Constraining the spending behavior of subnational governments through borrowing limitation: The case of Malaysia

In literature, subnational governments have been identified as being prone to fiscal profligacy. In response to this problem, some countries choose to put a limit on the borrowing capacity of the state and local governments. This is notably the case for Malaysia with the enactment of Article 111 (12) of the Constitution. However it remains to be answered whether such regulation really has an impact on the spending behavior of the state governments. This paper attempts to shed some light on this question by employing the methodology usually found in the study of intertemporal behavior. The underlying objective is to examine whether a decision to further decentralize the economy in the future will not be translated into macroeconomic instability due to the fiscally irresponsible behavior of the state governments. Indeed such eventuality can be avoided if the federal government has what it takes in order to put the spending behavior of the state governments under control. Our findings point to the conclusion that the regulation has failed to produce a significant effect on the spending behavior of the state governments. The results indicate that the state governments in Malaysia manage to observe a forward looking behavior implying that they are not subject to any liquidity constraint.