Nalas EU Logo

4. Local Government's Creditworthiness Assessment

Prior to establishing the terms and conditions of a financing agreement (be it loans or bonds), investors evaluate local governments' creditworthiness. The creditworthiness of a local government measures both quantitatively and qualitatively its ability to repay debt. This is a rather complex process and covers (i) a thorough analysis of the local governments' financial position, (ii) an assessment of the local economy in which the municipality operates (e.g. economic and political context) and (iii) an evaluation of the national macroeconomic environment. The depth of such analysis differs across financial institutions, depending on the degree of specialization and knowledge on/ of the local governments' segment. Local governments should perform a self-assessment of their creditworthiness prior to approaching financial institutions. Thus they will be able to determine roughly how much money they can borrow without impairing their financial stability. Moreover, this self-assessment prepares local governments for the discussions with financial institutions which will take place at the time when they want to issue debt. It can also be used as a diagnostic tool by local governments to better understand the factors which may affect their financial stability as well as to perform certain scenario analysis.

In general, the creditworthiness assessment of a local government is based on the following three broad factors:



Economic Risk,

Political Risk, and

Financial Risk

In this chapter, we identify a series of economic and financial indicators essential for understanding the past performance, projecting future financial position and consequently assessing the creditworthiness of the local governments. While many of the parameters are quantifiable, subjective judgments are also employed to assess qualitative factors such as government's policies.

4.1. Economic Risk

The ability of municipalities to repay debt is sensitive to economic conditions. Local governments that raise most of their funds from local taxes are especially vulnerable to local economic conditions. Local governments that rely primarily upon intergovernmental transfers are more exposed to the national macroeconomic conditions. One task of credit analysis is to identify the economic events which would impair the most a local government's ability to repay debt and come up with solutions to mitigate such risks.

The strength of the local economy is one of the most important factors influencing creditworthiness. Own revenues and shared-taxes of local government, as the main source to repay financial debt, are dependent on the performance of the local economy. Demographic trends, economic diversification and growth perspectives are key aspects which influence local government medium and long term revenues. Economic diversification is an important feature for a local economy. A highly diversified economic activity means that economic downturns will have a smaller impact on local output than compared to a concentrated local economy, where a few economic sectors hold a large share of total activity.

Key in the analysis of the strength of the economic structure are the following factors:

Economic and Social Infrastructure and socioeconomic trends underpinning the demand for public services provided by the Local Government

Per Capita Income and its volatility

Real Annual Local GDP Growth

Composition of Local GDP

Natural Resources

Employment Growth & Quality of Workforce

Economic Policies

Furthermore, the assessment should focus on the availability of basic economic infrastructure, relevant to the quality of life. This includes reliable electricity supply, transport system, health, water and wastewater treatment facilities, telecommunication system etc. Demographic indicators such as per-capita income, poverty levels, degree of urbanization, employment rate etc. are also very important. Favorable demographics significantly improve a local government growth potential while at the same time relaxing budgetary constraints related to high social expenditure allocations.

4.1.1 Political Risk

The objective of political risk assessment is to provide a means of evaluating the political stability of local governments on a comparable basis. Political stability is vital to continuity in economic decision making and growth as political consensus enables economic reforms. Political risk is a judgmental factor. It should be quantified by considering the (political) stability of the local government in the past and the attitudes of major political parties towards important issues for the local community.

The political relationship between the central and local governments has to be also taken into account as this may have an impact on transfers (grants) from the central government and direction of investments in new projects. Therefore it may have an impact on the local economic development.

4.1.2 Financial Risk12

The financial situation of a local government is crucial for its creditworthiness, as it determines the ability to meet current obligations and debt service. Factors that have an impact on the financial position of local governments include:

revenue and expenditure structure and dynamics

net operating result

ongoing liquidity and cash flow management

financial flexibility – autonomy to raise taxes and fees,

the ability to balance financial operations over the economic cycle

willingness and ability to control expenses

indebtedness – both on and off-balance sheet debt



Municipal senior management must be well prepared to identify, evaluate and mitigate the main sources of risk for the financial situation of the local government (currency, interest rate, maturity mismatch risk). The materialization of such risks would negatively impact cash flows: consequently, municipalities may be exposed to insolvency or default scenarios.

When assessing financial risk of a local government, each of the above mentioned factors have to be compared with relevant benchmark values established for a group of similar local governments. Such an approach must be supported by adequate technical and accounting expertise as well as by the establishment of reliable local statistics database.

4.2. Determining Local Government Borrowing Capacity

Local governments should be aware of their maximum borrowing capacity (i.e. how much money they can borrow) in order to be able to set and prioritize capital investment objectives.

Projecting the future financial position (revenues and expenditures) of a local government is key in determining the financial resources available to repay debt. The forecasting framework of local revenues and expenditures should incorporate the economic, political and financial risk factors that were described in the previous section. Local governments usually repay debt (principal plus interest) from the operating surplus, which is the difference between operating revenues and expenditures. Maximum borrowing capacity of a local government can be estimated as the present value of its future net operating surpluses (operating surplus minus debt service on outstanding debt). The discount rate used in the present value calculation should be the interest rate charged by banks for m loans.

