Tough and credible rules needed to prevent counties from amassing debts

Like many countries, Kenya has decentralised its government functions, shifting control to the counties.

Done properly, decentralisation, also known as “devolution”, will bring many benefits to the citizens, from quality public services to more accountability on public officials.

But with increased power comes greater responsibilities, including the challenge of fiscal management.

With devolution, “sub-nationals”, as states, counties, and cities are generically called, get cash transfers from the central government, they collect taxes, and borrow.

How they manage these resources defines whether devolution as a whole succeeds. What can we learn from countries where it did? There are five, main lessons.

First, both federal and local authorities need to take fiscal responsibility seriously, fight tax evasion, keep spending in check, avoid large deficits, and take financial decisions transparently.

Most critically, they must not over-borrow.

When county debt gets out of control, major crises follow, as they did in Brazil in the 1980s and ‘90s.

No central government wants debt amassed by counties left at its doorstep, while no local government wants to face a dilemma between paying creditors and firing civil servants.

Which brings us to the second lesson: to prevent local governments, and their lenders, from accumulating too much debt, a well-designed and well-enforced system of “sub-national borrowing regulation” is crucial.

In practice, these systems range between two extremes: giving sub-nationals almost total freedom to borrow (as in the US) to banning nearly all borrowing at the local level (as in Chile).

Most countries choose an intermediate system. Some, such as India, put ceilings on the deficit, and thus the borrowing, that local governments can run (say, three per cent of the local “gross domestic product”).

Others use alerts, such as Colombia’s creative “traffic lights”: If your financial accounts are strong, your light is “green” and you can borrow without authorisation from the central government; if it is “yellow” or “red”, well, the level of central scrutiny rises.

And several use financial penalties if a certain debt level is exceeded, after its sub-national crises, Brazil championed these thresholds.

TAKE RESPONSIBILITY

Third, when sub-nationals can’t pay their debts, there should be no doubt about who takes over not just the debt, but also the responsibility for fiscal decisions. This is trickier than it sounds.

If a mayor knows that the federal government will bail his city out, and no schools or hospitals will ever be closed down, he will be tempted to over-borrow, and its creditors could over-lend.

This is referred to as “moral hazard”. To avoid it, the penalties for indiscipline have to be tough and credible. For a sad example, look at the ongoing bankruptcy of the city of Detroit, and the host of public services its citizens have lost.

Fourth, sub-national fiscal responsibility calls for citizen participation. Good laws are of little use if they are not enforced consistently.

For that, nothing is better than a vigilant, informed citizenry that can press politicians into action.

In Peru, local governments have to consult civil society on their social spending plans.

The consultation is not legally binding, but what governor or mayor would dare ignore the direct messages from her constituency?

Finally, maintaining sub-national discipline is a lot more difficult when a country is blessed with natural resources such as oil, gas, and minerals. These bring large fiscal revenues that are then distributed among levels of government.

For local authorities, the pressure to spend mounts immediately, people rightly want to feel that they benefit from their country’s riches. Loan offers, collateralised on the local share of the resource multiply. So do opportunities for corruption.

Many resource-rich countries have squandered away their natural wealth and accumulated debt. Economists refer to this as the “resource curse”. This can and should be shunned.

The initial step is for central and local governments to agree on how much of the rents will be saved by the country as a whole, how the rest will be spent, and who will spend.

There are plenty of models for this: from the frugal “bird-in-hand” approach, you spend only the interest income from what you have already saved, to the lax “spend-as-you-go” — you burn every dollar that comes in as it comes in. You can guess which model is better for fiscal sustainability.

BORROWING

Kenya’s policy-makers and experts will gather in Nairobi on September 23 and 24 to debate the ins and outs of sub-national borrowing.

This is not an academic exercise. Behind all the fiscal talk are people who need water, roads, healthcare, sanitation — all services that you expect your county governments to provide.

How this pans out affects all citizens, especially the poor, who usually rely on those services. You want to be part of this debate.

The writer is the senior director of the World Bank’s global practice for macroeconomics and fiscal management.