6

# **Box 1:  Brazil States Debt Crisis and Reforms**

Brazil has substantially strengthened ex ante regulations in response to repeated waves of subnational debt crises. Statutory controls on subnational borrowing have always existed in Brazil—controls on new borrowing and on the total stock of debt, expressed as percentages of revenue. But they had loopholes, and SNGs had been creative in evading them. The regulations were strengthened in the late 1990s, leading to the unifying framework in 2000. The federal government bailed out subnational debtors in earlier crises, but the resolution of the third debt crisis in 1997 was conditioned on states undertaking difficult fiscal and structural reforms. The avoidance of unconditional bailouts in 1997 was to resolve moral hazard. The strengthened ex ante borrowing regulations were embedded in the debt restructuring agreements between 25 states and the federal government in 1997, sanctioned by legislation. The Fiscal Responsibility Law in 2000 consolidated various pieces of legislation into one unifying framework.

Source: Dillinger (2002). Webb (2004).

Legal and regulatory frameworks for SNG debt financing serve as a commitment device to allow SNGs to access the financial market within a common framework. An individual subnational government may adopt unsustainable fiscal policies for a variety of reasons. Inherent incentives exist for a subnational government to free-ride—it bears only part of the cost of unsustainable fiscal policies, but it alone receives all benefits. Realizing these benefits depends on good fiscal behavior by most of the other SNGs. So collectively governments benefit from a system of rules to discourage such defection and free-riding. This commitment device controls and coordinates SNGs across space in various localities and across time to commit future governments to a common borrowing framework (Webb 2004).

# **_Developing regulatory frameworks_**

The motivations for developing regulatory frameworks differ significantly across countries, reflecting a country’s political, economic, and legal and historical context, which in combination with triggering events results in country-specific motivations. These differences affect the entry point for reform, the framework’s design, and its relation to subnational borrowing legislation. In particular, the frameworks for SNG debt financing and restructuring define the respective roles of different branches and tiers of the government, and a country’s political and economic history plays a key role in shaping the design.

For example, Chapter 9 of the Bankruptcy Code in the United States (1937) was conceived with the narrow objective of resolving the holdout problem,<sup>14</sup> against the background of a mature intergovernmental fiscal system and a market-oriented financial system. Although the U.S. system offers a valuable reference, it cannot be copied without care. The Municipal Finance Management Act of South Africa (2003) was intended to address a number of challenges including the development of a diversified and competitive subnational credit market. The

> 14 Holdout problem occurs when individual creditors who have different interests and security provisions for the debt owed to them and may often demand preferential treatment and threaten to derail debt restructurings voluntarily negotiated between a majority of creditors and the subnational debtor.  See McConnell and Picker (1993)