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Metropolitan
Economic Strategy
EXPANDING LOCAL GOVERNMENT RESOURCES FOR
CAPITAL PROJECTS THROUGH MUNICIPAL BORROWING AND OTHER MARKET-BASED
FINANCING
Charles J. Billand
Introduction
An exciting paradigm shift is emerging
in developing and transitional economies. With increased
decentralization and urbanization, local governments have taken on
greater responsibility in the provision of basic municipal services. To
help fund education, solid waste management, water and sanitation, and
other economic development projects, municipalities have turned to
innovative financing mechanisms to meet local demand. Since central
government support cannot finance the service needs of most
municipalities, local governments are increasingly turning to: (1)
own-source revenues such as taxes, licenses and permits, user fees for
services, and municipal assets; and (2) borrowing from private capital
markets.
This article provides an overview of the
paradigm shift that is occurring in many developing countries and the
movement towards market-based municipal financing, and serves to assist
public officials in designing strategies that increase the supply of
local government resources to finance infrastructure, housing, health
care, education, economic development, and other services. The article
focuses heavily on the process of capital markets borrowing, either
through borrowing from banks or issuing debt instruments to investors.
Own-source revenues and cash transfers are examined only when needed to
articulate the interface between borrowing and the other two sources of
funds (own-source and transfers).
The Paradigm
Shift
Many developing countries are in the
midst of a paradigm shift on how to generate resources to increase the
delivery of municipal services such as drinking water, sanitation,
roads, and schools. Conventional thinking and practice has been that
the central government is the primary funder of municipal projects. This attitude was further supported by an international development
community focused on grant funding and concessionary loans. However,
this model for development finance was unsustainable given limited
budgets of both central governments and donor organizations.
Fiscal deficits and other investment
priorities have significantly reduced central government transfers to
local municipalities, limiting the provision of basic municipal
services. This situation is compounded by rapid urbanization. Demand
for municipal services, which already exceeds supply, is increasing
exponentially as more people live in urban environments. The inability
of municipalities to meet demand has resulted in the spread of diseases
such as cholera and typhoid, the failure of cities to realize economic
development potential and generate own-source revenues, and the
increased cost of building infrastructure within existing settlements.
A new paradigm is emerging given that
cash transfers from central governments and grants and concessionary
loans from bilateral and multilateral donors can only meet a small
portion of total local government infrastructure and services needs.
Local governments have become more innovative in obtaining sources of
funds to finance economic development, with many municipalities turning
to the local capital markets to fund municipal projects. In Mexico,
alone, local governments have raised US$10 billion from the domestic
capital market to build municipal infrastructure. Governments and
development organizations alike are beginning to realize the potential
of local capital markets.
Sources
of Funding for Building Municipal Facilities |
Old
Paradigm
Cash transfers
from higher levels of government, and/or grants and
below-market-rate loans from bilateral and multilateral donors. |
New
Paradigm
Leveraging
market-based local currency loans through strategic use of cash
transfers, grants, and concessionary loans. |
The prospects of utilizing local capital
markets are tremendous. In most developing and transitional economies,
the supply of capital available from the domestic private economy
greatly exceeds the opportunity for investment. Investors in many
countries are seeking alternative investment vehicles. Tapping into
private capital markets is not only good for municipalities, but also
for economic development. A significant portion of local funds is
invested in low-paying central government bonds, unproductive real
estate assets, or sent abroad.
Paradigm Shift Diagnostic
A
diagnostic analysis of a country’s capital market development status
shows where a given country fits within the old-to-new paradigm shift.
The figure below provides a simple comparative matrix for the
diagnostic analysis:
In countries with less developed capital markets, such as Bangladesh and
Yemen, municipalities must rely primarily on the old paradigm approach:
cash transfers from central government, grants and concessionary loans
from donors, and municipal revenues that can be generated through
increased collections and/or reduced operating costs.
Many municipalities, such as those in
India and the Philippines, have reduced their reliance on government
cash transfers and donor loans and grants through own-source revenues.
Increasing own-source revenues provides new funds to pay for building
critical infrastructure. To increase own-source revenues, local
governments have adopted programs to: improve billing and collections;
reduce operating costs by implementing energy efficiencies; and, in the
case of water supply, minimize lost water due to leaks. These actions
are all within the manageable interest of municipal elected officials
and managers and do not require difficult political decisions such as
raising rates. In some instances, where there have been improvements in
service delivery, governments have been able to raise service rates and
tariffs to increase local revenues.
In countries with more developed capital
markets, municipalities are able to rely more on new paradigm approaches
— raising funds directly from market-based sources such as banks and
investors (generally with the support of grants and concessionary
loans). As an example, the total development cost of a municipal
facility is determined. A feasibility analysis is used to determine the
sources of funds available for market-based borrowing. The gap between
market-based sources and total development costs is filled with grants
and below-market-rate loans. An example is the Chesapeake Bay
Foundation in the eastern United States where grants are competitively
awarded to local governments within the watershed to help finance
wastewater treatment facilities. The grants provide an incentive for
municipalities by decreasing borrowing costs, while achieving a larger
policy objective of reduced pollution for all residents living in the
watershed.
