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5. Improving Financial Management Performance

Adequate, accurate and timely financial information on local governments' operations benefits both investors and local governments. A uniform financial reporting format, which suites both local/ central governments' and investors' requirements, should be a top priority for national regulators, as a precondition for improved financial management performance. Local governments' annual reports should include at least an administrative report, a balance-sheet and income statement as well as a cash-flow analysis (if accounting system is accrual based). Public disclosure of financial reports should be mandatory. Independent audits should be conducted on a regularly basis. Local governments could also improve their financial management performance by applying for an external credit rating. By obtaining the credit rating, the local government will better understand what the main determinants of its creditworthiness are and can decide what changes are needed to improve its credit risk profile and thereby reduce its borrowing costs.

5.1. Sound Financial Management for Improving Creditworthiness

Both local government officials and investors need adequate, accurate and timely financial information to be able to take optimal decisions.

Financial analysis assists officials to better understand the local government's fiscal situation and identify emerging trends of which they may be unaware. Financial analysis can also be used to present the local government's strengths and weaknesses to the local council, citizens, central government and investors. This promotes budget transparency and enhances the local government's ability to borrow. Moreover, financial analysis guides the financial planning and fiscal policy.

Investors need relevant and reliable financial information in their credit risk assessment analyses. The financial reports that local governments prepare rarely present financial information in the form that credit market participants need. A uniform financial reporting format, which suites both local/ central governments' and investors' requirements, should be a top priority for national regulators.

Local governments' annual reports should include at least an administrative report, a balance-sheet and income statement as well as a cash-flow analysis (if accounting system is accrual based). In some countries, the local governments are required to consolidate their financial statements with those of the subordinated local public institutions.

Steps to Improve Systemic Creditworthiness
1. Standardize the financial reporting format of local governments to include information that is important to credit markets
2. Public disclosure of local governments' financial reports should be mandatory
3. Periodic independent audits
4. Central government should monitor local debt service and financial ratios to ensure financial stability
1. Standardize the financial reporting format of local governments to include information that is important to credit markets
2. Public disclosure of local governments' financial reports should be mandatory
3. Periodic independent audits
4. Central government should monitor local debt service and financial ratios to ensure financial stability

Table 9: Using Financial Data To Improve Creditworthiness

Besides the steps aimed at improving the quality of financial reporting, additional actions should be taken in the areas presented in Table 10.



  Steps to be taken for improvement of local government creditworthiness
Area Actions
Fiscal System

1.Intergovernmental
Transfers

2. Local Revenues
1a. Establish clear legislative or constitutional basis for revenue sharing and grants
1b. Maintain stable revenue-sharing formulas
2a. Provide for local control over local tax rates on some significant revenue sources
Municipal Development Funds

1. Problem Loans

2. Credit Assessment

3. Loan Policy
1a. Set explicit targets for maximum acceptable problem loan rates; monitor actual experience
2a. Assign explicit risk rating to each municipal loan
2b. Separate department or external credit-rating institution performs risk assessment.
2c. Compare ex post default or problem-loan experience with ex ante credit ratings; revise risk assessment methodology if necessary
3a. No new loans to borrowers who have problem loans outstanding
3b. No capital grants by Government to borrowers with problem loans outstandingy
Legal System

1. Default Procedures; Collateral Foreclosure
1a. Establish clear legal rules governing default procedures that are followed in practice, and enforceable by courts
Loan Defaults

1. Local Budget Intervention
1a. Establish automatic procedures for local budget intervention by Government at time of default
1b. Give intervention team power to restore budgetary balance by mandatory spending cuts and/or tax increases

Table 10: Steps to be taken for improvement of local government creditworthiness

5.2. Credit Rating

 

Local governments could improve their financial management performance by applying for an external credit rating. A credit rating is an opinion assigned by Credit Rating Agency on the ability and willingness of an issuer to make timely payments on a debt instrument over the life of that instrument. By obtaining the credit rating, the local government will better understand what the main determinants of its creditworthiness are and can decide what changes are needed to improve its credit risk profile and thereby reduce its borrowing costs.

Three major firms now provide this service for regional and local governments in South East Europe: Moody's Investors Service, Standard and Poor's and Fitch. Long-term bonds of the highest quality are rated "Aaa" by Moody's and "AAA" by Standard and Poor's and Fitch. Issues rated below "Baa" by Moody's and below "BBB" by Standard and Poor's are considered below investment grade. A separate set of ratings are used for short-term notes.

Table 11: Moody's Long-term Debt Ratings (maturities of one year or greater)

Investment Grade Aaa – "gilt edged"
Aa1, Aa2, Aa3 – high-grade
Baa1, Baa2, Baa3 – medium grade
Speculative Grade Ba1, Ba2, Ba3 – speculative elements
B1, B2, B3 – lack of characteristics of a desirable investments
Caa1, Caa2, Caa3 – bonds of poor standing
Ca – highly speculative
C – lowest rating, extremely poor prospects of attaining any real investment standing



Moody's Short-term Debt Ratings (maturities of less than one year)
Prime-1 (highest quality)
Prime-2
Prime-3
Not Prime (can be thought of as speculative grade)



The rating process:

Local governments approach Credit Rating Agency

Application with specific financial information related to the local governments' activity is sent out to the Credit Rating Agency.

Credit Rating Agency analyses the local governments' application along with the local and national economic conditions and assigns a credit rating to the local government. As a rule, the credit rating of a local government cannot exceed the country's sovereign rating.

After the initial rating, the Credit Rating Agency reviews periodically the rating to take into account the latest financial and economic information related to the local governments' position.



Important definitions pertaining to the rating process16:

Rating outlooks: These are opinions regarding the likely direction of an issuer's rating over the medium term, generally 18 months. Outlooks fall into 4 categories: positive, negative, stable, developing;

Rating review: A credit is placed on the watch list when it is on review for pos- 16 Moody's Investor Service – Rating Methodology 57 sible upgrade, or on review for possible downgrade, or (more rarely) on review with direction uncertain. A formal review is normally concluded within 90 days;

Confirmation of a rating: If after a formal review a rating committee decides not to change a rating, the rating is said to be confirmed.

Benefits of a credit rating for a local government:

Access to a broad number of potential investors, thereby reducing the local government's borrowing costs as competition will increase;

Independent opinion on the future ability and legal obligation of an issuer to make timely payments on its financial commitments;

Independent estimation of the current municipal credit condition and future revenue and expenditure scenarios based on budget trends and budget projections;

Diagnosis of the basic risk factors that contribute to the creditworthiness condition and identification of the critical risk areas that may threaten the ability of the local government to make timely principal and interest payments on their debt obligations;

Objective assessment of important municipal financial operations of critical concern to mayors, municipal councils and citizens;

Increased transparency and accountability of municipal operations.