Guidelines on Local Government Borrowing and Recent Developments in South East Europe
1. Basic Principles of Local Government Borrowing


1.1. Background, Issues and Challenges

The prospect of improving municipal credit worthiness and increasing local governments' ability to access and use credits (loans and bonds) as an additional source for local infrastructure investment has been discussed extensively in the public sector over the past several years in almost all territories covered by NALAS members. However, local credit markets are still in their infancy.

Every fiscal decentralization effort includes a legislative reform agenda that guides the further refinement of the national policy framework. The frameworks vary across countries in their comprehensibility but also in terms of their maturity (see chapter 2). In general fiscal decentralization processes in South Eastern Europe (SEE) have opened up the opportunity for local governments to use various instruments of borrowing to finance their local investment financing needs.

1.1.1. Issues and challenges

There are large policy issues about the role of credit markets in meeting municipal infrastructure finance requirements.

According to the results of our survey, in all Territories covered by NALAS members. the primary obstacle to the use of municipal credit has been largely on the demand side, i.e. the municipalities' readiness to borrow. Moreover, according to the national legislation related to municipal finance and municipal borrowing, local governments were prohibited from taking on debt until recently (Moldova 2003, Serbia and Montenegro 2005, Albania and Macedonia 2008, Kosovo 2009). On supply side, i.e. within financial institutions, funds for lending to local government were theoretically available. However, (i) the weak financial position of local governments coupled (ii) with a low experience of banks in assessing the credit worthiness of municipalities restricted the development of local credit markets.

Although the supply side of the municipal credit market in SEE countries appears to have sufficient liquidity and capacity to actively enter into transactions, the demand side of the market is currently limited to larger municipalities with sound financial position. Therefore, to enable municipal credit market development, the ongoing fiscal decentralization programs must strengthen local government financing capacities. To this end, creating and enforcing adequate legislation, building and supporting financial management capacity at local level are critical for the success of decentralisation process.

Municipal debt legislation that comprehensively addresses all key elements in an internally consistent manner would substantially benefit the development of municipal credit markets in this region. The existing frameworks in all respective countries provide to some extent clear principles and guidelines required for market development. Clear debt rules, stable revenues and expenditures assignments and objectively allocated transfers should be the governing principles of the local debt legislation framework.

There are some important distinctions between various debt instruments utilized in financing of local government capital investment projects. Among the most popular are bank loans and municipal bonds. Variations of these instruments are widely known and utilized in other countries in Central and Western Europe, USA and Canada. A basic legal framework can and should apply to all types of debt instruments.

A properly structured and competitive market for local borrowing instruments can help keep the costs of capital as low as possible for municipal borrowers. Furthermore, the availability of a local credit market helps municipalities to play a larger role in selecting and implementing capital investments.

The development of a domestic credit market for local governments is conditional upon the existence of a public finance system that assigns significant decision-making power, autonomy, responsibilities and corresponding financial resources to local governments.

Transparency and disclosure are also key elements upon which the development of local credit market depends. In order to assess credit worthiness of local governments, credit institutions need adequate, accurate and timely information related to local governments' financial performance and condition..

International financial institutions (IFI) including World Bank, EBRD, European Investment Bank and KfW, are becoming more active in the region, especially in the municipal sector. Credit enhancement mechanisms and guarantee funds established with donor or international lenders' support will significantly improve local governments' access to external financing..

Following the financial and economic crisis, many commercial banks started to diversify their credit portfolios by investing into sectors with higher resilience to economic downturns. In this context, lending to local governments is becoming increasingly attractive for financial institutions..

The establishment of state-funded development funds for regional/municipal investments could represent another solution to increase local governments' external financing sources. Examples of such funds from the region include: the Slovenian Environment Fund, the Slovenian Regional Development Fund, the State Development Fund in Serbia, the Agency for Regional Development in Macedonia, the Investment development Fund of Montenegro, Fund of Social Investments in Moldova..

European Union (EU) funds – pre-accession, structural and cohesion – can and should be used intensively by local governments from the region to finance infrastructure projects of regional importance.