Laws, subnational authorities are free to contract domestic loans on terms and conditions negotiated with lenders. Overseas loans are permitted subject, in principle, to the approval of the French Treasury.

Germany. Budget laws specify the conditions under which subnational borrowing can be undertaken. Borrowing by the Länder is supposedly linked to investment budgets and local authority borrowing to cash flow needs and is subject to approval by the Länder authorities. In practice, there are weaknesses in both the formulation and application of the Länder laws. The investment requirements are specified ex ante rather than ex post and the interpretation of what constitutes investment is flexible. At the same time, the extent of market discipline is muted by the fact that the federal government has provided assistance to Länder experiencing debt-service problems (see Chapter 10).

Greece. The deficits incurred by subnational governments are very small, largely reflecting the administtative control on borrowing by municipalities and communities. In general, loans are linked to investment projects and project studies must be submitted to support loans. No significant foreign borrowing has been undertaken at the subnational level.

Ireland. All domestic borrowing by local authorities is subject to the approval of the Minister of the Environment. Limits on terms and conditions of loans are often specified. Foreign borrowing is not undertaken.

Italy. Subnational governments are subject to legal borrowing limits. Regions are permitted to borrow domestically for capital budgets and share participation with the proviso that debt charges cannot exceed 25 percent of the sum of regional own revenue, net of health contributions and the Common Fund. Regions cannot borrow to fund current expenditure. Municipal and local governments are subject to ex ante ceilings on borrowing, much of which is financed by the Deposit and Loan Fund and other public financial institutions, for investment projects. Foreign borrowing is not permitted (see Chapter 11).

Japan. The Ministry of Home Affairs supervises and controls all local authority borrowing. Domestic borrowing is generally approved only to finance investment needs or emergency expenditure and local authorities must meet strict debt-service capacity criteria. There is no foreign borrowing at subnational level (see Chapter 12).

Netherlands. The Municipalities Act requires that the current account of subnational governments must be balanced. Borrowing is therefore possible only if interest and depreciation costs can be accommodated within a balanced current account. Loans cannot be denominated in a foreign currency or be linked to a foreign currency. Other restrictions on the terms and conditions of loans may be applied.

Norway. All domestic borrowing must be approved by the authorities. Decisions on access to credit are largely restricted to investment needs and the capacity to service loans is assessed as part of the approval process. Local authorities are not permitted to borrow in foreign currency except with the permission of the Ministry of Finance, but overseas borrowing in Norwegian kroner is permitted.

Portugal. Local governments are free to contract loans without limits from financial institutions including the Treasury. Although requests for debenture issues have to be approved by the Ministry of Finance, few restrictions appear to apply in practice. Medium- to longer-term debentures may be contracted for investment purposes or to redress financial difficulties. There are some restrictions on the amounts raised as annuities.

Spain. Ministry of Finance approval is generally required for domestic borrowing but there are some exceptions, including for those local authorities covered by Autonomous Communities. Long-term loans are generally restricted to investment needs. Overseas loans require Ministry of Finance approval, and the Central Bank and the Inter-Ministerial Committee on Foreign Borrowing may also issue restraints on such borrowing.

Sweden. Domestic borrowing is subject to only two restrictions: (1) real estate alone cannot be used as collateral for mortgages; and (2) in principle, loans should be made only for investment purposes. However, in practice, temporary loans can be made to cover cash flow deficiencies. There are no additional restrictions on overseas borrowing.

Switzerland. Subnational borrowing is normally linked to investment needs. At the canton level, borrowing is normally restricted by laws that require balanced current budgets (including interest payments and amortization of debt). Borrowing to finance investment can proceed only if it does not disturb the current budget balance (see Chapter 13).

United Kingdom. Domestic borrowing approvals are issued annually by the government on the amount that a local authority may borrow. The limit is based on the amounts required to meet capital expenditure needs less provisions for such expenditures and may include an allowance for temporary borrowing to meet cash flow fluctuations. No borrowing from the central bank is permitted, and restrictions may be placed on a number of aspects of loans raised, including the terms and type of loan instruments. Local governments cannot borrow abroad without the consent of the Treasury. In practice, local authorities rarely borrow in foreign currency except in connection with European Union schemes (see Chapter 14).

United States. The subnational sector has been in surplus throughout the 1990s. Virtually all state and local governments require “balanced budgets,” but the effective borrowing constraint imposed by such requirements, even when written into the Constitution, is often limited. Often the requirement applies only to the budget, excluding social security and capital spending; in some cases, the requirement only refers ex ante to the formulated rather than the realized budget; and there may be other escape clauses, including extrabudgetary sources of funds. Effectively, therefore, market discipline plays an important role in borrowing discipline (see Chapter 15).

Developing Countries

Argentina. Provincial, municipal, and local governments can borrow domestically subject to certain conditions. Municipal Deliberative Councils must normally authorize borrowing, and approval by provincial legislatures is also often required, particularly if foreign borrowing is contemplated. This is the case, for example, in Buenos Aires, Chaco, and La Pampa. Normally the limits imposed are related to current revenues (for example, in Buenos Aires, Juluy, and La Pampa the limit is set at 25 percent of revenues) and the borrowing must generally be used to finance capital works (see Chapter 16).

