Subnational Fiscal Sustainability Analysis
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1 The World Bank PREMnoes J UNE N U M B E R 7 ECONOMIC POLICY & DEBT Subnaional Fiscal Susainabiliy Analysis Elena Ianchovichina and Lili Liu, PRMED Why does Subnaional Fiscal Susainabiliy Analysis Maer? Subnaional fiscal susainabiliy is imporan because an insolven governmen canno provide public services. Alhough he basic susainabiliy framework applies o any governmen, subnaional fiscal adjusmen qualiaively differs from he naional one, reflecing he inerplay of subnaional and naional policies. Decenralizaion has given subnaional governmens significan spending, axaion, and borrowing power, and subnaional fiscal sress and deb crisis in emerging economies highligh he imporance of subnaional fiscal adjusmen and susainabiliy. Examples include he 997 deb resrucuring agreemens beween saes and he federal governmen and he Fiscal Responsibiliy Law in Brazil, he recommendaions of he 2 h Finance Commission in India mandaing saes fiscal responsibiliy legislaion, a new borrowing framework in Mexico, and fiscal legislaion in Colombia and Peru. Subnaional susainabiliy analysis should herefore be a cenerpiece of Bank s subnaional AAA work. Basic Framework of Subnaional Fiscal Susainabiliy Analysis The iner-emporal financing consrain of he subnaional governmen: B B = nb X ( is he fundamenal building block for sudying subnaional deb dynamics boh in a hisorical and forward-looking mode. In equaion (, B is he ousanding public sae deb measured a he end of period, X is primary fiscal balance in period, and n is he average ineres rae payable in year on he deb sock accumulaed by he close of year. For he budge consrain o hold, he primary balance should include all flows ha affec he deb level. For he purpose of policy analysis, i is useful o represen deb and he subnaional governmen budge consrain ( in percenages of gross sae domesic produc (GSDP and disenangle he growh and inflaion effecs on indebedness: g b b = i x b ( + g ( + π π b ( + π (2 where b,, i, and x are respecively he ousanding public sae deb, ineres paymens, and primary balance as a share of GSDP in period, g is he real annual growh rae, and π is he annual inflaion rae. The erms on he righ-hand side of equaion (2, in order, are he ineres rae, he primary balance (as a share of GSDP, he growh, and inflaion effecs on domesic deb. 2 Wih a consisen se of projecions for ineres raes, primary balance, growh, and FROM THE POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK
2 inflaion raes, we can assess deb susainabiliy under differen scenarios using: b where r is he real ineres rae defined as r ( + r = g b x ( + = [( n + /( π + ]. (3 Why do Subnaional and Naional Fiscal Adjusmens Differ? Alhough naional and subnaional deb dynamics are alike, subnaional fiscal susainabiliy analysis differs from he naional one. Subnaional deb susainabiliy is complicaed by he legislaive mandaes of cenral vis-à-vis subnaional governmens and he inergovernmenal finance sysem. Unable o issue heir own currency, subnaionals canno use seigniorage finance. Subnaionals canno freely adjus heir primary balance due o poenial legal consrains on raising own revenue, varying dependence on cenral governmen ransfers, and cenral governmen s influence on key expendiures such as wages and pensions. When public banks dominae he supply of subnaional credi, lending raes could be subsidized and credi risk could be compromised. Many policies affecing he subnaional economy and is fiscal healh can be largely se by he cenral governmen. Marke paricipans may olerae unsusainable subnaional fiscal policy if hey perceive ha he cenral governmen implicily guaranees subnaional deb service. When a sof budge consrain prevails, subnaional governmens may live beyond heir means, negaing compeiive incenives and fosering corrupion and ren seeking. Developing a Medium- Term Fiscal Framework A medium-erm fiscal framework (MTFP serves as he baseline for susainabiliy analysis. Ofen, he MTFP is driven by a fiscal crisis. The MTFP involves poliical radeoffs and debae over feasible parameers for expendiure adjusmen, ax reform, quasi-fiscal adjusmen, and reform of he borrowing framework. The MTFP needs o go beyond published fiscal accouns. Hidden and coningen liabiliies can lead o he sudden onse of a fiscal crisis wihou warning. Poenial sources of liabiliies include off-budge liabiliies of special-purpose vehicles and subnaional enerprises, governmen guaranees, civil servan pensions, nonperforming asses of subnaional banks, arrears under he cash accouning sysem, and liabiliies associaed wih judiciary decisions. Subnaional Fiscal Susainabiliy Analysis: Base Case We use he Indian sae of Tamil Nadu as an illusraion. 