Until Subnational Debt Do Us Part

Decentralization in many countries has given subnational governments certain spending responsibilities, revenue-raising authority, and the capacity to incur debt. Furthermore, rapid urbanization in developing countries is requiring large-scale infrastructure financing to help absorb influxes of rural populations. Not surprisingly, the subnational debt market in some developing countries has been going through a notable transformation. Private capital is emerging to play an important role and subnational bonds increasingly competing with traditional bank loans.

With debt, of course, comes the risk of subnational insolvency. There is -- as it is the case of any government -- the potential mismatch between the time horizon of public officials in pursuit of short-run political goals, and citizens' life spans. Multilevel governments are susceptible to two other sources of risks of over-indebtedness. Subnational governments may be tempted to abuse any perceived window through which they can share risks and costs with the other members of the federation. Likewise, creditors may overlook rising risks if they can fall back on some sort of national bail-out.

Subnational insolvency is not new. It has occurred in both advanced and developing countries. As a consequence, growing attention has been dedicated to frameworks to restructure subnational debt, when necessary, as well as to undertake legal, regulatory, and institutional reforms aiming at sustaining subnational debt finance in the long run. In a recently launched book -- Until Debt Do Us Part: Subnational Debt, Insolvency, and Markets -- we edited a vast array of analyses of past experiences in Brazil, China, India, Mexico, Colombia, France, Hungary, United States, The Philippines, Russia, and South Africa. They cover not only a diverse range of debt restructuring cases, but also frameworks built to deal with insolvency, and of reforms undertaken to enhance subnational debt market development.

How to balance the tension between the contractual rights of creditors, and the need to maintain public services in the event of subnational insolvency? Who has the authority over what, that is to say, how to define the respective role of different levels and branches of government in resolving insolvency? How to develop a collective framework for debt resolution that has clarity of rules and collective enforcement? Should a judicial or an administrative approach -- or a hybrid -- be adopted? The country cases exhibit a variety of responses to those questions, reflecting country-specific historic, constitutional and economic contexts, and entry points for reform.

Four broad lessons emerge from the study. First, debt and deficits arise from joint decisions of borrowers and creditors. Without lenders, there is no borrowing or debt, so their constraints and incentives deserve attention equivalent to the one laid on subnational governments.

Second, relying only on ex-ante constraints to over-indebtedness, without ex-post consequences to reckless behavior, gives irresponsible borrowers and lenders an incentive to get around the ex-ante rules and execute transactions that may later get bailed out.

Third, it is worth closely tying borrowing decisions to revenue decisions as a feature of good institutional design. Debt issuance that is tied to tax increases or dedicated revenue sources is much more likely to be repaid.

Finally, rule-based systems in which higher-level government treats all lower-level governments according to the same rules are crucial. Ad hoc or discretionary action is likely to be plagued with reckless behavior, both on creditor and debtor sides.

The rising weight of subnational finance has become a clear structural trend. Like any marriage thought to be indissoluble, multilevel governments should define rules of the game so as to avoid debt-originated sources of dangerous strain. This piece was co-authored with Lili Liu, a Lead Economist at the Poverty Reduction and Economic Management Network of the World Bank.

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