Brazil. Subnational debt reached 17 percent of GDP in 1996 and as a counterpart to restructuring agreements with the central government, strict controls on borrowing have been introduced. A constitutional amendment prohibits new issues of bonds, and legal rules and central bank regulations prohibit a state from borrowing from state-owned banks. The restructuring agreements with indebted states involve commitment to privatize most of their enterprises and to use the proceeds, among with other measures, to repay existing debt. Under these new arrangements, new borrowing in any year should not exceed the total debt service for the year, or 27 percent of revenue, whichever is greater, and total debt service (including on the new borrowing) should not exceed the states’ current surplus for the previous year, or 15 percent of its revenue, whichever is less (see Chapter 18).

Chile. Central government approval is required for all domestic and external borrowing. Specific laws may be passed authorizing borrowing for specific purposes under strict terms and conditions.

Colombia. The degree of central control varies with the type of instrument. While the issuance of bonds by subnational governments requires Ministry of Finance approval (after prior approval by the National Planning Department), other sources, including commercial bank borrowing and various state-owned instrumentalities, are not so regulated (see Chapter 19).

Ethiopia. State governments are legally empowered to borrow domestically subject to terms and conditions set by the center. No external borrowing is permitted (see Chapter 20).

India. The Constitution puts limits on the borrowing powers of the states. Only the central government can borrow abroad. The states are, in principle, entitled to borrow, but they have to get permission from the central government if they have any outstanding debt to the center. All states have such liabilities. Until recently, borrowing was mainly financed by banks under regulations that specified the portion of assets that had to be invested in state securities approved by the central government. Now the Reserve Bank, in effect, allocates state securities to commercial banks. The central government also allots shares in funds from small savings at post offices to states (see Chapter 21).

Indonesia. Subnational government accounts in recent years were close to balance. If borrowing needs arose, they were largely met by loans from the central government.

Korea. Subnational borrowing is regulated centrally. All borrowing proposals require the prior approval of local councils and the Ministry of Home Affairs. The procedures specify which local governments can borrow and which projects are eligible. A portion of the loan funds are raised through compulsory bond placements. Subsidized loans for specific purposes may be also provided by the Ministry of Finance and Economy. The close integration of the borrowing process effectively means that, once approval has been given, the loan is perceived to carry a central government guarantee (see Chapter 22).

Mexico. States and municipalities have the authority to issue securities in domestic capital markets but only the federal government is entitled to borrow abroad. Subnational governments may also borrow from the banking system (see Chapter 23).

Peru. In general, subnational governments are not permitted to borrow. The municipalities of the largest cities (Lima, Cusco, and Arequipa) have incurred debt with international agencies or with other countries to finance infrastructure investments. Their domestic debt has been for short-term credits of lesser amounts. Almost all provincial municipalities have a municipal credit institution that provides such financing.

South Africa. New arrangements have recently been introduced to cover borrowing by the nine provinces. They will be able to borrow on a multiyear basis for capital projects and annually for current expenditures. Borrowing must be approved by the Loan Consultation Committee, which includes the ministers of finance from each of the provinces and the national Minister of Finance (who will retain a veto power). Approvals are based on the debt-service capacities of the provinces, which, in practice, will be assessed against total revenues, including grants from the central government. Local governments will continue to be allowed to borrow (as under the old ordinances) to fund capital projects subject to the oversight of the national Minister of Finance.

Thailand. Subnational (provincial, district, town, and village) governments are legally prohibited from foreign or domestic borrowing.

Transition Economies

Although many transition economies have substantial payment arrears at all levels of government, most do not formally permit borrowing at the subnational level. The exceptions are:

China. Legally, local governments are not permitted to run long-run deficits. However, widespread domestic borrowing occurs, often from commercial banks or financial institutions created by local governments to raise funds for investments. Some subnational governments also borrow abroad through joint ventures, bond issues, and agreements with international lending agencies (see Chapter 26).

Estonia, Latvia, and Lithuania. The Baltic countries have generally permitted their subnational governments to obtain access to domestic loans in limited amounts, mainly for intrayear financing.

Hungary. Ceilings are imposed by the central government on subnational borrowing, most of which is financed by the state-owned savings institutions. Overseas financing is rare but has been obtained by some municipalities (e.g., Budapest council) from international lending agencies (see Chapter 27).

Russia. Laws passed in 1992 give oblasts, cities, and rayons the right, in principle, to unlimited domestic borrowing. However, in practice, the borrowing has been small both because most subnational governments would not qualify for substantial credit from financial markets and because those markets are themselves undeveloped. Overseas borrowing may become possible—using resources as collateral—but such borrowing would require approval from the central government (see Chapter 28).

Classifications attempt to capture the predominant form of control, in some countries, the approach used may involve a combination of several Techniques. See also notes to table below.

Notes to Table

Industrial Countries

Australia. A cooperative approach is followed in setting annual debt ceilings with state governments within a National Loan Council established for that purpose. The limits set for each state government subsume loan limits for combined local government borrowing within the state concerned. In practice, the limits have been administered flexibly and market discipline plays a major role on final decisions on borrowing targets set by each state (see Chapter 8).