3 The baseline simulaion follows he fiscal adjusmen proposed in Tamil Nadu s MTFP ( Beyond he MTFP imeframe, he baseline assumpion on real ineres rae and he subnaional primary balance and GDP growh are based on projecion in AAA (e.g., CEMs, DPRs, subnaional AAA. Sensiiviy Analysis Sensiiviy analysis helps address he failure of simple analyical models o ake ino accoun uncerainy. I analyzes fiscal risks and he probabiliy of insolvency. Recen sudies propose differen mehods for analyzing uncerainy. In he cases where hisorical ime series daa are available, one can apply economeric echniques. Wihou hisorical ime series daa, as in he case of Tamil Nadu, we rely on he se of sress ess, complemened by an in-deph discussion of key fiscal risks and consrains o fiscal adjusmen. The firs sensiiviy es ses he real effecive ineres rae, he real growh rae, and he primary balance afer 2006/07 a heir hisoric averages of he 990s. The es illusraes he ambiiousness of he adjusmen envisaged in he baseline projecion relaive o hisorical experience. The Governmen 2 PREMNOTE JUNE 2008
3 Table. Baseline Simulaion as Proposed in Tamil Nadu s MTFP Assumpions Real ineres rae (r Real growh rae (g Primary surplus (x Deb dynamics* Deb (% of GSDP (b Real ineres rae (r Real growh rae (g Primary surplus (x Deb dynamics* Deb (% of GSDP (b * Auhors simulaion based on equaion (3. of India sared o liberalize ineres raes in he mid-990s, hus he hisoric real ineres rae average does no provide an appropriae benchmark. Therefore, he second sensiiviy es leaves he ineres rae as in he baseline and ses only he real growh rae and he primary balance afer 2006 a heir hisoric averages of he 990s. This es reveals he coss of loose fiscal policy. One may conduc a number of sress ess changing he key variables, separaely or joinly, by one or more sandard deviaions from heir means, over a period of ime. Our ess show ha i is he unexpeced, adverse combined shock of a more permanen naure (low growh, high real ineres raes, and large primary deficis over a period of 5 o 0 years ha will have grave consequences and require a major fiscal adjusmen. Can Fiscal Space for Infrasrucure be Expanded during Fiscal Adjusmen? We simulae he impac of an increase in Tamil Nadu s capial expendiure afer 2007/08 o 3 percen of GSDP he average for Indian saes. We assume ha real economic growh and ineres raes will remain as in he baseline, and here will be no effec on he sae s revenue. We absrac from quesions abou he efficiency and effeciveness of public expendiure on infrasrucure invesmen. Under hese assumpions, he deb-o-gsdp raio will gradually climb from 27 percen in 2008/09 o 39 percen by 2026/27, bu is deb service paymens will increase o 6 percen of revenue over he same period below he deb sress raio of 20 percen (Figure. This suggess ha here is fiscal space for an increase in capial invesmen hrough addiional borrowing wihou jeopardizing he sae s deb service capaciy. Tamil Nadu may even avoid he increase in he deb burden if is annual real economic growh increases by.6 percenage poins from is expeced growh rae in 2008/09. Research has shown such an increase may occur as a resul of improvemens in invesmen climae. Figure. Impac of Increased Infrasrucure Invesmen in Tamil Nadu Deb as a % of GSDP Capial expendiure increase Source: Auhors simulaion based on equaion ( Baseline JUNE 2008 PREMNOTE 3
4 Risks o Fiscal Adjusmen I is imporan o appreciae how he subnaional deb crisis go sared and how he ineracion of naional and subnaional policies may evolve. In he case of India s saes, key fiscal risks include increases in real ineres raes and consrains o primary balance adjusmen. In Tamil Nadu, increases in borrowing and ineres raes in he 990s led o rising ineres expendiure. From 2000/0 o 2004/05 declining ineres raes helped sabilize ineres expendiure, bu he risk of rising ineres raes due o increased demand for credi and an upurn in inernaional ineres raes is real. A hypoheical 3 percenage poin increase in he real average borrowing cos afer 2007/08 will double Tamil Nadu s deb burden in 2026 compared o he baseline (Figure 2 and lif deb service as a share of revenue o he sress level of 20 percen. The deb mauriy srucure impacs rollover risks. One rigger of he Mexican deb crisis in he mid-990s was he shor mauriy of subnaional deb and variable ineres raes. Rapid currency depreciaion, a sharp rise in ineres raes, and a sharp conracion in he pool of shared revenues evenually riggered a subnaional deb crisis. In India, Figure 2. Policy Risks in Tamil Nadu Deb as a % of GSDP Source: Auhors simulaion based on equaion ( Baseline Ineres rae increase Wage increase Combined policy risks Oher expendiure increases disaggregae daa on saes deb mauriy are unavailable, bu he rollover risks are low due o fixed ineres raes and in many cases medium- o long-erm deb mauriy. Adjusmen in he primary balance also faces consrains. On he expendiure side, poliical impulse could push up he number of civil servans and backrack on progress wih wage and pension reform. Large pension liabiliies are a major concern for Indian saes due o he long-erm naure of pension policies, he acquired righs of exising employees, he aging civil service force, and he need for he governmen o conribue o a newly defined conribuion scheme. Moreover, pressures