Fiscal Sustainability

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                                           Achieving Fiscal
                                                                                     Sudarshan Gooptu

A well-designed system for fiscal decentralization       and subnational levels will yield to uncertain inter-
promises many benefits, including enhanced eco-          governmental flows, capricious revenue policies,
nomic growth and macroeconomic stability. If,            and a lack of medium-term fiscal planning.
however, decentralization is designed badly or               Much is at stake in getting this decentralization
implemented and monitored improperly, such a sys-        system right. East Asian countries have recovered
tem can foster “soft” budget constraints—loosened        rapidly from the 1997 financial crisis, posting high
controls on the fiscal activities of subnational         growth rates. Regional output grew by 6.7 percent
governments—that may undercut the spectacular            in 2002 and 7.9 percent in 2003 and an estimated
economic growth occurring in East Asia today.            7.8 percent in 2004. Growth is expected to reach
    This chapter highlights the challenges of decen-     7.1 percent in 2005—the strongest record since the
tralization in the context of macroeconomic man-         start of the global and regional recession in late
agement, especially in achieving fiscal sustainability   2000. The number of people living below US$2 per
and providing a medium-term environment for              day is estimated to have fallen to around 34 percent
sustained growth. The focus is twofold. First, the       in 2004, amounting to some 636 million people—
chapter highlights the critical need for central gov-    down from 50 percent as recently as 1999, repre-
ernments to monitor subnational fiscal and quasi-        senting 890 million people (World Bank 2004, 2005
fiscal activities through well-designed reporting,       table 1.1).
auditing, and financial management institutions, as          The policy challenge for each country is to
well as information databases. Second, the chapter       maintain its high growth rate while strengthening
addresses the need to institutionalize incentives for    its fiscal health through intergovernmental coordi-
subnational governments to publicly and regularly        nation and monitoring. Unfortunately, this task
report relevant financial information.                   is far from straightforward. For a start, whether
    Most East Asian countries are at the early stages    developing countries experience a causal relation-
of this twofold process. Unless the process keeps        ship between decentralization, macroeconomic sta-
pace with decentralization, the result will be subna-    bility, and economic growth is unclear. The reasons
tional arrears and pressures for central bailouts—the    are twofold. First, the data for measuring the extent
latter occurring through ad hoc financial transfers,     to which a country has fiscally decentralized are
or accounting “adjustments” that take significant tax    simply not available—a worldwide problem that
and spending activity off-budget. Once countries         also exists in East Asia. Second, the line is not
abandon the discipline of hard budget constraints,       always clear between formal and informal institu-
systematic budget planning and execution at central      tional arrangements for enforcing hard budget

54   East Asia Decentralizes

     constraints. Even if the right data and definition         time frame for assessing the impact of different
     were available to measure decentralization, track-         types of public spending is also important. Analysts
     ing fiscal risks can be difficult when subnational         see health and education spending, for example, as
     governments have hidden, off-budget expenses and           an investment in human capital with a long-term
     funds, as in some East Asian countries.                    payoff, resembling physical investment.4
        Still, the elements of responsible fiscal manage-           Ebel and Yilmaz (2003) reproduced this analysis
     ment, and the criteria for maintaining fiscal disci-       by weighing degrees of revenue autonomy. They
     pline in a decentralizing environment, are well            found that tax autonomy and nontax autonomy have
     known. This chapter therefore focuses on empirical         a positive correlation with economic growth, while
     conclusions regarding the links between fiscal             tax sharing has a negative relationship (see chap-
     decentralization and growth, the role of budget            ter 6).These results suggest that a country’s economic
     constraints in fostering fiscal discipline, the rela-      performance partly reflects the degree to which sub-
     tionship between subnational borrowing and a               national governments control their revenues.
     country’s overall fiscal sustainability, and the result-       In a study of the United States, Xie et al. (1999)
     ing need for managing financial risk.                      showed that further fiscal decentralization with the
                                                                aim of boosting efficiency and economic growth
                                                                would in fact harm growth. Akai and Sakata (2002)
     Links between Fiscal                                       refuted that finding, incorporating a more elabo-
     Decentralization and
                                                                rate definition of fiscal decentralization. Their
     Economic Growth
                                                                study examined the growth impact of giving sub-
     In theory, devolving fiscal responsibilities can           national governments the authority to raise taxes
     improve public sector efficiency, boost competition        and spend public funds.5 Since local governments
     among subnational governments in delivering pub-           do not necessarily spend locally collected revenues
     lic services, and stimulate economic growth (Bird          locally, the authors found that they may not in fact
     and Wallich 1993). These potential benefits reflect        have tax autonomy (Zhang and Zou 2001).
     the belief that subnational governments can best               Martinez-Vazquez and McNab (2001) con-
     make growth-promoting public expenditures in               firmed the inconclusive relationship between fiscal
     sectors such as education, health, and infrastruc-         decentralization and economic growth and the
     ture, because they have better information on local        importance of individual country circumstances—
     circumstances and interregional differences (Oates         including noneconomic ones—in determining
     1993).1                                                    causality. Lin and Liu’s analysis of China (2000),
         East Asia’s spectacular precrisis growth and           using provincial-level data from 1970 to 1993, sug-
     postcrisis rebound have depended significantly on          gests that fiscal decentralization has helped spur
     prudent macroeconomic management. However,                 that country’s impressive growth over the past 20 or
     empirical research has been inconclusive regarding         30 years.6 However, Zhang and Zou (2001) found a
     any causal relationship between decentralization           negative relationship between fiscal decentraliza-
     and growth in developing countries.                        tion and economic growth in China.7
         In a study of 46 countries from 1970 to 1989,
     Davoodi and Zou (1998) found a negative relation-
                                                                Subnational Fiscal Discipline
     ship between fiscal decentralization and economic
                                                                and Budget Constraints
     growth in developing countries, and no relation-
     ship in developed countries.2 The authors explain          Determining the degree of fiscal discipline among
     that “conventional wisdom points towards positive          subnational governments in East Asia requires
     growth effects of capital and infrastructure spend-        identifying the budget constraints they face. Doing
     ing and negative growth effects of welfare and cur-        so in countries like Cambodia—where subnational
     rent spending.” This implies that in developing            governments have little spending and revenue
     countries—where subnational entities spend a               authority and rely almost entirely on transfers from
     larger proportion of their budgets on wages and            the center—is relatively easy. At the other extreme,
     salaries and social welfare—decentralized systems          about half or more of the resources available
     exhibit slower long-term growth per capita.3 The           to China’s subnational governments come from
                                                                              Achieving Fiscal Sustainability      55

