Panel Paper: Markets, Laws or Regulations? the Impact of Institutions On Sub-Sovereign Debts

Saturday, November 10, 2012 : 10:35 AM
Jefferson (Sheraton Baltimore City Center Hotel)

*Names in bold indicate Presenter

Rui Sun, University of Central Florida and Gao Liu, Florida Atlantic University

The growth of sub-sovereign debts around the world, in both developed and developing countries, has drawn increasing attention of the public and researchers. For instance, the size of municipal bond market in the United States has doubled in the past decade. In China, where sub-national governments are prohibited from borrowing, the invisible off-budget debts have reached above $2.1trillion or 37 percent of its Gross Domestic Product (GDP). Studies have investigated the reasons for such growth and generally attributed the growth to decentralization and/or urbanization. Yet a more important question is how to manage and control these skyrocketing sub-sovereign debts, a vital element for maintaining a healthy economy.

Different countries use different mechanisms or institutions to manage sub-national government debts. In some countries, sub-sovereign borrowing is solely disciplined by the market, as it is believed that credit constraints and borrowing costs can efficiently direct the behavior of borrowers to make optimal decisions. In contrast, some countries with the belief of potential market failure employ constitutions or statues to control subnational borrowing behaviors. In other countries, subnational borrowing is constrained by administrative regulations. Which of the three institutions—market discipline, law-based approach and administrative-based regulations—is more effective in controlling the size and the credit risk of sub-sovereign debts?  

This study aims to answer this question empirically using a dataset that contains the information of 350 sub-sovereign governments around the world. The data is collected from the Organization for Economic Co-operation and Development (OECD) and Moody’s databases.

The proposed study is one of the first studies that empirically examine the sub-sovereign debt management mechanisms at the international level. It will also advance our understanding on the effectiveness of market discipline versus other mechanisms on regulating governmental borrowing. It is expected to contribute to the literature that examines the impacts of fiscal institutions, particularly debt limitations and tax and expenditure limitations, on the size, credit rating and cost of sub-national governmental debts by logically extending the studies to the international level comparison.

This study also has important policy implications for designing effective sub-national debt management in different countries. For instance, our findings will provide suggestions for countries such as China that is planning to launch a municipal bond market and help decision-makers to decide whether a mechanism of market solely will be sufficient for effective debt control and risk management, and whether an administrative-based discipline works better than a law-based mechanism.