Debt management practices and recommendations

Guidelines on Local Government Borrowing and Recent Developments in South East Europe

7. How to manage the credit?

7.2. Debt management practices and recommendations 7.2.1. Planning the structure of the loan and its components

Local governments in former communist territories covered by NALAS members are facing many drawbacks in terms of planning. While planning was a mantra during communist rule, it was rejected as impossible or unnecessary afterwards. By late 1990s it became obvious that at least financial and investment planning were needed if local communities were to harness their development potential and the grants from European Union and other donors. By then the entire administrative context had changed and planning skills were no longer up-to-date. Planning in the new legislative, economic and political background was a totally different experience as compared to communist times.

Although it looks as a straightforward job, debt management is complex, especially in medium and large municipalities which can afford to take several loans at a time. Before taking a loan local officials must decide where to spend the money and over how long a period. When negotiating the loan, they have to think at maturity, grace period, interest rates, fees, drawdown (loan disbursement), refinancing etc. After securing the loan local governments have to generate enough revenues to pay for debt service and also allow for additional lending or direct investment. Unfortunately, when things do not go as planned, local communities must deal with loan restructuring and sometimes default.

Despite the importance of rational debt management most local governments do not have any specific strategies and therefore act on an ad-hoc manner. The conclusion holds true for the surveyed territories covered by NALAS members, too; the few examples of debt strategies that were put forward had mostly been developed by foreign technical assistance teams.

Taking all this into account, local officials must be familiar with some general practical recommendations regarding the debt they are contracting.

The data from the research in the target territories covered by NALAS members on South-Eastern Europe show that bonds, although considered as the best instrument for long-term capital investment, are rarely used. As a matter of fact, only Romania, Croatia and Montenegro have witnessed local government bond issues. Loans make for the vast majority of debt instruments. Hence, we will focus on loans in the next paragraphs.

It is important that local governments borrow in national currency especially in developing territories covered by NALAS members, where exchange rates fluctuate and inflation is considerable. Although national currency interest rates can be dissuasively high, debt service should be denominated in the same currency as budget revenues. If borrowing in foreign currency with low interest rates proves irresistible, then local governments should secure hedging provisions to shelter from national currency depreciation. Hedging agreements should be as detailed as possible about their nature (forward contracts or options25), the reference exchange rate, interest rate, fees etc.

Some territories covered by NALAS members, such as Kosovo, forbid borrowing in foreign currency altogether. From a different perspective, Slovenia, which is part of the EURO area, also forbids local government loans in foreign currency.

Ideally, the loan maturity should be equal to the investment’s economic life. However, in volatile markets such as those in Southeastern Europe banks are reluctant to lend over long term in national currency. At the moment, in less developed markets maturities of local currency loans average 5-7 years while those in foreign currency may top 15-20 years. Inevitably the prospect of joining the European Union and adopting the EURO will increase the confidence of lenders in the macroeconomic policies so maturities for national currency loans will eventually grow. When that happens, local officials should aim for long-term maturities.

Grace periods are useful especially for loans given to revenue-generating activities, such as water, waste management, business parks, tourism etc. The grace period should last until the new revenues start flowing. This way the investments themselves will pay for the loan at least partly. Grace periods may also be used for infrastructure investment loans until the planned public works are completed. If needed, the local government may agree with the lender not to pay interest during the grace period.

Planning for debt service (both principal and interest) has to be correlated to revenue cycle, to the recurrence of other payment commitments and to the legal provisions for debt threshold. Local government must avoid the overlapping of multiple pay obligations at a time while lacking sufficient revenues. The revenue cycle of local taxes depends of the dates and number of pay deadlines. For instance, if property tax can be paid in two stages during the year, the local budgets will benefit from important flows of revenues around those dates. In the case of transfers from state budgets, including shared taxes, proceeds are generally transmitted monthly to local budgets. If such conditions hold true and taking into account the recurrent activities’ pay commitments, it may be wise to structure debt service in correlation with periods when the most revenues are collected during the year.

Regarding the principal payment it is important to structure the amortization to fit existing debt service commitments and planned revenues. The objective is to avoid the overlapping of peak service for multiple debt instruments or other expenditure com-

mitments. Such a situation may endanger the recurrent service provision and also the observance of the legal debt threshold. Also, one must deal carefully with bullet debt instruments, which can break the threshold or deny room for additional borrowing at given times. As a conclusion, the amortization of the loan must be fine tuned. Local governments have the option of even, progressively increasing or progressively decreasing principal amortization. In the first case, the principal is repaid in equal amounts during the maturity period; in the second situation, debt service begins with smaller amounts which increase progressively until maturity; finally, progressively decreasing amortization starts with high values of principal payment and ends up with low ones.

As for the interest rate setting, in developing territories covered by NALAS members it should be weighed against a national of international reference rate, such as the interbank exchange rates determined by national banks (of European Central Bank). Fixed interest rates are useful in volatile markets, but also very hard to obtain for long-term loans.

