The globalization of financial markets,has increased international pressure on the federalgovernments to maintain a hard budget constraint, withrespect to sub-national governments. Because growth insub-national deficits undermines investor confidence, thefederal government is under pressure to enforce the new debtcontrol system, if only to keep the foreign investmentflowing, and, political support for enforcement of thefiscal rules may also have increased. Nevertheless, there isthe case for shifting the system of sub-national debtcontrol from one that depends on central regulation, to onethat relies more on markets. The report looks atinstitutional models for doing so, which include bondmarkets, and specialized banks. If the market model is toprevail in Brazil, changes in the credit environment mustoccur: private long term funds must become available, atinterest rates compatible with infrastructure investmentreturns. But continued macroeconomic stability, anddeclining federal deficits are required before implementingthe market model; private lenders must have a level playingfield, and, limitations on subsidized government lending isnecessary to attract private sector interest; the federalgovernment should refrain from extending implicit guaranteeson private loans to sub-national governments, whileestablishing a pattern of non-interference in sub-nationaldefaults to private banks; and, reforms should removeobstacles that prevent sub-national governments frombecoming creditworthy. Likewise, the growing state pensionliabilities challenges the present system of fiscal controls.
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