off-budget sources, over which they have virtually       Information on these quasifiscal transactions
total control.8 In Vietnam, off-budget accounts          remains weak, and work on improving this infor-
such as the Social Security Fund, the Health Insur-      mation base is just beginning, even in China.
ance Fund, and the National Development Fund                 Finally, subnational governments in many coun-
constrain the budget autonomy of subnational             tries have faced difficulties in planning their activi-
governments.                                             ties and managing their finances owing to delays in
   In some East Asian countries, state-owned             allocation decisions and a lack of predictability
enterprises at the subnational level receive off-        regarding intergovernmental transfers. In Thai-
budget resources in the form of deferred taxes or        land, other than knowing with certainty that their
arrears accruals on debt service and other contrac-      nongrant revenues will equal those of the previous
tual payments. This is a particular concern in China     fiscal year, local governments find it difficult to
and Vietnam. In Thailand, this problem is miti-          predict their shared tax revenue allocations. This is
gated by the fact that subnational governments do        mainly due to delays in establishing the criteria for
not typically own enterprises, and by the inclusion      distributing the allocations from the center to local
of all state-owned enterprises in the “consolidated      governments.10
public sector’s” budgetary accounts.
   Extrabudgetary revenues and expenditures
                                                         Subnational Borrowing and
among subnational authorities make their true
                                                         Fiscal Sustainability
budget constraints difficult to ascertain. This is
especially problematic when data are not reported        Fiscal sustainability means that a subnational gov-
in a timely manner and are often incomplete, as in       ernment covers its expenditures out of its own rev-
most East Asian countries. Thus, when govern-            enues, reducing its dependence on borrowing and
ments rely substantially on extrabudgetary funds,        transfers from the center (Bird 2003). To determine
national budgets give only a partial picture of fiscal   whether a subnational government’s plans are fis-
realities.                                               cally sustainable, analysts need accurate informa-
   Enforcing hard budget constraints among subna-        tion on revenues and expenditures at the central,
tional governments requires clear expenditure            regional, and local levels. Analysts also need to
assignments, formula-based transfer systems, local       understand the interplay between intergovernmen-
revenues, prudent subnational borrowing rules, and       tal grants and government borrowing—that is, how
good financial reporting (see box 1.3 in chapter 1).     hard the subnational budget constraint truly is.
None of the East Asian countries examined here meet      Careful analysis of country-specific intergovern-
these prerequisites. Such a situation can lead to per-   mental relations, and the resulting incentive frame-
verse incentives to overspend, accumulate arrears,       work, should accompany any analysis of fiscal
and overborrow. Key among such incentives is the         sustainability.
prevailing practice of higher-level financial bailouts       Subnational governments in most of the East
for subnational governments that are already in or       Asian countries examined here rely heavily on
even heading toward default. This is of particular       intergovernmental transfers. The large bailouts
concern if the subnational government is large, as is    during the 1997 financial crisis and since, such as
often the case with soft budget constraints.9            the recent recapitalization of Chinese state-owned
   A country’s system of intergovernmental fiscal        banks in 2004, have undermined fiscal sustainabil-
management (or lack thereof) may also motivate           ity in East Asia by softening the budget constraints
subnational authorities to keep their transactions       imposed on subnational governments. Discre-
off-budget—especially richer provinces that do not       tionary transfers to deficit subnational govern-
want to cede part of their revenue base to the center    ments in China, Indonesia, and Vietnam, and
for tax sharing. Effective fiscal decentralization       unclear assignment of responsibilities throughout
requires an institutional structure that minimizes       the region, have compounded this result.
such adverse expectations. In China, “fee-to-tax”            Many subnational governments in East Asia also
reforms aim to bring some off-budget subnational         have access to onlending from the central govern-
revenues within the budgetary umbrella, but much         ment and donors. Such lending is typically in the
remains to be done in most East Asian countries.         form of sovereign guaranteed external loans that
56   East Asia Decentralizes