Grants and below-market-rate loans may
be structured on a competitive basis to achieve policy objectives. The
U.S. Environmental Protection Agency provides grants to help states
establish state bond banks. The bond banks use the funds to reduce the
cost of borrowing for municipalities through pooled finance and
revolving funds. These are described in Section 5: Municipal Finance
Strategies.
Countries between the two extremes rely
on carefully mixing old paradigm sources of funds to prepare them for
eventually realizing new paradigm sources of funds.
Unless thoughtfully applied, the use of
bi- and multilateral donor loans with below-market-rate terms and
conditions will preempt the development of domestic capital markets, and
make it more difficult to realize the new paradigm approach of municipal
private market-based borrowing. The below-market-rate terms and
conditions will crowd out private sector lending, as municipalities will
always borrow at the lowest possible cost. Moreover, municipalities
will only postpone the arduous process of coming to terms with the
reforms and discipline needed to access sustainable supplies of domestic
private loan funds.
Diagnostic
Indicators
There are several markers that can be
examined to determine where a country fits within the paradigm shift
matrix:
Interest Rates
Interest rates and their close relative
inflation provide one clue. Long-term interest rates are set, to a
great degree, on estimates of long-term inflation. Interest earned over
time on the principal amount of a loan will help to offset the
depreciation in value of the loan principal due to inflation. It is
difficult to borrow long-term in countries with high rates of inflation
and interest, as the amount to be repaid may be as much as three to four
times the amount of principal borrowed. Countries with low inflation
and long-term interest rates are prime candidates for new paradigm
strategies.
Loan Repayment Period
The repayment period for loans,
especially on government borrowing is another sign. Unless a country is
subjected to directed credit where the government sets interest rates
and repayment terms, the market for central government borrowing
establishes the longest repayment period. In other words, capital
markets set long-term interest rates for non-governmental borrowing by
observing the market reaction to government borrowing. Another factor
is that infrastructure to a municipality is similar to a house to a
family. Very few can afford the entire cost upfront; and the longer the
repayment period the more affordable it is to repay the loan. Repayment
periods of at least seven to 10 years are required to use new paradigm
approaches in municipal finance.
Stock Market and Debt Market Development
The level of development in a country’s
capital markets is also an important factor. Capital markets are
essential to the mobilization of private long-term capital since they
are the place where investors and investment opportunities come
together. Most capital market development starts with creation of a
formal market for launching and trading equities (stock) and the related
institutional structures of brokers, analysts, and market regulators.
For municipal finance, the subsequent development of a debt market is
crucial, although it need not be highly sophisticated to start. The
emergence of investment banking (either within or outside of commercial
banks), the use of credit rating agencies (domestic or international),
and the broadening of financial securities regulatory systems to cover
debt as well as equity securities will facilitate long-term municipal
borrowing.
Pension Fund and Insurance Deregulation
To promote long-term lending, there
should be sources of long-term funds. Long-term funds are the result of
long-term savings within a country’s financial system, and hence the
existence of pension funds and life insurance are a good indicator that
long-term savings are taking place. If these two types of financial
services are controlled by the central government, the long-term savings
they generate are normally directed into long-term central government
treasury bonds and state-owned enterprises. As pension funds and
insurance companies are given more independence and eventually become
privately owned and managed, they will seek to diversify their
investment portfolios and look for long-term securities with a
predictable risk and return. Long-term municipal bonds can benefit from
this evolution if they are introduced to investors as an opportunity for
them to diversify (and hence reduce the risk to) their portfolios.
Credit Rating
A credit rating system has three primary
actors. The first is that a municipality is in need of external
resources, and has the authority to raise revenues, borrow funds, and
pledge collateral. The second is a credit rating agency with the
motivation and experience to examine the financial condition of the
municipality and draw conclusions about the municipality’s capacity to
effectively raise revenues, repay debt, provide good financial
management, and maintain a stable political environment. And, the third
is private sector investors who have the resources and the incentive to
invest in municipal debt. Credit rating agencies are independent third
parties that offer a simple to understand credit score of a potential
borrower or issuer of debt such a municipal bond. Investors compare
credit scores across similar types of debt. They rely on the score to
make judgments about investment risk because they cannot evaluate the
creditworthiness of every potential investment opportunity.
Market-Based
Financing Strategies
Several market-based financing
strategies may be used to provide municipal services, including: micro
and small enterprise loans, bank loans, municipal bonds, pooled finance,
and revolving funds. For most of these strategies to succeed, however,
several enabling conditions need to be accomplished and are discussed
further in Sections 7 and 8.
Micro and Small Enterprise Loans
Micro and small enterprise loans are
often used to provide basic municipal services, primarily for the
poorest slum households. For example, a tea stall vendor will borrow to
connect to a reliable supply of clean drinking water. A small-scale
manufacturer will borrow to develop a dependable source for electricity
to run machines. Access by slum dwellers to microenterprise finance is
especially important, as this market is most difficult to service by
conventional lenders such as banks. Some reasons are:
• Slum dwellers
require weekly, sometimes-daily repayment schedules.
• Traveling long
distances to branch bank outlets to make payments is difficult.
• Slum dwellers are
unable to secure loans with assets.
• Group loans do not
meet standard credit underwriting criteria.
