## Annex 1. Suggested Financial Soundness Analysis Framework

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### I. Importance and central message
- Subnational governments can create sizable fiscal risks for central governments.
- Central governments need institutional mechanisms to systematically monitor subnational finances to proactively manage associated risks.
- Recommended central government actions:
  - (1) a stronger regulatory framework,
  - (2) improved fiscal reporting, and
  - (3) enhanced central oversight.

### II. How subnational fiscal risks are manifested
- Central government may need to:
  - bail out subnational governments whose debt becomes unsustainable (excessive deficits, off-budget borrowing, guarantees to subnational enterprises, or enterprises’ unsustainable debt);
  - honor central government credit guarantees to subnational governments—directly or through central institutions;
  - write off, restructure, or absorb erosion in value of central government loans to subnational governments;
  - scale up central transfers—equalization grants or conditional transfers—if subnational resources decline or obligations cannot be met.

### III. Quantified fiscal realizations and illustrative country episodes
- IMF study (80 countries, 1990–2014): 13 instances of macrocritical realizations of central government contingent liabilities from subnational governments; average cost 3.7 percent of GDP; maximum cost 12 percent of GDP.
- Brazil:
  - In 1997, subnational debt constituted nearly 40 percent of total public debt.
  - In 1993, subnational debt of R$39.4 billion was refinanced with federal loans as part of a bailout costing about 7 percent of GDP.
- Argentina: central government assumption of subnational debt during 2001–04 estimated at US$9.7 billion to US$12.1 billion.
- Mexico: extraordinary cash transfers during 1995–98 cost the central government an estimated 0.5 percent of GDP.
- India:
  - Combined center and state fiscal deficit increased from 7.3 percent of GDP in 1997–98 to an average of 9.3 percent of GDP during 1998–2004.
  - State’s debt rose to 32.8 percent of GDP in 2003–04.
- Hungary: between 2011 and 2014 the central government took over local government debt estimated at ft 1,344 billion (€4.26 billion).
- France: program in 2016 costing €1.2 billion to assist local governments with toxic loans.
- Austria: emergency loan of €350 million to save the state of Carinthia from insolvency.
- United States (New York City, 1975): the state advanced about $800 million; it created the Municipal Assistance Corporation to sell up to $3 billion in state-backed bonds; the federal government extended $2.3 billion in loans.

### IV. Sources and drivers of subnational fiscal vulnerabilities
- Key drivers:
  - Fiscal decentralization expanding spending responsibilities while granting revenue and debt powers, creating resource/responsibility mismatches.
  - Reliance on central transfers can lead to a deficit bias absent a “hard” budget constraint.
  - Perceived central guarantees create moral hazard and deficit bias.
  - Weak market discipline where credit ratings and bond markets are underdeveloped.
  - Debt composition risks: short maturities, floating rates, foreign currency exposure.
    - Pakistan (2019): provincial year-over-year provincial debt increases of 38 percent (Punjab), 25 percent (Sindh), and 20 percent (Khyber Pakhtunkhwa) following currency depreciation.
  - Pension liabilities and underfunding (IMF (2018) highest observed shortfall 27 percent of the state GDP in Illinois).
  - Project-related risks from public investment (delays, overspending).
  - Land-financing risks when asset prices are inflated (examples: China prior to 2003; Hong Kong SAR valuation fall during 1998–2002).
  - Off-budget borrowing via SOEs, special purpose vehicles, and PPPs (India: subnational SOE liabilities 8 percent of GDP in 2017; sector’s annual losses 0.6 percent of GDP).
  - Local macroeconomic and climate shocks due to territorial and sector specialization.

### V. Observations on cross-country patterns and data
- Nearly one-half of the 33 countries with Fiscal Transparency Evaluations (2013–21) lacked direct controls on subnational borrowing and had no or limited information on subnational finances.
- OECD-UCLG database (2016): subnational debt ranges from near zero (Bangladesh, Rwanda, Tanzania) to 67 percent of GDP (Canada).
- In Canada and Switzerland, subnational debt exceeds national government debt; in China and Norway, subnational debt is more than 40 percent of general government debt.
- Federated countries tend to have more subnational debt than unitary countries, with some unitary advanced-economy exceptions.

### VI. Core policy implications and institutional responses
- Strengthen the regulatory framework governing subnational borrowing and fiscal behavior.
- Improve fiscal reporting on subnational finances to enhance transparency and monitoring.
- Enhance central oversight and monitoring capacity to identify and manage subnational fiscal risks proactively.

---

### Subnational government guarantees, PFM observations, and analytical frameworks
- PEFA comparisons (nine countries: Albania, Cameroon, Ethiopia, Georgia, Jordan, Kenya, Serbia, Tanzania, Ukraine) show subnational PFM systems tend to score below national systems; weaknesses strongest in upstream budget formulation and fiscal risk management; accounting and reporting closer to national standards.
- Fiscal risk management framework: four steps—identification and assessment; mitigation; provision for residual risks; accommodation and disclosure.
- Quantitative risk-assessment analytical dimensions:
  - Fiscal capacity and flexibility
  - Operating performance
  - Liquidity management
  - Debt capacity
  - Asset management
- Reserve-policy practices:
  - UK: reserves policy integrated into legal/regulatory framework; annual financial statements must include a Statement of Movements in Reserves.
  - US: on average, state reserves cover about 48 days of operating costs.
  - Pew Charitable Trusts (October 2021 update):
    - Total balance aggregated for all 50 states at the end of fiscal 2021: $126.4 billion, enough to run state government operations for a median of 55.1 days, equivalent to 15.1 percent of spending.
    - Seven states have balances sufficient to cover less than one month of operations.
    - Two states—Illinois and Pennsylvania—have balances sufficient to cover less than one week of operations.

### Categorization, early-warning systems, and composite scoring
- Country practices: indicator-based early warning systems in China, Colombia, Iceland, Mexico, and Türkiye.
- Composite scoring examples:
  - Turley, Robbins, and McNena (2015): seven financial ratios for 34 Irish local governments scored –2 to 2; aggregate range –14 to 14.
  - Standard & Poor’s non-US subnational profiling: seven factors with weights:
    - Economy (20 percent)
    - Financial management (20 percent)
    - Budgetary flexibility (10 percent)
    - Budgetary performance (10 percent)
    - Liquidity (20 percent)
    - Debt burden (10 percent)
    - Contingent liabilities (10 percent)

### Mexico’s SHCP quarterly registry and thresholds (example)
- Quarterly reporting on three indicators:
  - Ratio of debt and other financial obligations to non-earmarked revenues
  - Ratio of debt service and other financial obligations to non-earmarked revenues
  - Ratio of short-term obligations to total revenues
- Classification into three categories: (1) stable (green); (2) under surveillance (yellow); (3) high level of indebtedness (red). Defaulting entities are automatically red.
- Box Table 2.1 thresholds (as presented):
  - Debt ratio: Low ,100 ; Medium 100–200 ; High .200
  - Debt service ratio: Low ,7.5 ; Medium 7.5–15 ; High .15
  - ST obligations ratio: Low ,8 ; Medium 8–12.5 ; High .12.5
  - Note: ST = short term

### Quantifying exposure and disclosure needs
- Quantification approaches:
  - Probability-weighted estimation of expected payments (present value) when feasible.
  - Recording maximum exposure may suffice in many cases.
- Measurement should include:
  - (1) debt and other financial liabilities that the central government may be required to assume; and
  - (2) likely unanticipated financial outflows from central to subnational governments if subnational finances weaken.
- Data gaps: timeliness, periodicity, reliability, comparability, and coverage of off-budget funds and local public enterprises.
- World Bank study: only 18 percent of low-income countries publish debt statistics consistent with legal framework and borrowing practices; subnational debt data unavailable for 60 percent of these countries.

