Fiscal discipline in large federations is a particularly complex issue, and this is obviously also the case in Latin America (Brazil, Mexico, Argentina…). Let me point out two reasons for introducing today the topic into our discussions on Latin American macroeconomics:
- The steady decline in market interest rates in Brazil has sparked some discussion on the hypothesis of sub-nationals resorting to market finance as a means to repurchase their debt held by the Federal government since the sub-national debt-restructuring agreements sponsored by the National Treasury in 1997-2000.
- George Peterson and Patricia Clarke Annez, both from the World Bank, launched last month a book on Financing Cities: Fiscal Responsibility and Urban Infrastructure in Brazil, China, India, Poland and South Africa, in which a very useful comparative exercise is offered on how these countries have addressed the tension between two key policy issues: the need to boost urban infrastructure investment levels and the need for appropriate fiscal management across all levels of government, all in a context of decentralizing service delivery responsibilities.
Tragedy of Commons and the Risk of Empowering Sub-Nationals
Federative states are riddled with a potential “tragedy of commons” problem in their fiscal management. As in the classical case of environmental problems that tend to rise when the absence of clear property rights can lead to an exhaustion of natural resources, because individuals rush to carelessly exploit the latter and collectively end up crossing sustainable limits of usage, there is a “collective action problem” when federative units individually face too soft budget constraints. If sub-national entities attribute a reasonable probability of being rescued by the central government if they face financial hardships, the temptation to adopt fiscal laxity will be high, as the onus will be shared with others. Exhaustion of fiscal space and a chronic tendency to display fiscal crises become a norm in such cases, as it has often occurred until recently in most Latin American large countries. The issue has acquired increasing relevance as many have recognized the benefits of decentralization of decisions and implementation in several spheres of public action. However, moving down the road of empowering sub-national governments also increases the risk of generating a fiscal “tragedy of commons”. There are basically two ways to mitigate those risks of fiscal collective action problems as decentralization takes place. One is in fact to limit partially the decentralization of responsibilities by combining it with top-down “command-and-control” types of policies: administrative controls and federal laws ruling the behavior of sub-nationals. The other one is to make full the alignment of costs and benefits of decisions at the sub-national level, with the federal government establishing some credible “no-bail-out” commitment. Only with such a credible pledge, financial markets can establish the discipline of hard budget constraints to sub-nationals. It is worth noticing that the option of aligning costs and benefits is not incompatible with transfers of funds among government units, a feature likely to be present in countries marked by wide regional economic inequality and/or federally based tax systems. The alignment is feasible as long as those transfers of funds are rule-based and the “no bail out pledge” is credible. The book edited by George Peterson and Patricia Clarke Annez compares the national frameworks built by China, Poland, India, South Africa and Brazil to balance fiscal discipline and local investment needs. Administrative controls (command-and-control policies) feature strongly in India, China and Brazil, whereas “a variety of institutions – including the financial sector, the courts and Constitutional prohibitions – are used to establish financial discipline in sub-national governments” in South Africa and Poland (p.29). Brazil is singled out as an extreme case of risk aversion in its treatment of municipal – and state-level – access to financial markets, as well as of high reliance on centralized administrative controls. The bluntness of the severance between market finance and sub-nationals that has prevailed in Brazil since the end of the 1990s is considered by the editors as an undesirable feature: “That the outcome is one in which local governments are blocked from tapping private savings through capital markets is unfortunate. (…) Inability thus far to break with the past practice of co-mingling sub-national and central government credit risk has kept a useful source of finance beyond the reach of municipalities. As a result, there is no scope for the extra fiscal discipline that capital markets and intermediaries could exercise with local governments, and institutional capacity in this area has declined” (p.35) According to this interpretation, while on the one hand the “fiscal responsibility framework” erected in 1997-2000 in Brazil has exhibited high effectiveness in terms of extracting fiscal results, on the other, as a downside, it would be trapping the Brazilian fiscal system far short from more efficient decentralization paths.