Austria. Domestic borrowing is subject to administrative controls. Länder have rules on the purposes for which loans can be raised, and local governments must seek the approval by the supervisional body for each Land, except for short-term loans and loans for public enterprises. Loans must be used to finance investment and are judged against the capacity to service debt as evidenced by the current budget balance. The Ministry of Finance must approve overseas loans.

Belgium. Substantial changes in fiscal federalism arrangements were introduced in 1989 with a number of functions devolved to the regions and communities (including local authorities). The arrangements envisage deficits at the subnational level in the early years of a transition period that are reversed toward the end of that period. Borrowing under these arrangements is supervised by a High Finance Council, which has mapped out a program of deficit sharing between the central and subnational governments. The Council subsequently monitors adherence to those targets and can initiate borrowing limitations if needed to meet commitments agreed to by both levels of government to stabilize debt service to revenue levels after 2000 (2010 for the Flemish communities). This debt-to- revenue target constitutes a crude method of capping the relative size of the overall debt burden and the distribution of that burden between central and subnational governments.

Canada. Each province in Canada is free to borrow overseas or domestically without limit. Market ratings have therefore played a crucial discipline on overall borrowing levels by provinces. By contrast, provinces impose strict limits on borrowing by local governments within their own jurisdiction (see Chapter 9).

Denmark. The central government engages in bilateral discussions with subnational governments leading up to the setting of limits on borrowing. Municipalities are allowed to borrow only for investments in certain items (such as water, electricity, urban renewal, housing for aged persons, and land acquisition). Borrowing for other purposes requires the permission of the Ministry of Interior. Strict controls are also set on the terms and conditions of loans. Limited access to overseas markets is permitted.

Finland. No administrative or legal restraints apply to domestic or foreign borrowing. Market discipline is therefore the main form of control.

France. Historically, deficits at subnational level have been small. Following the introduction of Decentralization Laws, subnational authorities are free to contract domestic loans on terms and conditions negotiated with lenders. Overseas loans are permitted subject, in principle, to the approval of the French Treasury.

Germany. Budget laws specify the conditions under which subnational borrowing can be undertaken. Borrowing by the Länder is supposedly linked to investment budgets and local authority borrowing to cash flow needs and is subject to approval by the Länder authorities. In practice, there are weaknesses in both the formulation and application of the Länder laws. The investment requirements are specified ex ante rather than ex post and the interpretation of what constitutes investment is flexible. At the same time, the extent of market discipline is muted by the fact that the federal government has provided assistance to Länder experiencing debt-service problems (see Chapter 10).

Greece. The deficits incurred by subnational governments are very small, largely reflecting the administtative control on borrowing by municipalities and communities. In general, loans are linked to investment projects and project studies must be submitted to support loans. No significant foreign borrowing has been undertaken at the subnational level.

Ireland. All domestic borrowing by local authorities is subject to the approval of the Minister of the Environment. Limits on terms and conditions of loans are often specified. Foreign borrowing is not undertaken.

Italy. Subnational governments are subject to legal borrowing limits. Regions are permitted to borrow domestically for capital budgets and share participation with the proviso that debt charges cannot exceed 25 percent of the sum of regional own revenue, net of health contributions and the Common Fund. Regions cannot borrow to fund current expenditure. Municipal and local governments are subject to ex ante ceilings on borrowing, much of which is financed by the Deposit and Loan Fund and other public financial institutions, for investment projects. Foreign borrowing is not permitted (see Chapter 11).

Japan. The Ministry of Home Affairs supervises and controls all local authority borrowing. Domestic borrowing is generally approved only to finance investment needs or emergency expenditure and local authorities must meet strict debt-service capacity criteria. There is no foreign borrowing at subnational level (see Chapter 12).

Netherlands. The Municipalities Act requires that the current account of subnational governments must be balanced. Borrowing is therefore possible only if interest and depreciation costs can be accommodated within a balanced current account. Loans cannot be denominated in a foreign currency or be linked to a foreign currency. Other restrictions on the terms and conditions of loans may be applied.

Norway. All domestic borrowing must be approved by the authorities. Decisions on access to credit are largely restricted to investment needs and the capacity to service loans is assessed as part of the approval process. Local authorities are not permitted to borrow in foreign currency except with the permission of the Ministry of Finance, but overseas borrowing in Norwegian kroner is permitted.

Portugal. Local governments are free to contract loans without limits from financial institutions including the Treasury. Although requests for debenture issues have to be approved by the Ministry of Finance, few restrictions appear to apply in practice. Medium- to longer-term debentures may be contracted for investment purposes or to redress financial difficulties. There are some restrictions on the amounts raised as annuities.

Spain. Ministry of Finance approval is generally required for domestic borrowing but there are some exceptions, including for those local authorities covered by Autonomous Communities. Long-term loans are generally restricted to investment needs. Overseas loans require Ministry of Finance approval, and the Central Bank and the Inter-Ministerial Committee on Foreign Borrowing may also issue restraints on such borrowing.

Sweden. Domestic borrowing is subject to only two restrictions: (1) real estate alone cannot be used as collateral for mortgages; and (2) in principle, loans should be made only for investment purposes. However, in practice, temporary loans can be made to cover cash flow deficiencies. There are no additional restrictions on overseas borrowing.

Switzerland. Subnational borrowing is normally linked to investment needs. At the canton level, borrowing is normally restricted by laws that require balanced current budgets (including interest payments and amortization of debt). Borrowing to finance investment can proceed only if it does not disturb the current budget balance (see Chapter 13).

