Decentralizing Borrowing Powers - World Bank

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Decentralizing Borrowing Powers - World Bank

In Argentina, for example, provincial governmentdeficits have been partly financedby provincial banks, many of which have gonebankrupt. The Central Bank’s policy of managingthese banks and absorbing their lossesprovided provincial governments with a circuitousmechanism of inflationary finance.It also weakened incentives for fiscal disciplineat the provincial level. In Brazil evidencesuggests that a soft budget constraintbetween tiers of government can existthrough the banking system despite a soundintergovernmental fiscal system (Dillinger1997). Similarly, in China the weak revenuebase of the center has put political pressureon the People’s Bank of China to offercredit to lower-level governments. Such policy-basedlending can have a negative impacton macroeconomic price stability and, presumably,fiscal discipline at the subnationallevel (Lall and Hofman 1995).Several mechanisms can be used to separatefiscal and financial systems. First, anindependent central bank is a key elementof a hard budget constraint. Second, wherepossible, the public sector must get out ofthe financial system (box 1). (At the veryleast, as Argentina suggests, subnational publicfinancial institutions should be closed.)Although this move includes privatizing thebanking system, privatization is insufficientto enforce the separation. As the U.S. savingsand loan debacle and recent East Asianfinancial crisis suggest, private banks mustbe supervised with a clear prudential regulatoryframework that monitors the leveland nature of their aggregate liabilities.Finally, if central authorities grant subsidiesto subnational governments, the subsidiesshould be provided explicitly through thefiscal transfer system rather than implicitlythrough the financial sector.Market decentralizationMarket decentralization may also reduce moralhazard. Privatization of public infrastructuremay enable the application of private sectorbankruptcy laws and allow other private companiesto bid for the assets in case of financialdifficulties—not a viable option underpublic ownership. To implement such anoption, however, governments must ensurethat a sector contains multiple service deliverers.Private participation creates options foraccessing financial equity as well as debt, creatingan incentive for “equity to monitor debt”that is not available in public financing systems.In addition, unbundling may shrink theentity involved, thus avoiding the “too big tofail” syndrome often associated with bailouts.Supervision and legislationFinally, the backdoor channels that leadto financial liabilities should be monitoredCentral subsidiesshould be providedexplicitly throughthe fiscal transfersystem rather thanimplicitly throughthe financial sectorBox 1 Evolution of capital markets and decentralization of borrowing powersIn countries without a domestic capital market,it may be preferable to have central fis-risks between the public and private sectors.lending, thus preserving the separation ofcal transfers—from central borrowing from Colombia offers lessons for designing discountfacilities.international sources—provide resources tosubnational governments while policy efforts The need for discount facilities will disappearas capital markets emerge with finan-focus on developing a private commercialbanking system. This approach avoids the creationof public financial intermediaries, keeps And as long as the fiscal system is well designed,cial instruments offering long-term finance.the fiscal and financial sectors separate, and subnational governments will be able to securecan offer a better starting point for a municipalfinance system.ipalities the fiscal transfer system will remainlonger maturities. Still, for fiscally weak munic-As the private banking system establishes an important vehicle for accessing funds. Initself, long-term finance can be provided more developed capital markets, private creditthrough centrally funded discount facilities. rating agencies and bond insurance agenciesThese facilities stretch the terms of commercialbank lending to municipalities but toring and regulating subnational borrowing.offer a market-based mechanism for moni-take on only the maturity risk. Commercial These institutions, however, require public sectorbanks retain the credit risk for their retail regulation.


Financialdecentralization canbe implementedusing a phased,asymmetricapproachand, where possible, closed. In particular,legislation must ensure that subnational governmentsare not allowed to dip into pensionfunds or use subnational corporationsto borrow, or must explicitly include suchborrowing in subnational debt. In addition,balanced budget requirements for subnationalgovernments can ensure that currentaccounts are balanced by the end of eachfiscal year, so that borrowing to match expenditureand revenue streams does not leadto the financing of current account deficits.Foreign borrowingThe question of direct access to internationalcapital markets by subnational governmentsis further complicated by issuesof capital market liberalization and foreignexchange regimes. This overall contextwill determine whether direct borrowing bysubnational governments in internationalmarkets should be permitted. Although thisnote is focused on decentralizing borrowingpowers in the domestic market, the regulatoryframework suggested here appliesequally to local and foreign borrowing.Next stepsFinancial decentralization—allowing subnationalgovernments direct access to capitalmarkets—is an important complementto the devolution of fiscal powers to regionaland local authorities. If properly designed,decentralization of borrowing powers canadd to the gains in efficiency and governanceexpected from fiscal decentralization. Buteffective financial decentralization requiresa well-designed regulatory framework.This is not to imply an all or nothing scenario:financial decentralization can beimplemented using a phased, asymmetricapproach. Policies may include sequencingfiscal decentralization before decentralizingborrowing; granting large urbancenters (which usually have strong fiscalresources and management capacity) quickeraccess to financial markets and perhaps evenforeign markets; implementing marketdecentralization as a first step; and replacingimplicit resource transfers through publicfinancial institutions with explicit fiscaltransfers. The challenge is to design theregulatory framework for financial decentralization;debating whether financial decentralizationis good or bad may be a moot pointgiven emerging local capital markets and astrong political push in many countries todecentralize powers to subnational governments.Further readingsAhmad, Junaid. 1996. “Structure of UrbanGovernance in South African Cities.”International Taxation and Public Finance3(2): 193–213.Dillinger, William. 1997. “Brazil’s State DebtCrisis: Lessons Learned.” World Bank,Latin America and the Caribbean Region,Poverty Reduction and Economic ManagementUnit, Washington, D.C.Lall, Rajiv, and Bert Hofman. 1995. “Decentralizationand Government Deficits inChina.” In Jayanta Roy, ed., MacroeconomicManagement and Fiscal Decentralization.Washington, D.C.: World Bank.Litvack, Jennie, Junaid Ahmad, and RichardBird. 1998. “Rethinking Decentralizationin Developing Countries.” SectorStudies Series. World Bank, PovertyReduction and Economic ManagementNetwork, Washington, D.C.This note was written by Junaid Ahmad (PrincipalEconomist, South Africa Resident Mission).If you are interested in similar topics, considerjoining the Decentralization Thematic Group. ContactJennie Litvack, x80519, or click on ThematicGroups on PREMnet.This note series is intended to summarize good practice and key policy findingson PREM-related topics. PREMnotes are distributed widely to Bank staff and arealso available on the PREM website (http://prem). If you are interested in writinga PREMnote, email your idea to Asieh Kehyari. For additional copies of this PREMnoteplease contact the PREM Advisory Service at x87736.Prepared for World Bank staff

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