Using Straitjackets to Enforce Fiscally Appropriate Behavior
Chapter 1 of the book, written by Luiz de Mello, from OECD, offers an accurate treatment of the Brazilian Fiscal Responsibility Framework and the place of local governments in it. This framework has been at the heart of the sea change in Brazil’s fiscal landscape since its installment, with sub-national governments contributing to the generation of fiscal primary surpluses and, more recently, to decreasing public sector consolidated debt-to-GDP levels. Three elements of that framework must be recalled: (A) The sub-national debt-restructuring agreements sponsored by the National Treasury in 1997-2000. They constituted a break from the tradition of previous bailing outs of regional governments, as they strengthened “federal control over sub-national finances through the introduction of explicit, legally binding sanctions for non-compliance and the use of shared revenue as collateral for the servicing of restructured debt” (p.48-49). The agreements were bundled with privatization or closure of existing instruments (sub-national public-sector-owned banks and non-financial enterprises) by which sub-nationals, prior to the debt restructuring, could avoid fiscal discipline. Minimum levels of commitment of local net revenues to service the federally absorbed debt were also included. (B) The introduction of caps on personnel outlays as a first step towards rules-based rationalization of sub-national spending. (C) The enshrinement of the institutional set-up in the Fiscal Responsibility Law enacted in 2000 (a general framework for budgetary planning and execution, provisions on indebtedness, transparency in fiscal reporting etc.). This Law, combined with Senate resolutions, has made possible the determination of debt ceilings: states have been given a time schedule to comply to an obligation of keeping debt below the equivalent amount of two-times their net revenues, whereas the corresponding cap is 1.2 in the case of municipalities. In fact, the round of debt-restructuring agreements already contained even more stringent limits, also prohibiting sub-nationals from issuing debt during the effectiveness of the 30-year debt refinance. The rationale for the radical nature of Brazil’s fiscal adjustment is easy to understand. Imposing straitjackets on sub-nationals came as an unavoidable measure, given the historical track record of fiscal laxity; the fact that sub-national debt levels had risen substantially as a result of high interest rates prevailing during the 1994-98 exchange-rate based anti-inflation program; the clear move to lower debt-tolerance abroad; as well as the widespread existence of channels through which sub-nationals could evade fiscal discipline until then. As one might expect, results have not been perfectly homogenous and some states are still over the upper debt limit. But overall the trend has been downwards and the effectiveness of the fiscal responsibility framework – maintained in President Lula’s posterior government – has been broadly acknowledged.
Market Finance as a Substitute for Federal Refinance?
Sub-national debts were refinanced for 30 years, to be serviced at annual interest rates that range between 6% and 9% plus the change in the Brazilian “General Price Index” (a weighted average of the wholesale, consumer, and construction price indexes collected by the Getulio Vargas Foundation). As market interest rates seem to be definitively heading downwards, some state governors in Brazil have started to talk about a possible upcoming scenario in which sub-nationals should be given the opportunity to use market finance to prepay their debts held by the federal government, and thus initiate a transition toward a more efficient “cost-benefit-alignment” type of fiscal structure. However, at least 6 pre-conditions must be fulfilled before any such a move can be made without jeopardizing the current fiscal responsibility condition: 1. First of all, in order for that swap to become attractive for sub-nationals, market finance will have to be available to them in terms more favorable than those prevailing in the federal refinance, and this is something certainly yet to be seen on the screen. From the federal financial standpoint, the swap would be only interesting if the front-loading of payments might allow it to also get rid of less-desirable portions of its own debt. 2. Some credible and much-hard-to-reverse legal prohibition of bailing out of sub-nationals by the federal government, precluding the possibility of the exercise of sovereign guarantees to defaulting sub-nationals, will have to be in place. 3. Market finance should be allowed only to substitute for – not to add to – debt with the federal government. 4. Even though sub-national governments should receive some leeway to search and find market opportunities, rules curbing the back loading of commitments will also have to be effective 5. The federal government should undergo a review of its own fiscal accounts, so as to create some fiscal space to accommodate the pressure for higher expenditures at the sub-national level that will tend to spring from the debt burden relief. After all, the Brazilian fiscal adjustment is still an on-going process: consolidated public sector debt-to-GDP ratios (currently 45%) are still high and feature very-short durations. 6. A thorough review of the currently pervasive earmarking of revenues and expenditures should be implemented if sub-nationals are really to be declared responsible for themselves. It is appropriate to mire at the ultimate goal of a federal system with optimum decentralization, fiscally responsible behavior and full alignment of costs and benefits. But it is also adequate not to precociously slacken the straitjackets that have fit so well in the Brazilian fiscal structure.