The World Bank MMA R C H 2 O O 2 notes NUMBER 64 ECONOMIC POLICY Monitoring fiscal risks of subnational governments The fiscal risks of subnational govemments can endanger central government finances. How can these risks be monitored and minimized? Growing experience with decentralization enue, indebted governments should main- indicates that a country's public finance sys- tain a primary surplus, defaulters should tem suffers when subnational governments not borrow further, outstanding guarantees expose themselves to excessive risk. But cen- should not exceed 25 percent of net cur- Prudent public tral governments often lack the informa- rent revenue, borrowing in anticipation of tion needed to monitor the fiscal risks of future revenue should not exceed8percent finance requires subnational governments. of net current revenue, new bond issues Several countries, having experienced (other than rollovers) are prohibited, and assessing subnational fiscal crises, have established at least 5 percent of all bond issues should systems to monitor such risks. These systems be retired at maturity. subnational fiscal assess subnational fiscal health and call for The central bank is authorized to con- central government attention-and possi- trol the amount of credit supplied to sub- risks ble intervention-if preset indicators of fis- national governments by domestic banks cal imprudence are exceeded. In developing and to advise the Senate on subnational bor- countries such systems also provide useful rowing practices. The Senate, however, is information for subnational credit ratings. free to bypass legal restrictions on borrow- This note describes several country expe- ing, which makes the control mechanism riences with indicators of subnational fiscal vulnerable to political pressures. risks, identifies some limitations of such indi- cators, and suggests alternative indicators. Colombia's "traffic light" system Brazil's limits on subnational During 1993-97 Colombia established a sys- risk tem that links each subnational govern- In the 1990s, after three subnational debt ment's debt to its payment capacity. Two crises, Brazil began tightening controls on indicators act as "traffic lights"-alerting subnational borrowing. The central gov- the central government to potentially exces- ernment now restricts both the demand for sive subnational debt (table 1). The first and supply of subnational debt. For indicator, the ratio of interest payments to instance, subnational governments are not operational savings, suggests a subnational permitted to borrow from their own enter- government's liquidity. The second, the prises or suppliers, total debt cannot exceed ratio of debt to current revenue, implies the capital budget, new borrowing cannot debt sustainability. Subnational governments exceed 18 percent of net current revenue, facing a yellow or red light are able to bor- debt service cannot exceed 13 percent of row only with permission from the Ministry net current revenue, the debt stock should of Finance and a performance agreement be less than 200 percent of net current rev- with the lender. The performance agree- FROM THE DEVELOPMENT ECONOMICS VICE PRESIDENCY AND POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK TABLE 1 COLOMBIA'S TRAFFIC LIGHT SYSTEM FOR SUBNATIONAL DEBT Autonomous debt- Intermediate debt- Critical debt- Indicator a green light a yellow light a red light Liquidity indicator: interest payments/operational savings a <40% 40-60% >60% Solvency indicator: debt/current revenue <80% <80% >80% a. Operational savings is defined as current income minus operational expenses and tmnsfers paid by the subnational government. Current income mainly includes tax revenue, nontax revenue, royalties and fees, transfers from the central government, national revenue sharing, and interest income. Operational expenses include wages and salaries, honorariums, social welfare benefits, and social security expenditures. Source: Law 359, 1997. Backward-looking ment sets binding targets for revenue power to review all of the local government's warning indicators increases, spending cuts, current surpluses, tax, spending, and borrowing policies, to and the debt profile. bring civil actions to enforce the fiscal emer- may not provide a gency law, and to ensure proper account- Ohio's Fiscal Watch Program ing and reporting. reliable signal of Following the defaults of New York City in * 1975 and Cleveland (Ohio) in 1978, in 1979 Limitations potential financing the U.S. state of Ohio, in a path-breaking Early warning indicators, some examples of move, launched a local government moni- which are given above, tend