### Reporting and consolidation practices (recommended)
- Reporting systems should at minimum span the entire general government sector.
- Objectives: consolidated annual financial statements and high-frequency fiscal reports covering the general government sector.
- Central agencies (typically finance ministry) should consolidate and publish in-year fiscal reports and annual accounts for general government.

### Country disclosure examples
- Finland: municipal accrual-based annual financial statements consolidated with enterprises; Statistics Finland publishes summary and quarterly data including Maastricht debt and deficit.
- Peru: monthly reporting of primary spending, investment execution, and regional/municipal debt stocks; quarterly and annual detailed fiscal performance; municipal enterprise operations reported annually.
- Philippines: Commission on Audit publishes annual compilation of local government financial statements; Bureau of Local Government Finance publishes quarterly aggregate outstanding bank loans for local governments.
- Russia: Ministry of Finance publishes monthly debt data by region; federal Treasury publishes monthly budget execution including consolidated subnational receipts and expenditure; regional and municipal governments must publish annual financial information.

### Illustrative example: New South Wales (NSW) Financial Sustainability Rating (FSR)
- 2013 NSW Treasury Corporation study assessed 152 local governments using a composite FSR based on 10 indicators across four categories; councils received positive/neutral/negative outlooks and were grouped into seven categories (very strong to distressed).
- NSW FSR Analytical Framework (ratio — benchmark — weighting (%) — subtotals (%)) highlights (numbers preserved as presented):
  - Financial Flexibility:
    - Operating Ratio: .(4.0%) — 17.5 — 35.0
    - Own source operating revenue ratio: .60.0% — 17.5
  - Liquidity:
    - Cash expense ratio: .3.0 months — 10.0 — 20.0
    - Unrestricted current ratio: .1.5x — 10.0
  - Debt Servicing:
    - Debt service cover ratio (DSCR): .2.0x — 7.5 — 10.0
    - Interest cover ratio: .4.0x — 2.5
  - Asset Renewal and Capital Works:
    - Infrastructure backlog ratio: ,0.02x — 10.0 — 35.0
    - Asset maintenance ratio: .1.0x — 7.5
    - Building and infrastructure asset renewal ratio: .1.0x — 7.5
    - Capital expenditure ratio: .1.1x — 10.0
  - Total: 100.0

---

### Reporting, controls on borrowing, and regulatory approaches (Box 4 and Box 5 highlights)
- Recommended central functions and database features:
  - Maintain a database of subnational debt and contingent liabilities (debt, other financial liabilities, contingent liabilities including SOEs, off-budget revenues/expenditure, PPP program size).
  - Update at least quarterly; consider a web-based interface for direct updates by subnational governments.
  - Intergovernmental relations unit typical functions: manage data repository; track early warning indicators; publish consolidated subnational sector reports; prepare periodic (at least quarterly) reports for finance ministry management; input to annual fiscal risk statement; design/oversee bailout programs if needed.

- Controls on subnational borrowing (administrative examples preserved):
  - Borrowing only with central government approval: Hungary, Spain, Thailand, Peru, Argentina, Kenya, Ethiopia, Bangladesh, India, Türkiye (with specified exceptions and modalities noted for each).
  - Borrowing only from the central government: Malaysia, UK (Public Works Loan Board).
  - No or restricted external borrowing (examples): India, Mexico, New Zealand, Slovenia; China prohibits external borrowing without central approval (2014 budget law opened borrowing subject to State Council preapproval and mandated early warning system; implementing orders reinforced “no bailout” and accountability).

- Rules-based constraints and enforcement examples:
  - Rules can constrain deficits, operating deficits, debt-servicing indicators, debt stock, or spending.
  - Enforcement/penalties examples: fixed fines (Slovak Republic); reduced transfers (Czech Republic); cuts in tax shares (Austria); fiscal consolidation plans (Colombia, Spain); administrative sanctions (Spain); sanctions on local officials (Türkiye, Poland).

- Table of illustrative thresholds (selected examples preserved):
  - Argentina: Debt service/net current revenue: 15%
  - Brazil: States Debt/net current revenue: 200%; Municipalities Debt/net current revenue: 120%
  - China: Debt/GDP: 60%; Debt/revenue: 100%
  - Czech Republic: Debt/revenue: 60%; Debt service/revenue: 30%
  - Colombia: Interest/operating balance: 40%; Debt/revenue: 80%
  - France: Debt/annual operating balance: 9–12 times
  - Greece: Debt/revenue: 100%; Debt service/revenue: 20%
  - Iceland: Debt/revenue: 150%
  - Poland: Debt/revenue: (entry shows "Deb/revenue"); Debt service/revenue: 15%
  - Türkiye: Metropolitan Debt/Revenue: 150%; Other Municipalities Debt/Revenue: 100%

### Approaches to controlling subnational borrowing (summary)
- Four main approaches (Ter-Minassian and Craig 1997; Singh and Plekhanov 2005):
  - Direct Controls: prior central approval and/or limits (high central control; requires constitutional/legal basis and monitoring capacity).
  - Rules-Based Constraints: fiscal rules and limits (requires credible rules, transparency, monitoring, enforcement).
  - Cooperation: negotiated limits (promotes dialogue; requires culture of fiscal discipline and cooperative institutions).
  - Market Discipline: reliance on markets (requires reliable information, developed capital markets, transparency, no-bailout track record).

- Market-discipline approach examples: Canada, South Africa, US—typically complemented by a no-bailout policy; less applicable where high transfer dependency or weak markets create perceived implicit sovereign guarantees.

### Holistic fiscal management recommendations
- Adopt an integrated fiscal management framework using general government as the unit for planning, objectives, and reporting.
- Harmonize fiscal rules across the general government sector.
- For federations, develop strong intergovernmental coordination mechanisms.
- Ensure fiscal reporting covers general government to expose off-budget borrowing and SOE circumvention.
- Resource subnational spending mandates adequately; clarify legal spending assignments; aim for optimal vertical fiscal gap and vertical fiscal balance (Boadway and Eyraud 2018).
- Devolution should be contingent on subnational PFM capacity acquisition.

### Central government oversight and examples
- Establish an intergovernmental relations unit in the central Ministry of Finance to monitor subnational finances, coordinate, and provide input for fiscal risk management.
- Country examples:
  - Kenya: Public Finance Management Act (2012) mandates strengthened national–county relations; Intergovernmental Fiscal Relations Department coordinates county finances.
  - South Africa: Inter-governmental Relations Framework Act (2005) mandates coordination (practical autonomy remains high).