United Kingdom. Domestic borrowing approvals are issued annually by the government on the amount that a local authority may borrow. The limit is based on the amounts required to meet capital expenditure needs less provisions for such expenditures and may include an allowance for temporary borrowing to meet cash flow fluctuations. No borrowing from the central bank is permitted, and restrictions may be placed on a number of aspects of loans raised, including the terms and type of loan instruments. Local governments cannot borrow abroad without the consent of the Treasury. In practice, local authorities rarely borrow in foreign currency except in connection with European Union schemes (see Chapter 14).

United States. The subnational sector has been in surplus throughout the 1990s. Virtually all state and local governments require “balanced budgets,” but the effective borrowing constraint imposed by such requirements, even when written into the Constitution, is often limited. Often the requirement applies only to the budget, excluding social security and capital spending; in some cases, the requirement only refers ex ante to the formulated rather than the realized budget; and there may be other escape clauses, including extrabudgetary sources of funds. Effectively, therefore, market discipline plays an important role in borrowing discipline (see Chapter 15).

Developing Countries

Argentina. Provincial, municipal, and local governments can borrow domestically subject to certain conditions. Municipal Deliberative Councils must normally authorize borrowing, and approval by provincial legislatures is also often required, particularly if foreign borrowing is contemplated. This is the case, for example, in Buenos Aires, Chaco, and La Pampa. Normally the limits imposed are related to current revenues (for example, in Buenos Aires, Juluy, and La Pampa the limit is set at 25 percent of revenues) and the borrowing must generally be used to finance capital works (see Chapter 16).

Brazil. Subnational debt reached 17 percent of GDP in 1996 and as a counterpart to restructuring agreements with the central government, strict controls on borrowing have been introduced. A constitutional amendment prohibits new issues of bonds, and legal rules and central bank regulations prohibit a state from borrowing from state-owned banks. The restructuring agreements with indebted states involve commitment to privatize most of their enterprises and to use the proceeds, among with other measures, to repay existing debt. Under these new arrangements, new borrowing in any year should not exceed the total debt service for the year, or 27 percent of revenue, whichever is greater, and total debt service (including on the new borrowing) should not exceed the states’ current surplus for the previous year, or 15 percent of its revenue, whichever is less (see Chapter 18).

Chile. Central government approval is required for all domestic and external borrowing. Specific laws may be passed authorizing borrowing for specific purposes under strict terms and conditions.

Colombia. The degree of central control varies with the type of instrument. While the issuance of bonds by subnational governments requires Ministry of Finance approval (after prior approval by the National Planning Department), other sources, including commercial bank borrowing and various state-owned instrumentalities, are not so regulated (see Chapter 19).

Ethiopia. State governments are legally empowered to borrow domestically subject to terms and conditions set by the center. No external borrowing is permitted (see Chapter 20).

India. The Constitution puts limits on the borrowing powers of the states. Only the central government can borrow abroad. The states are, in principle, entitled to borrow, but they have to get permission from the central government if they have any outstanding debt to the center. All states have such liabilities. Until recently, borrowing was mainly financed by banks under regulations that specified the portion of assets that had to be invested in state securities approved by the central government. Now the Reserve Bank, in effect, allocates state securities to commercial banks. The central government also allots shares in funds from small savings at post offices to states (see Chapter 21).

Indonesia. Subnational government accounts in recent years were close to balance. If borrowing needs arose, they were largely met by loans from the central government.

Korea. Subnational borrowing is regulated centrally. All borrowing proposals require the prior approval of local councils and the Ministry of Home Affairs. The procedures specify which local governments can borrow and which projects are eligible. A portion of the loan funds are raised through compulsory bond placements. Subsidized loans for specific purposes may be also provided by the Ministry of Finance and Economy. The close integration of the borrowing process effectively means that, once approval has been given, the loan is perceived to carry a central government guarantee (see Chapter 22).

Mexico. States and municipalities have the authority to issue securities in domestic capital markets but only the federal government is entitled to borrow abroad. Subnational governments may also borrow from the banking system (see Chapter 23).

Peru. In general, subnational governments are not permitted to borrow. The municipalities of the largest cities (Lima, Cusco, and Arequipa) have incurred debt with international agencies or with other countries to finance infrastructure investments. Their domestic debt has been for short-term credits of lesser amounts. Almost all provincial municipalities have a municipal credit institution that provides such financing.

South Africa. New arrangements have recently been introduced to cover borrowing by the nine provinces. They will be able to borrow on a multiyear basis for capital projects and annually for current expenditures. Borrowing must be approved by the Loan Consultation Committee, which includes the ministers of finance from each of the provinces and the national Minister of Finance (who will retain a veto power). Approvals are based on the debt-service capacities of the provinces, which, in practice, will be assessed against total revenues, including grants from the central government. Local governments will continue to be allowed to borrow (as under the old ordinances) to fund capital projects subject to the oversight of the national Minister of Finance.

Thailand. Subnational (provincial, district, town, and village) governments are legally prohibited from foreign or domestic borrowing.

