3 expensive debt.<sup>7</sup> With the fragility of the global recovery and increasing public debt, it becomes even more important to prudently manage subnational default risks. Beyond the current crisis, the structural trends of decentralization and urbanization are expected to continue with force, requiring prudent management of subnational default risks.

This paper draws lessons that may be gleaned from previous episodes of subnational financial distress and their interaction with sovereign defaults. We pay particular attention to the legal and institutional principles underpinning the debt restructuring and fiscal adjustment process in subnational insolvency proceedings. Looking across countries, regulatory frameworks for subnational insolvency share central features, though important variations are explained by the historical context and entry points for reform. An important objective of the regulatory framework is to address soft budget constraint and the problem of overgrazing of the common resources by SNGs. While fiscal rules for SNG or ex ante regulation attempt to limit the risk of subnational defaults, ex post regulation predictably allocates default risk, while providing breathing space for orderly debt restructuring and fiscal adjustment, as well as the continued delivery of essential public services. However, ex ante and ex post regulatory systems alone cannot assure the sustainability of SNG debt. Intergovernmental fiscal systems and financial market development, though outside the scope of this paper, are equally important.

The rest of the paper is structured as follows. Section 2 presents the motivation and rationale for regulating subnational debt financing. This motivation is country-specific and shapes the design. Section 3 summarizes regulatory frameworks for subnational borrowing based on cross-country experiences focusing on fiscal rules for SNG with respect to debt issuing procedures, specifying purpose, types, amount, and procedures of debt financing. Section 4 explores the key issues in designing insolvency mechanisms, encapsulated in the trade-off between protecting creditor’s contractual rights and maintaining minimum public services. Section 5 presents concluding remarks and draws policy lessons.

# **2.  Rationale for Regulating Subnational Debt Financing**

The development of regulatory frameworks for subnational debt financing in developing countries such as Brazil, India, Mexico and Russia has been in response to the subnational fiscal stress and debt crises there of the 1990s. Some newly decentralizing countries such as Peru developed SNG debt financing frameworks while initiating decentralization based on lessons learned from other countries on the fiscal risks associated with decentralization. Developed countries such as France and the United States have had their own experiences of subnational insolvency which led to the establishment of systems to regulate the risks.

# **_Subnational debt crises_**

Although expenditure-revenue imbalances may cause the development of subnational fiscal stress, the regulatory framework for debt financing profoundly affects the fiscal sustainability of SNG, because accumulation of the fiscal deficits is feasible only when they have been financed. Such financing can take multiple forms, including direct borrowing as well as running arrears.

7 Fitch 2009, Moody’s 2010, S&P 2010.