### Colombia case study (rules-based system)
- Post-1990s overborrowing reforms:
  - Law 358 of 1997: “traffic light” debt-to-payment capacity system (red: prohibited from borrowing; green: permitted up to limits; yellow: prior central government permission).
  - Law 795 of 2003 (FRL) eliminated the yellow zone.
  - Departments and large municipalities must obtain satisfactory credit ratings before borrowing.
  - Additional laws: Law 617 of 2000 (quantitative limits for operating expenses); Law 550 of 1999 (insolvency rules); Law 819 of 2003 (financial planning, budgeting, accountability).
  - FRL prohibits national government guarantee for subnational domestic debt.
- FRL sanctions for noncompliance include borrowing prohibition, mandated adjustment plans (two-year horizon), possible central administration takeover of finances or services, prohibition on national lending/guarantees if violating specified laws or having arrears, and invalidation/ restitution requirements for noncompliant credit contracts (Article 21 of the FRL).

---

### Insolvency frameworks, provisioning, disclosure, and four pillars of managing subnational risks
- Oversight and provisioning:
  - Establish a dedicated oversight unit to coordinate national, provincial, municipal fiscal relations and monitor/report.
  - Provision residual fiscal risks in the central budget (omnibus contingency head recommended to avoid creating claims on funds).
  - Estimate provisions via top-down (historical unplanned support over at least five to seven years) or bottom-up (entity-level risk assessment) approaches.
  - Avoid publicly assigning probabilities to individual contingent liabilities to limit moral hazard.

- Insolvency framework design elements:
  - Define insolvency and triggering criteria; clarify initiators and dismissal of bad-faith applications.
  - Provide principles and procedures for creditor recognition and priority (including employees).
  - Identify essential services and nonessential assets; prescribe restructuring negotiation procedures, timeframes, transparency, recourse, and protection against fresh claims while in insolvency.
  - Specify authority for higher-level interventions (directives, supervision, takeover), fiscal adjustment plans, monitoring regimes, reporting, and institutional structures for proceedings.
  - Financing restructuring: dedicated funds capitalized by subnational and central governments (example: Portugal’s Financial Support Fund, created in 2014).

- Disclosure recommendations:
  - Publish routine disclosure of fiscal risks (ideally in a fiscal risk statement accompanying budget documents).
  - Disclosure should show aggregate subnational performance (deficits/surplus, net assets/equity, gross and contingent liabilities), entity-level analysis for distressed entities, relations with central government (transfers, debt owed, arrears, guarantees), identified risks, mitigation, and oversight/regulation.
  - Central government financial statements should identify transactions (revenue sharing, transfers, loans, guarantees) with each subnational government and comment on risks to outstanding loans and guarantees.

- Four pillars (conclusions):
  - Central oversight of subnational finances: standardized indicator-based systems, dedicated finance ministry unit for risk analysis and fiscal risk statement input.
  - Regulatory framework for subnational financial management: borrowing for capital investment only; limits on deficits and debt including guarantees; procedural transparency; accounting and auditing standards; strengthened reporting.
  - General government policy focus: coherent framework across general government; align intergovernmental fiscal relations with spending responsibilities and resources.
  - Subnational PFM capacity: build institutional capacity; require standardized individual reporting and consolidated subnational sector reporting; foster communities of subnational finance ministries to build capacity and coordinate practices.

---

### Annex Table 1.1 — Suggested ratios for subnational government financial analysis (selected ratios)
- Fiscal capacity and flexibility:
  - Revenue per capita
  - Expenditure per capita
  - Own-source revenues/total revenues
  - Discretionary expenses/total expenses
- Operating performance:
  - Operating balance/revenues
- Liquidity and debt management:
  - Free cash and liquid assets/current liabilities
  - Short-term debt/total debt
- Debt capacity:
  - Debt/free own-source revenues (alternative: debt-to-subnational GDP if available)
  - Operating balance before interest and depreciation/debt service (or “maximum future debt service” when relevant)
- Asset management:
  - Maintenance expenditure/stock of infrastructure assets
  - Asset renewals/depreciation
  - Capital expenditure/depreciation

### Annex 2 — Essential elements of a sound subnational PFM system (high-level)
- Budget formulation and predictability: comprehensive, multiyear, guided by realistic macro assumptions; timely central transfer information; coordinated calendars.
- Public investment and fiscal risk management: integrate investment planning with budgets; fiscal risk function for SOE and extrabudgetary oversight.
- Budget execution and cash management: timely disbursements, consolidated cash management, internal controls, single account consolidation where feasible.
- Financial reporting, auditing, and information systems: accrual-compatible reporting, timely in-year and year-end information, legal audit mandates, financial management information systems, independent external audit with public reporting.
- Legal and institutional framework: legislative clarity on roles, reporting, accountability, and sanctions for misconduct (examples: India constitutional provisions; Malaysia Financial Procedures Act applicability).

*Source: Annex 1. Suggested Financial Soundness Analysis Framework, HOW TO MANAGE FISCAL RISKS FROM SUBNATIONAL GOVERNMENTS (FISCAL AFFAIRS DEPARTMENT HOW TO NOTES), International Monetary Fund | August 2022.*

### Annex 1. Suggested Financial Soundness Analysis Framework ...........................................21

### Annex 1. Suggested Financial Soundness Analysis Framework

### I. Importance and central message
- Subnational governments can create sizable fiscal risks for central governments.
- Central governments need to develop sound institutional mechanisms to systematically monitor the health of subnational finances to be able to proactively manage associated risks.
- Central governments would benefit from putting in place the following:
  - (1) a stronger regulatory framework,
  - (2) improved fiscal reporting, and
  - (3) enhanced central oversight.

### II. How subnational fiscal risks are manifested
- The central government may have to bail out a subnational government if its debt becomes unsustainable due to excessive deficits, off-budget borrowing, guarantees to subnational enterprises, or subnational enterprises’ unsustainable debt.
- Central government credit guarantees to subnational governments—directly or through central institutions—may be called.
- Central government loans to subnational governments may have to be written off or restructured, or their value may erode.
- Central transfers to subnational governments—conditional or unconditional—may need scaling up. Equalization grants may have to be increased if subnational resources decline. Conditional transfers may increase if the subnational government does not have enough resources to fulfill program obligations.

### III. Quantified fiscal realizations and illustrative country episodes
- IMF study covering 80 countries between 1990 and 2014 identified 13 instances of macrocritical realizations of central government contingent liabilities from subnational governments, with an average cost of 3.7 percent of GDP and a maximum cost of 12 percent of GDP.
- Brazil:
  - In 1997, subnational debt constituted nearly 40 percent of total public debt.
  - In 1993, subnational debt of R$39.4 billion was refinanced with federal loans as part of a bailout costing about 7 percent of GDP.
- Argentina: central government assumption of subnational debt during 2001–04 estimated at US$9.7 billion to US$12.1 billion.
- Mexico: extraordinary cash transfers during 1995–98 cost the central government an estimated 0.5 percent of GDP.
- India:
  - Combined center and state fiscal deficit increased from 7.3 percent of GDP in 1997–98 to an average of 9.3 percent of GDP during 1998–2004.
  - State’s debt rose to 32.8 percent of GDP in 2003–04.
- Hungary: between 2011 and 2014 the central government took over local government debt estimated at ft 1,344 billion (€4.26 billion).
- France: program in 2016 costing €1.2 billion to assist local governments with toxic loans.
- Austria: emergency loan of €350 million to save the state of Carinthia from insolvency.
- United States (New York City, 1975): the state advanced about $800 million; it created the Municipal Assistance Corporation to sell up to $3 billion in state-backed bonds; the federal government extended $2.3 billion in loans.

