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# **1. Introduction**

State and local government debt and guarantees for quasi-public agency debt have been growing in importance in developing countries. In Brazil, subnational debt accounts for about 30 percent of total public sector net debt.<sup>2</sup> The debt of Indian states is about 27 percent of GDP.<sup>3</sup> Subnational debt financing has been historically important in the United States, with outstanding subnational debt at US$2.36 trillion at the end of 2009.<sup>4</sup> The increasing share of subnational debt of the consolidated public debt is not limited to federal countries. In China, urban investment companies have been borrowing from financial institutions to finance large-scale infrastructure investments.<sup>5</sup> In France, a unitary country, subnational governments (SNGs) account for over 70 percent of public investment.

The increasing importance of subnational debt is due to, _inter alia,_ increasing decentralization of spending responsibilities, taxation power, and borrowing capacity to SNGs. The unprecedented scale of urbanization in developing countries requires large-scale infrastructure investment financing to absorb massive influxes of rural population. Subnational borrowing finances infrastructure more equitably across multi-generational users of infrastructure services, as maturity of debt service paid for by the beneficiaries can match the economic life of the assets that the debt is financing. In practice however, SNGs in some countries also borrow for current expenditures.

With subnational borrowing come the risks of subnational insolvency.<sup>6</sup> Systemic subnational insolvency may impede the growth of subnational capital markets, curtail fiscal space for infrastructure investments, and threaten the financial stability and core public services. Additionally such situations may create pressures on the central government to provide financial assistance to assure the continuing provision of essential public services. More autonomy for SNG increases the need for strong regulation for fiscal responsibility. During the 1990s there were widespread subnational debt crises in countries such as Argentina, Brazil, Mexico and Russia, which have led to reforms to strengthen regulatory frameworks for subnational borrowing and insolvency.

The global financial crisis has had a profound impact on subnational finance across countries (Canuto and Liu, 2010a). Subnational finances deteriorated across a broad range of advanced, middle income and low income countries, although the degree of impact has varied. Rating agencies viewed the impact of economic downturn on the credit qualities of SNG as significant due to declines in the tax base, expenditure pressures or rigidities, and increasing and more

> 2 The term _subnational_ in this paper refers to all tiers of government and public entities below the federal or central government. Subnational entities include states, counties, cities, towns, public utility companies, and other specialpurpose public entities that have the capacity to incur debt.  In Brazil, net debt is the difference between the gross debt and assets.  Data as of December 2009 (www <u>.bcb.gov.br/?FISCPOLICY).</u>

> 3 As of December 2009 <u>(www.rbi.org.in). The debt number would be higher if debt on the balance sheets of</u> companies such as power and water, which are wholly or largely owned by the states, is included. 4 <u>www.federalreserve.gov.</u>

> 5 Liu (2008).

> 6 In a legal sense, _subnational insolvency_ refers to the inability to pay debts as they fall due; however, details of the definition of “insolvency” vary across countries. In addition to default (failure to pay according to the terms of the debt instrument), insolvency is characterized by a genuine, and not merely temporary, shortfall of resources to service debt. See Liu and Waibel (2009).