Other examples of small-scale municipal
service providers utilizing microenterprise financing include private
sector medical clinics, taxi services, solid waste collectors, and
child-care early education providers.
Bank Loans
Banks represent the simplest strategy
for providing loans to municipalities; the repayment period, however, is
likely to be three to five years, much shorter than needed for large
capital projects. This is because banks rely primarily on deposits to
make loans. Proper portfolio risk management requires that deposit
terms be matched with loan terms. Like a home mortgage loan, to be
affordable capital projects such as water, sanitation, and roads often
require longer repayment periods; this is difficult for banks given
portfolio management risk restrictions. Banks rely on standard loan
agreements. These agreements often have terms and conditions that are
not in the best interests of a municipality as a borrower. For
instance, banks may restrict the use of loan funds or require a pledge
of assets in excess of the amount borrowed, which will limit further
borrowing by the municipality.
Municipal Bonds
Municipal bonds are a bit more complex.
Municipal bonds are an improvement over bank borrowing, as the
municipality creates a debt instrument with term and conditions that
meet its needs and the needs of the investor. The interest rate and
repayment period are negotiated. The use of funds and collateral
requirements can meet the needs of both the municipality and the
investors. Upon completion of the economic and financial viability
analysis, credit rating, and legal agreements, a bond prospectus is
prepared. The purpose of the prospectus is to inform investors of the
risks they undertake by purchasing shares in the bond transaction.
Thereafter the debt instrument is sold to investors. An example is a
municipal bond transaction sold to investors by the City of Ahmedabad in
India. To improve its water supply, a municipal bond was sold by the
government of Ahmedabad to institutional and individual investors
located in the city. In addition to a market rate of return, investors
also gained because their businesses derive economic benefits from the
water improvements. In addition to the financial incentives, individual
investors were attracted because they personally benefit from increased
water supply.
Credit enhancements are essential for
municipal bonds. They provide comfort to investors by providing layers
of protection against non-payment by the borrower. The typical credit
enhancement is a reserve fund. The first layer is an initial deposit
equal to 1.25 times the annual debt service payments held by a trustee.
The municipality pledges a stream of income to ensure that the fund is
always at 1.25 times the annual payment. If the municipality is unable
to make subsequent payments into the reserve fund, a second layer of
credit enhancement is often used. The second layer is an intercept of
cash transfers from higher levels of government to the municipality. If
the municipality is unable to keep the reserve fund at 1.25 times the
annual payment, the trustee intercepts sufficient funds to cover the
municipality’s payment.
Large-scale capital projects require
longer repayment periods. Life insurance companies and pension funds
prefer investing in long-term securities. Both collect streams of
income from individuals over many years before payout occurs due to
death or retirement. Investing these funds in long-term securities like
municipal bonds is the best way for them to manage their portfolio risk.
Vast amounts of resources are tied up in pension funds and life
insurance companies. Because of this, many central governments place
rigid controls over their investment choices. The need to finance
municipal facilities combined with the inability of central governments
to transfer sufficient funds needed by local governments will drive the
policy reforms needed to unlock these funds.
Pooled Finance
Pooled finance is a more complex
variation of a municipal bond. A new entity (a special purpose
institution) is created to issue a bond to investors. The proceeds of
the investment are passed through a trustee to a number of
municipal borrowers. The borrowers use
the proceeds to build projects, and pledge a stream of income to pay the
trustee. The trustee passes the repayments to the debt instrument
issuer, which in turn pays the investors. Credit enhancements,
financial viability analysis, credit ratings and offer prospectus are
similar to those used for municipal bonds. An example of a pooled
finance transaction is the city of Bangalore in India.
Bangalore is India’s Silicon Valley.
Due to the rapid expansion of India’s information technology (IT)
sector, several municipalities surrounding Bangalore were unable to
provide drinking water to meet the needs of the growing population.
With the assistance of private sector consultants, eight municipalities
identified and prepared water supply projects for financing. The
Karnataka Urban Infrastructure Development and Finance Corporation (KUIDFC)
developed the physical and financial standards for the pool of projects
to be included in the bond transaction. Upon completion of the legal
documents, prospectus, and a credit rating, KUIDFC will sell the bond to
the investors. The municipalities will use the proceeds of the bond
transaction to construct the facilities.
Pooled finance works best where a series
of municipalities have smaller projects and are willing to structure the
projects in a similar fashion. This provides significant savings in
loan origination costs to each municipality issuing its own individual
bonds. The pool sets the standards for the projects (e.g. all are water
supply), and defines the collateral requirements to be met by each
individual municipal borrower. Pooled finance is less of a repayment
risk to investors, then a single municipal bond. The risk is spread
among all the borrowers in the pool.
Revolving Funds
Revolving funds are a variation of the
pooled finance theme. Under pooled finance a special purpose
institution is created for each bond transaction. The revolving fund
approach is to create a long-term financial intermediary with assets
that will be contributed to the pooled finance transactions.
The best examples are the state bond
banks established in the US to finance municipal water and waste water
treatment facilities. By the early 1990s, it was evident that the US
government did not budget sufficient resources to fund municipal water
and sewer needs throughout the nation. Federal legislation was created
that allowed the US Environmental Protection Agency to provide grant
funds to states as seed capital for state bond banks.