Local governments should be able to demonstrate that they are able to generate persistent positive net operating results in the future, as a precondition for borrowing. If a local government has a temporary structural deficit (negative net operating result) in the future, it can still take on new debt, provided that the financing agreement foresees a grace period at the time the deficit is recorded. Alternatively it can use capital revenues to finance the operating deficit. However, if a local government runs on persistent structural deficits, serious efforts must be made to rationalize operating expenditures and increase revenues before borrowing should even be considered13.

The ratio of expected net operating result to expected debt service is probably one of the most important indicators of local governments' debt carrying capacity. If the ratio is close to one, then any major fluctuation in a local government's operating revenues or expenditures could result in serious problems in meeting the debt service obligation. A ratio significantly higher than one indicates that the local government has a comfortable financial position relative to its debt obligations.

4.3. Financial Risk1

The financial situation of a local government is crucial for its creditworthiness, as it determines the ability to meet current obligations and debt service. Factors that have an impact on the financial position of local governments include:

Economic and Social Infrastructure and socioeconomic trends underpinning the demand for public services provided by the Local Government

Per Capita Income and its volatility

Real Annual Local GDP Growth

Composition of Local GDP

Natural Resources

Employment Growth & Quality of Workforce

Municipal senior management must be well prepared to identify, evaluate and mitigate the main sources of risk for the financial situation of the local government (currency, interest rate, maturity mismatch risk). The materialization of such risks would negatively impact cash flows: consequently, municipalities may be exposed to insolvency or default scenarios.

When assessing financial risk of a local government, each of the above mentioned factors have to be compared with relevant benchmark values established for a group of similar local governments. Such an approach must be supported by adequate technical and accounting expertise as well as by the establishment of reliable local statistics database.

4.4. Determining Local Government Borrowing Capacity

Local governments should be aware of their maximum borrowing capacity (i.e. how much money they can borrow) in order to be able to set and prioritize capital investment objectives.

Projecting the future financial position (revenues and expenditures) of a local government is key in determining the financial resources available to repay debt. The forecasting framework of local revenues and expenditures should incorporate the economic, political and financial risk factors that were described in the previous section.

Local governments usually repay debt (principal plus interest) from the operating surplus, which is the difference between operating revenues and expenditures. Maximum borrowing capacity of a local government can be estimated as the present value of its future net operating surpluses (operating surplus minus debt service on outstanding debt). The discount rate used in the present value calculation should be the interest rate charged by banks for m loans.

Local governments should be able to demonstrate that they are able to generate persistent positive net operating results in the future, as a precondition for borrowing. If a local government has a temporary structural deficit (negative net operating result) in the future, it can still take on new debt, provided that the financing agreement foresees a grace period at the time the deficit is recorded. Alternatively it can use capital revenues to finance the operating deficit. However, if a local government runs on persistent structural deficits, serious efforts must be made to rationalize operating expenditures and increase revenues before borrowing should even be considered1.

The ratio of expected net operating result to expected debt service is probably one of the most important indicators of local governments' debt carrying capacity. If the ratio is close to one, then any major fluctuation in a local government's operating revenues or expenditures could result in serious problems in meeting the debt service obligation. A ratio significantly higher than one indicates that the local government has a comfortable financial position relative to its debt obligations.

4.5 Local Government Debt Statistics in South East Europe

Total Local Government Borrowing as a Percentage of the Capital Expenditures

Debt financing of capital expenditures varies across local governments from different territories covered by NALAS members. (Figure 1). For example, in Montenegro debt financed 80% of local governments' capital expenditures, while in Moldova only 10% (2008). On average, between 2006 and 2009 debt has financed around 37% of local governments' capital expenditures from all Territories covered by NALAS members., excluding Turkey. The share of debt in the overall financing sources of capital expenditures presents large deviations from one year to another in almost all of the analyzed countries.

Figure 1: Local government borrowing as percentage of capital expenditures

Total Local Government Borrowing as a Percentage of the Capital Expenditures



Source: Calculation based on the questionnaires answered by local experts

Outstanding Local Government Debt as a Percentage of GDP n all Territories covered by NALAS members, local credit markets are still in their infancy. In most of the analyzed territories covered by NALAS members (Albania, Bulgaria, Croatia, Macedonia, Moldova), local debt accounts for less than 0.5% of GDP and less than 5% of local governments total expenditures. In Serbia and Turkey the dynamics of local debt has been in line with economic growth, resulting in relatively stable debt ratios during the past years (Figure 2).

Figure 2 : Outstanding debt as percentage of GDP

Outstanding LG Debt as a Percentage of National GDP



Source: Calculation based on the questionnaires answered by local experts

Total Local Government Debt as a Percentage of the Local Government Revenues

Local governments' indebtedness varies across analyzed countries. In Croatia, Macedonia, Moldova and Romania local debt represents less than 5% of local governments' total revenues. Slovenia, Serbia and Montenegro have an indebtedness level ranging between 20-30%. Turkey stands out as the country with the highest indebtedness level (75% in 2008).

Figure 3: Total Local Government Debt as a Percentage of the Local Government Revenues

Total Local Government Debt as a Percentage of the Total Local Government Revenues (national level)


...Source: Calculation based on the questionnaires answered by local experts