### IV. Sources and drivers of subnational fiscal vulnerabilities
- Fiscal decentralization often increases subnational spending responsibilities while granting powers to raise revenues and to contract debt, creating potential mismatches between resources and responsibilities.
- Reliance on central transfers can lead to a deficit bias, particularly in the absence of a “hard” budget constraint (Singh and Plekhanov 2005).
- Perceived central government guarantees of subnational borrowings can create incentives for a deficit bias.
- In many countries, market discipline is weak where credit ratings and bond markets are underdeveloped; Lane (1993) identifies prerequisites for markets to enforce discipline.
- Composition of debt matters: short maturities, floating rates, and foreign currency borrowing expose subnational governments to market, liquidity, and currency risks.
  - Pakistan: currency depreciation in 2019 led to year-over-year increases in provincial debt by 38 percent (Punjab), 25 percent (Sindh), and 20 percent (Khyber Pakhtunkhwa).
- Pension liabilities can be sizable and underfunding is a major risk.
  - IMF (2018) found the highest observed shortfall of 27 percent of the state GDP in Illinois.
- Subnational governments often undertake a substantial share of public investment and face project-related risks (delays, overspending), which can strain finances.
- Land-financing of infrastructure can lead to overspending and unsustainable borrowing when asset prices are inflated (example: China prior to 2003; Hong Kong SAR valuation fall during 1998–2002).
- Off-budget borrowing via SOEs, special purpose vehicles, and PPPs creates contingent liabilities and transparency risks.
  - India: liabilities of subnational SOEs were 8 percent of GDP in 2017; the sector’s annual losses were 0.6 percent of GDP.
- Subnational governments may be more exposed to local macroeconomic shocks and climate risks due to territory and sector specialization.

### V. Observations on cross-country patterns and data
- Nearly one-half of the 33 countries that received a Fiscal Transparency Evaluation during 2013–21 did not have a direct control in place on subnational borrowing and had no or limited information on subnational finances.
- OECD-UCLG database (2016): subnational debt ranged from zero and near zero in Bangladesh, Rwanda, and Tanzania, to as high as 67 percent of GDP in Canada.
- In Canada and Switzerland, subnational debt exceeds national government debt; in China and Norway, subnational debt is more than 40 percent of the general government debt.
- Federated countries tend to have more subnational debt than unitary countries, although several unitary states among advanced economies also have high subnational debt.

### VI. Core policy implications and institutional responses (as highlighted)
- Strengthen the regulatory framework governing subnational borrowing and fiscal behavior.
- Improve fiscal reporting on subnational finances to enhance transparency and monitoring.
- Enhance central oversight and monitoring capacity to identify and manage subnational fiscal risks proactively.

*Source: Annex 1. Suggested Financial Soundness Analysis Framework, HOW TO MANAGE FISCAL RISKS FROM SUBNATIONAL GOVERNMENTS (FISCAL AFFAIRS DEPARTMENT HOW TO NOTES), International Monetary Fund | August 2022.*

### 1. Subnational Government Guarantees:

### 1. Subnational Government Guarantees

### Key observations on data and public financial management
- Available data point to somewhat weaker PFM systems at subnational levels; for the nine countries for which PEFA Assessments are available for both the national and subnational levels, average scores for subnational systems tend to be inferior to national level scores.
- PEFA sample countries listed: Albania, Cameroon, Ethiopia, Georgia, Jordan, Kenya, Serbia, Tanzania, and Ukraine.
- Weaknesses are particularly noticeable in upstream budget formulation and fiscal risk management areas; accounting and reporting functions appear on par with national systems.
- Lack of timely information and weak disclosure (including off-budget and quasi-fiscal operations and expenditure arrears in cash-based reporting) can blur the accountability chain and hinder central government oversight.

### Framework for managing fiscal risks from subnational governments
- A fiscal risk management framework involves four steps: identification and assessment, mitigation, provision for residual risks, and accommodation and disclosure.
- Risk assessment should focus on identifying distressed or potentially distressed entities and quantifying probability-weighted exposures where feasible.

### Analytical dimensions for quantitative risk assessment
A quantitative risk-assessment framework can be built around five analytical dimensions:
- Fiscal capacity and flexibility: capacity to manage fiscal position sustainably and flexibility to adjust future revenues and expenditures.
- Operating performance: ability to generate sufficient revenues to cover operating expenditures.
- Liquidity management: ability to meet short-term obligations efficiently.
- Debt capacity: level of indebtedness and capacity to take on additional debt.
- Asset management: capacity to manage assets.

- A suite of financial indicators can be developed to assess each dimension (see Annex 1 referenced in source).

### Use of reserves and reserve-policy practice
- Countries such as the UK and the US use financial reserves of subnational governments as indicators of financial health; reserves demonstrate financial soundness and prudence.
- The fundamental purpose of a reserves policy is to deliver public services while maintaining financial stability and avoiding unused funds or threatening cash shortfalls.
- In the UK, a reserves policy is part of the legal and regulatory framework of local governments; annual financial statements must include a Statement of Movements in Reserves.
- In the US, on average, the reserves of states cover about 48 days of operating costs.
- Pew Charitable Trusts (October 2021 update) estimates:
  - Total balance aggregated for all 50 states at the end of fiscal 2021 at $126.4 billion, enough to run state government operations for a median of 55.1 days, equivalent to 15.1 percent of spending.
  - Seven states have balances sufficient to cover less than one month of operations.
  - Two states—Illinois and Pennsylvania—have balances sufficient to cover less than one week of operations.

### Categorization and early-warning systems
- Subnational governments can be categorized into risk baskets using weighted financial ratios and past track records (example: Treasury of Türkiye groups local governments and SOEs into six risk categories).
- Indicator-based early warning systems are used in countries including China, Colombia, Iceland, Mexico, and Türkiye.
- Thresholds for categories are country-, context-, and time-specific and may vary by level of government and urban/rural differences.
- For some ratios, rolling two- or three-year averages may be useful to smooth one-off events.
- Composite scoring approaches exist; example methodology and considerations:
  - Turley, Robbins, and McNena (2015) computed seven financial ratios for 34 Irish local governments, scored each on a five-point scale (–2 to 2), and aggregated to an overall score with possible range –14 to 14.
  - Standard & Poor’s credit profiling of non-US subnational governments uses seven factors and weights; the seven factors and their respective weights are:
    - Economy (20 percent)
    - Financial management (20 percent)
    - Budgetary flexibility (10 percent)
    - Budgetary performance (10 percent)
    - Liquidity (20 percent)
    - Debt burden (10 percent)
    - Contingent liabilities (10 percent)

### Example: Mexico’s early warning system and thresholds
- The Mexican Secretaría de Hacienda y Crédito Público (SHCP) requires quarterly reporting to a public registry on three key financial indicators:
  - Ratio of debt and other financial obligations to non-earmarked revenues
  - Ratio of debt service and other financial obligations to non-earmarked revenues
  - Ratio of short-term obligations to total revenues
- Based on analysis, states are classified into three categories: (1) stable (green); (2) under surveillance (yellow); and (3) high level of indebtedness (red).
- Entities that have defaulted on financing obligations are automatically put in the red zone.
- Box Table 2.1: Mexico — Thresholds for Subnational Government Risk Categorization
  - Debt ratio: Low ,100 ; Medium 100–200 ; High .200
  - Debt service ratio: Low ,7.5 ; Medium 7.5–15 ; High .15
  - ST obligations ratio: Low ,8 ; Medium 8–12.5 ; High .12.5
  - Note: ST = short term
- The SHCP publishes a public registry of subnational debt data and posts its analysis publicly.

