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

1.3. Debt Management

Before long term borrowing is undertaken, it is recommended that each local government has in place a debt management strategy and a written debt policy.

Any decision to fund local government investment needs through borrowing has to be accompanied by debt management capability and capacity at the local level. In the immediate future, it is imperative that debt management capacity and capability should be enhanced as local borrowing also bears substantial financial risks for local governments (e.g. when debt repayment exceeds the financial capacities of local budgets).

Debt management may be defined as the process of providing for the payment of interest and principal payments on existing debt, and the planning for incurrence of new debt at a level which will optimize borrowing costs and not weaken the financial position of the local government. Estimating the impact of the current and future debt burden on the local budget in future years is also part of the debt management process.

The financial position of a debtor determines its maximum borrowing capacity as well as the cost of borrowing. Thus, the maximum indebtedness capacity of a local government varies in time, depending on economic and market conditions.

1.3.1. Debt Policy2

Any local government planning to issue a debt should adopt a written debt policy. A formal debt policy is essential to effective financial management. Debt policies are written guidelines and restrictions establishing maximum debt thresholds, the type of debt to be issued and at the same time documenting the issuance process. Such policy helps establish limits and provide general direction to local government executive officials in the planning and issuance of debt. A carefully crafted and consistently applied debt policy signals lenders and rating agencies that the local government is committed to sound and sustainable financial management.

The policy must be developed within the framework of existing laws and based on projections of the local government's future condition. It anticipates future financing needs and limitations that the policy imposes. Specifically, it should address the following questions:

What are acceptable levels of short and long term debt? Debt issuance involves a trade-off. In exchange for funds for current capital improvements, future spending is limited. The degree to which a local government is willing to make these trade-offs depend on the urgency of its capital needs, its expected rate of growth, economic trends, and the stability of its overall finances.

What are acceptable purposes for which debt can be issued? Does the investment have a life-span which equals at least the duration of the debt-repayment schedule?

To what extent and for what purposes will the local government use general obligation debt vs. revenue debt3?

What covenants, pledges, or securities is the local government willing to give, in order to make borrowing possible and/or lower the cost of borrowing (interest rates)?

How will the local government make sure that it is borrowing under competitive conditions (i.e. obtain the lowest possible cost)?

Furthermore a debt policy: 1) establishes maximum debt thresholds and ensures proper procedures are in place to keep debt within limits; 2) communicates to citizens the importance placed on financial management and to investors that the local government is being prudent with its resources; 3) communicates to the financial community that the local government is prudent and has a policy basis for debt.