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May 2000 - Because of the trend toward decentralization in more than 70 countries where the World Bank is active, subnational entities - states, regions, provinces, counties, and municipalities, and the local utility companies owned by them - are now responsible for delivering services and investing in infrastructure. And infrastructure investments are growing rapidly to meet increasing urban demand. How should the World Bank Group help? Subnational debt markets can be a powerful force in a country's development. Through delegated monitoring by financial intermediaries and through debt placed directly with investors, sub-national debt markets account for about 5 percent of GDP in Argentina and Brazil. But they remain embryonic in most developing and transition economies. To resolve a potential clash between the increased financing needs of subnational entities and the limited development of domestic subnational debt markets, it is critical to support the orderly, efficient emergence of such debt markets. As a framework for policy reform, the following steps (mirroring typical weaknesses) are prerequisites for developing a country's subnational debt market: Reducing moral hazard; Improving market transparency; Strengthening market governance; Establishing a level playing field; Developing local capacity for accounting, budgeting, and financial management. In countries where the government shows a clear commitment to market development, says Noel, the IBRD should support the framework needed for policy-based operations that establish hard budget constraints. In doing so, the IBRD should concentrate on (1) supporting national and local capacity building in those areas essential for developing a subnational debt market and (2) financing specific subnational projects with strictly nonrecourse loans. At the same time, the World Bank Group should offer a variety of lending and guarantee instruments that encourage private financing for investments by subnational entities - including, for example, equity participation in (or lines of credit or partial credit guarantees to) financial intermediaries specializing in subnational investment finance or in funds for financing local infrastructure. This paper - a product of the Private and Financial Sectors Development Unit, Europe and Central Asia Region - was prepared as background for a manual on policy issues relating to domestic debt markets. Michel Noel may be contacted at mnoel2@worldbank.org.

Agency Problems --- Bond Market Players --- Debt Market --- Debt Markets --- Decentralization --- Domestic Bond --- Domestic Bond Market --- Domestic Debt --- Domestic Debt Markets --- Finance --- Finance and Financial Sector Development --- Financial Sector Development --- Financial Systems --- Markets Development --- Sub-National Bond --- Sub-National Bond Market --- Sub-National Bond Markets --- Sub-National Debt --- Sub-National Debt Market --- Sub-National Debt Market Development --- Sub-National Debt Markets --- Transition Countries