31. The second possible source of moral hazard originates from the des]ign and modalities of implementation of specific components of the inter-governmental transfer system, namely deficit grants, capital grants, and transfer intercept arrangements.

_32. Deficit grants_ are allocated by the central government to local governments facing an unexpected deficit "through no fault of their own". In theory, these grants will not generate moral hazard if their allocation rules are rational, transparent and strictly adhered to by the authorities. However, in many countries, allocation rules foir deficit grants lack transparency, leading to rent-seeking on the part of sub-national governments, and contributing to a softening of their budget constraint.

33. _Capital grants_ may also be a source of moral hazard depending on the type of grant concerned and on the modalities of their implementation. Unconditional block grants, that are allocated for general budget support on the basis of objective socio-economic criteria and are not conditional upon the undertaking of a specific investment project do not constitute a source of moral hazard. By contrast, as mentioned above, conditional matching grants may be a source of moral hazard due to the ex-post conversion risk that is inherent in these types of grants. To the extent that there are deficiencies in the monitoring system for these grants, sub-national authorities may have an incentive to use the proceeds of the grants for purposes other than those intended by the central government. This risk is further intensified in cases where there is no distinction between capital and recurrent expenditures in sub-national budgets, as is often the case in developing and transition countries. In these circumstances, conditional matching grants may lead to a softening of the budget constraint for sub-national entities, and therefore contribute to moral hazard on the sub-national finance market.

34. _Transfer intercepts_ are arrangements under which sub-national borrowings are serviced directly by the central government, or under which a lender can seek payment from the central government for an overdue obligation by a sub-national borrower. In both cases, the payment by the central government to the lender is deducted from the transfer payment from the central government to the sub-national entity. These arrangements are generally appealing to lenders because they provide a strong security for their loans to sub-national entities. However, they also have several shortcomings. First, in the presence of an intercept, lenders may have a tendency to relax their credit criteria and their monitoring of sub-national borrowers since they know that they will be repaid irrespective of the quality of the risk taken and irrespective of the performance of the borrower. Second, because transfer intercepts are captured by the central government at the source, they tend to blur the perception of the debt burden by the sub-national entity, and they may reduce debt discipline. In many cases, sub-national entities only perceive fluctuations in the transfer payments from the central government, and they do not correlate these fluctuations with an intercept by one of their lenders. Third, in case of a default by a large sub-national entity, the central government will be under strong political pressure not to apply the intercept, because the contraction of local services that would result from the application of the intercept would be politically unbearable. If the central government suspends the application of the intercept, or applies it only partially, the credibility of the intercept system is damaged and moral hazard is generated.

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