A Balancing Act - Fiscal Interlinkages between Federal and State Governments

The moral hazard problem brought up by subnational government (SNG) fiscal imprudence would lead to the surge of country sovereign risks and the deterioration of sovereign rating. How to implement policies and laws to ensure the fiscal health of SNGs becomes the main topic of the project.

The Capstone team conducted two ramifications of research. One was the top-down approach to establish a high-level framework, and the other was the bottom-up approach, investigating country-specific experiences. The research showed that central governments can maintain the fiscal health of SNGs by building systems to enhance SNG self-discipline, imposing top-down fiscal rules, or some combination of both. States that borrow must do so transparently and with strong monitoring and enforcement mechanisms to bolster investor confidence.

The team found that it is useful to have a strong credit culture so the federal government can trust the states to borrow responsibly. Vertical fiscal imbalance provides a snapshot of the fiscal arrangement for a country and varies depending on a country’s system of government. By looking at a diverse set of countries with different fiscal linkages, including Mexico, Australia, Chile and China, similarities and differences can be correlated with better or worse outcomes. The findings from this research will help financial institutions make timely recommendations to governments and avoid soversign risks.