Guidelines on Local Government Borrowing and Recent Developments in South East Europe
3. Which debt instrument is suitable?

3.2. National and international development program loans

In all of the analyzed countries some sort of local government development fund is established. These development funds act as a credit institution at sub-national level. International development banks (World Bank, KfW, EBRD etc.) are using these funds as a way to channel loans to local governments. The financing of local governments through such programs occurs either directly or indirectly (on-lending), via intermediated loans to local banks in target countries.

The terms and conditions of these loans tend to be less rigid than that of "normal" banks. Their objective is to assist local government long-term development needs rather than make a profit. The maturity of the loan is often tied to the life of the asset. Another characteristic of these loans is the existence of an initial grace period on principal repayment, which shifts the debt burden further into the future.

Interest rates on these loans are typically below commercial banks' "normal" lending rates. Fixed interest rates are common and are set based on a relationship to government's borrowing rates. But it has to be stated, that such interest rates below the market price bear the risk of crowding out the local financial credit market and hinder its development. In addition to lending funds to local governments, the development programs use incentives in form of grants or technical assistance if borrowers meet some requirements.

The case of Macedonia, where the World Bank and the Ministry of Finance initiated EUR 18.9 million USD Municipal Services Improvement Project, is a very good experience, especially in the early stage of municipal credit market development. This on-lending program was launched in 2008 and its objective is to improve transparency, financial sustainability, and delivery of targeted municipal services such as water supply, sanitation, solid waste management, support for energy efficiency projects, urban transport and other services. Along with the loans the Project provides grants to local governments as an incentive and reward for implementation of reform initiatives aimed at performance improvements in service delivery. The awarded grant to an individual local government amounts to 20% of the investment loan.

Montenegro has a similar vehicle, the Investment Development Fund, which provides loans to local governments at lower interest rates compared to commercial banks. For example, the average interest in 2009 for local governments' loans originated by commercial banks was 10% while at the same time the Fund charged only 5%. The fund also controls the primary municipal bond market (i.e. buys bonds of issued by local governments). There is no secondary market for municipal bonds. The banks participating in the on-lending programs perform all the due diligence of the potential borrowers and bear the entire credit risk of the related loan portfolio.

Example 1:
Istanbul Municipal Infrastructure Project financed by World Bank Development Program Loan of Environmental Projects
The objectives of the Istanbul Municipal Infrastructure Project (IMIP) in Turkey are to assist the Istanbul Metropolitan Municipality in: (i) improving its solid waste management; and (ii) improving its capacity to mitigate earthquakes by retrofitting key facilities and infrastructure and upgrading the institutions and their procedures to help them respond to emergencies.
Project Owner: Istanbul Metropolitan Municipality
Name of the Project: Istanbul Municipal Infrastructure Project
Project Amount : USD 322,150,000
Lender/Creditor: International Bank for Reconstruction and
  Development (IBRD), a member of the World Bank
  Group
Guarantor: Under-secretariat of Treasury
Instrument Used: Project Financing
Credit Amount: USD 322,150,000
Maturity: 5 years of Grace Period + 10 years
  (20 equal installments)
Approval of the Bank: 28.06.2007
Credit Agreement: 25.07.2008 (between the Municipality and the Bank)
Guarantee Protocol: 13.09.2009 (between the Municipality
  and the Treasury)

The main point diverging from this example is that this loan agreement is under state guarantee. Therefore, Istanbul Metropolitan Municipality has signed a "Guarantee Protocol" with the Under-secretariat of Treasury in accordance with the requirements of the IBRD, a member of the World Bank Group; whereas, the Treasury has signed a "Guarantee Agreement" with the Bank. Moreover, with this protocol,the Municipality is obliged to transfer changing percentages of its various revenues into an official account in order to be facilitated during debt repayment periods. This account is named as "External Debt Repayment Account". These revenues are "Advertisement and Publicity Tax" and "Real Estate Tax"; which are collected by the Municipality. The transactions are audited and supervised by the Controllers of Treasury.

The main point diverging from this example is that this loan agreement is under state guarantee. Therefore, Istanbul Metropolitan Municipality has signed a "Guarantee Protocol" with the Under-secretariat of Treasury in accordance with the requirements of the IBRD, a member of the World Bank Group; whereas, the Treasury has signed a "Guarantee Agreement" with the Bank. Moreover, with this protocol, the Municipality is obliged to transfer changing percentages of its various revenues into an official account in order to be facilitated during debt repayment periods. This account is named as "External Debt Repayment Account". These revenues are "Advertisement and Publicity Tax" and "Real Estate Tax"; which are collected by the Municipality. The transactions are audited and supervised by the Controllers of Treasury. Since a part of Municipality's own revenues (taxes), whose ratios are determined in its sole discretion, goes under cede. Nevertheless, this is a bilateral guarantee mechanism for both sides and the transferred amount constitute very small portion of Municipality's annual revenues since most are formed by the mechanism of shared tax revenues of the central government. Another difference unique to state guaranteed agreements is that Turkey's Treasury, on behalf of borrower, conducts the negotiations with creditor. Hence, disproportionate consumption of time is a negative outcome in this sense.

Example 2:
European Investment Bank's (EIB) intermediary loans in some Central and Eastern European countries (as of June 2010)
The objectives of the Istanbul Municipal Infrastructure Project (IMIP) in Turkey are to assist the Istanbul Metropolitan Municipality in: (i) improving its solid waste management; and (ii) improving its capacity to mitigate earthquakes by retrofitting key facilities and infrastructure and upgrading the institutions and their procedures to help them respond to emergencies.

EIB finances small projects with total cost between EUR 40,000 and EUR 25 million indirectly through global loans (credit lines) to local financial institutions. EIB can fund up to 50% of total project cost. The financing aims to promote the building, upgrading or refurbishing of small municipal infrastructure via the Municipal Finance Facility.

Main local banks participating in the subsidiary financing agreement

- Hungary: OTP Bank, Erste Bank Hungary, UniCredit Bank Hungary
- Czech Republic: Ceská sporitelna, a.s., Komercní banka, a.s.,
- Bulgaria: UniCredit Bulbank AD, Société Générale Expressbank, DSK Bank EAD, OTP Group, Raiffeisenbank (Bulgaria) EAD
- Romania: Banca Comerciala Romana S.A., Bancpost S.A., BRD – Groupe Société Générale S.A.

The final financing decision on the local governments' projects rests with the local banks, thus EIB effectively leveraging on local market expertise. Usually the local banks participating in the MFF are also amongst most active in the local government credit markets.


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