The seed capital is used in several
ways:
• Providing assets
for bond banks to demonstrate sufficient net worth to attract investors.
• Mingling bond bank
funds with funds from investors to reduce the overall interest rate to
the municipality.
• Reducing the
proportion of total project development cost covered by investors.
• Providing
additional layers of credit enhancements in addition to those provided
by municipalities.
Revolving funds are particularly
well-suited as an approach to avoid bilateral and multilateral funds
distorting domestic capital markets. Instead of financing individual
municipal projects, donors can provide concessionary loans to help
establish revolving funds that will attract private capital market
investors into the municipal finance sector.
USAID’s Development Credit Authority
While not a financing strategy per se,
USAID’s Development Credit Authority (DCA) is an invaluable tool for
developing sustainable supplies of municipal financing from indigenous
capital markets, and can be used in combination with the strategies
described above. Many projects are financially viable because the
income from the venture is sufficient to pay operating costs and repay
the loan. Lenders, however, are reluctant to make the loan due to:
• Unfamiliarity with
the market for the product or service.
• Lack of adequate
collateral to guarantee repayment.
DCA can be used to share the risk with
lenders to help them move into new loan products and sectors. This is
beneficial to the financier as significant business expansion
opportunities may arise as a result of taking a partial risk with the US
government.
With DCA involvement, the mission will
have access to additional human resources to structure the transaction
and undertake the risk analysis. To assist missions with achieving
their strategic objectives, USAID’s Bureau for Economic Growth,
Agriculture and Trade (EGAT), Office of Development Credit (ODC), will
assist the mission with utilizing a US government partial guarantee of
local currency loans. The explicit cost to the mission is the funds
needed to provide an initial deposit into a loan loss reserve (called a
subsidy). The amount is based on a credit risk analysis provided by
ODC. Depending on the host country and inherent project default risks,
the subsidy amount generally varies from 3 percent to 10 percent of the
amount to be guaranteed. In high risk countries, it can be much higher.
The guarantee cannot exceed 50 percent of the total project development
cost and can only be used to guarantee private sector investors and
banks.
The DCA has been successfully used to
provide additional layers of credit enhancements for municipal finance
transactions such as the Local Government Unit Guarantee Corporation’s
(LGUGC) municipal bond transactions in the Philippines.
Another example is the KUIDFC pooled
finance transaction in Bangalore, India. For the KUIDFC transaction
described above in the pooled finance example, the DCA partial guarantee
is a third layer of credit enhancement. The DCA guarantee is not called
upon unless the first two layers fail. The first layer of credit
enhancement is the reserve fund that contains 1.25 times the annual debt
service payments. The second layer is the unrestricted ability of the
trustee to intercept of cash transfers from higher levels of government
to the municipality. The DCA provides the third level of credit
enhancement. If for any reason the cash transfers were unavailable to
be intercepted by the trustee, the US government would provide 50
percent of the funds needed to pay into the reserve account. KUIDFC is
a government entity. Its assets are majority-owned by the government of
the State of Karnataka and its management is majority-controlled by the
government. DCA provides a partial guarantee of repayment to the
private investors who purchase the bonds.
Understanding
Debt Risk
In structuring municipal finance
programs, it is important to understand debt risk. Municipal projects
are potentially risky. The following section provides a list of
possible risk factors that underlie municipal finance transactions:
Repayment Risk
There is a risk that the borrower may
not be able to repay the loan. In spite of extensive analysis and
financial modeling, unlikely events such as political upheavals and
natural disasters may disrupt loan repayment. This risk can be
mitigated through a reserve fund held in escrow by a trustee. Most
reserve funds usually have an initial capitalization greater than the
first year’s debt service payment. Other credit enhancements such as
intergovernmental transfer interceptors and credit guarantees may be
used. An intercept of transfers funds an additional escrow account for
debt repayment. A credit guarantee mitigates losses to lenders should
the borrower fail to make its payment obligations.
Construction Risk
Another primary risk is construction
risk associated with completing construction on time and within budget.
If the time to complete a project exceeds the initial estimate, the
project may require additional investment resources — potentially
increasing debt levels. Construction delays also prevent the project
from generating revenues that will likely add to already higher costs.
In the Philippines this risk is mitigated by the LGUGC, which requires
municipalities to hire professional construction management services in
order to ensure completion on time and within budget.
Foreign Exchange Risk
Foreign exchange risk is a major concern
with internationally financed capital improvement projects such as those
developed under build-operate-transfer (BOT) approaches. The principal
amount of foreign currency loans will rise or fall in value over time,
as exchange rate values of foreign and local currencies fluctuate.
Historically, developing country currencies fall in value. Under the
old paradigm, this is a major concern. Loans in foreign currency
denominations are converted to local currencies to build municipal
facilities at an initial exchange rate and reconverted to the foreign
currency at time of repayment. Over time, local currency devaluation
results in ever an increasing principle amount to be repaid.
Wrongly, foreign exchange risk is often
borne by the individual borrower. Unless a borrower such as a
municipality has access to a supply of foreign currency, which is not
the norm, the loan is more likely to be in default at one point or
another.
Under the new paradigm, loans are made
in local currencies. Donors use credit enhancements such as guarantees
(DCA), or foreign currency grants and equity as seed capital to
establish local currency revolving loan funds. This is why it is
critical to develop local currency markets to finance municipal
projects. Local currency financing means that foreign exchange risk is
not a factor in the risk analysis.