     the central government contracts but channels to         borrowing, subnational governments have incen-
     subnational entities at different interest rates.        tives to run unsustainable deficits.
     Onlending interest rates and terms vary across               Fiscal, political, and financial institutions that
     countries. In China, the final borrower bears the        strengthen competition at the local level, especially
     entire foreign-exchange risk associated with these       for capital, can promote hard budget constraints.13
     loans, while in other countries the center assumes       If institutions directly or indirectly suggest that the
     some or all of this risk. Most subnational borrow-       central government will step in to cover subna-
     ing in Indonesia has occurred through central gov-       tional liabilities in the case of default, they may
     ernment onlending mechanisms on terms that are           encourage subnational governments to “overbor-
     highly favorable to the center. However, the repay-      row, overspend, or undertax” (Rodden 2000a).
     ment record of Indonesian subnational borrowers              The Latin American experience suggests that
     has been poor.11 Thailand allows subnational gov-        subnational governments that are subject to hard
     ernments to borrow from domestic banks and               budget constraints are more likely to tax and spend
     bond markets, subject to legal ceilings in any given     prudently (Bird 2001). Fiscal sustainability is also a
     budget year. In Indonesia, the Ministry of Finance       forward-looking concept, in that it requires accu-
     sets the aggregate limits to regional borrowing for a    rate assumptions about revenues and expenditures
     particular fiscal year in August of the previous year,   and key economic variables. Making meaningful
     and no direct borrowing from foreign sources is          assumptions that are palatable to policy makers and
     permitted. Instead, all such borrowing occurs            their constituents requires a good understanding of
     through onlending arrangements with the min-             institutional and country-specific details.
     istry. Subnational governments in Vietnam may not            In Indonesia, for instance, only after it passed
     borrow at all (see table 3.1).                           Laws 22 and 25 on intergovernmental fiscal rela-
         International experience since the early 1980s,      tions in 1999 and issued implementing regulations
     especially in Latin America, suggests that without       (PP107) in 2000 could regions borrow without
     appropriate accountability and transparency mech-        strict approval from the center.14 Subnational
     anisms, decentralization can encourage dangerous         domestic borrowing is now subject to a rule-based
     opportunistic behavior by state and local authori-       approach and central government approval. For-
     ties. If left unchecked, such opportunism could          eign borrowing is not allowed, except through
     undermine macroeconomic stability. The most              onlending from the central government or donors.
     vivid manifestation of this phenomenon is the soft-          In view of Indonesia’s public debt burden, how-
     ening of subnational budget constraints (Rodden          ever, and as the country establishes local financial
     2000a; World Bank 2002). Avoiding this risk              management structures, a ministerial decree tem-
     depends on the ability of the central government to      porarily banned any subnational borrowing until
     prevent subnational authorities from passing their       the intergovernmental fiscal relations Law 25/99
     liabilities to higher-level governments.12 This, in      was revised. This ban has been in effect since 2000
     turn, requires institutional mechanisms to disci-        but was to be lifted at the end of fiscal year 2004,
     pline borrowing by state and local governments.          after the implementation regulations of the revised
         Examining experiences in Argentina, Brazil, and      Law 25 are in place. The goal is to maintain fiscal
     India, Rodden et al. (2003) show that unsustainable      discipline by strengthening both market and rule-
     subnational deficits emerge when provinces have          based mechanisms—highlighting the fact that
     powerful representatives, when they depend heavily       countries may sometimes require strong, centrally
     on intergovernmental transfers, and when they            imposed fiscal constraints, especially in the early
     have autonomous access to sources of deficit             stages of decentralization. Subnational govern-
     financing. The latter can include bonds, loans from      ments may rely on short-term borrowing (with
     domestic banks (which may themselves be state-           maturities of less than 12 months) to manage their
     owned, as in China), nonpayment of employee              cash flow. In theory, as in China, the Indonesian
     wages, and contingent liabilities. If these exist        central government can intercept general grant
     where the central government cannot commit to            funds if a region fails to meet its debt service
     a no-bailout policy, or cannot limit subnational         obligations.
     TABLE 3.1   Subnational Borrowing Practices

       of practices              Cambodia                  China               Indonesia             Philippines              Thailand              Vietnam