Loan fees may often prove burdensome, but are inevitable. Lenders sometimes combine lower interest rates with higher or multiple fees to disguise the real cost of borrowing. Quite often low profile fees may eventually become additional interest rates. Examples of such recurrent fees are: management fee (paid regularly), drawdown fee, utilization fee, non-drawdown fee. In addition, there is a plethora of one-off fees: commitment fee, arrangement fee, agency fee, approval fee, analysis fee, insurance fee, originating fee, refinancing fee, early repayment fee etc. Local government specialized personnel must be very careful in measuring the cost of all fees in any loan offer. In many cases, they make the difference between a good and a bad transaction.

In the majority of the surveyed territories covered by NALAS members loan proceeds are held in accounts with commercial banks. Some banks may choose to open escrow accounts on behalf of the local governments and direct themselves the payments to suppliers. In a minority of cases, loan proceeds are held within the State Treasuries, along with the other local government resources (Kosovo, Macedonia, Serbia and Slovenia).

Drawdown (loan disbursement) depends on the type of debt. In the case of bonds all proceeds reach the borrower immediately. The respective local government should deposit the money to a commercial bank, if possible; until drawdown begins in earnest the interest from the deposit may cover part of the debt service. For example, in Romania, Bucharest municipality deposited 500 million EURO from its 2005 bond issue with a commercial bank; for two years, the gains from the deposit were enough to pay the interest rate of the bonds.

In the case of loans, banks usually refuse to put all loan proceeds at the client’s disposal. In addition, they sometimes ask to verify the invoices from suppliers to ensure the pay89 ments are in keeping with the loan objectives. In such cases, drawdown takes place on demand from the local government. All loans have a drawdown plan; on the other hand, breaking the plan prompts some banks to charge non-compliant local governments a non-drawdown fee.

7.2.2. Keeping options open: budget planning during debt service

Debt servicing should not make use of all operational and capital surpluses. It is important that local governments preserve and plan for a resource-buffer for unexpected pay needs or costs incurred by additional borrowing. The budgetary indicator of such a buffer can be called net balance after existing debt service (or net result) and is determined with the following formula:

NBADS = [(recurrent revenues - recurrent expenditure) + (capital revenues - capital expenditure)] - (interest rate + principal)

where, (recurrent revenues - recurrent expenditure) = operational balance (capital revenues - capital expenditure) = capital balance

Net balance after existing debt service provides information on the capacity of a local government to take and service additional debt. It has to be estimated over the maturity period of the new debt instrument. The estimation can be calculated as follows

assume the three-year average structure and weight of operational and capital expenditure remain unchanged,

add the planned debt service for existing debt (direct or guarantees).

If the results are significantly positive values, then the local governments may plan for another loan. However, the new debt service has to fit within the estimated values of the net balance. In the results are close to zero or turn negative, the local government has the following options:

trim estimated revenues and/or expenditure,

restructure existing debt instruments so as to reduce debt service,

plan for a different structure of the new loan (e.g. longer maturity, customized debt service).

As far as revenues and expenditure are concerned the decisions lay with local elected officials. On the side of revenues, the options are to improve collection and/ or to increase tax rates, fees and charges. Unfortunately, many Southeast European countries limit the increase of tax rates. Local officials are inclined to use it as a last resort anyway. Collection improvements usually yield only marginal gains unless structural changes are undertaken (e.g. taxing properties at market value, full revision of tax inventory etc).

Hence, most savings can be made by trimming expenditure. As a rule, capital expenditure should not be significantly altered. Instead, local governments are set to save resources if they:

cut administrative costs by merging separate entities and use resources jointly (car fleet, human resources, budget & accounting, legal services etc),

cut the costs of purchasing goods and services by carrying out unified/ single public tenders for all local entities (e.g. for food, mobile phone subscription, replacement parts, consumables, fuels etc),

close service provision in inefficient locations: schools, social assistance units, libraries, cultural centers,

outsource services to private companies (e.g. waste collection, water & sewerage, public transportation, road works etc). Although some local officials and practitioners blame outsourcing for cost increases, they can be proven wrong provided public tenders are correctly carried out and service contracts allow for cost adjustments. The experience shows that determined local officials have managed to extract significant cost cuts from contractual suppliers.

7.2.3. What if debt restructuring is unavoidable?

Restructuring of a loan should be contemplated as an option when local governments enter a period of financial distress. Restructuring should be foreseen, whenever this is possible, from the beginning when the financing contract is signed with the bank.

Financial distress arises when a local government encounters serious difficulties in paying its obligations. This can be the result of a decrease in revenues following an economic downturn or an increase in current expenditures (due to increased responsibilities that are not matched by appropriate increases in revenues) or a rise in debt service obligations (due to a rise in interest rates or exchange rate depreciation) or a mixture of the above elements. Additionally, bad management capacity can also be responsible for such a situation.

Banks usually consider restructuring as a first option when clients enter into financial distress (especially in case of corporate clients). They regard foreclosure and seizure of clients’ assets and/ or bankruptcy only as alternatives of last resort. It is advisable for local governments to communicate with the bank and design a restructuring plan before arrears on bank debt occur.

Restructuring of a bank loan usually involves the following elements: (i) refinancing, (ii) maturity extension, (iii) reshaping the debt service schedule to match the client’s projected cash-flows, (iv) writing off a portion of the debt (haircut).