Legal Framework for Municipal Borrowing in Portugal

Abstract

Fiscal decentralization can create adverse incentives for subnational governments to borrow excessively, especially if there is a problem of “soft budget” constraint in intergov- ernmental fiscal relations. Under a soft budget constraint, the implicit guarantee that, in case of financial crises, sub- national governments can rely on central government’s bailouts leads to distortions in the conduct of fiscal policy. In such cases, the incentives for fiscal responsibility are weakened by the subnational governments’ expectation that the costs of their spending and borrowing are trans- ferred to the central government (moral hazard problem). Without the appropriate legal framework, subnational bor- rowing can then represent a serious threat to subnational financial solvability and undermine the center’s efforts at maintaining fiscal discipline, therefore jeopardizing macro- economic stability. The new Local Finance Law (Law No. 2/207) intro- duced profound alterations in the legal framework for mu- nicipal borrowing in Portugal. The new Law increased the restrictions on the ability of Portuguese municipalities to borrow, as a strategic measure to ensure the consolidation of public finances and the fulfilment of the commitments assumed by the Portuguese government within the scope of the Stability and Growth Pact. The new Local Finance Law has also strengthened the legal regimes for the recov- ery of financially distressed municipalities. This study analyses the background to the new legal framework for municipal borrowing in Portugal and the new restrictions to municipal indebtedness. It also analyses the legal framework for leading with municipal finan- cial distress.