### Quantifying exposure and disclosure needs
- Quantification typically involves probability-weighted estimation of expected payments (present value), but recording maximum exposure may be sufficient in many cases.
- Measurement should include:
  - (1) debt and other financial liabilities of subnational governments that the central government may be required to assume; and
  - (2) any likely unanticipated financial outflows from the central to subnational governments if subnational finances weaken significantly.
- Lack of timely and comprehensive information on subnational direct and contingent obligations is a common challenge.
- Studies highlight weaknesses in timeliness, periodicity, reliability, and comparability of subnational financial data and gaps on off-budget funds and local public enterprises.
- World Bank study: only 18 percent of low-income countries publish debt statistics consistent with legal framework and borrowing practices; data on subnational debt are not available for 60 percent of these countries.

### Recommended reporting and consolidation practices
- Governments should aim to develop reporting systems that at a minimum span the entire general government sector.
- Objectives include consolidated annual financial statements and high-frequency fiscal reports covering the entire general government sector.
- Central agencies (typically the finance ministry) should be tasked with consolidation and publication of in-year fiscal reports and statistics, as well as annual accounts and financial statements for the general government sector.

### Country examples of disclosure practice
- Finland:
  - Each municipality publishes accrual-based annual financial statements—operating statement, cash-flow statement, and balance sheet, plus notes—following standards akin to those for Finnish firms.
  - Statements present a consolidated view including enterprises controlled by the municipality.
  - Statistics Finland publishes a summary and quarterly data on consolidated finances of the entire local-government sector, including revenue, expenditure, a financial balance sheet, and Maastricht debt and deficit.
- Peru:
  - Subnational governments’ primary spending and investment execution and regional and municipal debt stocks are reported monthly; more detailed fiscal performance is reported quarterly and annually.
  - Operations of municipal enterprises are reported annually.
- The Philippines:
  - The Commission on Audit publishes an annual compilation of local government financial statements with income and expenditure, balance sheets, and cash flows on aggregated and individual bases, covering provinces, municipalities, and cities.
  - The Bureau of Local Government Finance publishes a quarterly report on aggregate outstanding bank loans for the local government sector.
- Russia:
  - The Ministry of Finance publishes data on the debt of regions and municipalities monthly, aggregated by region.
  - The federal Treasury publishes monthly information on budget execution, including consolidated receipts and expenditure by subnational governments.
  - Individual regional and municipal governments are required to publish financial information in compliance with national standards on an annual basis, at a minimum.

### Illustrative case: New South Wales (NSW) Financial Sustainability Rating (FSR)
- A 2013 NSW Treasury Corporation study assessed the financial sustainability of 152 local governments using a composite FSR based on 10 financial performance indicators across four categories. Each council received a positive, neutral, or negative outlook and was grouped into seven categories: very strong, strong, sound, moderate, weak, very weak, and distressed.
- Box Table 3.1: NSW FSR Analytical Framework (Ratio — Benchmark — Weighting (%) — Subtotals (%))
  - Financial Flexibility:
    - Operating Ratio: .(4.0%) — 17.5 — 35.0
    - Own source operating revenue ratio: .60.0% — 17.5
  - Liquidity:
    - Cash expense ratio: .3.0 months — 10.0 — 20.0
    - Unrestricted current ratio: .1.5x — 10.0
  - Debt Servicing:
    - Debt service cover ratio (DSCR): .2.0x — 7.5 — 10.0
    - Interest cover ratio: .4.0x — 2.5
  - Asset Renewal and Capital Works:
    - Infrastructure backlog ratio: ,0.02x — 10.0 — 35.0
    - Asset maintenance ratio: .1.0x — 7.5
    - Building and infrastructure asset renewal ratio: .1.0x — 7.5
    - Capital expenditure ratio: .1.1x — 10.0
  - Total: 100.0

*Source: IMF Fiscal Affairs Department, How To Notes (August 2022).*

### Box 4. Reporting of Subnational Finances in Selected Countries

### Box 4. Reporting of Subnational Finances in Selected Countries

### Reporting and Monitoring of Subnational Finances
- Develop a database of subnational debt and contingent liabilities (if not otherwise readily and publicly available), covering for each subnational government:
  - debt,
  - other financial liabilities,
  - contingent liabilities (including guaranteed and unguaranteed debt of their SOEs),
  - revenues from and expenditure on off-budget operations,
  - size of the PPP program.
- Update the database at least every quarter.
- A web-based interface could facilitate data updates directly by subnational governments.
- Central finance ministries should use this reporting framework to actively monitor subnational fiscal performance.
- Typical functions of an intergovernmental relations unit in the central Ministry of Finance:
  - manage the repository of data on subnational finances;
  - track early warning indicators;
  - prepare and publish reports on the fiscal performance of the consolidated subnational sector;
  - prepare periodic (at least quarterly) reports for the finance ministry management on analysis of fiscal risks from subnational governments;
  - provide input for the annual fiscal risk statement;
  - potentially design and oversee the implementation of subnational bailout programs.

### Controls on Subnational Borrowing — Forms and Country Practices
- Two broad control types:
  - Direct controls: limit the size of the risk (for example, ceilings or restrictions on subnational borrowing).
  - Indirect controls: influence risk-taking behavior of subnational governments.
- Administrative controls (examples and features):
  - Borrowing only with central government approval:
    - Hungary (exceptions: liquidity loans expiring within a year; reorganization loans; borrowing to cover cofinancing for international funds),
    - Spain,
    - Thailand,
    - Peru (may borrow only with national government’s agreement; financing must be channeled to capital projects),
    - Argentina (explicit authorization by federal government observing compliance with the debt rule in the fiscal responsibility law),
    - Kenya (long-term borrowing requires approval and a guarantee from the national government, and thereafter the approval of the Parliament),
    - Ethiopia (states may borrow short term with federal approval but loans must be repaid in the following fiscal year),
    - Bangladesh (central approval of subnational annual budgets and financing plans required),
    - India (a state in default on a loan from the central government may not borrow without central government approval),
    - Türkiye (central approval required if borrowing exceeds a specified percentage of annual revenues).
  - Borrowing only from the central government:
    - Malaysia (states may borrow long term only from the central government; may borrow short term from approved financial institutions with central bank approval; exceptions: Sabah and Sarawak enjoy greater constitutional autonomy),
    - UK (Public Works Loan Board centralizes all loans to local authorities).
  - No or restricted external borrowing:
    - Examples: India, Mexico, New Zealand, Slovenia (external borrowing prohibited; often channeled through the center by onlending),
    - China (prohibits external borrowing without central government approval; 2014 budget law opened borrowing subject to State Council preapproval and mandated an early warning system for local government debt; implementing orders reinforced a “no bailout” policy and accountability regime).

