ABSTRACT
In many countries, local borrowing is an important source for long-term development projects such as roads, bridges, and waterworks. Local borrowing for such projects is justified on the ground that the benefit of these projects often lasts for decades and the cost of these projects should be borne by future taxpayers. However, there are serious concerns with issue of local bonds by decentralized local governments. When transfers are based on ex post financial needs rather than ex ante characteristics, the central government can bail out regions experiencing financial difficulties. Knowing that, local governments may be inclined to overspend, under-tax, and borrow excessively, since they can expect the central government to eventually guarantee repayment of local debts (Rodden and Eskeland 2003). Moreover, lenders also lose incentive to monitor subnational governments because they view their investment as protected by a central government. This kind of soft budget constraint problem would not exist if the central government could commit to a non-bailout policy, but it is difficult for the center to do so in the short run.
