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 (i) which would not impair its financial stability and (ii) which would enable it to implement the investment objectives.
The financial framework of local governments plays a key role in the sustainable development of local credit markets. The design of intergovernmental fiscal structure together with the accounting system and reporting procedures are important factors that are taken into consideration by financial institutions when assessing the opportunity to finance local governments. By establishing the general structure of local revenues and expenditures, the intergovernmental fiscal framework determines in broad terms the borrowing capacity of local governments from within a country.
Financial institutions need readable, credible, transparent and comparable financial documents and reports as an input in the credit risk analysis of local governments. This can only be achieved if local governments adhere to national accounting standards, which accurately reflect the true financial position of local governments.
Authorisation process of local borrowing should ensure that (i) all legal aspects related to local indebtedness are met, (ii) there is a real necessity to pursue external financing which benefits the local economy, (iii) the financial stability of the local government is not threatened by the future debt repayment. The central government’s involvement in the authorisation process should be limited to the control of the legal aspects related to local borrowing.
Limits to local indebtedness should be clearly stipulated in legislation on local public debt and should include at least the purpose of borrowing and maximum debt thresholds. Short term borrowing should be pursued only to cover temporary liquidity shortages while long-term borrowing is warranted to finance capital expenditures.
There are two major types of debt instruments available to finance municipal capital expenditures: (i) loans and (ii) bonds. Loans are granted by a financial institution (e.g. commercial bank) directly to the local government. Applying for a loan is less complex than the procedures required for bond issuance. From this point of view, loans are more advantageous to small and medium size municipalities seeking external finacing.
Many international financial institutions have dedicated programmes aimed at supporting and financing local governments’ infrastructure projects, especially in the emerging markets. The financing occurs either directly or indirectly, via intermediated loans to local banks. The terms and conditions of such loans are more favorable to the local governments than in case of typical commercial banking loans.
Bonds are the preferred form of financing for large capital investment projects which require long term financing. Bonds are issued by local governments either directly or via financial intermediaries (e.g. funds, banks) to institutional or individual investors. The cost of borrowing using bonds is usually lower than in case of a loan. There are two types of municipal bonds. A. General obligation bonds are secured by the local governments’ revenues stream. Such bonds are used to finance investments in public goods (public safety, streets and bridges, public parks and open space, public buildings etc.). B. Revenue bonds are backed by the stream of revenues generated by the project financed from the bond sale. Revenue bonds are not backed by the taxing power of the local government. Typical projects financed by revenue bonds include: municipally-owned airports, water and sewer systems, electric utilities, athletic and sport facilities and limited access highways.
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 specialisation 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.
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.
Depending on which type of debt instrument (loans or bonds) a local government wants to issue, there are different specialised financial institutions which should be approached. Local government loans are originated by: (i) municipal banks, (ii) commercial banks, (iii) international financial institutions and (iv) municipal development funds. Bonds are intermediated by commercial/ investment banks or brokerage houses. The existence and availability of these financial institutions to finance local governments depends on the architecture (bank lending model or bond model) and development of the local credit market. Central and local authorities should promote specific measures aimed at supporting the development of sustainable credit markets by minimizing the risk of market failures.
Meeting lender’s expectations will increase local governments’ chances to borrow under good conditions. Local economic conditions, budgetary performance, financial and political flexibility, project management capacity, transparency and disclosure, the quality of the budgeting process, the existence of a debt management and capital investment strategy, available guarantees are all important aspects that influence a local government’s borrowing capacity.
In the process of contracting new loans or issuing bonds local governments have to undergo tender procedures in order to select the lending/ underwriting financial institution. Thus it is essential for local governments to draft the tender documentation in a way which ensures (i) that eligible bidders have the adequate level of knowledge and experience for the project to be financed and (ii) that selection criteria used to assess lenders’ offers enables local governments to obtain the most competitive loan structure in a transparent way.
Besides financial institutions, local governments in EU member and accession countries can tap on financial resources from grants offered by the European Union (EU). In member states such local government projects may frequently exceed 15 million EURO. The value of the projects put forward by local governments in accession countries is smaller, but the benefits of financing local capital investment through EU grants are unquestionable nevertheless.
Local governments can obtain external resources using a wide range of borrowing instruments. However, each instrument is suited to finance only certain types of activities. Short term financing instruments include: (i) working capital credit line – local government draws funds from the credit line, on which they pay interest, to finance temporary revenue shortages; principal is usually rolled over, (ii) bridge loans – are a special type of short term loan where financing for a capital investment project is provided for a transitory period until the main (long term) financing is obtained. Medium and long-term borrowing should be pursued by local governments when financing capital investment projects. Long-term borrowing to cover current expenditures is usually prohibited by law and must be avoided anyway.
Planning the structure of a financing package should be in line with a local government’s debt management and capital investment strategy. When negotiating with the financial institution(s), local governments have to think at maturity, grace period, interest rates, fees, drawdown (loan disbursement), refinancing etc. After securing the financing package 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.
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. 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).
The establishment of local government associations can help the development of the local credit market. Local government associations are voluntary membership organizations, which comprise local governments from within a country or region, acting as an effective and authoritative advocate on members’ behalf in relation to central government, the parliament, potential investors and other stakeholders. With regard to local public debt local government associations should aim to (i) create and/or improve appropriate legislation, (ii) monitor the impact of relevant legislation, (iii) provide information and statistics to potential lenders, central government and other stakeholders and (iv) assist member local governments to develop and improve debt management plans and operations.
In relation to lenders, local governments associations should mediate communication and information flows between local governments and potential investors.
In relation to member local governments, associations should (i) provide assistance to members in structuring and financing investment; (ii) maintain ongoing communication with member local governments to set/develop best practices in accordance with international standards.
In relation to central governments and parliaments, associations should lobby and campaign for changes in policy, legislation and funding on behalf of its members.