projects were delayed or cancelled.<sup>12</sup> Beyond local service delivery, systemic subnational insolvency may impede the growth of subnational capital markets, curtail fiscal space for infrastructure financing, and threaten macroeconomic and financial stability.

These perils have led many developing countries to search for the “right” subnational borrowing framework (Liu and Waibel, 2005; Webb 2005). However, cross-country experiences suggest that ex-ante subnational borrowing regulations need to be complemented by ex-post mechanisms for insolvency resolution. Ex-ante limits on subnational fiscal indicators (such as balanced budget rules, limits on the ratio of debt over gross subnational domestic product (GSDP), and debt-service ratios) are not sufficient.<sup>13</sup> Many countries lack robust mechanisms to resolve subnational financial distress efficiently and fairly.<sup>14</sup> Several arguments favor ex-post subnational insolvency mechanisms. First, insolvency mechanisms discipline debtors and creditors, structure negotiation and encourage collective action.<sup>15</sup> Second, insolvent subnationals are put back on a sustainable fiscal path to guarantee public service delivery. Third, restoring subnational sustainability serves creditors collectively. Fourth, protecting creditor rights helps nurture embryonic capital markets. Fifth, clarity in default helps improve creditworthiness of subnational entities and enable subnational entities to reenter the capital market for financing infrastructure. A well-designed workout procedure results in equitable debt collection for creditors, while lowering the costs of borrowing and creating fiscal space for infrastructure investment.

This paper surveys mechanisms for the resolution of subnational insolvency in selected countries. It fleshes out basic concepts and highlights transferable features. Focusing on the experiences of Brazil, Bulgaria, Hungary, Romania, South Africa and the United States, we draw lessons for tailoring subnational insolvency mechanisms to countryspecific circumstances. Although there are individual country case studies,<sup>16</sup> the literature lacks a cross-country survey. This paper seeks to fill this gap. Comparison of country experiences draws out core design issues concerning subnational insolvency 12 Bailey (1984).

> 13 Interestingly, Germany, whose subnationals have traditionally relied on bank financing, is actively exploring a subnational workout procedure because of the difficult financial position of many municipalities. See Paulus (2003), and Wissenschaftlicher Beirat beim Bundesministerium für Finanzen (2005).   The German Constitutional Court’s judgment of October 19, 2006, denying that Berlin is in a situation of extreme financial distress, will provide additional impetus for the development of subnational insolvency procedures in German (BVerfG, 2 BvF 3/03, Oct19 2006, available online. <u>http://www.bverfg.de/entscheidungen/fs20061019_2bvf000303.html).</u>

14 The United Nations Commission on International Trade Law (UNCITRAL) Guide on Insolvency (2004), which lays down recommended principles for corporate insolvency law, does not cover public entities (states and subnationals). Due to a lack of international consensus, the guide has so far refrained from recommending the introduction of insolvency procedures for municipalities. In Europe, the Council of Europe recommended already in 1996: “The competent authorities should clearly state the consequences in the event of local authority insolvency.” 15 For insolvency law exercising as a disciplining function, see Paulus (2006).

16 For example, McConnell and Picker on the United States (1993), Jokay, Szepesi, and Szmetana on Hungary (2004), and Glasser on South Africa (2005). Schwarcz (2002) compares the U.S. and Japan.

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