Subnational Government, Infrastructure, and the Role of Borrowing and Debt

Abstract

This chapter addresses the role of subnational government (SNG) borrowing and debt management as the financing conduit for the provision of a nation’s investment in its public infrastructure. It begins with a brief review of recent literature on infrastructure deficit and the link between infrastructure services, economic growth, and development. It then describes intergovernmental organizational and institutional arrangements to promote efficiency in the allocation of scarce resources as well as satisfy the equity goal of matching the cost of using those resources to those who pay for them. Spatial considerations lead to the conclusion that SNGs must play a key role in infrastructure financing. And to play this role, the subnational sector must develop the capacity to take on and manage long-term debt. Having established this normative framework, the discussion turns to organizational and institutional arrangements that must be in place to enable a subnational government to carry out its capital financing and spending role. From there the chapter moves on to address financial risks related to SNG debt finance. Two appendices provide a summary of the intergovernmental fiscal rules for nine East Asian countries and the role of subnational borrowing and debt in China.

Appendices

Appendices

1.1 Appendix 1: Fiscal Rules for Central Government Enforcement and Monitoring Mechanisms SNGs

Country	Fiscal framework	Enforcement mechanisms
Australia	A cooperative approach. The Australian Loan Council, established in 1923, is a Commonwealth-state ministerial council that coordinates public sector borrowing. The Loan Council considers each jurisdiction’s borrowing for the forthcoming year with regard to each jurisdiction’s fiscal position and the macroeconomic implications of aggregate borrowing. State participation in the Council was initially voluntary. In 1927, the six states and the Commonwealth signed a financial agreement that granted the Council the authority to determine the amounts, conditions, and timing of all loans of the Commonwealth and the states.a	Market discipline. States may borrow on their own account; the Loan Council provides information to the financial market on public sector borrowing plans.
		Peer pressure. State borrowings do not have to be approved. However, the Loan Council places a high emphasis on the transparency of public sector finances, through financial market scrutiny of proposed borrowing to restrict borrowing to prudent levels.
China, People’s Republic	Limited fiscal autonomy. The 2015 Budget Law (Article 35) of the People’s Republic of China states that the provincial governments are authorized and allowed to issue bonds for the province and on behalf of municipal governments within the limits determined by the State Council. Debt incurred shall be accompanied by repayment plans and only used for expenditures under capital accounts. Unless otherwise explicitly stated in the law, no local government or department may provide guarantee for debt of any entity or individual in any form. Additionally, SNG does not have any repayment obligations to Local Investment Corporations, which are treated like SOEs. (Also refer to Appendix 2).b	Central enforcement rules. SNGs may not borrow from a financial institution such as a commercial bank. Nor, is an SNG authorized to go directly to the international capital markets. The MOF has the responsibility to establish accountability enforcement rules for SNGs and supervise local government debt but does not set budgetary assumptions. Bonds are issued subject to quotas approved by the State Council. The quotas are the amount of money in Renminbi (RMB)
		Administrative controls. All governments above the county level are to establish institutions to monitor and evaluate different kinds of debt risks including local government bonds and the contingent liabliities. Debt risks are defined by four levels, I–IV, with level IV most high risk.