       Borrowing power      LGs cannot borrow.      LGs may not borrow    LGs can borrow or      LGs can borrow or       LGs cannot borrow,   Provinces and cities
         and practices      Stipulated according      against general       issue bonds in         issue bonds; some       domestically or      with provincial
         (excluding bor-       to central govern-     revenues or issue     domestic market        prudential              from abroad,         status can borrow
         rowing from cen-      ment regulations.      bonds.                subject to rules       restrictions.           without prior        within prudential
         tral government)                           LGs can and do          and central gov-                               approval             limits and as
                                                      borrow through        ernment approval.                              from CG.             approved by CG.
                                                      asset-holding       Temporary freeze on
                                                      or project            all borrowing up
                                                      companies.            to 2005.
       Borrowing from       LGs may not             Borrowing by LG       LGs borrow mainly      LGs borrow exclu-       LGs not allowed to
         the government/      borrow.                 (mainly special       from CG through        sively from gov-        borrow without
         donor onlending                              service units)        donor onlending        ernment financial       prior approval
                                                      from China            and from budget.       institutions;           from CG.
                                                      Development         50% of latter loans      largely donor
                                                      Bank; commercial      in arrears; 63% of     onlending.
                                                      bank loans to         loans to LGs in      GFIs monopolize
                                                      “off-budget”          arrears.               depository bank
                                                      funds.              New onlending            business, so de
                                                                            terms being            facto IRA intercept
                                                                            negotiated.            has led to good
                                                                          Under new PP107,         LG repayment
                                                                            CG can intercept       history.
                                                                            DAU.                 Terms of onlending
                                                                                                   loans by GFI to be
                                                                                                   in line with those
                                                                                                   of local commer-
                                                                                                   cial banks, but in
                                                                                                   practice GFI often
                                                                                                   sets a lower rate.

                                                                                                                                                          (Continued )

     TABLE 3.1   (continued)

       of practices            Cambodia                 China                Indonesia              Philippines              Thailand               Vietnam

       Banking sector     Not much banking       LG-owned               LGs borrow short        Private commercial      LGs are only now       LG-owned compa-
                           sector–related          companies borrow       term from banks         bank lending to         exploring oppor-       nies borrow from
                           activity; basically     primarily from         to cover cash flow.     LGs virtually           tunities to borrow     banks to finance
                           a cash economy.         commercial banks,    Banking sector still      nonexistent.            from local com-        infrastructure
                          Most banks               mostly 3–5 years;      under restructur-     Land Bank of the          mercial banks and      projects.
                           foreign-owned.          sometimes 10.          ing; 22 of 27 BPDs      Philippines, the        public revolving     Commercial banks
                          National Bank of       Interest rates           recapitalized.          largest provider        funds.                 purchased HCMC
                           Cambodia                regulated by PBC.                              of credit to LGs,     LGs mainly borrow        private placement
                           opened dollar-        Banking sector is                                now uses its own        from local             bond.
                           denominated             burdened by high                               resources (as well      development          Gradual liberaliza-
                           accounts for            rate (40%) of                                  as donor funds):        funds monitored        tion of interest
                           commercial banks        nonperforming                                  5 years.                by Ministry of         rate since 1996;
                           in 1998; deposits       loans; concern for                           Privatized Philip-        Interior.              State Bank of
                           with the bank are       the ability of LG                              pines National                                 Vietnam (SBV)
                           remunerated at          companies to                                   Bank still lends to                            removed lending-
                           7/8 of SIBOR.           depend on                                      LGs (eligible to be                            rate ceiling.
                                                   rollover of bank                               an LG depository):                           SBV launched
                                                   loans.                                         4–7 years.                                     banking-sector
                                                                                                New GFI players in                               restructuring
                                                                                                  LG credit.                                     program in 2001,
                                                                                                                                                 phasing in SOCB
     Capital markets       LG-owned compa-         Defaults of munici-    6 LG banks: West       13 LG bond issues       LGs cannot go           HCMC issued GO
                             nies cannot issue       pal bonds in early     Java, East Java,       since 1991: 4           directly to capital     bonds in 1995
                             bonds.                  1990s led to ban       Central Java,          issues guaranteed       markets.                (D 30 billion,
                           Credit to the private     on LG bond             North Sulawesi,        by Home Guaran-       Debt financing by         3-year, private
                             sector is 7 percent     issuance.              West Sumatra,          tee Corp. (govern-      LGs has been            placement) for
                             of GDP, loans are     LG companies issue       and PT Bank DKI        ment agency), 8         limited (some           toll-road project;
                             mostly short term.      bonds (Shanghai:       issued 12 bonds        issues guaranteed       revenue bonds           is preparing
                           Mainly providing          8 years); strict       (1991–2000);           by LGUGC; mostly        issued).                another. (Decree
                             import/export           procedures for the     3–7 years.             7-year.                                         93/2001 allowed
                             financing and           issuing corporate                           LGUGC established                                 HCMC bond
                             working capital to      bonds (single A or                            in 1998, owned                                  issuance.)
                             trade and service       better for issues                             51% by Bankers                                Ministry of Finance
                             sectors.                greater than Y                                Association and                                 approval required
                                                     100 million).                                 49% by Develop-                                 for bond issues;
                                                                                                   ment Bank of the                                market-rate
                                                                                                   Philippines.                                    pricing unlikely.
                                                                                                                                                 HCMC Securities
                                                                                                                                                   Exchange estab-
                                                                                                                                                   lished in 2000;
                                                                                                                                                   bond is 10% of
                                                                                                                                                   transaction vol-
                                                                                                                                                   ume; the Hanoi
                                                                                                                                                   exchange opened
                                                                                                                                                   in early 2005.
     Monitoring of local   Financial accounting    Government finan-      Regional financial     Ministry of Finance     Ministry of Informa-    Central budget
      government             centralized in          cial information       information            pilots new system      tion monitors sub-       guidelines.
      credit                 National Treasury       system being           system being           for LG fiscal/         national borrow-       City budget
                             and provincial          piloted.               prepared; Ministry     financing              ing from local           information not
                             branches.             LG credit not            of Finance starts      reporting.             development              disclosed.
                           Main financial state-     assessed.              mapping LG fiscal    GFI appraises central    funds and public       SOCB evaluates
                             ment for LG           Credit-rating            capacity?              government             revolving funds.         large-scale
                             expenditure man-        agencies exist.                               transfer and LG                                 projects.
                             agement pro-                                                          tax base.
                             duced by Ministry                                                   LGUGC has internal
                             of Finance Budget                                                     credit-rating
                             Dept.                                                                 system.

