Subnational Debt Management in Latin American. Joint World Bank - CEMLA Workshop Subnational Debt Management Performance Assessment Tool (SN-DeMPA)

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1 Subnational Debt Management in Latin American Joint World Bank - CEMLA Workshop Subnational Debt Management Performance Assessment Tool (SN-DeMPA) México march 18-22, 2013 Jaime Coronado Public Debt Programs Coordinator Content 1. Introduction 2.. Sustainability of Subnational Public Finances and Service Provision Debt Sustainability indicators 3. Rationale for Subnational Supervision Bailouts 4. Approaches Market Based approach Administrative approach Cooperative approach Rules based approach 5. International Experience 6. Conclusions 1

2 Introduction Democratic development and macroeconomic consolidation Facilitated the deepening of decentralization processes in Latin America and the world This process manifests itself by assigning various function to different government levels: Central Government: functions related to stabilization and redistribution Subnacionals Governments: resource allocation Decentralization processes imply: the assignment of responsibilities to SGs, as well as the allocation of the resources required for their fulfillment Transfers of the responsibilities and resources When vertical imbalances (i.e. inability to match responsibilities with revenue generation capacity) exists, the borrowing needs increase and may lead to a severe fiscal imbalance that could even affect macroeconomic stability Sustainability of Subnational Public Finances Policy analysis(asd, MTDS, PROG-FF) Debt Sustainabilyt Sustainability of Subnational Public Finances Fund strategy cost and risk analysis Fiscal Sustainabilyt(FF y RF) Sustainability of Service Provision Management Sustainability Planning Organization and management Financial systems (budget, finance, debt) Human Resources Control Acquisitions Evaluation and Management improvement (DeMPA, SP) 2

3 Debt Sustainability and Indicators Indicators to measure the debt burden have been developed by comparing the stock and flow variables of subnational debt with the reimbursement capacity of the relevant subnational government The debt burden (numerator) can be analyzed from a solvency viewpoint, i.e. the debt aggregates at a given time in nominal and/or present value, and from the point of view of liquidity through the debt service or its components The subnational government s revenue is generally used as the denominator because of the availability and timeliness of the information as well as the facility for its calculation and its standardization The analysis of the indicator path, together with past and projected financial flows (revenue, expenditure, and balances), allow the determination of the soundness of public finance at various moments in time. Rationale for Subnational Supervision 3

4 Sub national debt obligation affects Public Sector Debt Central Government General Government State Government Public Sector Rest of Public Sector Local Government Financial Public Sector Non Financial Public Sector Central Bank Other Financial Sector Significant Subnational debt affects in different ways Macroeconomic effect of subnational financial imbalances could be important The aggregate demand level may be strongly driven by an increase in expenditure by subnational governments while also affecting the balance of payments due, for example, to a greater volume of imported capital goods Financial health of subnational governments may affect: Monetary policy implementation, financial markets and exchange markets Creditworthiness and service provision It may very costly e.g. bailouts Thus, the establishment of fiscal and financial management regulations, in which debt is undoubtedly a key element, can be better understood from a macroeconomic and social welfare viewpoint. 4

5 Bailouts México , crisis del tequila, As a consequence of the crisis, the Federal Government had to bail out almost all the states when the previous high debt level worsened due to the fivefold increase of interest rates during the crisis; it did so through the State Financial Strengthening Program which provided the states with extraordinary transfers to reorganize their finances. Brasil 1997, After several negotiation rounds, and as a consequence of debt problems in various states (mostly bonds), the Government introduced a standard mechanism for debt rescheduling contracts. Such contracts, to be signed by the Federal Government and each state, involved the replacement of the state debt, both securitized and with banks, by a debt with the Federal Government. Argentina , As a result of the financial contagion caused by the Tequila Effect in 1994 i.e. financial panic and liquidity crisis, the Federal Government had to take over the provincial pension system in 11 jurisdictions, thus assuming the corresponding fiscal cost. Colombia 1995, Loans for the financial reorganization of Subnational Governments (Departamentos), subject to the signing of Performance Agreements. Approaches for Debt Supervision 5

6 Approaches to Subnational Debt Management Reliance on Market Discipline Rules Based Approach Approaches to Sub national Debt Mgt Cooperative Arrangements among different tiers of government Directt or Administrative Controls Market-based approach According to this approach, subnational debt is regulated or restricted by the financial market. In such cases, the central government does not establish any limits on subnational debt, and therefore subnational governments are free to decide the borrowing amounts, procedure for contracting it, sources and uses. However, in order to impose an effective discipline on subnational government borrowing, the financial markets need to fulfill a series of conditions: markets should be free and open; in particular, no regulations should exist (such as reserve ratios or rules on portfolio composition) forcing financial agents to grant subnational governments loans under preferential terms; Lenders should have access to adequate information on the outstanding debt of subnational governments and their repayment capacity; no assumption should be made of a possible bailout by the central government the institutional structure of the subnational government should ensure an adequate response to market performance, rather than reaching the point of being unable to contract new loans. A major drawback of this approach is the condition whereby the central government would not provide any bailout, as well as the strict compliance with the other conditions. Because of this, many developing countries do not see this approach as a viable option. 6