Transition Economies

Although many transition economies have substantial payment arrears at all levels of government, most do not formally permit borrowing at the subnational level. The exceptions are:

China. Legally, local governments are not permitted to run long-run deficits. However, widespread domestic borrowing occurs, often from commercial banks or financial institutions created by local governments to raise funds for investments. Some subnational governments also borrow abroad through joint ventures, bond issues, and agreements with international lending agencies (see Chapter 26).

Estonia, Latvia, and Lithuania. The Baltic countries have generally permitted their subnational governments to obtain access to domestic loans in limited amounts, mainly for intrayear financing.

Hungary. Ceilings are imposed by the central government on subnational borrowing, most of which is financed by the state-owned savings institutions. Overseas financing is rare but has been obtained by some municipalities (e.g., Budapest council) from international lending agencies (see Chapter 27).

Russia. Laws passed in 1992 give oblasts, cities, and rayons the right, in principle, to unlimited domestic borrowing. However, in practice, the borrowing has been small both because most subnational governments would not qualify for substantial credit from financial markets and because those markets are themselves undeveloped. Overseas borrowing may become possible—using resources as collateral—but such borrowing would require approval from the central government (see Chapter 28).

The sections below review, in turn, each of these approaches, followed by some main conclusions.

Reliance on Market Discipline

It has been suggested (Lane, 1993) that a number of conditions need to be satisfied for financial markets to exert effective discipline on subnational government borrowing:

  • Markets should be free and open; in particular, there should be no regulations (such as reserve or other portfolio composition requirements) on financial intermediaries that place government in a privileged borrower position.

  • Adequate information on the borrower’s outstanding debt and repayment capacity should be available to potential lenders.

  • There should be no perceived chance of bailout of the lenders in the case of impending default.1

  • The borrower should have institutional structures that ensure adequate policy responsiveness to market signals before reaching the point of exclusion from new borrowing.

These are indeed stringent conditions, which are unlikely to be realized in the majority of countries. Typically, especially in developing countries, available information on the finances of subnational governments suffers from serious weaknesses in coverage, quality, and timeliness. Many countries still utilize various forms of portfolio constraints on financial intermediaries to facilitate the placement of government securities (including local government ones) at a reduced cost. A number of countries also have experienced various forms of intervention by the central government to prevent default by subnational governments on their debts. Finally, and not least importantly, relatively short electoral cycles tend to make politicians at the subnational government level short-sighted and unresponsive to early warnings by the financial markets.

Recognition of these realities may be a major reason why sole reliance on market discipline to check subnational government borrowing is not usual. A major industrial country that uses this approach is Canada, at least regarding provincial government borrowing.2 To date, the Canadian provinces have no constitutional or legal limits on their borrowing (both domestic and external), and are not subject to central government controls on it (see Chapter 9). Their debt and debt-servicing capacity are closely monitored by financial markets, in particular by major debt-rating agencies. A review of the trends in provincial government indebtedness in recent years suggests that, even in a well-developed and relatively transparent financial market as in Canada, market discipline on subnational government borrowing has not been fully effective. Despite a clear deterioration in ratings, and related sizable increase in risk premiums on provincial bonds—more marked for the more indebted provinces—provincial debt has increased steadily over the last several years (reaching about 23 percent of GDP in 1994), and only in the last couple of years have the provincial governments begun to design and implement fiscal retrenchment programs. It may be argued that market discipline is finally starting to work, but only after a “recognition lag” that will necessitate a sharper and more painful retrenchment than would have been necessary if provincial debts, and their service, had not been allowed to rise to their present levels.

Brazil represents another example of a major country that initially shunned legal or administrative controls over state and municipal borrowing, but in recent years has been prompted by the rapid accumulation of subnational government debt to institute such controls (see Chapter 18).

State debt, both domestic and external, grew rapidly in Brazil from the end of the 1960s until the early 1980s. The abrupt drying up of external financing during the debt crisis led to widespread defaults by the states and to the eventual takeover and rescheduling of most of these debts by the federal government in 1989 (for the external portion of the debts) and 1993 (for debts to federal banks). This rescheduling significantly eased the debt-servicing burden on the states. Some of the latter, however, have continued to run up debt to state-owned banks, as well as to suppliers. Finally, a number of states have resorted extensively to the issue of bonds.

The service of this debt came virtually to a halt, and with the high level of real interest rates, especially since the introduction of the Real Plan in 1994, the capitalization of interest payments led to an escalation of this debt to the equivalent of around 17 percent of GDP by 1996. The withdrawal of most private investors from the market for state bonds, and the drying up of interbank lending to some state banks, forced various forms of intervention by the federal authorities (including the central bank and federal banks), which de facto shifted most of the default risk on these types of state debt onto the federal government.

As counterpart for the rescheduling of a part of the state debt, limitations have been introduced in recent years on new state borrowing. Specifically, legal rules and central bank regulations now prohibit a state from borrowing from its own commercial banks. New issues of bonds (other than to refinance maturing ones) are prohibited by a constitutional amendment until the end of this decade. At the end of 1995, the federal government through one of its large banks (Caixa Economica Federal) set up lines of credit to provide short-term financial support to the indebted states, as counterpart for the states agreeing to certain adjustment measures. In 1996, the federal government began negotiations with most of the indebted states toward a federally backed restructuring of their not previously rescheduled debt, at reduced interest rates. The counterparts of this restructuring are commitments by the states to privatize most of their enterprises (with the proceeds of sales to be used to reduce the debt), and to implement fiscal adjustment measures aimed at reducing the ratio of their debt to revenues to 1 within a number of years.