- Advantages and risks:
  - Administrative controls can be effective but may create the perception of implicit central government support and moral hazard; they do not combine well with a no-bailout policy.
  - Central control over external borrowing can aid macroeconomic stability and cost efficiency, and align with foreign lenders’ preference for sovereign guarantees, but constitutional/legal constraints and decentralization goals can limit applicability.

### Rules-Based Constraints and Regulatory Measures
- Fiscal rules can constrain:
  - overall budget deficit,
  - operating budget deficit,
  - indicators of debt-servicing capacity,
  - stock of debt or level of spending.
- Rules can be centrally imposed or self-imposed, and may be specified in central or subnational legislation (examples: Argentina, Brazil, Bulgaria, Colombia, Hungary, India, Philippines).
- Purpose constraints: many OECD countries have limited subnational borrowing to investment purposes (examples: Canada, Denmark, France, Germany, Luxembourg, New Zealand, UK).
- Procedural requirements: medium-term fiscal frameworks (Colombia), orderly and transparent budget processes (China).
- Enforcement and penalties for rule breaches (examples):
  - fixed fines (Slovak Republic),
  - reduced central government transfers (Czech Republic),
  - cuts in share of taxes (Austria),
  - fiscal consolidation plans (Colombia, Spain),
  - administrative sanctions on subnational governments (Spain),
  - sanctions on local officials including elected officials (Türkiye, Poland).
- Drawbacks of rules:
  - potential rigidity and circumvention (reclassification of expenditure, off-budget borrowing).
  - fiscal transparency and well-developed subnational fiscal reporting are critical to rule effectiveness.

### Table of Illustrative Thresholds Used for Subnational Borrowing Regulation (selected examples)
- Argentina
  - Debt service/net current revenue: 15%
- Brazil
  - States: Debt/net current revenue: 200%
  - Municipalities: Debt/net current revenue: 120%
- China
  - Debt/GDP: 60%
  - Debt/revenue: 100%
- Czech Republic
  - Debt/revenue: 60%
  - Debt service/revenue: 30%
- Colombia
  - Interest/operating balance: 40%
  - Debt/revenue: 80%
- France
  - Debt/annual operating balance: 9–12 times
- Greece
  - Debt/revenue: 100%
  - Debt service/revenue: 20%
- Iceland
  - Debt/revenue: 150%
- Poland
  - Debt/revenue: (entry shows "Deb/revenue")
  - Debt service/revenue: 15%
- Türkiye
  - Metropolitan Debt/Revenue: 150%
  - Other Municipalities Debt/Revenue: 100%

### Approaches to Controlling Subnational Borrowing (summary)
- Four main approaches (Ter-Minassian and Craig 1997; Singh and Plekhanov 2005):
  - Direct Controls: prior central government approval for borrowing and/or limits.
    - Advantages: High degree of central control.
    - Preconditions: Constitutional/legal underpinning; ability of central government to effectively monitor and implement controls.
  - Rules-Based Constraints: fiscal rules and/or limits set through legislation.
    - Advantages: Transparency; avoids bargaining.
    - Preconditions: Credible rules; transparency; monitoring and enforcement mechanisms.
  - Cooperation: limits set through negotiated agreement.
    - Advantages: Promotes dialogue; enhances responsibility of subnational policymakers.
    - Preconditions: Culture of fiscal discipline; constitutional underpinnings; cooperative decision-making institutions.
  - Market Discipline: no direct control on borrowing.
    - Advantages: Emphasizes self-control; external monitoring.
    - Preconditions: Reliable information; developed capital markets; transparency; track record of no bailouts.

### Market Discipline and Conditionalities
- Market-discipline approach (examples: Canada, South Africa, US) typically complemented by a no-bailout policy.
- Requires well-functioning financial markets; less appealing for many developing economies.
- High transfer dependency can reduce the disciplining role of markets and create perception of implicit sovereign guarantees.
- Empirical findings:
  - Subnational debt and deficit levels drive subsovereign spreads, but their weight diminishes when bailout precedent exists.

### Holistic Fiscal Management Framework and Resourcing
- Adopt an integrated fiscal management framework with general government as the unit for fiscal planning, objective setting, and reporting.
- Fiscal rules should apply harmoniously to the entire general government sector.
- For federations, develop strong intergovernmental coordination mechanisms.
- Fiscal reporting should, at a minimum, cover general government; wider coverage exposes off-budget borrowing and SOE-related circumvention.
- Adequate resourcing of subnational spending mandates:
  - Clarity in legal framework on spending assignments by level of government (IMF 2009).
  - Expenditure responsibilities assigned to subnational governments should be exclusive and based on efficiency considerations.
  - Aim to achieve an optimal vertical fiscal gap and vertical fiscal balance by designing the mix of subnational revenue authority, central transfers, and subnational borrowing (Boadway and Eyraud 2018).
  - Devolution of expenditure and revenue authorities should be harmonious and consider subnational PFM capacity; devolution should be contingent on acquisition of fundamental PFM capabilities.

### Central Government Oversight: Institutions and Examples
- Monitoring of subnational finances is effective for containing local financial distress; early detection facilitates timely action.
- Suggested institutional measure: establish an intergovernmental relations unit in the central Ministry of Finance to coordinate with subnational governments and perform monitoring/reporting functions.
- Country examples:
  - Kenya: Public Finance Management Act of 2012 mandates strengthening financial and fiscal relations between national and county governments; the Intergovernmental Fiscal Relations Department in the national Treasury coordinates and oversees county finances.
  - South Africa: Inter-governmental Relations Framework Act of 2005 mandates intergovernmental coordination (in practice subnational governments enjoy considerable freedom).

### Colombia: Case Study of a Rules-Based System
- After overborrowing and excessive expenditure growth in the 1990s, Colombia established a regulatory framework:
  - Law 358 of 1997: “traffic light” system rating subnational governments by ratios of debt-to-payment capacity into red, yellow, green:
    - Red: prohibited from borrowing;
    - Green: permitted to borrow up to limits based on debt sustainability calculations;
    - Yellow: required prior central government permission to borrow.
  - Law 795 of 2003 (Fiscal Responsibility Law, FRL) eliminated the yellow zone.
  - Departments and large municipalities must obtain a satisfactory credit rating from rating agencies before borrowing.
  - Subnational governments brought within the FRL; required to adhere to medium-term financial planning and budget management.
  - Additional legal framework features:
    - quantitative limits for operating expenses (Law 617 of 2000);
    - rules for dealing with financial insolvency (Law 550 of 1999);
    - provisions relating to financial planning, budgeting, and accountability (Law 819 of 2003);
    - prohibition against the national government guarantee for subnational domestic debt.
- FRL sanctions for noncompliance:
  - prohibited from borrowing if limits breached;
  - must adopt an adjustment plan to regain viability over the following two years;
  - national government may take over administration of finances or support services (education, health) by directing resources earmarked for transfers;
  - national government prohibited from lending to or guaranteeing subnational domestic debt if entity violates Law 617 or Law 358, or if it has debt service arrears to the government;
  - in cases of non-compliance, the credit contract is deemed invalid and borrowed funds must be restituted promptly (Article 21 of the FRL).

