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Financing Markets: Application of a. Market-Based Framework ... propose an analytical framework useful for identifying constraints to financial development and.
Development of Local Government Debt Financing Markets: Application of a Market-Based Framework CHRISTINE R. MARTELL and GEORGE M. GUESS

Needed is clear guidance on how to develop market-based debt financing systems in transitional and developing countries. We propose an analytical framework useful for identifying constraints to financial development and providing recommendations to overcome constraints to develop municipal financing capacity. The proposed framework is applied to five country case studies: Indonesia, Mexico, Philippines, Poland, and South Africa. The thesis of this paper is that municipal credit market development is related to improvements in the legal/regulatory framework governing local borrowing, the capacity of financial institutions to assess risk, and borrower capacity to support and manage debt.

INTRODUCTION With accelerated urbanization occurring globally, demands for urban infrastructure and financing have exploded. ‘‘Availability of long-term financial resources for financing urban infrastructure investments is essential for enhancing local economic development, at both the company and household level, and then for enabling cities to better cope with the globalization challenge.’’1 Traditionally, national governments in developing nations controlled investment choice and provided infrastructure finance centrally through Dr. Martell is an Assistant Professor at the Graduate School of Public Affairs, University of Colorado at Denver and Health Sciences Center, PO Box 173364, Campus Box 142, Denver, CO 80217-3364, where she focuses on issues of public finance, debt markets and policy, fiscal federalism, and international development. She can be reached at [email protected]. Dr. Guess is the Director of Research for OSI/LGI and Acting Director Master’s of Public Policy Program, Central European University. His research has been on public expenditure management, fiscal decentralization, and capital budgeting and financing. He has worked extensively as an international development consultant and as a university professor. He can be reached at [email protected]. 1. M. G. Attinasi and A. Brugnoli, Financial Instruments for Urban Development Support: The Role of the World Bank in Latin American Countries (Milan, Italy: EGEA, 2001), 1.

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grants or loans. Increasingly, central governments are decentralizing fiscal powers and service delivery responsibilities to subnational governments.2 But the pace is often slow and unsteady. Beyond the realm of larger capital cities, most transitional and developing countries face fiscal constraints, such as rigid and narrow tax bases, that impede mobilization of local resources to finance both services and infrastructure. For efficiency reasons, infrastructure and some services are best financed normatively over the long term so that users of the infrastructure are those who pay for it, creating the demand for debt financing instruments. The push to expand borrowing options for municipal governments, fueled by trends toward decentralization, privatization, and globalization of financial markets, is strong.3 In addition to exploratory work initiated by donor programs to develop municipal credit markets, credit rating agencies have been active in evaluating some municipalities in developing countries.4 Debt markets offer the promise of increased access to capital and lower borrowing costs, resulting in more efficient allocation of capital. Bond markets have the potential to be cost effective and equitable.5 Changing from no market to a functioning securities market will not be easy for many developing and transitional countries. The question is how to encourage a balanced evolution of the municipal credit system that does not jeopardize sovereign ratings, rewards municipalities for fiscal responsibility, and still shelters disadvantaged municipalities that are building market discipline. In many emerging economies, the banking system is the leading provider of local credit.6 In others, the bulk of capital projects may be short term (less than one year) and remain financed by pay-as-you-go, short-term financing through combinations of such means as special loan funds, small grants, and tax revenues. A major problem for development of local financing of capital investments is how to eliminate the institutional disincentives that encourage local governments to remain on grants and continue using subsidized financing. At early stages of municipal finance development, there is justification for grant and subsidized loan financing. However, what has to be addressed is how to make debt sustainable, encourage responsible subnational borrowing, and decrease local dependency on central government capital

2. A subnational government refers to any governmental construct whose jurisdiction is subordinate to the central government. For this paper, the term is used to refer to local and municipal governments. 3. John Petersen and John B. Crihfield, Linkages between Local Governments and Financial Markets: A Tool Kit to Developing Subsovereign Credit Markets in Emerging Economies (Arlington, VA: Government Finance Group, ARD, 1999). 4. Attinasi and Brugnoli; Christine Martell, ‘‘Transformation of Municipal Credit Systems in Developing Countries: Evidence from Brazilian Municipalities,’’ Doctoral Thesis, Indiana University, June 2000; Fitch, www.fitchratings.com (2003); Moody’s, www.moodys.com (2003); Standard & Poor’s, Local and Regional Governments (New York: McGraw-Hill, 2003). 5. James Leigland, ‘‘Accelerating Municipal Bond Market Development in Emerging Economies: An Assessment of Strategies and Progress,’’ Public Budgeting and Finance 17, no. 2 (1997): 57–79. 6. Petersen and Crihfield, 2.

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financing. Municipal bonds can offer an alternative financing option for advanced communities. While municipal bonds represent a financing alternative, they may pose a risk to the central government macroeconomic stability and future service delivery.7 Establishing and maintaining a responsible and viable borrowing environment for local governments is a widespread policy goal. How to achieve it is a much more difficult matter. The issues involved in making local government debt creditworthy are rich and complex, and they are made even more so because subnational market development, whatever its merits, is a ‘‘sideshow’’ to other main events in nation building. Although much has been written about how subnational infrastructure financing systems might be established, the alternative prescriptions have not as yet been applied to actual country cases of municipal finance development. What is lacking is a framework that explains differences in how the transformation from grant and subsidized financing to marketbased credit systems occurs in particular countries. The framework is important as a guide to country policy makers considering steps to encourage local borrowing to substitute state budget financing of infrastructure. Following a critical review of existing approaches to the topic, this paper (1) provides a financing framework, (2) applies it to data on five countries, and (3) draws lessons for countries seeking to modernize their municipal credit markets.

ISSUES AND APPROACHES Market-based borrowing refers to borrowing in ‘‘private’’ capital markets, where both borrowers and lenders have alternatives for raising and lending funds and credit is allocated among competing uses on the basis of risk and reward.8 Market-based borrowing requires the matching of investor demand to invest with borrower supply of borrowing instruments.9 Investors demand is enhanced by investor familiarity and confidence, the ability to trade securities, the freedom to invest, acceptable return on investments, strong credit quality of borrowers and/or instruments, information regarding risks, and assistance in interpreting information. Borrower supply of borrowing instruments requires tolerable borrowing costs, long-term debt amortization, assistance for small borrowers, and facilitative formal oversight. One cannot understate the importance to borrowers of having a long-term capital supply that is risk sensitive.10 7. This relates to the keeping of a ‘‘hard budget’’ constraint. Is it politically possible to permit defaults and/or reductions in service delivery? 8. That many major investors in developing countries are likely state-owned, not private, entities is not a concern so long as they behave in a market-determined way in trying to maximize returns. 9. Leigland. 10. In many developing countries, the municipal credit markets are dominated by short-term investments. As domestic currency lending at high rates, long-term borrowing in the domestic currency is a great problem and can only be accomplished with substantial intermediation. Yet, foreign currency loans are most often considered too susceptible to currency risk for subnational borrowers.

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The literature offers three main approaches to local infrastructure financial development. Previous research on the development of municipal credit markets has focused on the development of the market place, development of financial systems such as instruments and institutions, and development of the borrower’s creditworthiness.11,12 Legal and Policy Environment of the Markets A first approach focuses on developing the credit marketplace rather than emphasizing potential local borrowers and their capacity and powers.13 Establishing a broader marketplace, such as a corporate bond market with long-term maturity bonds, will make possible a shift toward a market system for municipal borrowing when the governments are ready and able. Leigland and Thomas recommend using public–private partnerships (PPPs) to stimulate a municipal credit market. This approach centers on the initial development of a corporate bond market and the issuance of private long-term bonds. It requires improving information flows through legislation and regulation, facilitating local debt management, and mobilizing private capital to finance infrastructure.14 Leigland and Thomas view this approach as a reasonable way to finance infrastructure in markets where funds for municipal bonds are unavailable at reasonable rates because of the paucity of creditworthy municipal borrowers. Advancing credit markets is predicated on having a broad regulatory framework and established local debt policy. Financial Instruments and Institutions A second set of sequencing proposals focuses on the development of specialized financial system instruments and institutions in response to project revenue raising capacity.15 Under this model, the choice of financial instruments is a function of the project’s revenue-raising capacity.16 A project with no return requires grant funding. A project whose return partially covers costs but requires some public assistance to access markets would be suited for bonds (general obligation, double-barreled, or special assessment) or asset-backed securities. A project able to return enough to cover financing costs fully 11. Ibid. James Leigland and H. Thomas Rosalind, ‘‘Municipal Bonds as Alternatives to PPPs: Facilitating Direct Municipal Access to Private Capital,’’ Development Southern Africa 16, no. 4 (1998): 729– 50. Attinasi and Brugnoli; Petersen and Crihfield; Christine R. Martell, ‘‘Municipal Investment, Borrowing, and Pricing under Decentralization: The Case of Brazil,’’ International Journal of Public Administration 26, no. 2 (2003): 173–196. 12. Petersen and Crihfield, 3. Municipal credit market development is embedded in the coordination of different vantage points: the integration of municipal securities into domestic and international credit systems, the desires of the borrowers to have flexibility in financing decisions, and the investor’s need for information to evaluate risk and structures to protect investors. 13. Leigland and Thomas (1998), 748. 14. Ibid., 749. 15. Attinasi and Brugnoli. 16. Ibid.