     Source: World Bank.
     Note: BPD state-owned commercial banks; DAU dana alokasi unam, the main intergovernmental fiscal transfer mechanism in Indonesia; HCMC Ho Chi Minh City;
       GO government order; IRA Internal Revenue Allotment; PBC People’s Bank of China; LG local government; CG central government; GFI government
       financial institution; LGUGC local government unit guarantee corp.; SOCB state-owned commercial bank.

60   East Asia Decentralizes

         In Thailand, local governments may borrow           do not intend such an outcome, or if local gov-
     domestically and internationally, with prior            ernments do not use the allocated resources effi-
     authorization from the cabinet. These governments       ciently, the resulting trends will undermine fiscal
     may issue debt securities and borrow from official,     sustainability.
     external bilateral creditors for development proj-         For such rules to be credible and sustainable,
     ects. In practice, local debt financing is somewhat     they must be part of a well-articulated fiscal frame-
     limited, including from domestic capital markets.       work that improves the government’s position over
     The primary source of borrowing has been local          the long term. Such a framework includes clear
     development funds managed by the Ministry of            intergovernmental fiscal relations, appropriate sub-
     Interior. Subnational governments have more             national tax structures, and public pensions.20
     recently borrowed from commercial banks and             The central government needs to clearly define
     public revolving funds.                                 accountability and establish financial management
         In Vietnam, subnational governments may not         practices to enforce these rules.21 In fact, the tem-
     run fiscal deficits. Provinces may borrow, but only     porary ban on subnational borrowing in Indonesia
     domestically, by issuing project investment bonds,      is a prudent interim measure until the country
     or by borrowing from the Development Assistance         establishes a more solid framework for regional
     Fund.15 Provinces may use these funds only for          borrowing and a regional financial information
     projects with prior approval from the Provincial        system. A more solid framework for subnational
     People’s Council under the five-year provincial         borrowing must include procedures for handling
     Public Investment Plan. The province must also          regional default. Otherwise, without a credible legal
     allocate funds for debt service in future budgets       or regulatory threat, the center will end up paying
     until the debt matures.16 Local state-owned enter-      the bill.22
     prises that provide essential services, such as waste
     disposal, water, electricity, and transportation, may
                                                             Managing Fiscal Risks
     borrow from both external and domestic sources.
     All external borrowing is subject to approval by the    Rules and administrative controls can help reduce
     central government, which provides a sovereign          the risks of subnational borrowing. Key measures
     guarantee.                                              include strengthening the intergovernmental fiscal
         To promote responsible subnational borrowing,       system and, when the situation warrants, requiring
     some East Asian governments have disseminated           ex ante authorization and ex post monitoring. For
     well-defined, transparent fiscal rules. The rationale   instance, the central government could set annual
     is that all borrowing decisions should take into        limits on the debt of individual local governments,
     account the fiscal implications for future genera-      review individual loans, including their terms and
     tions.17 The issue of implementation remains to be      conditions, and centralize all borrowing, with
     addressed, however.                                     onlending to local governments.23 Other measures
         In Indonesia, regulations implementing the          to encourage fiscally sustainable borrowing include
     decentralization framework limit the debt-to-           prohibiting subnational authorities from issuing
     revenue ratio to 75 percent of the previous year’s      guarantees (see table 3.2 for the kinds of explicit
     general revenue, and the debt service-to-revenue        and implicit guarantee mechanisms that may exist
     ratio to 40 percent in any given budget year. Regula-   at subnational levels), and imposing ceilings on the
     tions also govern onlending to the regions.18 In the    net worth or loan portfolio of borrowers. Indonesia
     Philippines, the central government limits transfers    and Thailand have established ceilings on debt or
     to local governments to 40 percent of their internal    debt service as a share of local revenues. Other
     revenues from three years before.19 Since the ratio     countries, such as Vietnam, require local govern-
     of revenue to gross domestic product has been           ments to balance their budgets and restrict their
     falling, this rule implies that some local govern-      borrowing to specific purposes, such as capital
     ments may receive higher transfers than intended,       investment.
     or than the central government can afford. Declin-          Countries can also rely on the market to regulate
     ing trade taxes also build upward bias into the rev-    subnational borrowing. A market-based system
     enue share of local governments. If policy makers       requires minimum legal and regulatory structures,
                                                                               Achieving Fiscal Sustainability    61