Indonesia	Limited autonomy. Subnational governments in Indonesia can borrow from (i) the central government, (ii) other subnational governments, (iii) banks/financial institutions, (iv) non-bank financial institutions, and (v) the public (through the capital market, in the form of regional bonds). They may not, however, borrow directly from overseas sources. However, the central government may on-lend foreign loan (e.g., from international financial institution) to subnational governments via an agreement signed by the Minister of Finance and the respective Head of Region.	Administrative rules and regulations. Indonesian law stipulates three types of SNG debt (short, medium, and long term), each associated with an allowable source (type of lending) and stipulated use funds. Thus, an SNG can turn to banks, non-bank institutions, and other SNGS for short-term finance to cover cash flow shortages. Medium and long-term loans for financing non-revenue-generating public facilities may be sourced from banks, non-bank financial institutions, and the central government. To qualify for loans SNGs must meet several requirements such as consistence with regional government plans and debt service coverage ratios.
		Sanctions. Sanctions may apply if the form of postponement and/or cuts the Central Allocation Fund (CAF) grant and/or a CAF intercept for payment of debt service.
Japan	Limited SNG fiscal autonomy. The Local Autonomy Law authorizes borrowing by prefectures, cities, towns, and villages, Tokyo special wards, and local government cooperatives. The Prefecture is a central government administrative area (though with the prefect governor elected to a 4-year term). The local government (LG) debt is called chihousai, which is usually translated as local government bonds (LGB). There are four types of LG borrowing: private placement funds (commercial banks and non-bank institutions such as insurance companies); public (LG); borrowing from Japan Finance Organization for Municipalities (a quasi-public non-profit organization wholly owned by Japanese local governments), and national government funds (a source that has been of decreasing importance since the Treasury Investment and System Reforms of 2001).	Administrative procedures. An LG can issue bonds in its name, but the conditions of bond issuance are strictly controlled by the Central Ministry of Internal Affairs and Communications or the prefectural governor.
		Central/sovereign guarantee. The central government fully guarantees revenue sources to pay for the principal and interest of LGBs whereby payment is guaranteed through the Local Allocation Tax (grant) system. As such, LG debt has a history of creditworthiness and, with that, strong high ratings.c
Republic of Korea	Limited fiscal autonomy. Subnational governments must run balanced budgets. These are monitored and controlled by the Ministry of Government Administration and Home Affairs.	Peer pressure. Because all borrowing must be approved by the central government, the Ministry of Government Administration and Home Affairs has the responsibility of monitoring SNGs to ensure balanced budgets.
	Borrowing. All local borrowing must be approved by the central government.	Limitation. A debt ceiling is specified for each SNG; however, the central government may permit additional borrowing for specific projects even if they do not meet the criteria if it finds the additional debt can be serviced. However, debt repayment is one important factor considered by the central government before approval is granted.d
Malaysia	Asymmetry. The federal (central) government consults the National Finance Council in respect to the exercise of the states’ borrowing powers. Article 111 (2) of the Federal Constitution states that “A State shall not borrow except under the authority of State law, and State law shall not authorize a State to borrow except from the Federation or, for a period not exceeding 5 years, from a bank or other financial source approved for that purpose by the Federal Government.” Local governments borrow for special purposes relating to residential, commercial, and industrial undertakings, according to Section 46 of the LGA 1976.	Sanctions. If a local government defaults in paying back a loan, after 3 months of written demand by the lender, the affected lender may apply to the High Court to seek redress. Subsequently, the Court may order a levy on property in the local government area (which is to be enforced in like manner as any rate imposed by the local authority) and the proceeds paid to the Court for the lender. [(This is provided by Section 45(1) of the Local Government Act (LGA) 1976].