This brief overview makes clear that the conditions listed above for the effective working of market discipline on state debt were not, and continue not to be, present in Brazil. While it is unfortunate that the need for controls was not recognized and acted upon before state debts reached their present very high levels, it is encouraging that financial support by the federal government to the states is increasingly being made contingent upon specific commitments by the latter to undertake needed corrective actions. The effectiveness of these adjustment programs will, of course, depend crucially on firmness in their implementation.

A Cooperative Approach to Debt Controls

Closest to sole reliance on market discipline in the spectrum of controls is an approach whereby limits on the indebtedness of subnational governments are not set by law or dictated by the center, but are arrived at through a negotiation process between the federal and the lower levels of government. Variants of this approach may be found in some European countries, such as the Scandinavian ones, and, in recent years, in Australia.

Under this approach, subnational governments are actively involved in formulating macroeconomic objectives and the key fiscal parameters underpinning these objectives. Through this process, agreement is reached on the overall deficit targets for the general government, as well as on the guidelines for growth of main items of revenue and expenditure. Specific limits are then agreed upon for the financing requirements of individual subnational jurisdictions.

In several countries, negotiations are essentially a bilateral process between the center and individual local governments. In Australia, the process is a multilateral one, taking place within the framework of a long-established Loan Council, in which all states, as well as the center, are represented (see Chapter 8). Until 1993, the Loan Council provided the forum for both the negotiation of global debt limits for individual states and the monitoring of compliance with such limits. The experience of widespread attempts by the states to elude these limits through resort to off-budget operations, innovative financing techniques, such as sale and lease-back arrangements, and through borrowing by state-owned enterprises, has prompted the Council in recent years to shift its focus to the ex ante analysis and discussion (as well as ex post monitoring) of the overall net financing requirements of the states, rather than of their outstanding debt. Thus, now the states have to bring to the negotiating table detailed projections of their budgetary operations, and discussions focus on corrective measures, when needed. The Council has also stepped up efforts to promote more effective market discipline on state borrowing, by facilitating the collection and dissemination of timely information on developments in the states’ finances.

The cooperative approach has clear advantages in promoting dialogue and exchange of information across various government levels. It also raises the consciousness, in subnational-level policymakers, of macroeconomic implications of their budgetary choices. It seems, however, to work best in countries with an established culture of relative fiscal discipline and conservatism. It may not be effective in preventing a buildup of debt in conditions where either market discipline or the leadership of the central government in economic and fiscal management are weak.

Rules-Based Approaches to the Control of Subnational Borrowing

A number of countries, both federal and unitary, have relied on approaches to the control of subnational government borrowing that are based on standing rules, specified in the constitution or in laws. Some of these rules set limits on the absolute level of indebtedness of subnational jurisdictions; others specify that borrowing can be resorted to only for specified purposes (typically investment projects); yet others stipulate, for instance, that new borrowing is permitted up to a level consistent with a maximum allowed service ratio. Finally, some countries prohibit or severely restrict certain types of borrowing that involve greater macroeconomic risks (such as borrowing from the central bank).3 Many countries utilize a combination of such rules.

Rules that limit subnational governments’ borrowing to investment purposes (the so-called golden rules) are quite common in industrial countries. Examples can be found in Germany (Chapter 10), Switzerland (Chapter 13), and in the majority of the state constitutions in the United States (Chapter 15). Countries that allow short-term borrowing for liquidity purposes generally stipulate that such borrowing has to be repaid by the end of each fiscal year. This is the case, for instance, for some of the states in the United States, and for regional and local governments in Spain.

Examples of rules that “mimic” market discipline by linking limits on the indebtedness of subnational (especially local) governments to the projected debt service on the debt, or to other indicators of their debt-servicing capacity (such as past revenues or the tax base) can also be found in some industrial countries (United States (Chapter 15), Spain, Japan (Chapter 12)), as well as in some developing ones, such as Korea (Chapter 22).

Rules-based approaches have the obvious advantage of transparency and evenhandedness, as well as of avoiding protracted bargaining between the central and the subnational levels of government, a process the outcome of which often ends up being determined more by short-term political factors than by considerations of sound macroeconomic management. On the other hand, by their very nature, rules-based approaches lack flexibility and often end up fostering the development of behavior and practices aimed at circumventing the rules. Such practices include, for instance:

  • The reclassification of expenditures from current to capital, to escape current budget balance requirements.

  • The creation of entities whose operations—albeit of a governmental nature—are kept off-budget, and whose debts are not counted against the debt ceilings.

  • The use of state or local government-owned enterprises to borrow for purposes that should be funded through the relevant government budget.

  • The use of debt instruments—such as sale and leaseback arrangements or the so-called private revenue bonds in the United States (see Chapter 15)—that are not included in the debt limits.

  • The resort to arrears to suppliers, which are typically difficult to monitor for inclusion in the public debt ceilings.