to be static and pressures toring system called the Fiscal Watch Pro- backward-looking. They also tend to focus gram. The program,implemented by the on cash flows.and direct debt (see table 2 -Office of Auditor of the State, covers local for more examples). But in developing and governments in Ohio-defined to include transition economies the fiscal perfor- counties, municipalities, school districts, mance, off-budget fiscal activities, and asso- and state universities and colleges. In sim- ciated contingent liabilities of subnational plified terms, if a local government's governments are often significant. (For a accrued deficit exceeds one-twelfth of its discussion of contingent liabilities, see, annual revenue, the state auditor issues a PREMnote 9.) Thus backward-looking warn- fiscal watch warning. Once under fiscal ing indicators may not provide a-reliable sig- watch, local authorities and agencies are nal of potential financing pressures. required to limit spending and build Furthermore, without sound fiscal report-. reserves. During this process the Office of ing and auditing at the subnational level, even Auditor of the State provides advice, such the best-designed early warning system will as in the form of a performance audit indi- be ineffective. To capture subnational fiscal cating options for budget cuts and opera- risks, 'reporting requirements must, be tional improvements. broad-including, for instance, activities of If the situation worsens,--a local govern- and guarantees issued by financial institutions ment may experience a fiscal emergency- owned by subnational governments. Infor-- defined by Ohio state code as occurring mation reported to the central government when, among other things, the're is more is-useful only if it can be used to analyze risk. than a 30-day default on a debt obligation, In addition, clear rules are needed for a failure to pay employees within 30 days, dealing with subnational governments in or a deficit or overdue amounts payable financial distress. In Argentina, Colombia, exceeding one-sixth of the previous year's Hungary, and South Africa such rules revenue. Once a local government is include a control board or performance declared in emergency, the state is required agreement that empowers the central gov- to establish a financial planning and super- ernment to straighten out subnational vision commission. The commission has the finances. Clear rules reduce moral hazard PREMNOTE 64 MARCH 2002 TABLE 2 LIMITS ON SUBNATIONAL BORROWING IN SELECTED COUNTRIES Country Debt service ratio Debt-revenue ratio Other restrictions Italy <25% of own revenue net of Only for capital spending;. no foreign certain earmarked funds borrowing allowed Japan Three-year average <20% Mainly for subnational infrastructure of own revenue projects; no foreign borrowing allowed Lithuania <15% of general revenue <30% of total revenue No state guarantees; Ministry of (proposed) Finance can lower the ceiling for municipalities; long-term credit can be used only for investment Russian <15% of general revenue <30% of own revenue for provinces Federation <15% of own revenue for municipalities Spain <25% of total revenue 'Long-term credit can be used only for investment; approval required for foreign borrowing Source: Counlcil of Europe 1993; Ma 1994; Ter-Minassian 1997; Budget Code of the Russian Federation, Federal Law 145-FZ,July 1998; Peteron 1997. in intergovernmental finance because sub- (For a more precise theoretical derivation, national governments know the conditions see Ma forthcoming.) that will trigger higher-level government The composite risk index can be sup- action as well as the nature of such action. plemented by other indicators and medium-term fiscal projections (table 3). Alternative indicators Given the presence of contingent liabili- To overcome some of the limitations of early ties in the calculation, the composite risk warning indicators, a composite indicator index is measured in a probabilistic sense. can be constructed that is both compre- For the indicator to convey useful infor- hensive (reflecting likely fiscal pressures as mation, it is crucial to disclose its under- well as the current fiscal position) and easy lying assumptions and scenario analysis. to calculate. First, a subnational govern- Several techniques, such as those used in ment's comprehensive borrowing require- credit risk models, can be adapted to ment can be estimated as: model the possibility of a subnational default. Two thresholds can be set for the comprehensive borrowing requirement = composite risk index: one to indicate a comprehensive deficit + (repayment rate potential