Enabling
Conditions at the National Level
Moving from the old to the new paradigm
in terms of sources of funds requires a series of policy and regulatory
actions at the central government level. Reforms are needed to
establish the enabling conditions that are required across a country for
a successful municipal finance sector to emerge. An early diagnostic
will help to set priorities for allocating technical assistance and
training resources.
For international donors that wish to
support a municipal finance agenda in developing countries, the enabling
conditions at the national and local level provide a menu of activities
to pursue a policy reform agenda with host country governments. A
detailed list of technical assistance and training activities that can
help move the reform agenda forward includes the following elements:
1)
level of decentralization;
2)
legal and regulatory environment;
3)
municipal accounting and financial reporting
standards;
4)
regulatory reforms;
5)
revenue generation; and
6)
clearinghouse and training network.
Level of Decentralization
Decentralization of authority to local
governments is a worldwide phenomenon. Many central governments are in
the process of shifting responsibility for providing basic services to
local governments. This is good, as local officials can be held
accountable for the quality of service delivery. And shifting
responsibility for the provision of services is politically appealing.
What also is required to complete the process is shifting authority for
raising resources and managing costs. Higher levels of government,
however, are often reluctant to shift revenue-generation authority to
local governments. Unless local governments have both the
responsibility for delivering services and the authority to raise
revenues and manage costs, it will be difficult to apply new paradigm
approaches.
Legal and Regulatory Environment
Legal and regulatory authority is
required for local governments to borrow funds and pledge collateral.
Municipalities must have the legal authority to:
• Enter into loan and
bond agreements.
• Pledge revenues
from taxes and fees as credit enhancements.
• Mortgage assets
such as land.
Regulatory constraints often can be
overcome by convincing approval authorities at higher levels of
government that initial municipal finance transactions are trial or
pilot activities to better understand what, if any, reforms will be
needed to replicate the transactions.
Municipal Accounting and Financial
Reporting Standards
Municipal accounting and financial
reporting standards are the bedrock for:
• More accountable
and transparent local government.
• Increased civil
society participation in local government affairs.
• The establishment
of a municipal credit rating system.
Key actors involved in setting policy
and implementing regulatory aspects include the central government
ministry responsible for local governments and the national certifying
body for chartered accountants. Most countries follow generally
accepted accounting principles for private sector corporations. It is
necessary to promote similar accounting standards and guidelines for use
by local governments.
Clear municipal accounting standards and
reporting guidelines should be based upon double entry accounting,
meaning that local government financial management will be standardized.
Municipal managers will be able to understand the consequences of
decisions, higher levels of government will be able to monitor local
government performance, and civil society will be able to hold local
elected officials accountable.
Credit rating agencies are independent
third parties that offer a clearly understandable credit score of a
potential borrower or issuer of debt such as a municipal bond.
Municipal accounting standards enable rating agencies to compare
financial performance across local governments and make judgments about
risk. As a result, investors are able to compare credit scores across
similar types of investments.
Depending on the type of transaction,
the credit rating agency may rate the debt issue, the municipality, or
both. The primary benefits of a credit rating for the municipality are:
• With a credit
rating a municipality has access to a broad number of potential
investors, which reduces the municipality’s borrowing costs as investors
will compete for more creditworthy borrowers.
• The municipality
will understand why and how it earned its creditworthiness score and can
decide what changes are needed to improve its credit rating and thereby
reduce its borrowing costs.
Regulatory Reforms
Independent regulatory frameworks are
essential for pricing of municipal services and for setting standards
for performance and privatization. A fundamental issue is setting the
price for municipal services. In the case of municipal water supply the
process is highly politicized as individual households and businesses
have a strong stake in the outcome. An independent regulatory authority
places responsibility for regulating pricing with a third party that
does not have a conflict of interest in terms of the outcome.
Setting prices requires that there be
minimum performance standards for municipal service delivery. Using
water supply, some examples of performance standards include:
• Twenty-four hour
supply.
• Minimum percentage
of unaccounted-for water lost due to leaks.
• Target ratios for
operating costs as a percent of billable income.
• Minimum response
time on requests for maintenance.
Standards for private sector
participation in the delivery of municipal services also are essential.
It is very easy for uninformed local government officials to enter into
contracts that give too many advantages to the private sector.
Standards provide a level playing field for both public and private
sector entities to achieve their objectives.
In addition, changes to regulations for
municipalities and debt markets may be needed to undertake municipal
finance transactions. This is especially true for the municipal
authority to borrow funds, pledge collateral, and generate own-source
revenues. The initial diagnostic will identify the key regulations that
need changing. In many cases, the first financial transactions can be
used as pilot projects to better understand the regulatory issues. In
other cases, changes in legislation such as laws establishing
municipalities may be needed.
Revenue Generation
Matching responsibility for provision of
municipal services with the authority to raise revenues is critical.
Technical assistance for designing regulations to increase local
government revenue generating powers may be needed. Technical
assistance may include something as simple as business licenses, or as
complicated as the ability to issue debt instruments.