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could be financed fully by private capital and could access the markets through revenue bonds and project finance instruments.17 The approach superimposes financing structure on revenue-generating capacity as a means of achieving economic development. However, the borrower’s role toward debt and financial management is not explicitly addressed, which is particularly important considering that economic development activities may bear upon not only the local government’s capital budget but also its operating and maintenance expenditures. The approach also overlooks requirements for a central registry of debt and various prudential requirements. The question remains as to what overarching incentives encourage local governments to want to finance and to do it well. Imposed on the development of financial instruments is a sequenced development of financing institutions.18 When financing resources are public and terms are subsidized, there are no intermediaries, and grants and loans are dictated by the government. As resources become more private and terms become more market based, financial institutions take the form of municipal development funds, state infrastructure banks, and bond banks. A compatible framework looks at financial system development as a function of the type of financial intermediation.19 The argument holds that different types of financial intermediation are needed for different stages of municipal credit system development. As municipal credit systems develop, financial intermediation structures are designed to advance market behavior by allocating and pricing credit by risk, producing reliable information and conveying it through signals; and allowing borrowers, with the aid of nonfunding financial intermediaries, to develop their own reputations. These arrangements are important to overcome information asymmetries as a means of increasing investor supply of long-term capital. The views of instruments and institutions imply but do not specify an existing regulatory framework, whereby credit is priced by risk and provided through instruments appropriate to payment capacity, addressing the relationship between the financing vehicle and the project’s risk and return. As markets develop, one would expect to see instruments respond to revenue generation and institutions and intermediaries allocate and price by risk. However, none of these views of instruments and intermediary institutions directly addresses the borrower’s creditworthiness. Borrower Creditworthiness and Financial Management A third view of municipal credit market development treats the borrower’s creditworthiness as paramount, where the borrowing price is a function of risk.20 This approach 17. Ibid., 134. 18. Ibid., 135–136. 19. Christine R. Martell, ‘‘The Transformation of Municipal Credit Systems: From Relationship-Based to Market-Based’’ (paper presented at the Annual Association for Budgeting and Financial Management Conference, Washington, DC, October 1999). 20. Martell, ‘‘Municipal Investment.’’

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categorizes municipalities according to inherent risk and their capacity to manage debt. Financing structures, then, follow increased capacity and decreased risk, where graduation from one sphere to the next is a function of creditworthiness. According to this approach, countries that have entities that assess risk and local governments that can manage debt would expect reduced reliance on grant financing (grants and subsidized loans) and increased use of market-based debt financing (pooled debt districts, enhanced loans, and eventually risk-based loans and municipal bonds). Nothing is said about how incentives and the legal and regulatory frameworks affect risk assessment. It is clear that countries typically move from simpler to more complex financing institutions. The path may not be linear, however, and how one might distinguish the better performers from the worse performers is yet to be examined. Review of the above frameworks suggests some remaining issues. First, a discussion of the broad institutional framework and policy needed to mature municipal markets, even among perspectives that have a market focus, is absent. Second, the incentives needed for local governments to do well, especially with respect to managing debt and capital, are unidentified. Finally, what creates the incentives for market-based pricing is unresolved. This review suggests that three classes of factors affect municipal credit system development: legal and regulatory framework, financial institutions and instruments that allocate and price according to risk, and borrower creditworthiness and local debt management capacity. Consistent with the three approaches in the literature, we explore their application and relevance in five countries.

EXPLANATORY VARIABLES AND INDICATORS Our framework proposes that three sets of variables are related to local debt market development. First, an appropriate legal and regulatory borrowing framework needs to be in place. Absence of a framework leaves the country open to major risks of contingent liabilities to the national treasury from irresponsible local borrowing, such as Brazil in the early 1990s and Argentina more recently. Additionally, a legal and regulatory framework of rules and regulations can stimulate demand by building investor familiarity and confidence of tradable securities, investment choices, and information regarding risks. Regulations on subnational borrowers can mitigate moral hazard problems and encourage hard budget constraints.21 The local borrowing framework goes hand in hand with fiscal decentralization. The country should adopt an organic finance and budget law, as well as laws that provide for local borrowing. In many developing countries, public finance remains centralized and local governments are prohibited from borrowing to finance infrastructure projects. In countries 21. Christine R. Martell, ‘‘Brazilian Municipalities and the Law of Fiscal Responsibility’’ (paper presented at the Annual International Public Management Network Conference, Rio de Janeiro, Brazil, November 17–19, 2004).

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moving toward advanced municipal debt markets, it is suggested that provision should be made for a number of regulatory items that are directly observable: 1. 2. 3. 4. 5. 6. 7.

Devolution of sufficient own-source revenues to encourage debt payback. Devolution of authority to permit local determination of budget composition. Borrowing authority to issue short- and long-term debt. Provision of public uses of borrowing. Limits on sources of borrowed funds. Requirement that debt approximates the economic life of the asset or project. Transparent and reasonable debt limits, such as percent of total expenditures for either the past budget year or a period of years. 8. Provision for payment of debt service arrears and remedies for debt default. 9. Budget law clearly distinguishes capital from recurrent expenditures. In the case of the above attributes, the expectation is that with market development, the local unit gains more independent authority and is increasingly limited in its actions by the capital market rather than command and control laws and regulations. For example, explicit legal borrowing ceilings would be replaced by a market determination of affordability limits. One might expect that to be affected by the bond rating. Second, financial institutions need to allocate credit on the basis of risk, which can be approximated by credit ratings.22 The credit ratings measure the risk of debt instruments’ and issuers’ repayment capacity to lenders. Absence of allocation by risk would permit financing of uneconomic and political projects with debt instruments that threaten fiscal balances. An important constraint to debt market development is the availability of cheap credit or grants from alternative sources. The availability of subsidized financing unconnected to creditworthiness discourages local governments from improving their fiscal position to become creditworthy. Creditworthy governments would be happy to receive subsidized credit or grants instead of paying back obligations at market terms and conditions. Indicators of risk assessment capacity would include the following: 1. Yields priced for risk. 2. Instruments placed through a marketplace, with private parties acting as underwriters or lenders. 3. Risk assessed by institutions, such as banks, insurance, pension, and securities firms. 4. Criteria for budgetary grants and subsidized market loans are clearly established and applied to subnational units classified from low to high risk. Third, it is critical that local governments be able to manage their debt. Incapacity to manage debt leads to budget arrears, deficits, and potential debt defaults. Market-based 22. Municipal development banks are often proposed as a financial institution to develop the alignment of risk and return. Their effectiveness in advancing municipal credit markets is to be evaluated.

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local debt systems require technical capacity to manage debt obligations to ensure affordability and repayment. We employ the following indicators of performance in this area: 1. Accounting systems that support local liability management. More advanced systems use asset management systems. 2. Regular reports to compare planned-to-actual expenditures and to track budget progress, including scheduled debt payments. 3. Projects evaluated individually and according to economic criteria. This means that local units have professional capital programming and budgeting systems and are able to apply cost/benefit and net present value techniques. These three sets of indicators fall into two classifications, whereby the legal and regulatory framework and allocation by risk are institutional variables and the final set of debt management refers to capacity variables. Collectively, the sets, conceptualized in Figure 1, pressure the development of a municipal credit market. In Figure 1, arrows a represent pressure on the legal and regulatory framework to connect the local sector to the private market and arrows b represent pressure on private capital markets to eventually pull in the subnational governments. These are consistent FIGURE 1 Sequence of Market Development and Subnational Government Access Investors