fiscal emergency-in the lingo * comprehensive debt), of Colombia's system, a yellow light-and another to indicate an actual emergency- where comprehensive deficit is the sum of a red light. the primary deficit and off-budget deficit Although the-indicators suggested in (which reflects any increase in arrears and table 3 are useful, they are not ideal and contingent liabilities) and comprehensive should not be applied too rigorously or. as debt is the sum of direct debt and contin- an end in themselves. Rather, results in gent debt (adjusted for risk). Then, divid- the yellow and red light zones indicate the ing by revenue, a composite fiscal risk index need for more detailed analysis of subna- adjusts the borrowing requirement to reflect tional fiscal risks. Such analysis should the subnational government's revenue- consider the structure of subnational gov- raising capacity, making the index compa- ernment assets and liabilities, exposure of rable across subnational governments: subnational finances to different types of risks (such as interest rate, exchange rate, coimiposite risk index = comprehensive and rollover risks), institutional arrange- deficit/general revenue + comprehensive ments and capacity for managing subna- debt/general revenue. tional finances, and compatibility between PREMNOTE 64 MARCH 2002 TABLE 3 POSSIBLE INDICATORS OF FISCAL HEALTH Indicator Advantages Disadvantages Debt/revenue Indicates future debt service burden Does not indicate risks in the debt portfolio or the impact of fiscal balance on debt sustainability Debt service/revenue Indicates fiscal pressures from the Does not indicate obligations poised to debt portfolio become debt or the impact of fiscal balance on debt sustainability Deficit/revenue Indicates current borrowing requirement Does not indicate future borrowing requirement Contingent liabilities adjusted for risk Indicates future fiscal pressures Requires scenario analysis and many assumptions. Results can be disputed Liquid assets/spending needs Indicates liquidity risk Does not reflect revenue capacity, overall balance, or debt sustainability Borrowing requirement/revenue Predicts likely fiscal pressures Does not indicate borrowing capacity, present discount value of debt, or risks in the debt portfolio. Coefficients (the revenue growth rate and interest rate) are arbitrary the assignment of subnational government Ter-Minassian, Teresa, ed. 1997. Fiscal Fed- responsibilities and financing capacity. eralism in Theory and Practice. Washington, D.C.: International Monetary Fund. Further reading Council of Europe. 1993. Borrowing by Sub- This note was written byJun Ma (Senior Econo- national and Regional Authorities. Brussels: mist, Deutsche Bank) and Hana Polackova Brixi Council of Europe Press. (SeniorEconomist, PREM Sector Unit, East Asia Ma, Jun. 1994. "Intergovernmental Fiscal and Pacific Region). It is based on a policy note Relations: The Cases ofJapan and Korea." by Jun Ma (then Senior Economist, PREM Sec- Working Paper 41-1994. World Bank, Eco- tor Unit, East Asia and Pacific Region) and tech- nomic Development Institute, Washing- nical assistance work in China. The authors ton, D.C. received supportfrom the PREM Network's Qual- . Forthcoming. "Monitoring Fiscal ity ofFiscal Adjustment and Subnatioanal Regional Risks of Subnational Governments: Economics thematic groups and the decentral- Selected Country Experiences." In Hana ization and subnational economics team in the Polackova Brixi and Allen Schick, eds., EastAsia and PacificRegion's PREM Sector Unit. Government at Risk. New York: Oxford Uni- If you are interested in similar topics, consider versity Press. joining the Quality of Fiscal Adjustment The- Peterson, George. 1997. "Measuring Sub- matic Group (contact Craig Burnside, x39607) national Government Credit Risk and or the Subnational RegionalEconomics Thematic Improving Creditworthiness." World Group (contact Vivian Hon, x33429). For more Bank, Latin America and Caribbean information, click on Thematic Groups on Region, Urban Cluster, Washington, D.C. PREMnet. _ ~ iq _ _This note series is intended to summarize good practice and key policy find- *wm nnaings on PREM-related topics. The views expressed in these notes are those of the authors and do not necessarily reflect the views of the World Bank. PREM- P it' - ^r | notes are distributed widely to Bank staff and are also available on the PREM website (http://prem). If you are interested in writing a PREMnote, email your idea to Sarah Nedolast. For additional copies of this PREMnote please contact IblAR66SRsmal the PREM Advisory Service at x87736. Prepared for World Bank staff