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1. Basic Principles of Local Government Borrowing


Implementation of local governments’ investment projects depends on their ability to raise the necessary funds from a combination of own resources and external financing. Debt financing enables municipalities to carry out more infrastructure projects in a shorter time period as compared to the financing from own funds. However, the risks associated to borrowing have to be well understood and documented in terms of their potential impact on local budget in the future. Thus, before borrowing is undertaken, it is recommended that each local government has in place a debt management strategy and a written debt policy. The debt management strategy should ensure that the local government maintains at all times an adequate level of indebtedness which (i) would not impair its financial stability and (ii) would enable it to implement the investment objectives.

1.1. Background, Issues and Challenges

The prospect of improving municipal credit worthiness and increasing local governments' ability to access and use credits (loans and bonds) as an additional source for local infrastructure investment has been discussed extensively in the public sector over the past several years in almost all territories covered by NALAS members. However, local credit markets are still in their infancy.

Every fiscal decentralization effort includes a legislative reform agenda that guides the further refinement of the national policy framework. The frameworks vary across countries in their comprehensibility but also in terms of their maturity (see chapter 2). In general fiscal decentralization processes in South Eastern Europe (SEE) have opened up the opportunity for local governments to use various instruments of borrowing to finance their local investment financing needs.

1.1.1. Issues and challenges

There are large policy issues about the role of credit markets in meeting municipal infrastructure finance requirements.

According to the results of our survey, in all Territories covered by NALAS members. the primary obstacle to the use of municipal credit has been largely on the demand side, i.e. the municipalities' readiness to borrow. Moreover, according to the national legislation related to municipal finance and municipal borrowing, local governments were prohibited from taking on debt until recently (Moldova 2003, Serbia and Montenegro 2005, Albania and Macedonia 2008, Kosovo 2009). On supply side, i.e. within financial institutions, funds for lending to local government were theoretically available. However, (i) the weak financial position of local governments coupled (ii) with a low experience of banks in assessing the credit worthiness of municipalities restricted the development of local credit markets.

Although the supply side of the municipal credit market in SEE countries appears to have sufficient liquidity and capacity to actively enter into transactions, the demand side of the market is currently limited to larger municipalities with sound financial position. Therefore, to enable municipal credit market development, the ongoing fiscal decentralization programs must strengthen local government financing capacities. To this end, creating and enforcing adequate legislation, building and supporting financial management capacity at local level are critical for the success of decentralisation process.

Municipal debt legislation that comprehensively addresses all key elements in an internally consistent manner would substantially benefit the development of municipal credit markets in this region. The existing frameworks in all respective countries provide to some extent clear principles and guidelines required for market development. Clear debt rules, stable revenues and expenditures assignments and objectively allocated transfers should be the governing principles of the local debt legislation framework.

There are some important distinctions between various debt instruments utilized in financing of local government capital investment projects. Among the most popular are bank loans and municipal bonds. Variations of these instruments are widely known and utilized in other countries in Central and Western Europe, USA and Canada. A basic legal framework can and should apply to all types of debt instruments.

A properly structured and competitive market for local borrowing instruments can help keep the costs of capital as low as possible for municipal borrowers. Furthermore, the availability of a local credit market helps municipalities to play a larger role in selecting and implementing capital investments.

The development of a domestic credit market for local governments is conditional upon the existence of a public finance system that assigns significant decision-making power, autonomy, responsibilities and corresponding financial resources to local governments.

Transparency and disclosure are also key elements upon which the development of local credit market depends. In order to assess credit worthiness of local governments, credit institutions need adequate, accurate and timely information related to local governments' financial performance and condition..

International financial institutions (IFI) including World Bank, EBRD, European Investment Bank and KfW, are becoming more active in the region, especially in the municipal sector. Credit enhancement mechanisms and guarantee funds established with donor or international lenders' support will significantly improve local governments' access to external financing..

Following the financial and economic crisis, many commercial banks started to diversify their credit portfolios by investing into sectors with higher resilience to economic downturns. In this context, lending to local governments is becoming increasingly attractive for financial institutions..

The establishment of state-funded development funds for regional/municipal investments could represent another solution to increase local governments' external financing sources. Examples of such funds from the region include: the Slovenian Environment Fund, the Slovenian Regional Development Fund, the State Development Fund in Serbia, the Agency for Regional Development in Macedonia, the Investment development Fund of Montenegro, Fund of Social Investments in Moldova..

European Union (EU) funds – pre-accession, structural and cohesion – can and should be used intensively by local governments from the region to finance infrastructure projects of regional importance.

1.2. How to Finance Capital Items? Current Revenue or Debt Financing?

When considering what resources are available to fund capital investments, it is most important to consider all possible financial alternatives. A wide range of sources are possible, for example current revenues, grants from central governments or the EU (or other donors), private sector investments (PPP). Long-term debt is only one option out of many.