o increase uiliy subsidies could inensify. On he revenue side, he poenial for increasing he sae s ax revenue is limied. The cenral governmen reserves he righ o ax he service secor, which is he fases growing secor in Tamil Nadu. Successive cenral finance commissions have reduced Tamil Nadu s share in he pool of ne shareable cenral axes. The 2h Finance Commission has increased incenives for responsible subnaional fiscal behavior, wih deb consolidaion and a waiver scheme linked o reducion in saes fiscal and revenue deficis. However, he enforcemen mechanism is lacking. I is also unclear if he incenives offse he negaive effec of he defici gran disribuion. The 2h Finance Commission has depared from is radiion of greaer weigh o equiy han economic performance. For Tamil Nadu, his implies reversing he pas rend of diminishing saes share in he pool of sharable ax revenue. Noneheless, i is unclear how fuure finance commissions will decide on he disribuion of revenues given growing dispariies among Indian saes. Individually, he above risks may no hreaen fiscal susainabiliy, bu heir combined effec may derail deb susainabiliy. A 3 percenage poin increase in he real borrowing cos, a percenage poin decline in he GSDP growh, and a worsened primary balance reflecing revenue sagnaion, de- 4 PREMNOTE JUNE 2008
5 crease in cenral devoluion, subsidy increase, and he wage shock afer 2008/09 4 will dramaically worsen deb dynamics. Under his hypoheical scenario in 2026/27 he deb services are expeced o be 5 percen of revenue much higher han he deb sress hreshold of 20 percen, 5 while he deb burden is expeced o be nearly 80 percen of GSDP (Figure 2. Concluding Remarks Assessing fiscal susainabiliy is a complex ask as i requires one o form a view abou how much fiscal adjusmen is poliically and socially feasible, and how various componens of subnaional fiscal accouns respond o policy reform and shocks. A he subnaional level, of paricular concern are he respecive legislaive mandaes of cenral vis-à-vis subnaional governmens and he inergovernmenal finance sysem, which make subnaional fiscal adjusmen differen from he naional one. The possibiliy ha such mandaes may change is real and paricularly relevan for many developing counries where inergovernmenal sysem and he srucure of financial markes are coninuously evolving. Thus, counry conex maers. Finally, he analysis is subjec o all he caveas peraining o fiscal susainabiliy analysis a he naional level. References Ianchovichina, Liu, and Nagarajan Subnaional Fiscal Susainabiliy Analysis: Wha Can We Learn from Tamil Nadu? Economic and Poliical Weekly XLII(52, December. (Also available as World Bank Policy Research Working Paper, No. 3947, 2006, World Bank, Washingon, DC. Burnside, Craig Theoreical Prerequisies for Fiscal Susainabiliy Analysis. Chaper. 2 in Fiscal Susainabiliy in Theory and Pracice. Washingon, DC: World Bank. Burnside, Craig Some Tools for Fiscal Susainabiliy Analysis. Chaper 3 in Fiscal Susainabiliy in Theory and Pracice. Washingon, DC: World Bank. This PREM Noe, one in a series of PREM Noes on subnaional finance, is based on Ianchovichina, Liu, and Nagarajan, Subnaional Fiscal Susainabiliy Analysis: Wha Can We Learn from Tamil Nadu? World Bank Policy Research Working Paper, No. 3947, 2006 and Economic and Poliical Weekly, Vol. XLII, No. 52, December Abou he auhors Elena Ianchovichina is a Senior Economis wih he Economic Policy and Deb Deparmen of he PREM Vice Presidency. Lili Liu is a Lead Economis wih he Economic Policy and Deb Deparmen of he PREM Vice Presidency. Endnoes. Time is discree, deb maures in one period, and financing and ineres paymens ake place evenly hroughou he year. Deb should be ne of comparable asses, while ineres paymens should be ne of any receips. 2. For counries allowing subnaional governmens o access exernal financing, equaion (2 mus be amended o include he exchange rae effec. 3. Tamil Nadu was he firs Indian sae where he World Bank worked wih he sae governmen o apply he fiscal susainabiliy framework presened in his PREM Noe. 4. The decision of he fifh pay commission of he cenral governmen, emulaed by many saes, conribued o he rapid increase in wages and pensions wihou accompanying reducion in civil service employmen. One canno rule ou he recurrence of such an even. 5. The governmen of India defines 20 percen or above of deb service over revenue as a hreshold of deb disress. JUNE 2008 PREMNOTE 5
6 This noe series is inended o summarize good pracices and key policy findings on PREM-relaed opics. The views expressed in he noes are hose of he auhors and do no necessarily reflec hose of he World Bank. PREMnoes are widely disribued o Bank saff and are also available on he PREM Web sie (hp:// If you are ineresed in wriing a PREMnoe, your idea o Madjiguene Seck a mseck@worldbank.org. For addiional copies of his PREMnoe please conac he PREM Advisory Service a x PREMnoes are edied and laid ou by Grammarians, Inc. Prepared for World Bank saff
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