Association for Public Policy Analysis & Management

Literature suggests that good public governance promotes economic growth (e.g., Barro, 1991; Acemoglu et al, 2005; Rodrik, 2007), international trade (Levchenko, 2007), and corporate governance (Doidge, 2007; Erkens, et al., 2012). Theoretically, if good governance can “promote equity, participation, pluralism, transparency, accountability and the rule of law, in a manner that is effective, efficient and enduring”, as claimed by the United Nation (2015), one can feasibly expect that governments with high capacities would help keep public debt at a “healthy” level and maintain a lower credit risk. Indeed, recent studies on the U.S. municipal bond market found that the management capacity or performance of a state or local government affects the credit rating of its bond issues (e.g., Denison, et al., 2007; Zhao and Guo, 2010). However, the existing studies focus on only municipal bonds in the United States. It is unclear whether the conclusions are applicable to other nations. Furthermore, the managerial factors examined in previous studies only measure a very narrow perspective of government capacity. They neither capture the quality of government regulations on businesses nor reflect the independence of civil service from politics.

This study aims to address the above limitations by investigating whether the government capacity of a country affects the debt level and credit rating of its sub-sovereign governments. As a key component of public governance, government capacity is defined as the ability of government to effectively formulate and implement sound policies for the development of both public and private sectors (World Bank, 2010). To answer the research question, we organize a novel panel dataset that consists of over 200 sub-sovereign issuers in 31 countries between 2004 and 2017. Government capacity is measured in two dimensions: government effectiveness and regulatory quality based on the World Bank’s Worldwide Governance Indicators. We find that whereas government capacity reduces the debt level of subnational governments in advanced countries, the opposite was observed for developing countries. We also find that government capacity improves the credit rating of subnational governments, regardless of the development status of the nation.