Cash transfers from the national
government based on incentives for municipalities to undertake reforms
are needed, because local government officials and staff are often
reluctant to change. In many cases central governments use ad hoc
approaches to allocate revenue sharing funds. The aim is to carefully
target these cash transfers to achieve needed reforms. For instance,
funds may be allocated on a competitive basis to municipalities that
pledge to institute double entry accounting systems, or develop pro-poor
policies to ensure that people living in slum settlements have access to
clean water and sanitation. A portion of the cash transfer can be used
to pay for local accounting firms to provide assistance to the
municipality. Other examples of criteria for competitive allocation of
transfer funds include decreasing operating costs, increasing customer
services, and instituting energy savings improvements.
Clearinghouse and Training Network
Creating an information clearinghouse
and training network within a national municipal finance resource center
is essential to scale up the initial successes accomplished with
international donor support, and to ensure long-term sustainability of
the municipal finance system. An information clearinghouse will be able
to disseminate the lessons learned from donor supported best practices.
The resource center will act as a primary source of information on
municipal finance including conferences and training opportunities. It
can act as a market place to bring together municipal projects being
planned with:
• Private sector
consultants to help conceptualize them.
• Private sector
municipal service providers and financial institutions.
• Investors
interested in participating in the project.
The resource center will use the
clearinghouse to develop and implement a unified municipal finance
training network. The network will build on existing training
institutions, providing them with content and access to a market of
potential trainees. Institutions participating in the training network
will be provided with an assessment of municipal training needs around
which to develop new courses. New training institutions can be created
based on an analysis of gaps in training provided by existing
institutions, combined with the need for training on the part of local
elected officials and staff. The resource center will help develop
course material based on lessons learned from best practices, and if
needed provide training for trainers to support the development of the
network. The clearinghouse and training network may be self-sustaining
through membership fees, services, and central government cash transfer
incentives for local government to support the training of municipal
officials.
Enabling
Conditions at the Local Level
There are a series of enabling
conditions that are required to accomplish successful municipal finance
transactions. Technical assistance and training will be required to
achieve the reforms needed to create these enabling conditions.
City development strategies
are useful for identifying a municipal vision and prioritizing
strategies needed to achieve the vision. Through a successful process
proven by the World Bank in numerous countries around the world,
stakeholders representing citizens, civil society organizations,
businesses, and governmental agencies are convened to reach a consensus
on what the long-term image of the city should be. Is it a
manufacturing hub, a university center of higher learning, or a tourism
dominated economy? Once this is decided, a series of strategies to
support the vision are identified and prioritized. Many of these will
include capital projects such as water and sewer, housing, health, and
education facilities. A participatory approach to strategic planning is
essential to develop committed stakeholders willing and interested in
carrying out these strategies.
Capital improvement plans
are needed to estimate the cost, and to prioritize which basic service
improvement projects to undertake within budget resources that are
available to the municipality. Building on the priorities identified
through the city development strategy process, the capital improvement
plan will estimate the total development cost of each project. It will
match the cost of the projects with the resources available over the
coming five years to fund projects. For countries relying on old
paradigm sources of funds, projects in the early years will rely on cash
transfers and own-source revenues. As the paradigm shifts, municipal
finance will play an important role in increasing the number of projects
to be undertaken.
The last process is comparing project
costs against funds available and identifying which projects can be
undertaken within one year, two years, and up to five years. The first
year is clearest, with the later years being less clear. The capital
improvement planning process is repeated every year to take into account
changes in project costs, priorities, and resources available to build
the projects.
Financial management and accounting
improvements are essential to
identify collateral to be pledged to finance projects in the short-term,
and to help build the credit rating system and replicate initial
municipal borrowings over the long-term. The support needed here is to
install and train municipal staff on using a double entry accounting
system. Initially a series of municipalities may be identified based on
willingness to participate in reforms needed to increase the supply of
municipal resources through borrowing. Cash transfer incentives will
help them move forward through greater revenue sharing, including a
portion to pay for local accounting support. A national resource center
can offer training courses and facilities for training.
Focusing resources on a few
municipalities to create some initial successes will provide incentives
to other municipalities and gather momentum towards replication.
Achieving creditworthiness, a credit rating, municipal borrowing, and
the construction of a much-needed facility will demonstrate the results
of initiating accounting reforms to other municipalities.
Operations and maintenance
improvements are needed to ensure that the asset’s value will not
diminish due to physical deterioration. Once substantial human and
financial resources are invested in providing the basic services, they
must be operated and maintained properly or the asset’s value will
diminish due to physical deterioration.
Management contracts may be an effective
way to benefit from private sector participation. Privatization
strategies where the private sector owns the asset have mostly failed.
With technical support, management contracts are easier to develop and
negotiate because the physical asset remains in the hands of the
municipality. For instance, billings and collections, and/or operations
and maintenance for a water and sewer facility can be contracted to
local firms on a performance fee basis:
• Increased revenues
will determine how well the contractor has performed under the contract.
• The municipality
will benefit from sharing the increase in revenues with the private
sector contractor.
