# **1. Introduction**

Three factors have propelled the growth in subnational capital markets in developing countries since the 1990s and will drive their future growth.<sup>2</sup> First, decentralization in many developing countries has given subnational governments significant spending responsibilities and taxation power and the capacity to incur debt. Second, large infrastructure projects in developing countries increasingly tap into capital markets for financing.<sup>3</sup> Third, liquidity and growing mobility of international capital across national borders have lowered the cost of borrowing and thereby strengthened financing opportunities for infrastructure.<sup>4</sup> This growth in subnational credit markets displays two distinct features. First, subnational bonds have become an increasingly important source of funding competing with traditional bank finance. Second, private capital has emerged to play an important role in subnational finance in countries such as Hungary, Mexico, Poland, Romania, and South Africa, and a dominant role in Russia, though public institutions continue to dominate subnational lending in a number of countries such as Brazil and India.

Yet, growth in subnational bond markets in developing countries has not been steady. Annual volume gradually increased from US$5.7 billion in 1992 to US$22.2 billion in 1995, to be followed by a general downward trend to US$3.5 billion in 2001.<sup>5</sup> Since 2001, growth in subnational bond markets has picked up in emerging markets such as Russia, Mexico, Poland, and Romania.<sup>6</sup> Notwithstanding the recent revival, the availability of credits to subnational governments remains limited to top-tier subnational governments. By developed country standards, the market was small even at its growth peak. In the United States, US$400 billion subnational bonds are issued per year on average.<sup>7</sup> In contrast, 19 Mexican subnationals issued US$1.44 billion bonds over the period 2001-2005. In Colombia, only the capital Bogota accessed the capital market from 2003-2006.

> 2 The term subnational refers to all tiers of government and public entities below the federal or central government. Subnational entities include states/provinces, counties, cities, towns, public utility companies, school districts and other special purpose government entities which have the capacity to incur debt.   The term subnational capital market refers to both the banking system and the bond markets.

> 3 Infrastructure networks benefit future generations as well; thus sound public policy demands that the financing of infrastructure networks be shared by future generations through matching repayment of debt financing with maturity of assets.

> 4 See Eddy and Richter (2000), at 9-10 on international capital financing of subnationals.

5 Subnational bonds issued bond issues outside Canada, Europe and the United States were $5.7 billion in 1992, $9.4 billion in 1993, $12 billion in 1994, $22.2 billion in 1995, $12.7 billion in 1996, $4.3 billion in 1997, $4.4 billion in 1998, $1.5 billion in 1999, $6.4 billion in 2000, $3.5 billion in 2001. The 1990s therefore saw huge positive, but also strongly negative growth rates (Source: Thompson Financial) Securities Data).

6 The Russia sub-sovereign bond market has grown vigorously since its re-emergence in 2001 and has now become the largest sub-sovereign market among emerging economies with US$5.6 billion bonds outstanding as of June 2006 (Noel, Kantur, Krasnov, and Rutledge, 2006).

7 In January 1, 2006, subnational bonds outstanding reached US$2.26 trillion. This represents close to 10 percent of the US domestic bond market and 26 percent of all US public sector bonds (authors calculated based on World Bank 2006). The figure of US$400 billion issues is from Petersen (2005).

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