*Source: Box 4. Reporting of Subnational Finances in Selected Countries (excerpt).*

### Box 5. Framework for Regulating Subnational Borrowing in Colombia

### Box 5. Framework for Regulating Subnational Borrowing in Colombia

### Central oversight and institutional arrangements
- A dedicated oversight unit is recommended to coordinate fiscal relations between the national, provincial, and municipal levels and to promote sound subnational financial planning, reporting, and management.
- Where oversight is assigned to entities other than the finance ministry (for example, the Ministry of the Interior or Local Government), a protocol should be in place for the oversight unit to provide information to the finance ministry unit responsible for fiscal risk management.
- Oversight requires close interdepartmental coordination and exchange of information; examples:
  - In the Philippines, government financial institutions, the central bank, and the Local Government Unit Guarantee Corporation submit local government debt data to the Bureau of Local Government Finance (BLGF) under the Department of Finance.
  - Local governments are required to submit quarterly financial statements to the BLGF.
  - The central bank monitors loans by government financial institutions to local governments and purchases of local government bonds.

### Subnational PFM capacity
- Building sound PFM systems and practices at the subnational level is an important element of risk mitigation regardless of the governance approach to subnational borrowing.
- Institutional weaknesses may render risk mitigation and management ineffective even if they are not the primary source of macrocritical fiscal risks.
- Elements of a sound subnational PFM system are similar to those at the central government level; Annex 2 presents essential ingredients.
- New Zealand case features (contextual example):
  - Subnational sector size: about 4 percent of GDP.
  - Ten-year plans and budgets must be prepared and made available to the public for comment before adoption; auditor general reviews them for reasonableness of assumptions.
  - The annual operating budget—prepared on an accrual basis—should be balanced.
  - Annual reports—including audited annual financial statements—comparing actual and intended performance must be produced and adopted within four months of the end of the financial year, and they should be made public within one month of adoption.
  - Local governments may borrow in domestic markets with credit rating or through the central agency for local government borrowing; central government imposes no administrative controls beyond prudential limits set in central government regulations; law prohibits central government guarantees of subnational debt.
  - Office of the Auditor General provides main oversight; central government’s Office of Local Government provides limited oversight.

### Provisioning for and accommodating residual risks
- Residual fiscal risks should be provisioned for in the budget to ensure funds are available if risks materialize; an up-front budget provision helps avoid surprises.
- The size of potential contingency must be estimated carefully to avoid underestimation or overestimation.
- Two general approaches to estimate needed provisions:
  - Top-down analysis based on historical data on support to subnational governments, identifying unplanned support provided in recent years; horizon should consider at a minimum the preceding five to seven years.
  - Bottom-up approach involving risk assessment of subnational governments, identification of risks likely to crystallize in the coming year (or medium term), and estimation of their respective sizes; dovetails with the risk assessment framework.
- In making budget provisions, avoid explicitly identifying subnational governments likely to call on central resources; assigning probabilities to individual contingent liabilities in a published document is likely counterproductive and can create moral hazard.
- Budget provisions can be placed under an omnibus contingency head to avoid claims on those funds.
- Residual risks should be assessed alongside other fiscal risks when setting longer-term debt targets; a cushion in debt targets allows absorption of fiscal risk realizations without threatening debt sustainability.
- Any bailout programs already agreed/approved should be explicitly provided for in the budget as a distinct line item for transparency and monitoring purposes.

### Disclosing fiscal risks from subnational governments
- Routine disclosure of fiscal risks promotes awareness and shapes policy debate and decision-making; disclosure should ideally be in a fiscal risk statement accompanying or preceding annual budget documents.
- If a fiscal risk statement is not prepared, include an analysis of fiscal risks from subnational governments in fiscal strategy or budget documents.
- Disclosure should provide insights into:
  - Aggregate fiscal performance of subnational governments using key performance indicators (for example, deficits/surplus, net assets/equity, and gross firm and contingent liabilities).
  - Financial analysis for each subnational government to identify those in financial distress or potential distress; distressed entities should be analyzed in greater detail while the remainder may be aggregated; analysis should examine revenue sufficiency, liquidity, leverage, and solvency (see Annex 1).
  - Relations with the central government in terms of central transfers; debt owed; arrears of debt, if any; and outstanding central guarantees.
  - Main identified risks, mitigating measures, central oversight regime, and regulations promoting fiscally sustainable policies.
- Central government financial statements should enable easy identification of financial transactions—revenue sharing, central transfers, loans, and guarantees—with each subnational government, and include a comment on risks to the stock of outstanding loans and guarantees.

### Insolvency framework for materialized risks
- An insolvency framework complements ex ante regulations by moderating lenders’ risk-taking behavior, promoting market discipline, and enhancing predictability of insolvency consequences in terms of burden sharing.
- Main objective: restore the financial health of a distressed subnational government; liquidation is neither an objective nor feasible in most jurisdictions.
- Design must address two critical requirements:
  - A debt restructuring to provide immediate relief to a distressed subnational government.
  - A timebound fiscal adjustment program to restore fiscal sustainability while maintaining essential public services.
- Two main models for insolvency procedures:
  - Judicial approach: courts establish insolvency and guide restructuring; advantage is insulation from political influence.
  - Administrative approach: higher-level government directs restructuring and may take over financial management; may be more effective for designing and implementing fiscal adjustment.
  - Hybrid approaches are possible; chosen approach must fit the country’s political-legal structure.
- An insolvency framework should:
  - Define insolvency unambiguously and establish triggering criteria.
  - Clarify who can initiate proceedings and provide mechanisms to identify and dismiss applications not in good faith.
  - Establish principles and procedures for recognizing creditors and determining claim priority, including employees.
  - Identify essential services and distinguish assets required for continued delivery from those that can be liquidated.
  - Prescribe debt restructuring negotiation procedures, time frames, recourse if agreement is not reached, and transparency requirements.
  - Specify authority and scope for higher-level government intervention—including directives, supervision, and, in extreme cases, taking over financial affairs—and how intervention should be carried out.
  - Establish elements of a fiscal adjustment plan, monitoring and surveillance regimes, and reporting and transparency requirements.
  - Provide protection against fresh claims while in insolvency.
  - Create institutional structures required for carrying out insolvency proceedings.
- Financing restructuring: some countries establish dedicated funds with capital from subnational and central governments to pool resources, design and monitor fiscal adjustments, and assist with debt restructuring; existence of such a fund can lend credibility to a no-bailout policy (example: Portugal’s Financial Support Fund created in 2014 reportedly reduced municipal debt levels).

