exempt for a while. And local governments had been creative at exploiting the loopholes. In the spectacular debt crisis of the 1990s, state governments simply stopped servicing their debt, allowing interest to capitalize to immense proportions. On several occasions, the federal government bailed out states and municipalities. From the late 1980s to 1990s, the federal government restructured subnational debt three times.

In the subnational debt crises in the 1980s and the early 1990s, the central government bailed out insolvent subnational entities. The first subnational debt crisis was a legacy of the international debt crisis of the 1980s, when states, along with the federal government, ceased servicing their debt to foreign creditors. After the federal government reached agreement with the creditors, in 1989, the federal government consolidated accumulated state and municipal arrears and remaining principal into a single debt to the federal government. US$19 billion was rescheduled. The second crisis involved debt owed by the states to federal financial institutions. In 1993, the federal government refinanced debt amounting to US$28 billion. The third and largest debt crisis was resolved through the conditional bailout of the federal government in 1997. The federal government restructured the states’ debt, equivalent to 11.5 percent of GDP. However, the central government’s restructuring was conditioned on states fiscal reforms. This adjustment program tackled the root causes of fiscal insolvency. It aimed at instilling fiscal transparency and essentially imposed a fiscal and debt adjustment package.

With the first two debt workouts, the federal government tightened regulations on state borrowing. These efforts turned out to be insufficient. The 1997 debt workout was conditioned upon each state’s compliance with a fiscal and structural reform program. The motivation for the conditional bailout was to resolve the moral hazard associated with unconditional bailouts. In exchange for the rescue package, the federal government negotiated agreements with 25 States in 1997 and 1998.<sup>42</sup> These agreements were sanctioned by Law 9496 of September 1997.

Law 9496 established a comprehensive list of fiscal targets: a debt/revenue ratio, primary balance, limits on personnel spending, own-source revenue growth, investment ceilings, and a list of state enterprises to be privatized or concessioned. Each State had to agree to such targets in exchange for financial relief. Crucially, the debt adjustment agreement collateralized resources for debt service and threatened withholding central government transfers in case of breach. Subsequent Senate Resolution No. 78, 1999 imposed fixed ceilings on new borrowing, debt servicing, and the stock of debt. All these controls were strengthened by the 2000 Fiscal Responsibility Law which consolidated many restrictions and regulations into one unifying framework.<sup>43</sup>

# **2.5 Albania, Bulgaria, and Romania**

A group of Central and Eastern European Countries – Albania, Bulgaria, and Romania – represents another set of interesting cases. These countries see a subnational borrowing

> 42 Only two States (Tocantins and Amapá) did not have any bonded debt, and hence did not participate in the refinancing agreements.

> 43 For a detailed survey of the Brazilian subnational borrowing legislations, see Liu and Waibel (2005).

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