Project preparation
by effectively conceptualizing the financial and physical aspects of
basic services projects, and planning for their implementation, will
help make them much more bankable. As described earlier there is
sufficient capital available from local investors. And there are
overwhelming needs for the construction of municipal facilities. The
problem is that municipalities lack the capacity to identify, package,
and describe municipal projects in a manner that is understandable to
lenders and investors. Outside technical assistance can help
demonstrate to municipalities how this is accomplished. It can help
build a market between municipalities and private sector financial
consultants, architects, and engineers to replicate financing
transactions in other municipalities.
Effectively procuring contractors
to spend the proceeds of the long-term borrowing will ensure that
additional interest costs will not accrue due to construction delays
once the money has been borrowed. Municipalities need capacity-building
on how to efficiently and effectively contract for goods and services.
Model procurement documents combined with on-the-job training on how to
solicit, evaluate, negotiate, and award contracts will help accomplish
the task. Support for a few municipalities can demonstrate the way for
others. A more open and transparent process will reduce costs and help
alleviate corruption in the procurement process.
Budget and scheduling
overruns can be mitigated through construction management services.
Once the contract is awarded to build the facility, the main risk is
completing construction within budget and on schedule. The local
government must be ready to initiate procurement of contractors to spend
the proceeds of the long-term borrowing. Otherwise additional interest
costs will accrue due to delays starting construction. Donor support
can help the municipality contract with local architects and engineers
to provide construction management services.
Increasing own-source revenues
will provide the municipality with the financial capacity to undertake
priority projects without waiting to borrow funds. As described in
Section 3, there are several areas that are well within the manageable
interest of municipalities. Donor support to a few municipalities can
demonstrate this approach for others by helping create a market between
municipalities needing services and private sector consultants adept at
this approach.
Observations
on Municipal Financing
As more developing countries shift
towards the new paradigm on municipal finance, several key observations
may be useful in designing and implementing municipal projects.
1.
Creating bankable infrastructure projects is the key to facilitating
development of viable capital markets for municipal finance.
The lack of bankable projects is one of
the primary constraints to the development of municipal finance markets.
There are many examples of lenders, both internationally and in the US,
that were unable to make loans due to a lack of loan applications.
Increasing the supply of applications can be achieved through helping
potential borrowers identify why they are borrowing, how they will repay
the loan, and what collateral they are willing to put at risk if the
loan is not repaid.
For municipal finance, USAID has
successfully addressed this issue in South Africa by supporting the
development of the Municipal Infrastructure Investment Unit (MIIU). The
MIIU allocates grants on a competitive basis to municipalities to hire
local consultants to help with project development such as:
• Project
identification.
• Preparation of
economic and financial analyses.
• Preparation of
preliminary engineering sufficient to develop a realistic total
development cost analysis.
• Preparation of
legal documents.
• Management and
operating plans.
If the project does not reach a
financial closing the grant is forgiven by MIIU. If the project
proceeds to construction the grant is repaid from the loan proceeds.
With large-scale municipal projects the cost to prepare a project for
financing is enormous; perhaps 5 to 10 percent of the total development
cost. If the project turns out to be not feasible for financial or
other reasons, the project preparation costs will not be repaid. Few
project developers, either municipalities or private developers, are
willing to assume these levels of risk. The MIIU support mitigates this
risk for South African municipalities by forgiving the grant if the
project turns out to be not feasible. Another benefit of the program is
that MIIU’s activities have helped to build a market where
municipalities and project development service providers come together
to form project development teams. MIIU has stimulated the development
of a whole host of private sector businesses offering project
development services to municipalities. This in turn has provided the
impetus for more projects submitted for financing by municipalities.
2.
Developing larger capital facility projects requires financing
strategies utilizing long-term repayment periods that result from
municipal bond, pooled finance, and revolving fund strategies. Examples
of projects include large-scale water distribution, sewer collection,
bridges, hospitals, housing, schools, commercial complexes, and
industrial parks.
An objective of widely replicating
increased supplies of potable water, housing development, school
construction, or industrial parks will be more appropriate in countries
where new paradigm strategies are possible. Longer repayment periods,
lower interest rates, decentralization of authority and responsibility
to local governments, and the ability of municipalities to borrow funds
and pledge capital are important for these strategies to succeed.
Where the “paradigm shift diagnostic”
shows that conditions exist for moving from the old to the new, it is
possible to start strategically by developing one-time projects, while
applying multi-year technical assistance and training resources to
promote policy reforms and establish enabling conditions at the national
and local government levels.
Large-scale project development during
the startup period requires a commitment of cash transfers from higher
to lower levels of government, plus international donor support. A good
example of donor collaboration is the US-Japan Clean Water Initiative.
The Japan Bank for International Cooperation (JBIC) has agreed to work
with USAID missions in India, the Philippines, Indonesia, and Jamaica to
combine the use of DCA partial guarantees with JBIC sovereign loans to
increase the supply of drinking water, especially for the poor.
3.
It is also wise to begin with smaller-scale capital facilities that can
be undertaken with bank financing. Examples are improvement projects
tied to increasing municipal revenues: reducing water leakage combined
with energy improvements to water supply systems, school repairs to
increase enrollment, hospital expansion, and improvements to public
markets. Income-generating projects are important starting points as
they result in a stream of new revenue for the municipality to make the
payments on the loan.
Another good example is solid waste
collection and management. With the exception of acquiring a site for
controlled solid waste disposal, there is little required in the way of
capital improvements. And the immediate benefits to the population are
immense. Lack of solid waste collection was found by India’s Supreme
Court to be the primary cause of the 1996 outbreak of bubonic plague.
