Subnational bond markets in emerging economies remain thin for a number of reasons. As highlighted by the World Development Report (2000), subnational debt is “one of the thorniest issues for decentralization, with many potential pitfalls.” Obstacles range from incomplete decentralization, which limits a subnational’s own-revenue capacity, to a lack of transparency in fiscal accounts, which makes it difficult to evaluate subnational creditworthiness. Furthermore, several emerging economies have restricted subnational borrowing after experiencing subnational or national debt crises.<sup>8</sup> Such tightening is part of broader ongoing efforts to develop a sound regulatory framework to tackle subnational debt crises.

Several major emerging markets experienced subnational debt crises in the 1990s. Newly decentralized countries face similar risks. To many observers run-away provincial debt in the Provinces of Mendoza and Buenos Aires was a major factor behind Argentina’s sovereign debt default in 2001. Brazil experienced three subnational debt crises in the 1980s and 1990s. In India, many states experienced fiscal stress in the late 1990s to the early 2000s, with a rapid increase in fiscal deficits, debt and contingent liabilities. The 1995 Tequila crisis in Mexico exposed the vulnerability of subnational debt to the peso devaluation and led many Mexican subnationals into debt crises. In Russia at least 57 out of 89 regional governments defaulted over 1998 - 2001.

Subnational insolvency is a reoccurring event in development.<sup>9</sup> In 1842, eight US States and the Territory of Florida defaulted on their debt and three other States were in perilous financial condition (Wallis, 2004). During the Great Depression, 4,770 local governments defaulted on US$2.85 billion of debt. By 1933 over 16% of the U.S. municipal market was in default (Maco, 2000). As capital markets and their regulatory framework matured, defaults by US subnationals became less frequent. Yet crises continue to occur. Prominent examples include the fiscal crisis of New York City in 1975, the default on US$2.25 billion in bonds of the Washington Public Power Supply System in 1983, and the bankruptcy of Orange County in 1994 and the District of Columbia in 1995.<sup>10</sup> There have also been cases of local government financial distress in Japan and Western European countries.<sup>11</sup> The perils of subnational insolvency are serious. At a minimum, provision of local public goods and services may be severely impaired. When New York City was in fiscal crisis in 1975, essential services such as fire protection, police patrols, garbage collection, and schools were cut back. Maintenance on bridges and roads was postponed. Many capital

> 8 For a survey of recent developments in controlling subnational borrowing in several emerging economies, see Liu and Waibel (2006).

> 9 This paper uses insolvency and bankruptcy interchangeably. Both refer to the financial condition of a particular subnational entity. We add “mechanism” or “procedure” to refer to the legal framework. 10 Cf. District of Columbia Financial Responsibility and Management Assistance Act (Public Law 104-8), April 17, 1995.  Spiotto (1984) lists 6,195 defaults on US municipal bonds from 1839 to 1969.

> 11 Moody’s (2002) eight subnational default studies covering France, Italy, Switzerland, the UK, Argentina, Brazil, Mexico and Russia provide quantitative and qualitative evidence of a limited number of documented defaults and numerous cases of non-payment and distressed exchanges. Sars (1999) provides evidence on Western Europe, at 1-2 (“As illustrated by these cases, local governments sometimes do face financial distress despite the strength and stability of the underlying local government system”).  For a discussion on Japan local debt, see Schwarcz (2002).

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