Investors

Investors a

a

a Private Capital Markets

Private Capital Markets

b Central Government Direct Grants / Lending

c Subnational Government

Government Financial Intermediaries

c Subnational Government

a

b

Private Credit / Capital Markets for Subnational Governments

c Subnational Government

TIME

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with the institutional variables. Arrows c represent pressure on strengthening the local sector to push its way into the private market, consistent with the capacity variables. Each force contributes to the development of a municipal credit market. Expected Results It is suggested that positive trends in three sets of variables will lead to local debt market development, from which we establish three propositions. 1. Legal and regulatory policies that support market development in general also affect municipal credit market development. 2. Financial instruments and institutions that advance allocation and pricing by risk affect municipal credit market development. 3. Borrower creditworthiness and capacity variables affect municipal credit market development. Given our experience, Propositions 1 and 2 are more important than 3. Solid information is readily available to examine 1 and 2. However, while data exists on 3, they do not present usable comparative data because of the diversity of local experiences both within and across countries. For example, some low-capacity local government units (LGUs) have borrowed and repaid, yet some high-capacity LGUs have borrowed and not repaid. More research needs to address comparative borrower capacity, and we recommend it for further study. We treat the third proposition as dependent on the first two, such that legal and policy environments and financial engineering create incentives for LGUs to improve fiscal management and borrow and repay responsibly. Our ideal research hypothesis is that where the institutional variables (legal and regulatory framework; creditworthiness used to allocate credit) are stronger than capacity variables (risk and debt management and capital budgeting capacity), the local debt markets will be more advanced. The fundamental difference between institutional and capacity variables is that the former act as incentive drivers by defining the rules and boundaries of borrowing whereas the capacity is a passive feature. We further hypothesize that capacity without incentives to use it will not result in measurable or sustainable local credit market development. Conversely, institutional incentives will lead to greater local market development. Thus, to develop local credit markets, emphasis should be placed on developing the necessary legal and regulatory frameworks and institutional incentives (or at least eliminating major disincentives). This is consistent with the conclusion that ‘‘[g]overnments can support the development of the government bond market and enhance their credibility as an issuer of debt by building a strong institutional framework for debt management.’’23 The implication is that institutions matter more

23. World Bank/ International Monetary Fund, Developing Government Bond Markets: A Handbook (Washington, DC: World Bank/International Monetary Fund, 2001), 113.

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than capacity for building local debt markets, supporting the work of Leigland and Thomas. When these variables are strengthened through local or international technical assistance and training over time, one can expect the following measurable results for market development: 1. Market structure will expand: The size of credit market, including the number of bond issues, as compared with the total amount borrowed, will grow. 2. Diversity of investors and instruments will broaden: The breadth of the investor pool, such as whether it includes institutional investors, and the breadth of investment choices, such as flexible and various instruments, indicate greater market choice. 3. Markets will deepen: Primary market with placements through syndication grows into secondary market with individual buyers. 4. Instrument maturities will lengthen: Longer maturities of issues signal the strengthening of credit markets. The first three indicators reflect investor demand for investment freedom and the ability to trade securities.24 An expanded market, a variety of investors and instruments, and active secondary markets indicate response to demand. These market structures enhance competition for investments. The last indicator reflects the supply of long-term debt amortization. Longer maturities ‘‘allow borrowers to amortize costs of construction over periods of time that approach the long-term life spans of the infrastructure assets being built, thus reducing the size of annual debt service costs.’’25 Longer maturities are desired by borrowing entities.

SELECTION OF COUNTRIES We have selected five countries for comparative analysis. They were selected on the basis of their efforts to develop primary and secondary municipal debt markets. Thus, despite differences in region (Latin America, Africa, Asia, and Eastern Europe), historical development (transitional or developing countries), and income (South Africa is uppermiddle income while Indonesia is low income), the important similarity is an effort to develop the market for subnational securities. Our method is to focus on the differences that affect debt market development from a study of similar cases. The ‘‘matched-case’’ method of comparison used by Xavier26 for comparison of Malaysian and Australian budget reforms is useful for our purposes. We used that method to select countries

24. Leigland. 25. Ibid., 60. 26. J. A. Xavier, ‘‘Budget Reform in Malaysia and Australia Compared,’’ Public Budgeting & Finance 18, no. 1 (1998): 99–118.

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FIGURE 2 Municipal Bonded Debt Data for Most Recent Year Available in Millions 600 500

500 410

US $

400

300

200 141,6 100 31,5 0

0 Indonesia, 1999

Philippines, 2003

Mexico, 2003

Poland, 2001

South Africa, 2000

having similar programs to stimulate local debt management development under similar conditions. Classification of the similarities allows one to hold constant the key factors expected to influence development, reducing the problem of multiple causation, which otherwise besets comparative analysis.27 By picking local debt market development cases with similar key variables, we then focused on those measures, conditions, and variables that are different. Our analytic framework will focus on differences in approach, allowing us to develop lessons and recommendations that would be useful to stimulate development of markets in both (a) the weaker of the five cases and (b) other similar cases of emerging markets, such as Russia and China. A limitation to this research is that valid and reliable data do not exist as yet and have to be estimated. MUNICIPAL CREDIT MARKET DEVELOPMENT VARIABLES If our propositions are valid, one would expect countries with greater institutional capacity to have a deeper market structureFmore borrowing, with longer maturities, diverse instruments and investors, and diverse experience with institutions. Debt Market Structure and Size As indicated in Figure 2, one of the outcomes of recent development has been a small, but evident, increase in market size. Nearly every country for which data were available 27. Ibid., 100.

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demonstrated an increase in debt issuance, particularly bonded debt. Only Indonesia stands out as the exception in that subnational borrowing is still concentrated in bank loans to only 60 percent of LGUs. Bonded debt as a percent of gross domestic product (GDP) is zero. Up through 1999, 307 loans were disbursed to 185 local (135 district and 50 municipal) governments. Local government borrowing accounts for less than 1 percent of GDP and two-thirds of borrowing is by regional water authorities.28 By 1999, US$86.7m29 had been issued, averaging US$0.10m per loan.30 The Philippine bond market is relatively young. Six bonds had been issued through late 2000. In the 1990s, bonds were small, ranging from $148,000 to $482,000, with maturities of two to three years. Most were partially tax exempt.31 As of May 2003, US$31.5m in municipal bonds had been floated.32 This amount represents 3.95 percent of GDP. The majority of these bonds are insured by the Local Government Unit Guarantee Corporation (LGUGC), a company that underwrites investor insurance of local government bonds.33 Similarly, six municipal bonds were issued by Mexican municipalities between December 2001 and June 2003. The total amounts to US$141.6m, averaging US$20.2m each. The issues ranged in size from US$9m to US$75.6m. The US$141.6m represents 2.58 percent of GDP. The South African municipal credit market slowed substantially in the late 1990s, with only US$250m in municipal debt from March 1998 to March 1999, of which less than 20 percent was long-term debt.34 Coincident with the post-Apartheid regime from 1997 to 2000, the securities fell from near US$1.58b to US$0.5b and long-term loans increased from US$0.5b to US$1.16.35 The US$0.5b represents 4.10 percent of GDP. Because of data inconsistencies, the best estimates of total municipal debt from 1999 to 2003 range from US$1.77b to US$3b.36

28. Blane Lewis, ‘‘Local Government Borrowing and Repayment in Indonesia: Does Fiscal Capacity Matter?’’ World Development 31, no. 6 (2003): 1047–1063. 29. All conversions are approximate and based on conversion rates available on August 5, 2003. For comparative clarity, each value is converted from the host currency to US$. 30. Lewis. 31. John E. Petersen, ‘‘Philippines,’’ in Subnational Capital Markets in Developing Countries: From Theory to Practice, eds. Mila Freire and John E. Petersen (Washington, DC: The World Bank, 2004), 461– 486. 32. Jesus G. Tirona, Mapping the Future: Philippine LGU Debt Market: 5 Years After (Philippines: LGU Guarantee Corporation, May 2003). 33. Petersen, ‘‘Phillippines.’’ 34. Department of Finance, ‘‘Policy Framework for Municipal Borrowing and Financial Emergencies’’ (Republic of South Africa, Department of Finance, 2000); available from: www.dof.gov.za, accessed 5 August 2003. 35. Fitch, ‘‘South AfricaFCreditworthiness of South African Municipalities,’’ International Public Finance Review 2 (May 2003): 11. 36. Ibid.