This nonexhaustive listing suggests that, to be effective, a rules-based approach needs to be supported by clear and uniform accounting standards for government entities, strictly limiting, and preferably eliminating, the scope for off-budget operations; comprehensive definitions of what constitutes debt; and the setting up of a modern government financial management information system, capable of providing timely and reliable data on all phases of expenditure,4 as well as on financial operations of the various levels of government. Also needed are policies like privatization that minimize the scope for use of financial and nonfinancial enterprises for government purposes.

Direct Controls of the Central Government over Subnational Borrowing

In a number of countries, the central government is empowered with direct control over the borrowing of subnational governments. This control may take alternative forms, including the setting of annual (or more frequent) limits on the overall debt of individual subnational jurisdictions (or some of its components, such as external borrowing); the review and authorization of individual borrowing operations (including approval of the terms and conditions of the operation); and/or the centralization of all government borrowing, with on-lending to subnational governments for approved purposes (generally investment projects). Control powers generally encompass not only the ex ante authorization of proposed borrowing, but also the ex post monitoring, on a more or less detailed and timely basis, of the subnational governments’ financial operations.

Direct central government controls are, of course, more common in unitary states than in federations. In the United Kingdom until 1988 the central government exercised direct controls on capital spending of local authorities, which varied according to the source of finance of the project. In recent years, the central government has sought to influence the level of local governments’ capital spending through the amount of financial support (grants or loan approvals) provided to them and through a requirement that localities set aside a part of their receipts from asset sales to fund new investment. Credit approvals are determined in two parts: a basic amount set on the basis of need criteria and a supplementary authority earmarked for specific projects.

In Japan, the central government exerts a strong influence on the entire budgetary process of local authorities. Guidelines for borrowing by the latter are set out in the annual Local Government Fiscal Plan, which is approved by the parliament at the same time as the central government budget. Borrowing is generally approved only for investment purposes, paying regard to both the projected debt-service ratio and the overall financing needs of the locality. Much of the financing of local authorities is carried out by the Fiscal Investment and Loan Program, which is effectively a form of government financial intermediation, channeling surplus funds of government entities (such as the postal savings and the social security systems) to the funding of local investment projects.

Tight controls are also exercised by the central government on local government borrowing in France. In Spain, which is not a federation, but has granted considerable autonomy to its regions, central government controls have been tightened in recent years in an attempt to stem the rapid growth of deficits at the regional level. Currently all bond placements by regional governments (as well as most borrowing by local governments) need prior approval by the central government.5

Among federal countries, in India central government approval is required for borrowing by states that have outstanding indebtedness to the center (Chapter 21). Virtually all the states are currently indebted to the center, since the large vertical imbalance that characterizes intergovernmental fiscal relations in that country has made all the states dependent on central government support through grants and loans. Moreover, the central government has created, through portfolio coefficients on financial intermediation, a substantial captive market for the placement of state debt, until recently at below-market interest rates. Thus, the extensive control of the center over the state finances has, by and large, failed to impose an effective discipline on the latter. India’s experience illustrates well the fact that borrowing controls are not a substitute for a sustainable design of intergovernmental fiscal relations, that is, one that does not give rise to excessive vertical or horizontal imbalances.

Several considerations argue in favor of direct central government controls on the external borrowing of subnational governments. First, external debt policy is intimately linked with other macroeconomic policies (monetary and exchange rate policies and foreign reserve management) that are naturally the responsibility of central-level authorities (in particular, the central bank). Second, a well-coordinated approach to foreign markets for sovereign borrowing is likely to result in better terms and conditions than a fragmented one. Third, a deterioration of foreign ratings for one or more of the subnational borrowers may well have contagion effects on the ratings for other borrowers, both public and private. Finally, foreign lenders frequently require an explicit central government guarantee for subnational borrowing. At a minimum, they tend to count on an implicit guarantee. Thus, the central government is likely, de facto, to bear ultimate responsibility for the subnational governments’ foreign debt.

These arguments are less compelling in the case of domestic borrowing of subnational authorities. Detailed administrative control of the latter may involve the central government in micro-level decisions (for example, about the financing of individual investment projects) that would be best left to the relevant subnational jurisdictions. Moreover, administrative approval by the central government of individual borrowing operations of the subnational governments may well make it more difficult for the former to refuse financial support to the latter in the event of impending defaults. On balance, effectively and timely monitored aggregate limits on the overall debt of individual jurisdictions, based on market-type criteria, like maximum ratios of debt service to revenues, would seem preferable to either centralized borrowing or preapproval of individual borrowing operations.

Main Conclusions

The review of selected country experiences with controls on subnational governments’ borrowing shows that the nature and coverage of these controls vary widely, reflecting in particular the individual country’s history, the balance of power among the different levels of government, macroeconomic and fiscal conditions, and the state of development of financial markets. Each of the “models” of control analyzed in the previous sections presents advantages and disadvantages, the balance of which would make it more or less suitable to a particular country’s circumstances. Moreover, as these circumstances evolve—that is, as fiscal and macroeconomic imbalances improve or worsen—the preferable model may change over time.

From the review of country experiences, it would appear that the following main conclusions can be drawn.