### Conclusions — Four pillars of a framework for managing subnational risks
- Central oversight of subnational finances:
  - Stronger central oversight helps identify risks and contingent liabilities before they crystallize.
  - A systematic analysis of subnational finances can provide early warning about stressed entities.
  - Governments could develop a standardized indicator-based system for analyzing subnational financial performance and position.
  - A dedicated unit at the central Ministry of Finance should be tasked with risk analysis and monitoring, provide input for the fiscal risk statement, and contribute to overall risk management strategy.
- Regulatory framework for subnational financial management:
  - Common features include (1) borrowing only for capital investment; (2) limits on key fiscal aggregates—deficit and debt parameters—including guarantees; (3) procedural requirements for transparent budget processes and adherence to accounting and auditing standards; and (4) improved fiscal reporting.
  - National authorities must monitor and build safeguards against attempts by subnational governments to circumvent controls and rules.
- General government policy focus:
  - Framework should be developed as part of the larger fiscal management framework and operate coherently with a general government focus, beyond central government budgets.
  - Intergovernmental fiscal relations should align spending responsibilities with available resources.
- Subnational PFM capacity:
  - Augmenting institutional capacity at the subnational level is important to address weaknesses that can exacerbate risks or render mitigation ineffective.
  - Fiscal reporting is critical for accountability and transparency; reporting should include standardized individual reporting and consolidated reporting for the subnational sector and the general government.
  - Fostering communities of subnational finance ministries can facilitate coordination, reinforce good practice, and build capacity across jurisdictions.

### Annex 1 — Suggested Financial Soundness Analysis Framework
- Financial standing can be measured along five dimensions:
  - Fiscal capacity and flexibility.
  - Operating performance.
  - Liquidity and debt management.
  - Debt capacity.
  - Asset management.
- Use a manageable number of indicators focused on those that identify key areas of risk for the entity.

*Source: Box 5, How to Manage Fiscal Risks from Subnational Governments, International Monetary Fund | August 2022.*

### Annex Table 1.1. Suggested Ratios for Subnational Government Financial Analysis

### Annex Table 1.1. Suggested Ratios for Subnational Government Financial Analysis

### Fiscal capacity and flexibility
- Revenue per capita  
  - Measures the revenue base of a government relative to its population; useful for comparison with other similar jurisdictions and changes over time.
- Expenditure per capita  
  - Measures expenditure relative to population; useful for comparison with other similar jurisdictions and changes over time.
- Own-source revenues/total revenues  
  - Measures a government’s degree of reliance on external funding sources.
- Discretionary expenses/total expenses  
  - Measures a government’s capacity to contain its expenditure. Discretionary expenditure can be defined as nonessential expenditure; i.e., total expenditure minus essential expenditure on wages, interest, mandatory services, and important ongoing capital projects.

### Operating performance
- Operating balance/revenues  
  - Measures a government’s operating performance in terms of its achievement in containing operating expenses within operating revenues.

### Liquidity and debt management
- Free cash and liquid assets/current liabilities  
  - Measures adequacy of cash resources for meeting short-term obligations.
- Short-term debt/total debt  
  - Measures the debt structure; useful in assessing whether the entity is exposed to significant refinancing risk.

### Debt capacity
- Debt/free own-source revenues  
  - Measures debt burden of a government; an alternative is debt-to-subnational GDP (debt-to-GDP for national governments), if reliable estimates of subnational GDP are available.
- Operating balance before interest and depreciation/debt service  
  - Measures debt service cover in terms of the adequacy of operating surplus to meet the annual debt service obligations. Using debt service in the current or budget year is most useful when the underlying debt is based on level repayment. If, however, debt terms include features such as bullet payments, grace periods of repayment of principal, or low initial interest rates that reset to a market rate at some future point, then it may be more useful to use the “maximum future debt service.”

### Asset Management
- Maintenance expenditure/stock of infrastructure assets  
  - Compares maintenance expenditure to the stock of infrastructure assets. If there are set norms for maintenance, actual maintenance expenses can be compared with the norm to measure the maintenance gap.
- Asset renewals/depreciation  
  - Measures whether existing assets are being renewed at the same rate at which they are being consumed. Considers major repairs/refurbishments to existing assets for restoring their capacity. A ratio of less than 1 would indicate a depleting stock of existing assets.
- Capital expenditure/depreciation  
  - Measures the rate at which a government is expanding its asset base. Considers capital expenditure on both new assets and replacement/renewal of existing assets.

### Key statistics (from the table context)
- Page/section reference: Annex Table 1.1 (within the document)

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### Annex 2. Essential Elements of a Sound Subnational PFM System

### Budget formulation and predictability
- A robust budget formulation process capable of delivering credible estimates of annual resource requirements for achieving expected policy outcomes.
- A well-developed budget process allows resource allocation to strategic priorities in a multiyear framework within the overall fiscal constraints. It enhances the predictability of resource availability.
- The budget should be comprehensive, covering all public spending, and the process should be guided by transparent and consistent objectives for fiscal aggregates, based on realistic macroeconomic assumptions.
- A common constraint for subnational budgeting systems is the predictability (or lack of it) of central transfers. Central governments should ensure the timely availability of this information to subnational levels. Coordinating budget calendars can facilitate this goal.

### Public investment and fiscal risk management
- A public investment management framework that integrates investment planning with budget formulation, coordinates with the central and other subnational governments, and ensures the delivery of quality investment outcomes.
- A fiscal risk management function that is capable of identifying, monitoring, and reporting on major fiscal risks and suggesting appropriate risk mitigation measures, as needed. This would include building capacity for the effective oversight of subnational state-owned enterprises, and extrabudgetary entities.

### Budget execution and cash management
- An efficient budget execution process that ensures timely disbursements and efficient revenue collection, regulated by a system of internal controls to ensure compliance with the legal requirements and to guard against the risk of misappropriation.
- A system of cash management should be in place to support budget execution by ensuring liquidity required for payments. Consolidation of cash into a single bank account and centralization of disbursements should be sought to improve budget execution efficiency.

### Financial reporting, auditing, and information systems
- A financial reporting system capable of producing quality information on financial performance and position in a timely manner. Reports should provide comprehensive coverage of revenues, expenses, and all assets and liabilities—accrued and contingent—in accordance with internationally accepted accounting principles and reporting standards.
- The reporting system must be capable of producing reliable in-year (monthly, quarterly) and year-end information on subnational finances. Reporting and auditing requirements should be established in legislation, with a specification of the main elements of reporting, the standards to be followed, the timelines for submission, and a clear mandate to external auditors.
- The legislation could also require in-year reporting—monthly budget execution reports and more comprehensive quarterly fiscal reports, including reports on debt and other financial liabilities.
- A financial management information system—appropriate for the size and complexity of operations—should be considered for more efficient transaction processing, automating of selected controls, and ease of reporting consistent with the applicable standards.
- An independent external audit ensures accountability for the use of resources. Audit reports should be routinely submitted to the legislature and made public. The audit could perform a useful role in monitoring and commenting on subnational financial performance and highlighting vulnerabilities.

### Legal and institutional framework
- A comprehensive legal framework, encompassing the entire budget management cycle, should be established to guide financial management and ensure its orderly conduct.
- The framework, preferably enshrined in legislation—national or local—should clarify the respective roles and responsibilities, define the main features of the budget management process, specify the reporting requirements, and establish accountability. Sanctions for financial misconduct and breach of compliance should be built in.
- Examples noted in the text:
  - In India, the overarching elements of financial management in the states are enshrined in the constitution.
  - In Malaysia, the relevant provisions of the Financial Procedures Act are applicable to both the central government and the states.

*htnea2022003 - Annex Table 1.1. Suggested Ratios for Subnational Government Financial Analysis — How to Manage Fiscal Risks from Subnational Governments (IMF How To Note)*

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_Source: https://www.imf.org/-/media/files/publications/howtonotes/2022/english/htnea2022003.pdf_