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Recent growth in South African municipal debt is attributed to public sector lending. While municipal debt to the private sector remained steady at about US$1.45b to $1.58b from 1997 to 2001, municipal debt to the public sector increased from US$0.75b to $1.08b over the same period. Thus, the private sector is the major supplier of credit, while growth is attributed to the public sector.37 Upon development and implementation of the borrowing framework developed in the late 1990s and early 2000s, one would expect the South African market to develop in two tangible ways. First, in the near term, the market will advance via issuance of long-term, negotiated sale bonds by some large, urban municipalities. Second, in the longer term, the majority of large, urban municipalities will have issued long-term bonds, by negotiated sale or competitive bid, some medium-sized municipalities will have issued bonds (seven to ten years), and there will be an active secondary market in municipal securities.38 Expectations for 2002–2003 were issuance of two to three municipal bond issues ranging in size from US$66m to $132m, by 2005, 10 to 15 issuers of over US$33m, with an aggregate debt market of US$3.9b, and by 2010, 50 issuers of over US$33m with an aggregate subsovereign debt market near US$13.2b.39 Polish municipal debt has grown since 1996, when no municipal bond market existed. The number of municipal bond issues increased steadily from 10 in 1996 to 70 in 2001. In 1998, Polish municipalities had close to US$1.55b in total debt, of which US$232m was bonded debt.40 By 2001, they had US$3.18b, of which US$0.41b was bonded debt,41 representing 2.37 percent of GDP. Thus, the amount of municipal bonded debt increased by US$178m in the three-year span. In 1998, individual issue amounts ranged from US$0.24m to US$52.9m. The larger city/county governments have issued the most in bonded debt.42 The amount of municipal government debt is rapidly approaching statutory debt limits.43 The recent surge in borrowing has been tempered by economic

37. IGFR, ‘‘Intergovernmental Fiscal Review’’ (Republic of South Africa, National Treasury, 2001); Mathew D. Glasser and Roland White, ‘‘South Africa,’’ in Subnational Capital Markets in Developing Countries: From Theory to Practice, eds. Mila Freire and John E. Petersen (Washington, DC: The World Bank, 2004), 313–336. 38. Mathew D. Glasser et al., ‘‘Formulation of a Regulatory Framework for Municipal Borrowing in South Africa,’’ Final Report (Republic of South Africa, National Treasury, February, 1999). 39. Mathew D. Glasser, ‘‘Local Government Finances,’’ PowerPoint presentation sent to author (RTI International, 2003). 40. Agnieszka Kopanska and Tony Levitas, ‘‘The Regulation and Development of the Subsovereign Debt Market in Poland: 1993–2002,’’ prepared for the Open Society Institute’s Local Government Initiative Program (Levitas Consultants, LTD, December 2002). 41. Fitch, ‘‘Polish Local GovernmentsFIndependent but Constrained,’’ Special Report, FitchRatings; available from: www.fitchratings.com; accessed January 2003; see also Miguel Valadez and John Petersen, ‘‘Poland,’’ in Subnational Capital Markets in Developing Countries: From Theory to Practice, eds., Mila Freire and John E. Petersen (Washington, DC: The World Bank, 2004), 545–570. 42. Kopanska and Levitas. 43. Richard Morawetz, ‘‘Local and Regional Governments: The 2004 Accession Countries’’ (ABN AMRO UK); available at: www.abnamroresearch.com; accessed June 2003.

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recession and restrictions for local governments associated with European Union requirements. Figure 2 displays the amounts of total municipal bonded debt and their shares of GDP for the five countries, based on data from the most recent year available.

Maturities One would expect that countries evolving to market local credit would have longer maturities. Early bond issues in the Philippines, dating to the mid-1990s, had maturities of two to three years.44 In Poland, both the loan and bond instruments had longer terms in 2001 than in 1997. Over the four-year period, commercial bank loans with one-to fiveyear maturities to local governments decreased from 71 to 29 percent of total loans, whereas loans with maturities over five years increased from 14 to 47 percent of total loans.45 Bond maturities have increased from two to three years in the early 1990s to 10 to 15 years more recently.46 ‘‘In 1997, the municipal bond market was dominated by issues of two to five years, while in 2001 four to seven years (78%) prevailed. . . .’’47 The one Eurobond (US$38.5m), issued by Krakow, has a maturity of seven years. Maturities on municipal bonds in Mexico range from five to ten years, where principal amortizes every six months or at maturity.48 The average loan maturity in 1994 was 6.6 years, with a low of 2.7 years.49 Under the former regime, South Africa has a history of municipal debt issuance and maturities have been up to 20 years.50 However, under the current regime, expectations for new borrowers are maturities of up to 10 years.51

Diversity and Depth of Market The range of borrowing instruments available and utilized by local governments also reflects the development of the municipal credit market. In an ideal market model, a borrower has a choice of borrowing instruments. Guided by market parameters, the borrower selects the instrument that best meets its needs. In a more constrained market, choices are limited. Of the five countries examined, Indonesia has the least amount of financing choices available (loans and grants). In general, ‘‘few debt instruments of any 44. Petersen, ‘‘Phillipines.’’ 45. Calculated from data in Kopanska and Levitas. 46. Valadez and Petersen. 47. Fitch, ‘‘Polish Local Governments,’’ 7. 48. Moody’s, ‘‘Moody’s Opiniones Crediticias: Me´xico Gobiernos Estatales y Municipales,’’ Moody’s Investor Service; available at: www.moodys.com; accessed July 2004; Steven Hochman and Miguel Valadez, ‘‘Mexico,’’ in Subnational Capital Markets in Developing Countries: From Theory to Practice, eds. Mila Freire and John E. Petersen (Washington, DC: The World Bank, 2004), 299–312. 49. Hochman and Valadez. 50. Mathew D. Glasser, personal electronic mail correspondence (6 August 2003). 51. Glasser et al.

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kind are traded in the capital markets, in part because the [Indonesian] market is dominated by the recapitalization bonds.’’52 In the Philippines, aside from donor-based credit financing, credit to local government has been provided by two government financial institutions, two on-lending institutions, and a municipal development fund. Loan financing by the government financial institutions has been mostly available to higher-income borrowers at prime commercial rates. Loans to LGUs, totaling US$305m in 2000, have had two to four years maturities, slightly longer than commercial loan maturities.53 Although there is almost no lending by private commercial banks to LGUs, private banks are the main purchasers of municipal bonds.54 Municipal bonds have been issued for revenue-backed or self-liquidating projects. Recently, all the bonds have been double barreled, secured with revenues (project and/or transfers) and a guarantee from a state insurance agency, the LGUGC. Originally the LGUGC insured housing bonds. In 1999, they supported revenue bonds to finance an abattoir, port and terminal, hospital, public marketplace, commercial building, and a convention center.55 Municipal credit in Poland followed decentralization in the early 1990s. It is dominated by bank lending and concessionary financing. Bank loans are a major source of financing and, in 2001, commercial bank credits and loans accounted for 75 percent of municipal debt.56 Bonds account for about 20 percent of local debt issuance in Poland, nearly two-thirds of which is issued by the larger city/county jurisdictions. Prior to 2000, all municipal bonds had to be backed by the general obligation of the local government. A change in 2000 allows the securitization of municipal bonds with assets and revenue, resulting in expanded borrowing flexibility. The number of bond issues increased from 89 in 2000 to 140 in 2001. The PKO Bank Polski is the largest lead manager of municipal bond issues.57 Subnational debt in Mexico is dominated by bank loans from commercial banks and the development bank of Mexico, Banobras. It is concentrated in three states. Municipalites are prohibited from borrowing in foreign currency or from foreign sources. Spawned by new efforts to break out of top-down intergovernmental relations, Mexican municipalities can issue a new bond instrument. The Exchange Certificate (Certificado Bursa´til) offers versatility in terms of maturity and rates. As nearly 95 percent of Mexican local government revenues come as a transferred share of the federal government’s 52. Robert Kehew and John Petersen. ‘‘Indondesia,’’ in Subnational Capital Markets in Developing Countries: From Theory to Practice, eds. Mila Freire and John E. Petersen (Washington, DC: The World Bank, 2004), 444. 53. Petersen, ‘‘Phillipines.’’ 54. The national bond market is dominated by central government notes, which attract the biggest institutional investors. The big institutional investors have largely limited their investments to central government treasury bills 55. Tirona. 56. Valdez and Petersen, 555 57. Ibid.

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collected revenue, recent Mexican municipal bonds are securitized with this transfer, known as participaciones. In an effort to reduce the moral hazard, the federal government has reformed Art. 9 of the Fiscal Coordination Law to end any explicit or implicit federal guarantees of municipal debt. The mechanism developed to reconcile using participaciones as securitization and not increasing the federal government’s liability is the ‘‘Master Trust.’’ Participaciones are channeled through the Master Trust, which distributes payments among creditors.58 Both loans and bonds are available to South African municipalities. Loan financing is dominated by two institutions, which hold about half of the outstanding municipal debt: the Development Bank of Southern Africa, a governmental finance institution, and the Infrastructure Corporation of Africa, a private institution.59 The increasing concentration of lenders is antithetical to developing vibrant primary and secondary markets.60 Both institutions have a bias toward large metropolitan areas. In addition to loans, municipalities in South Africa are afforded a wide range of bonded financing instruments. These securities can include bonds backed by general obligation (GO), assets, local taxes and revenues, intergovernmental transfers and grants, and tax and tariff covenants. In addition to various instruments, it is believed that a ‘‘larger and more diverse assortment of potential lenders, the market would certainly work better.’’61 Market development would be accelerated as financial institutions are allowed to invest in alternative borrowing instruments. The Mexican law allows retirement funds to be invested in local bonds. As of January 2003, the national retirement system (CONSAR) permitted investment of retirement funds (SIEFORES) into municipal bonds. In Poland, pension funds and insurance companies are allowed to invest in municipal bonds, so long as no more than 5 percent of their portfolios is held in privately issued municipal bonds and no more than 15 percent is held in publicly traded municipal bonds. While institutional investors in Poland have invested in municipal bonds, their investment levels are well below statutory limits, suggesting underdeveloped demand or not enough compensation, either via yield or other mechanisms such as tax exemptions. An arrangement in the Philippines encourages investment in municipal governments. Local government bonds could be used to meet the ‘‘agri-agra’’ requirement, a mandatory credit allocation imposed on banks.62 The pool of potential investors in South Africa is extensive and includes those that are already active in municipal debt (Development Bank of South Africa, INCA, and banks), as well as those that are not currently active in the municipal market (mutual funds, individuals, pension funds, and insurance companies).63 58. Moody’s ‘‘Regional and Local Governments: The Mexican Case Rating Methodology,’’ Moody’s Investor Service; available at: www.moodys.com, accessed September 2000. 59. Glasser and White. 60. Ibid. 61. Glasser et al., 82. 62. Tirona. 63. IGFR.