Although appealing in principle, sole reliance on market discipline for government borrowing is unlikely to be appropriate in many circumstances. This is so, because one or more of the conditions for its effective working frequently are not realized in any particular country. However, market discipline can be a useful complement to other forms of borrowing controls, in particular to help contain resort by subnational governments to practices aimed at circumventing those controls. In this respect, greater transparency and dissemination of information on recent and prospective developments in the finances of subnational governments are highly desirable, and governments should be encouraged to make any necessary changes in the legal and institutional framework to promote these objectives. Equally desirable—on other grounds as well as that of fostering more effective market discipline—are steps to reduce government intervention in financial markets, such as the privatization of federal and state banks and the elimination, or at least a substantial reduction, of any requirements for financial intermediaries to hold government debt, as well as of other regulatory or fiscal privileges for government borrowers. In countries with a history of bailouts of insolvent subnational governments by the central government, a firm and sustained refusal to engage in further operations of this kind will be necessary to change expectations and behaviors of market participants vis-à-vis subnational government borrowing. It must be recognized that this may be a prolonged process, the more so the longer the previous history of bailouts.

The increasing worldwide trend toward devolution of spending and revenue-raising responsibilities to subnational governments seems likely to come into growing conflict with systems of administrative controls by the central government on subnational borrowing (involving, for example, a centralization of borrowing or approval of individual loan operations). While the case—on macroeconomic management and perhaps cost-effectiveness grounds—for administrative controls appears strong as concerns external financing, it is clearly less so for domestic borrowing, for the reasons indicated in the preceding section. It would not, therefore, be surprising to see administrative controls on domestic subnational borrowing decline in importance in the years ahead.

Rules-based approaches to debt control would appear preferable, in terms of transparency and certainty, to administrative controls and also to statutory limits defined in the context of the annual budget process, the outcome of which may be unduly influenced by short-term political bargaining. There is a clear macroeconomic rationale for barring all levels of government from borrowing from the central bank (or, at a minimum, for severely restricting this type of borrowing). Also, as indicated above, borrowing abroad by subnational governments should be strictly limited, in accordance not only with the debt-servicing capacity of the subnational jurisdiction involved, but also with macroeconomic (especially monetary and balance of payments) considerations.

In principle, a good case can be made for limiting all borrowing to investment purposes. However, the so-called golden rule may not be sufficiently restrictive in countries that need to generate government savings to finance at least a part of public investment. Moreover, it may not be desirable to allow government borrowing to finance investments that do not have an adequate rate of economic and social return. Finally, in practice it may be difficult to avoid circumvention of the rule through the inclusion in investments of certain expenditures for current purposes.

These considerations would seem to argue for setting global limits on the debt of individual subnational jurisdictions on the basis of criteria that mimic market discipline, such as the current and projected levels of service of the debt in relation to the jurisdictions’ revenues. It is clearly crucial that the projection of the debt service and of revenues, utilized in testing compliance with the ceiling, be realistic and indeed preferably conservative ones. It is equally important that a comprehensive definition of the debt subject to the ceiling be adopted (including, to the extent feasible, extrabudgetary operations, suppliers’ credits, guarantees to credits contracted by the subnational government’s enterprises, and relevant financial innovations, such as sale and leaseback arrangements).

Finally, even in the context of rules-based approaches, there seems to be scope for increased cooperation of all levels of government in containing (or reversing, if needed) the growth of public debt. Enhanced involvement of the subnational governments (especially at the regional or state level) in formulating and implementing medium-term fiscal adjustment programs (along the lines of the approach recently adopted in Australia) should result in these governments becoming more responsible in the conduct of their budgetary affairs. A multilateral forum for discussion of budgetary policies and prospects of various levels of government should facilitate the recognition of any need for reforms of the existing system of intergovernmental fiscal relations and help muster adequate political consensus for such reforms. Effective political and intellectual leadership by the central government in such a forum remains essential, and may be viewed as the natural evolution of the traditional administrative controls in an increasingly decentralized world.

The authors wish to acknowledge helpful comments from a number of colleagues in the IMF, in particular Vito Tanzi and Ehtisham Ahmad.

Municipalities in most provinces, by contrast, are required to balance their current budgets. Municipal borrowing for investment projects must be approved by the relevant province. Provinces assist municipal borrowing through public financial intermediaries (the municipal finance corporations) and/or through matching grants.

Direct government borrowing from the central bank has been prohibited for all European Union members by the Maastricht Treaty. For a review of other countries’ experiences in this area, see Cottarelli (1993).

As indicated in Chapter 6, timely and reliable information on obligations to pay, as well as on actual payments, is essential to prevent the accumulation of arrears.

Specifically, regional governments have to obtain approval from the central government for the placement of domestic or foreign bonds. They can borrow from banks for investment purposes without central government approval. Local governments can borrow from banks for short-term liquidity purposes and also, without higher level government approval, for investment purposes, as long as their total borrowing for any year does not exceed 25 percent of revenues for the previous year.

References

    BayoumiTamimMorrisGoldstein andGeofreyWoglom1995“Do Credit Markets Discipline Sovereign Borrowers? Evidence from U.S. States,”Journal of Money Credit and BankingVol. 27 (No. 4) Part 1 pp. 104659.

    CottarelliCarlo1993Limiting Central Bank Credit to the Government: Theory and PracticeIMF Occasional Paper 110 (Washington: International Monetary Fund).

    LaneTimothy D.1993“Market Discipline,”Staff PapersInternational Monetary FundVol. 40 (March 1993) pp. 5388.

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