Uncontrolled landfills contaminate rivers and aquifers, the primary
sources of drinking water. The actions needed to improve clean and
fresh water supply conditions can be financed with short-term loans from
banks, and with much less sophisticated technical support and training.
4.
Private sector delivery of municipal services provides new skills and
resources to municipalities. It is also possible to utilize micro and
small enterprise businesses to provide the services. And credit
enhancement from international donors can be used to help leverage bank
financing.
Two examples of health care services are
private healthcare clinics where doctors are the owners and borrowers,
and mother-and-child health care and family planning clinics owned and
operated by midwives. The doctors can borrower from banks. The
midwives need assistance to borrow from micro and small enterprise
lenders.
Some capital facilities can also be
provided by the private sector. Housing is normally a private sector
endeavor. Municipalities should help facilitate this process by
providing infrastructure such as water, sanitation, roads, and surface
water management. The housing developer includes the cost of the site,
municipal sewer and water connections, the house, and utility
connections to the municipal infrastructure in the cost of the house.
Purchasers borrow from lenders such as banks to repay the cost for the
house.
Private sector hospitals and emergency
care clinics can be built and operated by groups of doctors. The
private sector can build and operate toll roads, electric power
generating capacity, and natural gas supply networks. Long-term local
currency loans will help make these facilities less expensive with
reduced risk of repayment due to foreign currency valuation.
Appendix 1 is an illustrative analytic
framework that can be applied at an early stage to assist in determining
which financing strategies are most appropriate to pursue when designing
a municipal finance program. The framework identifies the strategic
public and private sectors, and pinpoints the facilities and services
that will be improved through technical assistance, training, and
capital investment leveraged through partial donor guarantees. The
framework links facilities and services with the most appropriate
financing strategies.
Appendix 1: Illustrative Analytical
Framework
|
Micro and small enterprise loans |
Banks |
Municipal Bonds |
Pooled Finance |
Revolving Funds |
Development Credit Authority |
Public
Infrastructure facilities consist of: |
Water supply and sewer collection networks |
|
ü |
ü |
ü |
ü |
ü |
Water treatment and sewer treatment and disposal |
|
ü |
ü |
ü |
ü |
ü |
Solid waste disposal sites |
|
ü |
ü |
ü |
ü |
ü |
Roads, bridges, and underpasses |
|
ü |
ü |
ü |
ü |
ü |
Parks and recreation facilities |
|
ü |
ü |
ü |
ü |
ü |
Surface water drainage |
|
ü |
ü |
ü |
ü |
|
Electric supply |
|
ü |
ü |
ü |
ü |
ü |
Natural gas supply |
|
ü |
ü |
ü |
ü |
ü |
Community level improvements for slum upgrading projects |
|
ü |
ü |
ü |
ü |
ü |
Public/Private
Infrastructure services include: |
Solid waste collection |
ü |
ü |
|
|
|
|
Facility operations and maintenance |
|
ü |
|
|
|
|
Street lighting |
ü |
ü |
|
|
|
|
Street cleaning |
ü |
ü |
|
|
|
|
Private Housing
includes: |
Individual residences |
|
ü |
|
ü |
ü |
ü |
Utility connections |
|
ü |
|
ü |
ü |
ü |
Public/Private slum
upgrading includes: |
Housing improvement and expansion |
ü |
ü |
|
|
|
|
Utility connections |
ü |
ü |
|
|
|
|
Community improvements |
ü |
ü |
|
|
|
|
Informal sector commercial and industrial activities |
ü |
ü |
|
|
|
|
Public Health care
facilities include: |
Hospitals |
|
ü |
ü |
ü |
ü |
ü |
Emergency clinics |
|
ü |
ü |
ü |
ü |
ü |
Public sector
health clinics |
|
ü |
ü |
ü |
ü |
ü |
Public sector
drug outlets |
|
ü |
ü |
ü |
ü |
ü |
Private Health care
services include: |
Private sector well family, child care, and family planning |
ü |
ü |
|
|
|
ü |
Private sector doctors’ clinics |
ü |
ü |
|
|
|
ü |
Private sector drug outlets |
ü |
ü |
|
|
|
ü |
Medical equipment providers and servicers |
ü |
ü |
|
|
|
ü |
Medical testing laboratories |
ü |
ü |
|
|
|
ü |
Public/Private
Education facilities include: |
Public schools |
|
ü |
ü |
ü |
ü |
|
Private schools |
|
ü |
ü |
ü |
ü |
ü |
Maintenance and administration facilities |
|
ü |
ü |
ü |
ü |
|
Facility operations and maintenance |
|
ü |
|
|
|
|
Early child care and education centers |
ü |
ü |
|
|
|
ü |
Public Economic
development facilities include: |
Commercial developments |
|
ü |
ü |
ü |
ü |
ü |
Industrial developments |
|
ü |
ü |
ü |
ü |
ü |
Charles J. Billand
is President of TCG International in Washington, DC, and a member of the
Advisory Board of Global Urban Development. His article is adapted from
a background paper prepared in 2005 for the US Agency for International
Development (USAID), and is reprinted by permission of the author.
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