Outcomes in South Asia

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because they reduce local investments for multiple years. 5. Shocks do not have purely external sources or origin. Instead, they respond to political incentives, can be mitigated through increased transparency, and their impact depends on states’ fiscal capacity. 6. Fiscal rules and markets currently do not impose sufficient discipline on states’ finances to mitigate contingent liability shocks.

improved Transparency and Fiscal Rules, the Disciplining Role of Markets, and Better intergovernmental Frameworks Are Needed to Achieve Better Subnational Fiscal Outcomes in South Asia

This chapter has reviewed the exposures to subnational fiscal risk across South Asia and has provided new evidence on the adverse effects of contingent liability shocks on fiscal and economic outcomes in India.

It shows that contingent liability shocks occur relatively frequently, trigger fiscal adjustments, and are influenced by policy makers’ incentives as shaped by the prospects of election, transparency, fiscal rules, existing fiscal space, and the softness of budget constraints. It also shows that contingent liability shocks significantly affect local economic development: triggered contingent liabilities reduce investment in Indian states for up to four years after the shock and thus dampen local economic activity. India’s experience is illustrative for the rest of the region, especially for countries such as Pakistan, where provincial borrowing has been expanding, and for Maldives and Nepal, which have started to decentralize fiscal policy.

Our analysis suggests some pathways to mitigate contingent liability shocks and the associated negative spillovers. For the pathways to be effective, policy makers must understand that the realizations of contingent liabilities are rarely exogenous events. The accrual of contingent liabilities is a policy decision that is shaped by the incentives of local policy makers and their abilities to manage subnational fiscal risks. Broadly, our analysis has focused on four factors that influence fiscal risks. The first is transparency, which, in an electoral system, is crucial to hold policy makers accountable. The second is a legal framework, including fiscal rules—either self-imposed or imposed by the central government—that limits the ability of subnational decision makers to accrue excessive liabilities. The third is market pricing, which ensures that the debt financing cost incurred by SNGs is commensurate with the subnational fiscal risk. The fourth is fiscal capacity and its reflection in the intergovernmental framework. Based on these considerations, the discussion that follows proposes policy recommendations for governments in South Asia to achieve greater fiscal discipline.

The accrual of contingent liabilities is a policy decision that is shaped by the incentives of local policy makers and their abilities to manage subnational fiscal risks.

Policy Recommendations

Transparency

The effect of transparency measures on the management of subnational fiscal risks may be slower but more significant and persistently positive than the other factors. Gradually, the Indian states adopted measures to improve transparency and public information on subnational debt and contingent liabilities. The positive effect of these measures took time to materialize, but when they did, the effects appeared significant and lasting. There is no reason why India’s positive experience with fiscal transparency at the subnational level could not be replicated more widely in South Asia and beyond.

To increase fiscal transparency across South Asia, central and subnational governments could undertake three measures. A first step would be the adoption of accounting standards that highlight contingent liability risks when they accrue, not when they materialize,

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to allow for adequate budgeting and decision making. This would require moving from the cash-based standards prevalent in South Asia toward accrual accounting. Second, SNGs should collect and consolidate information on debt and other sources of fiscal risks in a single entity at the subnational level.29 This unit could be a specialized debt management unit within the finance department that fulfills a back-office function for the entire subnational government. While many Indian states and Pakistani provinces have established debt management offices, information on debt and sources of fiscal risks remain scattered across institutions. Centralizing them into one entity would enable the production of consolidated, whole-of-government financial statements. Third, this information could then be audited, publicized, and analyzed by an independent national agency to ensure its consistency and accuracy. This agency could be an independent fiscal council (see discussion that follows).

While data on state finances in India are more comprehensive and easier to access than those of Pakistan, there are still gaps in reporting that hinder greater fiscal transparency. There are no consolidated financial statements for the whole of government, while audited accounts at both the central and state level take about 10 to 12 months to be produced. Moreover, there are no consolidated accounts on state-owned enterprises. The quality of accounting standards is also uneven across government levels, making it difficult to consolidate information across government jurisdictions. Publishing an integrated, total public debt database that includes explicit and implicit guarantees would help the states and the central government identify threats to fiscal sustainability in a more systematic and timely manner.

Legal Framework and Fiscal Rules

Although many countries have imposed limits on subnational borrowing through fiscal rules, our analysis has shown that these are not always effective in limiting fiscal shocks. Part of the problem is moral hazard. When states are in fiscal distress, the central government transfers more resources to the state through tax devolution. This bailout hurts the central government’s finances. It reinforces the states’ perception of the “soft budget constraint” that exists in federalist systems and reduces the incentives for states to address underlying sources of fiscal risk.

India has had a mixed experience with subnational fiscal rules. However, other countries in the region should not automatically discard this policy tool. For instance, Pakistan already has a legal limit on domestic borrowing; however, it does not consider that most of its provincial debt comes through external loans that are on-lent from the central government. This practice makes the limit irrelevant. Before Pakistan can start adopting recommendations concerning fiscal rules and other debt limitations, more comprehensive and timely data collection on provincial finances is needed (see box 4.1).

International experience suggests that fiscal rules are most effective when they help reinforce a political commitment to fiscal responsibility. To that end, establishing state-level institutions and strengthening central-level institutions could improve the implementation of fiscal responsibility legislation in India.

Specifically, the recommendation by the Fiscal Responsibility and Budget Management Act (FRBM) Committee for the central government to set up an independent fiscal council could also cover Indian states. This council would be responsible for ensuring compliance of states with the fiscal rule and examining justifications for deviating from expected fiscal targets—rather than arbitrarily evoking “escape clauses” in existing legislation. The independent fiscal council could have powers to punish fiscal laxity and reward subnational fiscal discipline.

In countries with strong public sector governance and high institutional capacity, subnational fiscal councils could also be a solution. For example, in Iceland, the Municipal Fiscal Oversight Committee (MFOC) has the power to impose sanctions on municipalities that breach fiscal rules. While fiscally responsible municipalities have greater autonomy, municipalities with