TABLE 3.2 Subnational Fiscal Risks

                                      Direct                                      Contingent
   Liabilities              (obligation in any event)              (obligation if a particular event occurs)

   Government           Local government debt.                     Local government provides
     liability is       Arrears (if legally binding).                guarantees for debt and other
     recognized         Nondiscretionary budgetary                   obligations of financial and
     by law or            spending.                                  nonfinancial enterprises and
     contract.                                                       other entities.
                                                                   Local government insurance
                                                                     schemes (such as crop insurance).
   A “moral”            Capital and recurrent costs of local       Claims arising from local
     obligation on        public investment projects.                government letters of comfort.
     the part of the    The cost of future benefits under          Claims by failing local financial
     government           local social security schemes.             institutions and other entities.
     that mainly                                                   Claims related to enterprise
     reflects public                                                 restructuring and privatization.
     expectations                                                  Claims by beneficiaries of failed
     and pressure by                                                 social security or other funds,
     interest groups.                                                beyond any guaranteed limits.
                                                                   Claims related to local crisis
                                                                     management, such as public health,
                                                                     environment, and disaster relief.

   Source: Brixi and Mody 2002.

such as supervision and disclosure practices; guide-          Subnational governments that relax their budget
lines for issuing, settling, and repaying debt; bank-     constraints contribute to public sector deficits and
ruptcy procedures (including creditor remedies);          threaten national solvency. Hidden budget channels
protection against disruption of essential public         include off-budget borrowing; arrears on civil serv-
services; and measures to prevent moral hazard.           ice wages and payments to suppliers and other levels
East Asian countries are only now establishing            of government; indirect liabilities through public
these institutional structures.                           enterprises or publicly owned banks, which are often
    Another market instrument for reducing the            insolvent; and other contingent liabilities such as
credit risk of subnational borrowing is regular           unfunded pension and provident funds. Soft budget
monitoring of creditworthiness. Private sector enti-      constraints and the expectation of central bailouts
ties can help investors by rating the likelihood that     contribute to moral hazard. Data on these “hidden
subnational governments will default. Such credit         deficits” in East Asia are just becoming available
ratings should reflect both the capacity and the          (Kharas and Mishra 2001). Thus central govern-
willingness of debt issuers to make timely payments       ments lack the information they need to monitor the
on both principal and interest. Key elements of           fiscal risks of subnational governments. In most East
creditworthiness include the subnational govern-          Asian countries, the Ministry of Finance typically
ment’s economic base (net worth), revenue auton-          receives regular reports on budgetary revenues and
omy and stability, revenue-expenditure balance,           expenditures on a cash basis from subnational gov-
intergovernmental fiscal relations, the subnational       ernments. The ministry does not, however, have
debt burden, and contingent liabilities. Financial        access to timely information on many extrabudgetary
management practices in the region matter, as do          and off-budget capital expenditures and borrowing,
guarantees, insurance, and other mechanisms to            or on local guarantees, financial institutions, pen-
enhance the credibility of subnational borrowing.         sion funds, employment insurance funds, and other
However, credit ratings of subnational entities are       transactions that could generate liabilities (Ma and
not yet available in most East Asian countries.           Brixi 2002). Anecdotal evidence on provincial-level
62   East Asia Decentralizes

