Guidelines on Local Government Borrowing and Recent Developments in South East Europe
2. What to consider in the national legislation?

2.1. General Financial Framework of the local governments in the region

In formulating a municipal debt policy, policy-makers must decide a number of important issues which must comply with the corresponding legal framework concerning 21 municipal debt as well as borrowing procedures. The frameworks vary across countries, although the underlying issues are largely the same. Developing a coherent, efficient and prudent debt policy requires first of all thorough knowledge and understanding of the laws and regulations that govern all the fields related to municipal borrowing.

The legal framework for local borrowing (should) provide a set of clear and comprehensive rules that would guide municipalities seeking external financing. The legal framework defines the overall objectives for debt management, sets out borrowing restrictions, clarifies the transparency and accountability, outlines the budgetary and financial reporting and auditing requirements. Procedures for local government default, insolvency or what happens in case of financial market failures are other areas which should be regulated in the legal framework for borrowing.

2.1.1. Local public administration competencies, revenues and intergovernmental fiscal relations

Intergovernmental fiscal frameworks are crucial in determining local governments' overall financial health (i.e. solvency, financial situation). They define the assignments of revenues (taxes and transfers) and expenditures, the financial autonomy and the fiscal authority of local governments to set taxes, tariffs or fees.

Financial health of a local government determines its creditworthiness. It is ultimately reflected in the cost of credit (i.e. interest rate): higher credit risk – willingness and ability to repay debt is relatively poor – is associated with higher interest rates. Stable, predictable and certain revenue streams correlated with expenditures incurred as budgeted result in an improved creditworthiness (reflected in lower interest rates).

Regulatory framework alone cannot support the development of a healthy municipal credit market. Unless local governments can demonstrate that they have a track record of reliable revenues from which to repay debt, financial institutions will not enter into financing agreements with municipalities .

In general, own revenues and shared taxes account for the largest share in local governments' budgets. Such revenues include local taxes, local fees, local charges, revenues from ownership, share of personal income tax, profit tax, VAT and property taxes. It is from these revenues, that local governments would pay pack in the future the debt incurred to finance capital investment projects.

The intergovernmental transfer system plays a key role in establishing the local governments' revenues base. It constitutes an important share of municipalities' total revenues and may act as security on local government debt. Very often intergovernmental transfers, if not tied to particular investments, are a key feature of local government budgets and play a crucial role in financing of capital expenditures.

In Annex 2, we briefly outline the general financial framework of local governments from the analyzed countries4.

2.1.2. Accounting systems and reporting procedures

National standards for local financial management and accounting are fundamental components of fiscal frameworks. They set the rules and procedures for local budgeting, accounting, financial reporting and control, and are thus a precondition for sound financial management as well as for transparency and accountability. The way financial data is aggregated and presented in local budgets, financial statements or other finance-related documents is mostly determined by the accounting system in place. Accounting standards and their applications vary greatly among countries, but there are two basic accounting systems: cash accounting and accrual (or commercial) accounting.

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

Cash accounting is generally regarded as the more simple accounting system. Traditional cash accounting is focused on the actual cash flow in a predetermined period of time (the budget year), and captures incoming payments and outgoing payments. Transactions are only recognized when there is an exchange of cash. This leads to credits being regarded as incoming payments. Traditional cash accounting (if not modified) does however not require registering asset values, nor does it account for depreciation. Critics therefore argue that the information it provides does not support sound decision-making because the real financial situation is disguised and there is little or no information about the actual consumption of wealth and resources.

Accrual accounting records revenues and expenses as they occur, regardless of whether or not cash has actually been transferred. Accrual accounting therefore tries to measure the actual financial performance and thus accounts not only for profits and losses, but also for assets and liabilities. The system alows for depreciations, and if all fixed and mobile assets are registered, which is normally required, the yearly balance sheet gives decision-makers an accurate picture of the actual consumption of wealth and resources, and the real financial situation. Since accrual accounting generates information essential to potential investors, it is regarded as the more favourable accounting system for sub-sovereign lending.

Table 2: Central government approval procedures

Country Central Government Approval for local debt issue
Albania YES

Municipal loan must be approved by the Ministry of Finance. There are two different procedures for loan authorization 1) when municipality borrows domestically and 2) on the international credit market.