	However, Article 112b states that Article 111 (2) “shall not restrict the power of the Borneo states of Sabah or Sarawak (which are accorded higher degree of autonomy compared to the other 11 peninsular states) to borrow under the authority of State law within the State, if the borrowing has the approval of the Central Bank for the time being of the Federation”
New Zealand	Autonomy. Local authorities are required by law to set operating revenues at a level sufficient to cover operating expenses in any financial year (with a relatively narrow exception to run deficits). Local authorities are largely self-funded, and the central government has no formal role in reviewing or approving the budgets of local authorities	Market discipline. Subnational loans are not guaranteed by the central government
	Borrowing. No restrictions on borrowing
Thailand	Central permission. According to the Public Debt Management law (PDM 2005), local government organizations include Provincial Organization, Municipality, Tambon Organization, Bangkok Metropolitan Administration (BMA), Pattaya City, and other local government organizations established by the law	Administrative constraints. Unlike other local government organizations, the PDM law permits Bangkok Metropolitan Assembly and Pattaya City to issue bonds subject to clearance from the Ministry of the Interior. In practice, however, the clearance from the Ministry of the Interior is seldom granted as a way of limiting the degree of moral hazard which may arise if local government determine that they can borrow and easily receive support from the central government in the event of a default
	Source of funds. All tiers of local administration are permitted to borrow from “public and corporate agencies” subject to the approval of the Ministry of the Interior (MOI). (Vu 2019) A traditional source of borrowing for local governments is an MOI fund. A fund committee is chaired by MOI’s permanent secretary and is authorized to determine rules and criteria on the fund’s management and administration in respect to loan approval. Local governments are permitted to make applications to borrow for a 15-year term maximum below market interest rates from a central pool (Vu 2019).	Sanctions. There is a lack of clarity regarding punitive measures imposed on a local government that has a financial emergency.
	Purpose. Local government units (LGUs) can borrow for specific purposes including (i) investment, (ii) debt restructuring, and (iii) revolving fund. The borrowing must not create debt service of more than 10% of the LGU income. The law related to LGU borrowing is the Public Debt Management and Policy Committee’s regulation on LGU borrowing B.E.2561 (2018). They borrow mainly from SFIs such as Krung Thai Bank, Government Saving Bank, and Government Housing Bank.
Vietnam	Fiscal practice. In general, borrowing is restricted for financing capital spending at the provincial level as a golden rule. More particularly, however, the State Budget Law (SBL) provides for debt stock limits against decentralized revenue.	Administrative controls. The central government imposes a debt service limit of 10% against annual decentralized revenue (Decree 52, 2017).
	Sources of funds. Provinces can borrow from the following sources: (a) the State Treasury for short-term loans not exceeding 1 year; (b) on-lending from the central government of ODA funding; (c) the Vietnam Development Bank (VDB); (d) state-owned and commercial banks; and (e) bond issues to tap the capital markets. A large proportion is from the VDB, from the State Treasury, and from on-lending by the central government, with a small part (i.e., about 27%) supplied through the issue of municipal bonds and other sourcese(World Bank 2014).	The 2015 SBL and its guiding legislation as well as the Law on Public Debt Management are silent on recourse to ensure that, if a provincial government defaults on borrowings from other sources (such as commercial banks or capital markets), the lenders or financiers could recover them from the provincial budget. However, the Ministry of Finance has an informal recourse mechanism, which involves subtracting the amount of arrearages from the provincial government’s future budget allocations. It should be noted that advances from the state treasury are not legally regarded as borrowing or loans provided by the central government (i.e., the MOF) to the provincial government.f
		Escape clause. The SBL provides a formal enforcement procedure of the rules as well as possibility to violate the rules in special cases such as serious natural disasters or catastrophes.