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Of the information attained, only South Africa has a developed secondary market for municipal issues. ‘‘The institutional components needed for a vibrant municipal bond secondary market already exist.’’64 However, ‘‘[i]n recent times there have been only a limited number of new municipal bond issues and few of the previously issued municipal bonds are being traded.’’65 In 1997, only US$27.6m in local authority bonds traded on the secondary market, an amount representing less than 0.5 percent of all bond secondary market trades.66 The optimistic hope is that stimulating the secondary municipal credit market will broaden the range of municipal investors, and efforts are underway to improve liquidity by reducing information asymmetries (disclosure, ratings, and accountability).67 The secondary market in South Africa will have a better chance of developing with the termination of tax incentives to provide loans over tradable securities.68 APPLYING THE EXPLANATORY FRAMEWORK: INSTITUTIONAL VARIABLES PREDICT MUNICIPAL CREDIT MARKET DEVELOPMENT Legal/Regulatory Borrowing Framework Borrowing restrictions and opportunities differ among the countries. In Indonesia, presently all long-term borrowing has been from the central government.69 While Law 25 of 1999 gives local governments the right to borrow, a partial moratorium in response to post-1997 concerns of excessive public debt countermands this right. Regulatory restrictions on local borrowing are based on the operating surplus and outstanding debt.70 The central government evaluates the ability of a local government to borrow based on its calculated capacity. Any local government with capacity is entitled to borrow from one of two central government loan programs (Subsidiary Loan Agreements [SLA] and Regional Development Account [RDA]), even if that government happens to be in arrears on a former loan.71 Yet, the center may not approve a loan even if the local government satisfies the regulatory restrictions. Local governments have few options for securitization: there are no provisions for use of a trust and certain assets cannot be pledged to secure debt. Also, SLA loans are tied to donor projects and participants are selected on donor criteria. Borrowing is not market based: The loan terms are standard, with similar maturities (18–20 years) and constant borrowing rates (11.5 percent). 64. Glasser et al., 66. 65. DOF. 66. Glasser et al., 27. 67. Ibid. 68. Ibid. 69. A partial moratorium on local government borrowing responds to International Monetary Fund requirements. 70. The debt service coverage ratio is a function of the operating surplus. Local government outstanding debt may not exceed 75 percent of the previous year’s general revenues. 71. Lewis; Kehew and Petersen.

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Provisions in Law 25 and Regulation 107 of 2000 are expected to allow local governments to borrow from noncentral government sources. The financial management systems of Indonesia are weak.72 Although mechanisms for financial management exist, there is a disjunction between regulations and application of them. Among the mechanisms are debt limitations, intercepts of transfer payments in the event a local government defaults on a loan, and restrictions on borrowing when in arrears. Recent legislation to affect local borrowing restricts consolidated public sector outstanding debt to be less than 60 percent of GDP. South Africa has developed but not enacted a subnational government borrowing policy framework that calls for as little central control as possible.73 The main functions of the federal government are to establish a broad borrowing policy, as documented in the Policy Framework for Municipal Borrowing and Financial Emergencies.74 The Municipal Finance and Management Bill sets forth the legislative provisions to execute the policy framework.75 Each municipality is responsible for determining its specific debt policy and for coordinating debt with its capital improvement strategy. Municipal Councils, not the federal government, have the responsibility for authorizing municipal debt. The intent of decentralizing the debt policy function is to explicitly and implicitly end the central government’s liability of municipal debt. ‘‘Moving to this new regime will require establishing not only market-oriented incentives for both borrowers and lenders to use the market but also clear guidelines as to how information channels will be established, managed, and used.’’76 In addition, there are no country-wide debt limits. While presently the municipal debt market is dominated by financial intermediaries, where loans originate from and are held by banks and other financial institutions, municipal governments in South Africa are given broad leeway to craft securities that meet the needs of the issuer. Services that comprise the essential services of the municipality cannot be pledged. A final restriction, imposed by the federal government, limits the use of debt to capital for property, plant, and equipment that is budgeted and approved.77 In the Philippines, a local government’s debt ceiling is a function of its repayment capacity. The Local Government Code of 1991 increased decentralization and local responsibility for infrastructure finance, also allowing municipalities to issue tax-exempt 72. Ehtisham Ahmad and Ali Mansoor, ‘‘Indonesia: Managing Decentralization,’’ Conference on Fiscal Decentralization, Fiscal Affairs Department (November 2000). 73. Glasser and White. Documentation relevant to the development of the municipal bond market includes the ‘‘White Paper on Local Government’’ (1998), which enables market-capable municipalities to access private capital to finance infrastructure; ‘‘Formations of a Regulatory Framework for Municipal Borrowing in South Africa’’ (1999); the ‘‘Policy Framework for Municipal Borrowing and Financial Emergencies’’ (2000); and the ‘‘Municipal Finance and Management Bill’’ (to be adopted 2003). Glasser, ‘‘Local Government Finances.’’ 74. DOF. 75. IGFR; MFM, ‘‘Municipal Finance Management Bill’’ (Republic of South Africa, Draft 29 April 2003). 76. Glasser et al., 28. 77. MFM.

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municipal bonds. The borrowing restrictions require a borrower’s debt service to be no more than 20 percent of income, that all contracted debt is on budget, and that projects pass a financial impact study by the central government. The same code ends a federal guarantee of subnational debt. In Poland, the Law on Local Self-Government of 1990 set forth a decentralized governance structure and provided legal protection for local autonomy. Governance of local budgets, local responsibilities and revenues were assigned a year later. The 1999 Law on Local Government Revenue, which redefined local governments, further devolved revenues and expenditures. The 1993 Law on Municipal Finance authorized localities to issue securities and the 1995 Law on Bonds regulated issuance. However, municipalities have found the regulatory and disclosure requirements burdensome.78 In this context, the bond market for municipal obligations developed on the margins in the mid-1990s. Borrowing authority reflects the balance of local responsibilities and revenues, which differs for different types of jurisdictions,79 as well as overall restrictions. Each Polish local government must meet restrictions for total debt and debt service, especially for issues and loans not secured by real property. Additionally, because of requirement of European Union accession, the collective debt of the nation cannot exceed 60 percent of GDP, a policy that has led to uncertainty and gaming by local borrowers.80 All local government debt is limited to 60 percent of total revenue and debt service to 15 percent of total revenue.81 As the restriction can limit the amount of debt the municipalities can hold collectively, it effectively limits the long-term borrowing horizon of municipalities. Finally, since 1999, localities are prohibited from issuing debt in foreign currencies. The Mexican municipal borrowing framework reflects a political will to pay.82 The Fiscal Coordination Law of 1980 began a reversal of centralized governance. In an effort to shift from ad hoc and negotiated subnational borrowing to stricter and more transparent subnational borrowing rules, the Mexican Treasury promulgated a new subnational borrowing framework in 2000: ‘‘The new regulations eliminated discretionary federal transfers, required lending institutions to adopt prudential limits and get risk assessments (ratings) on state debt, and provided incentives for regular financial reporting by states and municipalities.’’83 Debt limits in Mexican municipalities are usually defined in terms of debt service, as opposed to debt stock, which could inaccurately

78. Valadez and Petersen. 79. The jurisdictions with the most financial autonomy (gminas, or towns and municipalities) have the greatest autonomy to set local taxes and fees subject to central government maximums. The larger regions (voivodships) have extensive borrowing capacity while the intermediate administrations (powiats) are more limited. Valadez and Petersen. 80. Valadez and Petersen; Kopanska and Levitas. 81. Valadez and Peteresen. 82. Hochman and Valadez, 300. 83. Ibid., 304.