     off-budget and contingent liabilities abounds in           vehicles that carry explicit or implicit guarantees
     some countries.                                            from the central government raise the latter’s risk.
        In China—where direct and indirect support of           Yet estimating the scope of the contingent liabilities
     expanded investment and credit to subnational              that subnational spending and borrowing impose
     entities has driven much recent growth—reliance            on the central government is difficult, especially if
     on banking and off-budget funds has been impor-            no one government agency is cataloguing these
     tant.24 Poor monitoring of such investment implies         transactions. East Asian countries are just begin-
     that the health of the financial sector is at risk. Sig-   ning to undertake this task, at least for large contin-
     nificant investment in industries such as cement,          gent liabilities. China and Thailand have been
     steel, and aluminum seems even riskier, given sub-         building the capacity of the central government to
     stantial excess capacity.                                  manage overall public debt.
        Table 3.2 outlines typical sources of contingent           Early warnings, such as those used in Brazil,
     liabilities, which can be explicit or implicit. For        Colombia, and the United States, can provide a
     instance, the explicit fiscal burden from rising           good starting point for monitoring the fiscal risks
     safety net expenditures may generate liabilities for       of subnational borrowing, but such indicators may
     the central or provincial government. Also, what           not reliably reflect future financing pressures.27 Ma
     may be “contingent” for the central government             (2001) has proposed a composite indicator that
     may be a direct liability for a provincial or subna-       reflects both fiscal pressures and the current fiscal
     tional government. Cataloguing such liabilities is         position of subnational governments. Information
     an essential first step in establishing a system to        on their assets and liabilities, exposure to market
     assess the obligations and fiscal risks of local           and rollover risks, capacity for managing these
     governments.25 China, Indonesia, Thailand, the             finances, and the compatibility between revenue
     Philippines, and Vietnam are now embarking on              and spending responsibilities will enable informed
     this important endeavor.                                   judgment concerning fiscal risks that may need
        As provincial and municipal governments gain            immediate attention. Without sound fiscal report-
     greater authority to tap domestic and international        ing and auditing at the subnational level, even the
     financial markets, the financial risk at subnational       best-designed early-warning system will not be
     levels will also grow—and will need managing.              effective. Countries need clear rules for dealing
     Weaknesses in regulation and oversight have led to         with debt-distressed subnational governments.
     the proliferation of off-budget financing, govern-         Vietnam is examining the fiscal risks of borrowing
     ment guarantees, and other contingent liabilities.         by state-owned enterprises, but most East Asian
     Decentralization has given subnational governments         countries are just beginning to tackle this issue.
     a greater role in managing and delivering public
     services, and more budgetary responsibility for civil
     service pensions and provident funds. All these fac-
     tors exert a significant impact on the quality of serv-    A piecemeal approach to intergovernmental fiscal
     ices and expenditure mix of local governments.             reform is unlikely to succeed because it will not
        Countries need to estimate the costs of deliver-        take into account the interdependence between
     ing devolved responsibilities so they understand the       transfers and revenue assignments, or between
     potential fiscal risks. For example, if Thailand allo-     expenditure assignments and own-source revenues
     cates 20 percent of revenues to local authorities but      and transfers. To enforce hard budget constraints,
     does not devolve commensurate responsibility for           institutions must clearly and credibly convey the
     expenditures, then the central government bears a          message that local governments will bear the costs
     significant risk of assuming the resulting deficit.26      and benefits of their fiscal decisions. One such
     These risks will grow if service delivery declines         institution is the capital market, which in theory
     owing to capacity constraints among subnational            rations access to capital among subnational bor-
     governments. In China and Indonesia, where sub-            rowers based on the soundness of their fiscal deci-
     national governments have more expenditure                 sions. Institutions that ensure that public officials
     responsibilities than revenue-raising authority,           must answer to the needs and aspirations of the
     subnational borrowing and off-budget financing             local populace are essential as well. However, such
                                                                                    Achieving Fiscal Sustainability             63

