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

1.2. How to Finance Capital Items? Current Revenue or Debt Financing?

When considering what resources are available to fund capital investments, it is most important to consider all possible financial alternatives. A wide range of sources are possible, for example current revenues, grants from central governments or the EU (or other donors), private sector investments (PPP). Long-term debt is only one option out of many.

Local governments rarely maintain cash surpluses large enough to pay for the entire cost of big capital projects. They can either finance a capital project from own resources, by accumulating savings in their current account budget (pay-as-you-go financing) or by tapping credit markets (pay-as-you-use financing1).

Borrowing allows a local entity to carry out more ambitious investments than otherwise would be possible. In principle, it also promotes intergenerational equity by having the future generations of citizens which will benefit from a facility's services pay for its construction.

However borrowing is not always an appropriate financing strategy. Borrowing to cover current expenditures or account deficits has just the opposite effects. It shifts the costs to future generations, while today's taxpayers enjoy the benefits.

Many municipalities practice a combination of Pay-as-you-use and Pay-as-you-go policies.

There are mixed views as to whether long-term debt financing is a superior method of capital financing than pay-as-you-go. There are advantages and disadvantages to both approaches, municipalities need to consider the merits of both methods to guide their future financing in accordance with a long term plan. In doing so, municipalities should establish parameters to guide the financing of their capital budgets, and develop policies to implement these guidelines.

"Pay-as-you-go" financing is normally useful for low cost repair and maintenance projects or the purchase of equipment with short useful life. "Pay-as-you-use" is appropriate for capital improvements with a high cost and a long useful life.

Pay-as-you-go” financing has important advantages over pay-as-you-go financing schemes:

lets municipalities build more projects sooner;

allows for greater inter-generational equity, and

spreads out capital expenditures over time.

Many capital investments that municipalities can undertake yield benefits in the form of economic development. Even the so-called social investments such as water and wastewater systems and education contribute to the local economic development. When projects are built sooner, people benefit earlier. When projects are deferred, the benefits are postponed as well.

When considering debt financing as an alternative to finance an investment project, the risks associated to borrowing have to be well understood in terms of their potential impact on local budget in the future. For a borrower, the main risks of a plain vanilla loan are related to the dynamics of interest rate and exchange rate (if the loan is denominated in foreign currency). If the loan is originated at variable interest rate, then an increase in reference interest rate would be reflected into a higher debt service. Volatility of exchange rate has also to be considered when evaluating the possibility to borrow in hard currency (e.g. euro, U.S. dollar). During the recent financial and economic crisis, emerging market exchange rates from almost all Territories covered by NALAS members. have depreciated significantly. This led to an increase in debt burden of unhedged foreign currency borrowers (e.g. local governments, households) and a deterioration of their financial position.