1. Framework for Local Borrowing Dana Weist Lead Public Sector Specialist PRMPS 31 March 2004

2. Advantages of Local Borrowing
Finance long-lived assets efficiently and equitably
Overcome liquidity problems of lumpy investments
“Pay-as-you-use” financing
Improve selection of investments
Increase local revenue mobilization

3. Local Borrowing Risks Macro-instability “Soft” budget constraint
Vertical imbalance; high reliance on transfers
Poor loan repayment history
Moral hazard

4. Borrowing Risks Can Be Managed
Strengthen intergovernmental fiscal system
Apply administrative controls
Implement rule-based framework
Establish market-based system
Impose other controls

5. Intergovernmental Fiscal Relations
Clear expenditure assignments
Stable, predictable and adequate revenues
Local budgeting and financial management
Transparent budgets with public disclosure
Standardized financial reports
Credible accounting systems
Independent audits above defined thresholds
Efficient service delivery
Rational pricing policies
Monitorable performance indicators
Monitoring of local debt service and financial ratios

6. Administrative Controls
Central government controls local borrowing directly
Set annual limits on overall debt of individual local governments
Authorize and review individual loans, including approval of terms and conditions
Centralize all borrowing, with on-lending to local governments
Controls include ex ante authorization and ex post monitoring

7. Local Borrowing Rules Type of Restriction Description Countries
Affordability Formulae
Ceilings on (i) debt service / local revenues; (ii) debt service / local current saving
Argentina, Brazil, Italy, Japan, Spain, Lithuania, Poland, Colombia
Indebtedness Formulae
Limit on total outstanding debt / net revenues
Brazil, Colombia, Italy
“Golden Rule” Provision
Borrowing for capital expenditures
Brazil, Canada, USA, Austria, South Africa, Switzerland, India
Balanced Budget
Local councils are required to pass balanced budgets
Brazil, Canada, Germany, Netherlands, USA
Local Approval
Local councils are required to approve borrowing for individual projects
Canada, Switzerland, USA
Affordability formulae: ceilings on (i) debt service expenditures (interest plus amortization) as a share of local government net revenues (total revenues net of general allocation grants, special allocation grants, and shared revenues); and (ii) debt service expenditures as a share of local government current saving (total current revenues minus total current expenditures).

8. Market-Based Systems
Credit quality determines market acceptance and debt pricing
Credit ratings
Provide independent “opinions” to investors as to credit quality of debt issuers
Based on likelihood of default
Reflect both “capacity and willingness” of issuers to make timely payment of principal and interest in accordance with terms of obligations
Significant transaction costs

9. Elements of Creditworthiness
Economic base
Revenue autonomy and stability
Revenue-expenditure balance
Intergovernmental fiscal relations
Debt burden and contingent liabilities
Financial management
Use of guarantees, insurance and other credit enhancement mechanisms
Quality of collateral

10. Legal and Regulatory Frameworks
Supervision and disclosure
Debt issuance, settlement and repayment
Bankruptcy/work out procedures (including creditor remedies)
Protection against disruption of essential services and moral hazard

11. Options for Lending to Creditworthy Local Governments
Government Financial Institutions
Financial intermediaries
Municipal bond market

12. Development Funds Desirable characteristics
Market-based interest rates
Economically and financially viable projects
Transparent eligibility criteria
Graduation to private market – level playing field
Use of intercepts to strengthen repayments
Institutional development
Capitalization
Financing framework
Loan-grant mix
Competing funding sources

13. Other Controls Prudential regulations on net worth
Limit overexposure to any single borrower
Mandate special provisioning requirements for particularly risky classes of borrowers
Colombia, Mexico
No “bail-out” provisions
National government does not guarantee subnational debt
Mexico, South Africa
Colombia has 32 provinces, and 1064 municipalities
One of most decentralized governments in Latin America
About 40 percent of total government spending at subnational level
Operational savings = (local revenues + central transfers + interest – operating expenses – transfers paid)
Current income mainly includes tax revenue, nontax revenue, royalties and fees, transfers from the central government, national revenue sharing, and interest income.
Operational expenses include wages and salaries, honoraria, social welfare benefits, and social security expenditures
In 1993, Law 80 forced financial intermediaries to monitor destination of loans and debt capacity of subnational government
In 1997, Law 358 limited subnational debt to payment capacity, by means of associating payment capacity with the generation of operational savings.