1. ^aHulbert and Vammalle (2016)
2. ^bEmail correspondence with Baoyun Qiao (4.2019), Quanshe Yang (4.2019), and Xu and Yang (2015)
3. ^cEmail correspondence with Natsuko Kikutake, World Bank Country Team, January 18, 2019
4. ^dChoi, Choe and Kim (2013)
5. ^eWorld Bank (2014), Correspondence with Quyen Hoang Vu, World Bank Country Team. January 17, 2019
6. ^fCampanarom and Dang (2018)

1.2 Appendix 2: The Evolving Role of China Local Investment Corporations and SNG Borrowing and Debt

• The People’s Republic of China is structured as a hierarchy of five tiers: (i) central; (ii) 28 provinces (the 28 include 5 autonomous regions and Taiwan) plus, in this same second tier, 4 provincial-level municipalities and the Hong Kong Special Administrative Region (HKSAR) and Macao Special Administrative Region; (iii) 334 prefecture subordinate to the 22 provinces; (iv) 2851 counties, county-level cities, and urban districts that are subordinate to both the prefectures or the provincial municipalities; and (v) 39,888 townships/town/street communities subordinate to the counties. The four provincial-level municipalities are Beijing, Shanghai, Tianjin, and Chongqing.

• The 1994 Budget Law prohibited all subnational government (SNG) borrowing without explicit permission from the State Council. To circumvent this rule, starting in the 1980s, SNGs, mostly provincial, began setting up Local Investment Corporations (LICs). These first LICs were limited in scope as their revenues were restricted to generating monies from operating toll roads and utilities.

• At first the LICs were limited scope. Then, in 1992, Shanghai created a broad-based investment corporation, the General Corporation of Shanghai Municipal Property (SMPC), assigning a variety of fiscal funds to the SMPC from the municipal budget and then authorizing the SMPC to borrow.

• Other SNGs (provinces, prefectures, counties) quickly followed the SMPC approach to finance universities, schools, hospitals, airport subways, museums, and sports facilities and, too, support for private development. At first, it all looked promising.

• But, concerns were growing: (i) the collateral for the LIC debt is that of SNG-owned and SNG-managed land; thus, (ii) to increase their borrowing collateral, the SNGs began exercising their power of rezoning rural to urban land and reaping the appreciation due to the rezoning; and (iii) much of all of this is off-budget.

• Then came the fiscal crisis of 2009–2011, and as part of a national fiscal stimulus policy, the People’s Bank of China and the China Banking Regulatory Commission (CBRC) encouraged SNGs to borrow for infrastructure (job, growth creating) spending. And, with that, LICs proliferated. As of the end of December 2017, there were 9185 LICs nationwide. Before 2009 the LICs had accumulated ¥5trillion in bank loans; and, in 2009 alone, they took on another ¥3trillion. As of June 2013, the National Audit Office (NAO) estimate is ¥17.9 trillion (a 70% increase from between 2010 and 2012). More than 40% of local government borrowing has been through non-bank institutions (e.g., securities, firms, insurance and leasing companies).

• All this occurred with little supervision, prompting the National Development and Reform Commission (formerly the State Planning Commission) to issue a warning that the system was one that had “no funding framework, no limit, and no accountability” (NDRC 2010 as cited in Xu and Yang, 2015).

• The central government turned to the National Audit Office (NAO) to audit all SNGs (five levels). The key findings of the NAO audit were released in December 2013 with the NAO conclusion that the rapid increase of local government debt levels is “under control” but that there are “potential risks in some places” (Thomas Mitchell, Financial Times, 12.30.2013). The NDRC and NAO reports led to an overhaul of borrowing and debt risk management policies.

• The 2015 Budget Law (approved by the National People’s Congress in, August 2014) newly permits “provincial governments the authority to issue bonds, subject to central government approval for financing only capital projects.” Provincial governments can borrow for themselves, and also on behalf of local governments and municipal governments (Xu and Yang 2015). The province may also deny the local government to issue debt (bonds).

• The Opinions on Strengthening Management of the Local Government Debts (Document No. 43, October 2014) dictated local governments to separate the LICs from the Council. The LICs were unauthorized to borrow for the government; hence only governments and its departments are authorized to borrow. (“Close the back door.”)

• In May 2017, the Notice on Further Regulating the Borrowing of the Local Government enacted by the Ministry of Finance stated that the reserve land are not allowed to be injected into the LICs as asset and the LICs were forced to change their roles they have been taking as the financing platform for local government. By the end of 2017, 2549 LICs had been removed by CBRC from the management and no longer serve as investment financing vehicles for local governments.

Sources: Yang, Quanshe Yang, Capital University of Economics and Business, emails of April and May 2019; Yang, Quanshe, Dong Zhang, and Hang Qi (January 2019), China’s Fiscal Rules. Working Paper, Capital University of Economics and Business; Lam and Wang (2018); Wong (2013) in Bahl et al. (2013), WB 2012; Mitchell (Financial Times, 12.30.13). Note: The CBRC was transformed to the China Banking and Insurance Regulatory Commission (CBIRC) in March 2018.