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portray the extent of liability.84 Municipal debt also has to be approved by the local legislature85 and proceeds must be used for capital investments. Municipalities are prohibited from borrowing from foreign sources or in foreign currency. A limitation to using debt service is that it obscures debt associated with contingent liabilities and guarantees. An interesting bond arrangement in Mexico is a mechanism that allows bondholders to accelerate debt payments in the event a municipality is noncompliant with payments.86 The 2000 framework requires lenders to have risk-weighted reserves, which increases the borrowing costs. Information, creditor rights, and default procedures. Another indicator of a developed municipal credit market is the extent to which rules that deal with information flows, creditor rights, and default procedures are developed. Investors, likewise, require accurate and timely information. Building investor confidence requires establishing well-defined procedures in the event of municipal default. The procedures should deal with the rights and legal enforcement of contractual agreements. Reliable information disclosure is important, although available to different degrees among the five countries. Designed by the Polish Securities Commission, registration and disclosure requirements in Poland for publicly traded municipal bonds are comprehensive and on par with developed markets.87 The 1998 Public Finance Act initiated local budgets. Unfortunately, budgetary definitions of debt and surplus ‘‘make it difficult in practice to determine whether long term borrowing and/or surpluses from previous years are being use to finance capital investments or short-falls in operating revenue.’’88 In South Africa, despite having satisfactory infrastructure to support the development of a municipal securities market, information asymmetries have existed for some time and have contributed to the contracting municipal market.89 The central government is developing disclosure requirements for initial and continuing information disclosure.90 To support the disclosure requirements, the government is creating an antifraud law, regulations specifying fraudulent behavior, and suggesting that borrowers follow industryestablished best practices and guidelines.91 Additionally, the South African government is working to create an official repository of information.92 Procedures to deal with defaults are inadequate.93

84. Grupo Financiero Banamex, ‘‘Financiamiento Estatal y Municipal: El Futuro ya Esta´ Aqui,’’ Perspectiva Regional (22 May 2003). 85. Only local legislative approval is required if the bond is repaid within the term of the borrowing administration. Both local and state approval is required for long-term bonds. Hochman and Valadez. 86. Moody’s, www.moodys.com. 87. Kopanska and Levitas; Valadez and Petersen. 88. Kopanska and Levitas, 13. 89. Leigland; Fitch, ‘‘South Africa’’; Glasser and White. 90. DOF; MFM. 91. Glasser et al. 92. DOF; Glasser et al. 93. Glasser and White.

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In Indonesia, the local borrowing operations are less than transparent. Information flows are either untimely or unheeded, such that warranted corrective action is not taken.94 Information that does reach the Ministry of Finance may be guarded. Inadequate financial reporting and disclosure limits lending to subnational governments95 and fuels investors’ lack of familiarity and perceptions of noncreditworthiness. While reporting standards need to be improved, efforts are complicated by low levels of managerial and financial competency. No country has done exceptionally well with developing a framework for creditor rights. Ultimately, irrespective of any framework, the proof comes at the time of enforcement. However, investor confidence is built as legal procedures are established, as is underway in South Africa. As the bond markets are nascent, the system has yet to be tested. With respect to default procedures, the five markets explored here are in various stages of development. Indonesia and the Philippines lack default and bankruptcy legislation for regional governments.96 In South Africa’s policy framework for municipal debt, the groundwork was laid for the creation of a mechanism to intervene in distressed municipalities. The Municipal Financial Emergency Authority (MFEA), similar to a financial control board, provides an external party temporary authority to control the finances of a municipality and to implement a ‘‘turn around plan’’ to revert the distressed situation. Leigland wrote in reference to South Africa: ‘‘As with any truly nascent municipal market one important development goal will be to avoid early defaults that undercut investor confidence in new kinds of debt instruments and borrowing purposes.’’97 If it functions as intended, the MFEA should ease investor fears about municipalities on the brink of default.

Risk Assessment In most countries, institutions exist to determine credit by a variety of criteria. The important goal is to match borrower creditworthiness to available financing and price instruments appropriately. This avoids wasting scarce funds and allocating them to the wrong borrowers. Banking law in Poland provides incentive for banks to invest in municipalities, but does not encourage attention to risk. The Banking Law allows local governments to deposit in any bank, and banks can have up to 25 percent of their portfolio attributed to a single investor, thereby creating a large pool available for the banks to provide entities with loans or bonds. However, ‘‘[t]he ordinance [Banking Law, Art. 128] does not enumerate different risk coefficients for different types of debt instruments and is thus neutral with respect to loans and bonds, or for that matter, public and private issues.’’98 Also no adjustment is made to the bank’s risk coefficient for rated and unrated debt instruments. Moreover, banks do not have to monitor bonds and do have to monitor loans. For all these reasons, there is incentive for banks to purchase/ 94. Ahmad and Mansour. 95. Kehew and Petersen. 96. John E. Petersen, Municpal Bonds in Emerging Markets (Manila, Philippines: Government Finance Group Inc., October 2000). 97. Leigland, 75. 98. Kopanska and Levitas, 17.

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underwrite bonds. As a result, ‘‘banks continue to chase after local government clients in ways that suggest that they are not always really examining the credit-worthiness of individual local governments.’’99 In contrast to Poland, Mexican banking regulation requires banks to keep in reserve an amount proportional to the risk of their subnational government investments. In the past, South African banks had a capital adequacy regulation that provided a 90 percent privilege to municipal debt. That privilege has been withdrawn, and now municipal debt is treated on par with all other debts, requiring that municipal capital adequacy reserves be paid in full.100 Differential treatment of borrowing instruments can retard complete market development. In the Philippines, bank loans can be secured by GO pledge, but ‘‘bonds can only be sold for self-supporting and liquidating projects.’’101 As municipalities must keep deposits in governmental financial institutions, private commercial banks have less security. They are, therefore, less likely to provide credit to municipalities and more likely to be cautious about underwriting bond issues.102 Additionally, they risk being undercut by government financial institutions (GFIs) after costly investment in underwriting. In Indonesia, a revenue intercept mechanism gives repayment priority to government financial institutions over other creditors, dampening non-GFI lending interests. The use of nonfinancial intermediaries also varies among the five countries. Indonesian municipalities have not been rated by any credit rating agency, although local credit rating agencies have an interest in doing so and the Ministry of Finance has a rating scheme.103 In the Philippines, all recent bond issues have been secured by the LGUGC. Credit rating has been used by GFIs and the LGUGC, but the ratings are not public. The LGUGC has brought in a variety of industry professionals to form a rating commission, which provides a more broad-based examination than a bank.104 The LGUGC ‘‘evaluates the criteria and if [municipalities] meet the credit criteria, they are charged a premium reflecting risk.’’105 However, GFI loan amounts are still a function of transfers from the central government.106 ‘‘Until the securities market, consisting of many passive investors with substantial holdings, becomes more important as a source of capital to local governments, there will be little effective demand for published external ratings.’’107 Ratings in Poland and Mexico have been conducted by a number of international rating firms (Standard & Poors, Moody’s, and Fitch Ratings). In Poland, only eight subnational governments have been rated, all of them being the larger city/county 99. Ibid., 35. 100. Glasser, ‘‘Local Government Finances.’’ 101. Petersen, ‘‘Municipal Bonds’’; Petersen, ‘‘Phillippines.’’ 102. Petersen, ‘‘Phillippines.’’ 103. Kehew and Petersen. 104. Tirona. 105. Petersen, ‘‘Municipal Bonds,’’ 35. 106. Petersen, ‘‘Phillippines.’’ 107. Ibid., 479.

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governments. The ratings range from BBB- to Baa1 and appear geared to international transactions. Demand is limited because, so far, there has been only one public issue of a municipal bond, there is no differentiation of local government creditworthiness by bank investors, and Polish local governments are restricted from issuing bonds in international issues unless they are a direct issue by a multinational financial institution.108 Twenty-two Mexican municipalities have been rated to date, although only six have issued bonds. The ratings are used by banks to fulfill the requirement that required reserves are a function of municipal risk. There is explicit recognition that ratings will improve municipal access to the bond market and ‘‘more than municipal size, ratings reflect the financial capacity and management.’’109 According to the rating industry, ‘‘entities with the best ratings will most likely receive more favorable financing terms.’’110 Willingness to rate reflects awareness that negotiable bond offerings can offer lower interest costs than bank loans.111 Rating agencies are increasingly active in South Africa. The dominant agencies are Fitch Ratings and CA Ratings (an affiliate of Standard & Poor’s). Each collects information on the financial condition of municipalities and their databases include municipalities that have not requested ratings. The Development Bank of South Africa uses an internal rating system for its existing loans.112 Despite the development of ratings in South Africa, ‘‘not all segments of the investor community are fully familiar with the rating resources and, hence, may not use rating agency information to facilitate secondary market trading.’’113 Another aspect of market development is that of private credit enhancements. The LGUGC of the Philippines insures municipal bonds, which provides incentives for investors to buy local government bonds. As the United States Agency for International Development (USAID) offers a 30 percent reinsurance of LGUGC, investors are ‘‘reassured’’ about the insurance. Supramunicipal guarantees. South Africa, Mexico, and the Philippines have taken measures to mitigate moral hazard problems by ending federal government guarantees of local government debt and by developing systems where borrowing price reflects risk. While the South African government has a tradition of classifying borrowers according to risk, the government has let the market determine the risk and return of any particular borrower. ‘‘Classifying a municipality in a way that encourages it to seek assistance and avoid responsible borrowing on its own is exactly the opposite of the effect the government intends to have.’’114 In Mexico, 1999 reforms modified Art. 9 of the Fiscal Coordination 108. Kopanska and Levitas. 109. Grupo Financiero Banamex, 6, translation by author. 110. Fitch, ‘‘Financing of Mexican States, Municipalities, and Agencies: Alternatives and Strategies,’’ International Special Report, Fitch IBCA & Duff & Phelps; available at: www.fitchratings.com; accessed 31 January 2002, 4. 111. Hochman and Valadez. 112. Glasser et al. 113. Ibid., 64. 114. Ibid., 17.