institutions can work only if local governments            appropriate early-warning systems for fiscal risks.
have considerable fiscal autonomy, and when the            East Asian countries have begun work in these crit-
central government makes a credible commitment             ical areas, but success will require consistent effort
that it will not provide bailouts (World Bank              over the short and medium term.
2000b). None of the countries in East Asia now
meet these conditions for enforcing hard budget
                                                            1. This theory assumes that labor and capital mobility will
    East Asian countries need a comprehensive
                                                               ensure competition among subnational governments for
approach to intergovernmental fiscal reform, tack-             effective public sector service delivery, as well as a match
ling subnational expenditures and revenues at the              between the preferences of local citizens and governments.
same time. Subnational governments must have                2. Davoodi and Zou (1998) define fiscal decentralization in
                                                               terms of spending by subnational governments as a fraction
enough revenues to implement their spending                    of total government spending. Fiscal decentralization rises if
responsibilities (see chapters 5 and 6). Toward                spending by state and local governments expands relative to
this end, incentives that encourage cooperation                spending by the central government. The authors use the
                                                               average growth of real per-capita output over 5-year and
between officials at different levels are essential.           10-year periods as a proxy for long-run growth.
China and Indonesia need such incentives, for               3. Davoodi and Zou (1998) did not use disaggregated subna-
example.                                                       tional data to determine which province or region spent
                                                               more on capital and infrastructure relative to others. The
    Central governments need to carefully monitor
                                                               authors also noted that countries may not realize the effi-
subnational borrowing and the resulting fiscal                 ciency gains of fiscal decentralization if central authorities
risks in order to maintain fiscal discipline and pru-          constrain subnational revenue collection and spending,
dent macroeconomic management. Before countries                and if local citizens do not elect local officials. Labor and
                                                               capital mobility may not be as easy as theory assumes.
give subnational governments free rein to borrow—           4. A significant part of spending in these sectors often occurs
domestically or abroad—they need to make infor-                under “current expenditure.”
mation critical to analyzing subnational creditwor-         5. See chapter 2 in Litvack et al. (1998) for a discussion of the
                                                               distinction between decentralization, deconcentration, and
thiness available to stakeholders. Appropriate checks          delegation.
and balances must ensure that these data are reliable       6. Lin and Liu (2000) found that rural reform, development
and consistent across provinces. Domestic and                  of the nonstate sector, and capital accumulation have also
                                                               been driving forces in China.
foreign capital markets play an important role in
                                                            7. In the same study, the authors found a positive relationship
diversifying local government funding sources and              between fiscal decentralization and provincial economic
tracking subnational creditworthiness. East Asian              growth in India. Questions about the appropriateness of
countries—especially those with weak financial                 the “decentralization variable” again arise. See Ebel and
                                                               Yilmaz (2003).
systems—will need to implement a complex set of             8. See World Bank (2002). Subnational governments in China
institutional reforms to support these efforts.                also often engage in commercial activities to supplement
    Finally, to achieve fiscal sustainability, countries       their revenue, using land resources and enterprise assets as
                                                               their investment capital. Under a model pioneered in
will also need to reform governance, public enter-
                                                               Shanghai, many municipalities are creating “corporations”
prises, sectors such as power, and the intergovern-            to manage public resources and debt obligations. These
mental fiscal structure to ensure hard budget                  corporations may “enhance their debt servicing capacity”
constraints for subnational governments. Central               by engaging in profit-making activities. The General
                                                               Corporation of Shanghai Municipal Property Devel-
governments also must monitor contingent liabili-              opment is one of the first such vehicles, created to
ties to ensure prudent fiscal management. Over the             help finance the city’s enormous need for facilities and
longer term, a database and analytical indicators              infrastructure.
                                                            9. Wildasin (1997) showed that a local government’s ability to
can form the basis for a credit-rating system for              extract a bailout from the central government depends on
local governments. Such a system is critical to                the former’s size. Larger subnational governments thus
opening up subnational borrowing and developing                tend to operate under softer budget constraints, creating
                                                               incentives for overspending and overborrowing if not ade-
a municipal bond market.28 Also important in
                                                               quately monitored by the center.
minimizing future surprises from the decisions of          10. For example, although Thailand’s central government set
subnational governments is a clear division of                 grant allocations well in advance of fiscal year 2002, it did
                                                               not disburse these grants until the very end of the fiscal
responsibilities across levels of government, formal
                                                               year because of delays in establishing the allocation rule.
channels for reporting contingent liabilities              11. Empirical evidence in Lewis (2003) suggests that local
and analyzing their potential fiscal impact, and               governments have borrowed “well within their fiscal
64   East Asia Decentralizes

           capabilities to repay,” but that they have largely been          25. Such a system can potentially be used to generate a ranking
           unwilling to repay these debts. The key issue is therefore           of local governments based on their fiscal health, and to
           one of credit risk rather than fiscal sustainability of subna-       enable the central government to decide when to intervene
           tional borrowing in Indonesia.                                       and provide emergency assistance (Ma and Brixi 2002).
     12.   For example, state-level defaults on debt payments helped        26. These risks will be compounded as the local share of rev-
           trigger Brazil’s financial crisis in 2000. See Rodden 2000a.         enues grows to 35 percent by 2006.
     13.   Rodden et al. (2003) draw on the experiences of seven            27. See World Bank (2002). Brazil had imposed limits on sub-
           developing and transition economies and four OECD                    national borrowing, Colombia had a “traffic light system,”
           countries in identifying institutional arrangements associ-          and Ohio in the United States has a “fiscal watch program.”
           ated with soft and hard subnational budget constraints.          28. See Ma and Brixi (2002) for relevant experiences in
           This exercise provides lessons for East Asian countries.             Australia, Brazil, Colombia, New Zealand, and the
     14.   States in Indonesia can now borrow for projects that gener-          United States, and a list of risk indicators for monitoring
           ate a “direct or indirect” financial return, per Implementing        the contingent liabilities of subnational governments.
           Regulation 107 of 2000. However, the central government
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