7 Administrative Control Under this approach, the central government retains the power for exercising direct management on subnational government debt by means of annual or semi-annual individual debt ceilings, establishing administrative requirements to authorise borrowing by subnational government, or centralising national debt and transferring resources by means of loans to subnational governments (on-lending). The direct management of the central government over subnational government debt is obviously more frequent in constitutionally centralized countries than in federal countries. Cooperative Approach In this category, the subnational debt ceiling is not established by law or by the central government, but is determined through negotiation between the national and subnational governments. This approach has several advantages. By promoting dialogue among the various government levels it has the potential for ensuring macroeconomic policy coordination and for raising the awareness of subnational governments about the macroeconomic impact of their budgetary policies. Nevertheless, it also has some weaknesses, as its poor implementation may soften the budgetary constraints on municipal governments, promote bargaining on intergovernmental transfers, and weaken policy coordination. 7

8 Rules Based Approach This approach involves the establishment of fiscal regulations restricting subnational debt, in compliance with an established national legal framework. Such regulations may include: restrictions on the overall debt amount or debt level Expenditure ceilings; the golden rule according to which debt can only be allocated to investment expenditures have the advantage of being transparent and impartial, as well as avoiding extensive negotiations between central and subnational governments that usually involve a political rather than an economic component However, rules-based methods, by their own nature, lack flexibility and ultimately promote evasive behavior and practices, such as Classifying current expenditure as capital expenditure in order to evade regulations on current and capital fiscal results Creating entities which, even if operating as government-owned enterprises, have extra-budgetary status, so that their debt is not accounted when determining debt ceilings Using enterprises owned by subnational governments in order to obtain loans for purposes that should be funded by the budget of each subnational government; Approaches for Debt Supervision Empirical evidence on subnational government debt supervision methods14 and on examples of the bailout of subnational governments by the central government, would indicate that none of the approaches analyzed in the previous section appears to be better than others. This fact suggests that the subnational debt supervision approach to be implemented depends largely on the existing institutional arrangements of the country, by the country s progress in decentralization, and by the financial soundness of the subnational governments. The information presented in Table 2 overleaf summarizes the results of a study carried out in 43 countries where financial bailout has actually taken place, independent of the method adopted by the country for supervising subnational debt. 8

9 Brasil Initially attempted to rely entirely on markets Introduced a rules based approach in the 1980s to deal with debt crises induced by huge SNG debts accumulated from early 60 s to early 80s CG now restricts both demand and supply of SNG debt, for instance: SNGs are not allowed to borrow from own enterprises or suppliers Total debt cannot exceed their capital budget New borrowing cannot exceed 18% of net current revenue Debt service cannot exceed 13% of net current revenue Among others Canada Sole reliance on market discipline for provincial (state) government borrowing Provinces have no constitutional or legal limits on their borrowing and are not subject to any control from centre The approach has not been fully effective In the 1990s, despite falling ratings and sizeable increases in risk premiums on provincial bonds, provincial governments continued to borrow and their debt rose to about 24 % of GDP Provincial governments later began to pull back but only after a considerable lag that made adjustment more painful 9

10 Colombia Controls over SNG borrowing have varied over time SNG political and fiscal autonomy led to increased borrowing and debt problems in the 1980s and 1990s During , Columbia established a system linking each SNG s debt to its repayment capacity using ratio of interest to operational savings and debt to current revenue Sub nationals rated yellow light are able to borrow only with permission from the Ministry of Finance after review of their debt service projections Those rated red have to agree to an adjustment plan to be able to borrow México Constitution stipulates SNGs can only borrow In pesos From mexicans And only for productive investments SNGs can use revenue sharing funds as collateral for borrowing but cannot have deductions at source in case of default Obliged to publish their debt levels and banks required to evaluate risk of SNG lending 10

11 South Africa A loan coordinating committee set up under the Borrowing Powers of Provincial Governments Act (under the chairmanship of the Minister of Finance) coordinates the borrowing requirements of provincial governments Every province is obliged to publish in each financial year an account which shows its budgeted and actual transactions in respect of, among others: Its current revenue Its current expenditure Receipts from bridging loan Repayments of bridging finance Provinces are prohibited from contracting foreign loans under the Public Finance Management Act The constitution: Prohibits provinces (states) from raising loans for current expenditure Grants provinces the competence to raise loans for capital expenditure provided they does so within the framework of reasonable norms and conditions prescribed by an Act of Parliament Permits states to raise bridging finance for current expenditure during a fiscal year provided that such credit Conclusions Sub national borrowing critical to financing infrastructure and other services Unregulated Sub national borrowing can lead to widespread debt crisis, impact public services and threaten financial and macro stability Individual country experiences vary widely and reflects A country s history Balance of power between central and state governments Macroeconomic and fiscal conditions, and state of development of financial markets There is no ideal model and the preferable model may change over time depending on circumstances 11

12 Thanks! Joint World Bank - CEMLA Workshop Subnational Debt Management Performance Assessment Tool (SN-DeMPA) México march 18-22, 2013 Jaime Coronado Public Debt Programs Coordinator 12

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