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Law to end the federal government’s guarantee of subnational debt payments. The guarantee was replaced with the Master Trust mechanism in 2000. Even loans granted by financial intermediaries align price with risk. As discussed, a 1999 change in Mexican banking regulations requires banks to keep in reserve an amount proportional to the risk of their subnational government investments. The measure of risk would be determined by rating agencies. In the Philippines, the Local Government Code of 1991 ends the federal guarantee. The LGUGC was later established to provide more arms-length security to investors. Although in Poland there were early signals of a federal guarantee, the provision has never been activated.115

Capacity to Budget, Borrow, and Manage Debt While local government fiscal capacity is expected to bear upon the development of local credit markets, local data on borrowing, budgeting, and debt management capacity are difficult to find and interpret. They are plagued with issues of aggregation, degree of decentralization, source (purely public, or public authorities too), definitional consistency, timeliness, and accuracy. Ideally, this paper would present a comprehensive picture of the local data landscape of each country studied. They would signal the extent to which municipal financial capacity is developed. Despite the substantial amount of work on increasing LGU fiscal management capacity around the world, no known evaluation of capacity has assessed whether the LGUs will repay borrowed funds. It could be that proprietary data are held by banks and institutional lenders, and the data show that capacity is positively related to repayment: If this is the case, there is a publishing lag. Further research is needed. As a crude proxy for municipal capacity, this study uses the aggregate local government current budgetary surplus (or deficit) as a ratio to total current expenditures.116 The data measure local government operating deficits and surpluses, including debt service principal and interest payments. They do not measure borrowed amounts. The data are limited, in that they do not pick up the sustainability of debt repayment or how much of current obligations are being financed by arrears. Another limitation is that local-level data are not provided by the International Monetary Fund (IMF) for Indonesia and are taken from a different source.117 Indonesia’s surplus and deficit data, however, do not distinguish current and capital revenues and expenditures. Thus, the local revenue and expenditure data for Indonesia do include capital and are not a perfect comparison with the values of other countries. The surplus/deficit measure is a proxy and debt management capacity is implied. The data show that three of the five countries have a local deficit and the remaining two have a surplus. The greater the deficit, the less capacity the collective of localities has to budget, borrow, and manage. The greater the surplus, the more capacity the collective 115. Valadez and Petersen. 116. International Monetary Fund, Government Finance Statistics Yearbook (Washington, DC: International Monetary Fund, 2002). 117. Bland Lewis and Jasmin Chakeri, ‘‘Decentralized Local Government Budgets in Indonesia: What Explains the Large Stock of Reserves?’’ Working Paper, 2005.

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0 2.58 3.95 2.37 4.10

Country

Indonesia Mexico Philippines Poland South Africa

Longer Longer Longer Longer Longer

Path: Maturity Structures Low Medium High Medium High

Diversity: Instruments from Multiple Types of Credit Institutions Low High Medium High High

Diversity: Investors None None None None Low

Depth: Secondary Markets No Yes Yes Yes Yes

Legal and Regulatory Borrowing Framework

Low Medium High Medium Medium

Allocation of Credit by Risk

High (13.87%) High (15.85%) Low ( 47.5%) Low ( 35.0%) Medium ( 7.61%)

Capacity – Proxy of Current Surplus/Deficit*

Explanatory Variables

* Source: Values for Indonesia are based on data in Lewis and Chakeri (2005): Values for other countries are calculated from International Monetary Fund (2002), Table L, (AIII–CIII)/ CIII. Data are based on the following years: Indonesia (2002), Mexico (2000), Philippines (1992), Poland (2001), and South Africa (2001). GDP, gross domestic product.

Size: Total Amounts Borrowed as % GDP

Results Credit Market Development Measures

TABLE 1 Institution Building for Local Government Credit Market Development

of localities has to budget, borrow, and manage. Based on this measure, Poland and the Philippines show the least capacity, South Africa shows medium capacity, and Mexico and Indonesia show the most capacity.118 The results are displayed in Table 1. Evidence suggests that municipalities have varying management capacities. In the Philippines, at current borrowing levels ‘‘there is little reason to characterize local governments as weak or undependable credits.’’119 Yet, municipalities there need technical aid in presenting capital requests, debt fund accounting,120 and more certainty about bond market procedures. Debt management strategies are also hamstrung by restricted own-source revenue raising authority. While South African municipalities have debt capacity at two to three times current debt levels, efforts are needed to develop basic skills (accounting, planning, reporting, and marketing) and capital improvement plans. The intracountry variation in financial management ability and skill is largely a function of recent demarcation. Poor budgetary performance, weak financial management, and limited human resources characterize the majority of local jurisdictions.121 Mexican municipalities are increasingly using independent audits, a signal of increased transparency and professionalism. However, they are plagued with weak revenue-raising powers, few revenue resources, low tax rates, poor financial record keeping, and inefficient revenue collection procedures.122 In Poland, cities have narrow operating surpluses. Low levels of debt service reflect that the majority of budgets are allocated to noncapital intensive operations. Capacity to borrow must be separated from political will to repay. While Indonesian local governments have a history of arrears, their surpluses have grown extraordinarily since the implementation of decentralization in 2001.123 Discussion of Framework Application and Results As indicated in Table 1, those countries with more comprehensive borrowing frameworks and institutions that allocate credit by risk have more developed financial institutions. For the sake of developing this argument, consider a loose quantification of the above qualitative measures, where each variable is given a relative rating of 1, 2, or 3. One

118. This result is consistent with comments of an anonymous reviewer: ‘‘local governments have run small surpluses for years. As fiscal decentralization began implementation (in 2001), surpluses have grown extraordinarily. The stock of surplus revenues now is around 13–14 percent of total expenditures. So there is plenty of capacity to repay.’’ 119. Petersen, ‘‘Phillippines,’’ 471. 120. It is unclear whether local governments have legal authority to separate debt service funds; Petersen, ‘‘Phillippines.’’ 121. Glasser and White. 122. Hochman and Valadez. 123. The authors thank a reviewer for pointing out this paradox.

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1 2 3 2 3

Country

Indonesia Mexico Philippines Poland South Africa

GDP, gross domestic product.

Size: Total Amounts Borrowed as % GDP 2 3 2 3 3

Path: Maturity 1 2 3 2 3

Diversity: Instruments 1 3 2 3 3

Diversity: Investors 1 1 1 1 2

Depth: Secondary Markets

Results Credit Market Development Measures (Y)

6 11 11 11 14

Sum

1 2 2 2 3

Legal and Regulatory Borrowing Framework

1 2 3 2 2

Allocation of Credit by Risk

3 3 1 1 2

Capacity to Budget, Borrow, and Manage Debt

Explanatory Variables (X)

TABLE 2 Institution Building for Local Government Credit Market Development

5 7 6 5 7

Sum

FIGURE 3 Sum of Explanatory and Results Variables Municipal Credit Market Development Municipal Credit Market Development Variables

16

7, 14

14

12 5, 11

6, 11

7, 11

10

8

5, 6

6

4

4

5

6 Explanatory Variables

7

8

represents the below-average case, two the average case, and three the above-average case. Based on the preceding text, the translated variables and the cumulative scores for the independent and dependent variables are seen in Table 2. Figure 3 graphs the cumulative scores and relationships between the explanatory variables and results. These institutional features correlate roughly with measures of market development. If the institutional variables are the major differences between more and less successful market development, then efforts should focus on how to strengthen them. More negative or undeveloped cases need to be included to strengthen this conclusion. This suggests that further efforts should focus on the legal and financial institutions prior to emphasis on local capacity building for debt/cash management and capital budgeting. While local capacity is critical for local service provision, real incentives to improve local fiscal management will occur largely on the heels of options to borrow from financial institutionsFthe availability of funds. In many cases as discussed above, subnational units can receive grants without improving their financial performance, which acts as a disincentive to build borrowing capacity. As subsidized sources become increasingly scarce and as other subnational units borrow from new sources at market or semimarket rates and repay these loans, interest will grow in how to improve local financial performance.

