16 decentralization and urbanization are likely to continue with force with the need to finance urban infrastructure investments.

Unlike the 1990s when subnational debt crisis affected major developing countries, SNGs in various major developing countries entered the current global financial crisis with stronger liquidity and fiscal positions, as a result of the reforms in fiscal rules and regulatory frameworks established in these countries.<sup>38</sup> However, there are continuing pressures on subnational finance – from the uncertainty of the global public debt market, potential risks of rising cost of capital, fragility of global recovery, and currency uncertainties and associated refinancing risks (Canuto and Liu, 2010b).

There are also risks of increasing contingent liabilities. As a result of debt limitations that have been imposed on SNGs, shifting borrowing off budget may become a convenient way of circumventing fiscal rules. To cope with rising demand for infrastructure, given the limited fiscal space, various forms of infrastructure investing become tempting: public private partnerships, special purpose vehicles, and off budget financing.

A range of middle income countries and low income countries with transition to market access are also contemplating expanding subnational borrowing and debt financing. Before doing so, the first priority should be to establish clear fiscal rules for SNGs specifying the type and purpose of borrowing, the procedural steps for contracting debt, any limitations on borrowing, and control and accounting for off-budget liabilities.

Ex post insolvency mechanisms are also essential to the sustainability of SNG debt financing. Even if rarely invoked, they shape expectations about defaults and allow and encourage the stakeholders to resolve subnational financial distress efficiently. Notwithstanding the fiscal problems of a particular SNG, an effective insolvency system helps maintain access of other SNGs to the public finance markets. Clear and predictable rules on priority of repayment ease the struggle and allow faster resolution of financial distress. Effective insolvency and creditor rights systems allow better management of financial risks.<sup>39</sup> Managing subnational default risks is intertwined with broader macroeconomic and institutional reforms. Macroeconomic stability and sovereign strength cap the financial ratings of SNG, and thereby determine the availability and cost of funds for SNGs. Moreover, the intergovernmental fiscal system underpins the fundamentals of the subnational fiscal path. Without increased fiscal autonomy and greater own-source revenues, SNGs will rarely be in a position to borrow sustainably on their own. Furthermore, to manage default risks is not to minimize SNG access to debt financing. On the contrary, developing a competitive and diversified subnational credit market is critical to intermediating national savings and infrastructure financing. Thus an

> 38 In Brazil, SNGs’ net debt as a percent of GDP decreased from 18 percent in 2003 to 14 percent in 2007. In India, the fiscal deficit of states declined from 4.0 percent of GDP on average in 2000–05 to 1.5 percent in 2007–08; and states achieved positive operating balances.  In Colombia, gross debt as share of GDP for subnational governments declined from 3.6 percent in 2001 to 1.42 percent in 2008. Sources: government Websites.

> 39 The World Bank (2005) addresses creditor rights and insolvency standards in the context of corporate bankruptcy. Key principles apply to the subnational context, bearing in mind the differences between public and private bankruptcy.