Local governments rarely maintain cash surpluses large enough to pay for the entire cost of big capital projects. They can either finance a capital project from own resources, by accumulating savings in their current account budget (pay-as-you-go financing) or by tapping credit markets (pay-as-you-use financing1).

Borrowing allows a local entity to carry out more ambitious investments than otherwise would be possible. In principle, it also promotes intergenerational equity by having the future generations of citizens which will benefit from a facility's services pay for its construction.

However borrowing is not always an appropriate financing strategy. Borrowing to cover current expenditures or account deficits has just the opposite effects. It shifts the costs to future generations, while today's taxpayers enjoy the benefits.

Many municipalities practice a combination of Pay-as-you-use and Pay-as-you-go policies.

There are mixed views as to whether long-term debt financing is a superior method of capital financing than pay-as-you-go. There are advantages and disadvantages to both approaches, municipalities need to consider the merits of both methods to guide their future financing in accordance with a long term plan. In doing so, municipalities should establish parameters to guide the financing of their capital budgets, and develop policies to implement these guidelines.

"Pay-as-you-go" financing is normally useful for low cost repair and maintenance projects or the purchase of equipment with short useful life. "Pay-as-you-use" is appropriate for capital improvements with a high cost and a long useful life.

Pay-as-you-go” financing has important advantages over pay-as-you-go financing schemes:

lets municipalities build more projects sooner;

allows for greater inter-generational equity, and

spreads out capital expenditures over time.

Many capital investments that municipalities can undertake yield benefits in the form of economic development. Even the so-called social investments such as water and wastewater systems and education contribute to the local economic development. When projects are built sooner, people benefit earlier. When projects are deferred, the benefits are postponed as well.

When considering debt financing as an alternative to finance an investment project, the risks associated to borrowing have to be well understood in terms of their potential impact on local budget in the future. For a borrower, the main risks of a plain vanilla loan are related to the dynamics of interest rate and exchange rate (if the loan is denominated in foreign currency). If the loan is originated at variable interest rate, then an increase in reference interest rate would be reflected into a higher debt service. Volatility of exchange rate has also to be considered when evaluating the possibility to borrow in hard currency (e.g. euro, U.S. dollar). During the recent financial and economic crisis, emerging market exchange rates from almost all Territories covered by NALAS members. have depreciated significantly. This led to an increase in debt burden of unhedged foreign currency borrowers (e.g. local governments, households) and a deterioration of their financial position.

1.3. Debt Management

Before long term borrowing is undertaken, it is recommended that each local government has in place a debt management strategy and a written debt policy.

Any decision to fund local government investment needs through borrowing has to be accompanied by debt management capability and capacity at the local level. In the immediate future, it is imperative that debt management capacity and capability should be enhanced as local borrowing also bears substantial financial risks for local governments (e.g. when debt repayment exceeds the financial capacities of local budgets).

Debt management may be defined as the process of providing for the payment of interest and principal payments on existing debt, and the planning for incurrence of new debt at a level which will optimize borrowing costs and not weaken the financial position of the local government. Estimating the impact of the current and future debt burden on the local budget in future years is also part of the debt management process.

The financial position of a debtor determines its maximum borrowing capacity as well as the cost of borrowing. Thus, the maximum indebtedness capacity of a local government varies in time, depending on economic and market conditions.

1.3.1. Debt Policy2

Any local government planning to issue a debt should adopt a written debt policy. A formal debt policy is essential to effective financial management. Debt policies are written guidelines and restrictions establishing maximum debt thresholds, the type of debt to be issued and at the same time documenting the issuance process. Such policy helps establish limits and provide general direction to local government executive officials in the planning and issuance of debt. A carefully crafted and consistently applied debt policy signals lenders and rating agencies that the local government is committed to sound and sustainable financial management.

The policy must be developed within the framework of existing laws and based on projections of the local government's future condition. It anticipates future financing needs and limitations that the policy imposes. Specifically, it should address the following questions:

What are acceptable levels of short and long term debt? Debt issuance involves a trade-off. In exchange for funds for current capital improvements, future spending is limited. The degree to which a local government is willing to make these trade-offs depend on the urgency of its capital needs, its expected rate of growth, economic trends, and the stability of its overall finances.

What are acceptable purposes for which debt can be issued? Does the investment have a life-span which equals at least the duration of the debt-repayment schedule?

To what extent and for what purposes will the local government use general obligation debt vs. revenue debt3?

What covenants, pledges, or securities is the local government willing to give, in order to make borrowing possible and/or lower the cost of borrowing (interest rates)?

How will the local government make sure that it is borrowing under competitive conditions (i.e. obtain the lowest possible cost)?

Furthermore a debt policy: 1) establishes maximum debt thresholds and ensures proper procedures are in place to keep debt within limits; 2) communicates to citizens the importance placed on financial management and to investors that the local government is being prudent with its resources; 3) communicates to the financial community that the local government is prudent and has a policy basis for debt