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Lessons and Conclusions A variety of lessons surface from the experiences presented. One is that uncertainty stunts market growth. Uncertainty over rules and regulations has had impacts on investors in the Philippines, resulting in a role of the national government to implement in full its local government capital access plan.124 Uncertainty about future responsibilities and fiscal powers, as exists in South Africa, impedes municipal capital planning, and subsequent borrowing. Uncertainty about the imposition of tariff caps in South Africa retards private investment. Uncertainty about the accuracy and completeness of information and default proceedings, as in South Africa, limits investment, especially affordable investment. Uncertainty about subsidies and distortive policies negatively affects market development. Policies that bias one type of investor, or one type of borrowing instrument, over another create disincentives for broad-based market participation. This is especially true when policies squeeze out private investors. South Africa, Indonesia, and the Philippines offer examples of distortive policies. In the extreme case, distortive policies can result in unexpected outcomes: In response to Indonesian lending distortions, borrowers sought offshore financing at substantial exchange risk. The South African experience is illustrative of how uncertainty creates a negative spiral, whereby uncertainty retards investment which releases pressure on decision makers to mitigate uncertain environments, which ultimately spawns more uncertainty. A second lesson is that political commitment is critical to market development. The differences in the development of municipal markets that have been supported by political will for some time, like Mexico, and those that have been supported only recently, like Indonesia, are remarkable. Policies that support nonpayment, such as bailouts and further financing borrowers who are in arrears, are counterincentives to market development. In the Philippines, ‘‘[p]rivate market investors see local politics as volatile and undependable and still subject to the national government’s intrusion or to changes in the rules of the game.’’125 A third lesson is the need for municipal borrowers to balance prudence with flexibility. Indonesia has a small investment sector, with 97 percent of public pension assets held in central government insured bank deposits. Similarly, Polish decision makers and legislation holds fiscal management paramount to fiscal flexibility. The prudence over flexibility restricts the use and development of debt financing. From these lessons learned, one can deduce impediments that need to be overcome for the development of municipal credit markets. One of the main goals of markets is to balance risk and reward. As risks are great, especially under conditions of heightened uncertainty, rewards demanded can be too high for municipal borrowers. A role of institutions is to mitigate the risks associated with municipal borrowing. National governments and donor agencies can intervene. For example, donors that require

124. Petersen, ‘‘Phillippines.’’ 125. Ibid., 476.

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municipalities to borrow in foreign currency create currency risk and thus impede developing domestic municipal credit markets. Based on the application of our framework, we offer three major conclusions for municipal market development. The three conclusions are also tentative recommendations on a sequence of reform. First, countries that seek to establish market-based municipal credit markets should focus first on the municipal borrowing framework. The more successful cases of budding municipal credit markets, such as Mexico, included provisions for collateral and debt security, remedies for nonrepayment of loan termination of central government guarantees, devolution of authority to borrow, and tighter reporting requirements on commitments and capital expenditures. National governments and donor requirements can direct institutional savings into domestic investments. They can also be mindful of the subsidies provided to certain actors and reduce them over time. Equally important is the implementation design of central government policies and how they affect municipal development. Legal frameworks alone are insufficient market generators. Less successful countries, such as Indonesia in our sample, require more than a framework. Despite promulgation of laws in 1999 on municipal and regional finance, confusion still reigns on both local government functions and local financing mechanisms. A framework and infrastructure for capital markets have existed in Indonesia since before the 1997 financial crisis, and the country, through Law 25 and Regulation 107, has clarified provisions with regard to all aspects of local borrowing.126 Despite the existing financial infrastructure, there is no primary market for local government bonds. Weaknesses of the regulatory framework governing debt transactions are that the assets that local governments can pledge to secure debt are restricted, trust mechanisms are poorly developed,127 secured debt design gives priority to the central government over other creditors, and financial reporting and disclosure systems are inadequate, in part because of weak coordination among central government oversight units.128 Contextual factors affecting the development of the local bond market are the weak banking sector, the market domination by central government recapitalization bonds, the perception that local governments are not creditworthy, and lack of investor familiarity with local governments and their accounts.129 Related to the borrowing framework is the existence of top-level support for decentralization and modernization of municipal financing of infrastructure. One would think that the existence of a legal borrowing framework indicates top-level support for implementation of its provisions. This is not always the case. It is clear that the South 126. Kehew and Petersen. 127. ‘‘Trust mechanisms are particularly important in countries where rule of law is poorly developed. . . .’’ Kehew and Petersen, 453. This notion is supported in a discussion on social capital and market development; Luigi Guiso, Paola Sapienza, and Luigi Zingales, ‘‘The Role of Social Capital in Financial Development,’’ American Economic Review 94, no. 3 (2004): 526–556. 128. Kehew and Petersen. 129. Ibid.

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African government supports the evolution of key roles and functions, such as underwriters, bond counsels, and bond insurers. By contrast, Indonesian policy makers have received significant international advice on this topic, but have moved slowly on implementation. Over the past 10 years, almost $100 million in U.S. foreign aid alone has been provided for local government financial management reforms, some of which included advice on financing infrastructure through bond issues. Other donors such as the World Bank have provided similar assistance during this period. To date, not a single LGU has issued any debt. Top-level lack of enthusiasm acts as a constraint on market development. If a national government were to explicitly abandon guaranteeing subnational debt, then a clear message in support of a market-based approach would surface. Experience, however, suggests a clash between this position and donors’ requirements of sovereign guarantees, causing one to consider the appropriate position of donors that want to support market development. Second, the regime must encourage the establishment of modern financial institutions. This means facilitation of primary dealers, secondary dealers, banks and nonbank institutions that perform municipal credit analyses, and the due diligence reviews. The regime should also enforce regulations that require reporting and ensure that credit is actually allocated by risk. Much of the work needed requires providing the right information to the market, eliminating red tape, letting the market control itself, and enforcing regulations (many of which would be in the borrowing framework). As part of the broader municipal credit system development, consideration could be given to the establishment of municipal development funds or municipal development banks as an alternative to grants and market loans through which local governments can gain finance and experience in requesting funds, managing them, and repaying loans. Central to the design of alternative institutions should be a commitment to allocation by risk and encouragement of a broader market. Lack of market-based pricing, especially in tandem with subsidized and distortive policies, retards market development. Third, local governments should increase their capacity to manage cash/debt and to plan and finance capital projects. Local governments need experience in managing budgets to protect debt service obligations from absorption by salaries and other current expenses. They also must develop capital project planning and analysis systems through which all proposals flow for approval on formal economic criteria. Pet projects need to be screened out by this system to avoid increasing local debt service for uneconomic and inefficient purposes. To improve capacities in these areas, local government reporting and analysis systems need to be strengthened. Local officials need to know how to analyze project costs/benefits and prepare financing plans. They also need to know how to report commitments and accrued expenses to prevent fiscal deficits that often occur from cash-based accounting systems. We speculate that the third priority would occur should the first priority be achieved. It is true that without improved fiscal condition data, creditworthiness cannot be evaluated by financial institutions. But, the rationale for this sequence is that the framework and institutions will provide local officials the

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incentives to learn and apply methods and systems, and for improved reporting and cash/debt management. Without those incentives, there will be no demand for newly supplied skills and systems. Two final points ought to be addressed. This paper illustrates the data limitations to research. Data were extremely difficult to obtain, which unfortunately limits hypothesis testing. To these authors’ knowledge, there is no public repository of municipal borrowing data (such as amounts, types, yield, maturity, capacity measures, and credit ratings). National data gathering agencies can play a helpful role in the collection, as in Poland,130 and dissemination of local government financial and borrowing data. We encourage efforts to build information in these areas. Finally, this study raises an important question about how municipal credit systems should be sequenced, particularly in countries where local governments are disparate in their resource bases and capacity levels. When, under what conditions, and which countries and subnational units should strive to develop a municipal credit market? At what point should an LGU shift from reliance on banks to individual borrowers to deepen the market for local financing? Given the breadth of borrowing capacity and need within a country, it will be important to consider segmented markets where different financing alternatives are available for different classes of municipal borrowers. Further research might consider the effects of external factors such as capital transfers to municipalities, competitive banks, and mandates for capital expenditure.

NOTE The authors gratefully appreciate the feedback and support provided from anonymous reviewers. Any errors remain ours.

130. Valadez and Petersen.

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