The MoF verifies the procedural compliance with the law as well as reevaluates the increased risk of borrowing.
Bulgaria NO

No approval of central government required, but (according to Municipal Debt Act) a Central Municipal Debt Register must be established at the MoF with individual records for each local government. The register is reported to the MoF every month. The register has three sub-registers on for loans, bonds and guarantees features (lender, principal, interest rate, fees, and maturity).
Croatia YES

According to the Budget Law the local governments can take on debt pursuant to the decision of the representative body of the LGU with the prior consent of the Government of the Republic of Croatia.
Kosovo YES

After approval by the Municipal Assembly for the requested loan should be approved by the Minister of MFE, if the Minister of MFE within 60 days does not answers then this loan is considered as approved by the Minister of MEF
Macedonia YES

Municipalities may borrow from the country and abroad only upon prior consent by the Government of Macedonia, on the basis of an opinion by the Ministry of Finance (MoF). Any initiative, pursuant to the Public Debt Law on beginning negotiations for conclusion of loan agreement should be started upon prior consent by the Government of Macedonia. This initiative should mandatorily contain positive opinion by the MoF.
Moldova NO

No approval of central government required. According to the Law on public debt local authorities only report to MoF the level of debt and the guarantees issued
Montenegro YES

According to the Law on Local Government Finance municipalities need Central Government approval for borrowing
Republika Srpska – BiH YES

The National Assembly of Republika Srpska gives an approval for municipal borrowing based on Central Government proposal. Ministry of Finance is responsible for implementation of the respective activities in case proposal for local debt issue is approved.
Romania YES

Commission on local government debt authorization (MoF based committee)
Slovenia YES

Municipality must receive an approval for borrowing from the Ministry of Finance and the decision for borrowing has to be included in the annual budget.
Serbia Ministry of Finance provides opinion on the local government request for borrowing

- proposals for new draft of Law on public debt are that Ministry of Finance, Public debt department should give approval for local government borrowing and not just opinion. This approval should consider several different criteria before being issued.
Turkey NO

Local governments do not need approval from the national government. For local debt issuance local governments must stay within the borrowing limits only. Regarding external (foreign) borrowing, the Treasury permission must be obtained by submitting related documents.

Although central government's approval is required for municipal borrowing in a majority of the analyzed countries, it does not imply any state guarantees or liabilities.

Public consultation prior to local debt issuance is foreseen in the legislation of some countries (Albania, Bulgaria, and Republika Srpska-BiH8). Even without specific provisions in the laws, sometimes the local government may organize a public consultation process on the opportunity to undertake external financing in order to build trust and obtain the citizens commitment.

One of the most important issues facing regulators and potential investors is how to deal with default or insolvency of local government. There is no clear answer as to whether or not regulations should prescribe for central government bailouts in cases of local government default.

One point of view is that national regulations should not contain prescriptions for bailouts in order to avoid that this might lead to moral hazard (i.e. less fiscal discipline and prudence in local governments). But then the question remains what can be done when local governments are "too big to fail" (as seen with banks in the financial crisis)? This suggests that a greater responsibility of states exists and that a bailout or state guarantee in these cases is likely necessary. One can also observe that state guarantees can encourage lenders to skip a thorough project review altogether and to even ignore local financial conditions. As long as a loan is adequately covered by central government commitments, the lender has no strong incentive to limit its lending to economically feasible projects.

The other point of view is that prescribing for central government bailouts or state guarantees in national regulations can lead to better credit ratings and interest rates, and thus better access to financial markets. In some countries there are such regulations, but state guarantees and central government bailouts for defaulting or insolvent local governments are then mostly accompanied by severe sanctions, such as the (part) loss of financial and/or administrative autonomy and submission to central government control.

The state cannot be invoked as a guarantor of local debt in Albania, Bulgaria, Moldova and Romania. In the rest part of the analyzed countries, the majority provides state guarantees and has legal provisions regarding this issue as follows:

In Croatia, based on the proposal of the Ministry of Finance, the Central Government can issue a guarantee;

In Macedonia, the Government of the Republic of Macedonia may guarantee and take liabilities which may derive from the long-term debts of the municipality, including also the municipal public services founded by the municipality, only in cases when liabilities are undertaken according to law on issuance of a sovereign guarantee; The Minister of Finance signs the agreement on issuance of a sovereign guarantee on behalf of the Republic of Macedonia;

In Montenegro, the government can make decision with regard to borrowings and issue guarantees in accordance with the annual budget law. End-user of guarantee shall pay risk fee, in the amount of 0.5% of the amount of the guarantee; for the time being9, the government hasn't issued any guarantees for local governments;

In Serbia, the central government has the right to issue guarantee and to refund principle, interest and other expenditures occurred if the requirements are not met by the local government; central government recover these funds by suspension of the rights of local government on share of taxes/transfers;

In Turkey, the under-secretariat of Treasury is authorized to issue state guarantees for specific projects and they are mostly concentrated on basic infrastructure projects, i.e. subway projects, solid waste management projects.

In Republika Srpska, the National Assembly approves issuing of guarantees, as per proposal of the central government; minister of finances is authorized to sign guaranties upon the approval by the Assembly; Guarantees of Republika Srpska can be issued to the creditor of borrower only to guaranty obligations of local communities, funds for social security and some other public institutions, for the purpose of financing capital investment of public interest.