Guidelines on Local Government Borrowing and Recent Developments in South East Europe
4. Local Government's Creditworthiness Assessment

4.1. Economic Risk

The ability of municipalities to repay debt is sensitive to economic conditions. Local governments that raise most of their funds from local taxes are especially vulnerable to local economic conditions. Local governments that rely primarily upon intergovernmental transfers are more exposed to the national macroeconomic conditions. One task of credit analysis is to identify the economic events which would impair the most a local government's ability to repay debt and come up with solutions to mitigate such risks.

The strength of the local economy is one of the most important factors influencing creditworthiness. Own revenues and shared-taxes of local government, as the main source to repay financial debt, are dependent on the performance of the local economy. Demographic trends, economic diversification and growth perspectives are key aspects which influence local government medium and long term revenues. Economic diversification is an important feature for a local economy. A highly diversified economic activity means that economic downturns will have a smaller impact on local output than compared to a concentrated local economy, where a few economic sectors hold a large share of total activity.

Key in the analysis of the strength of the economic structure are the following factors:

Economic and Social Infrastructure and socioeconomic trends underpinning the demand for public services provided by the Local Government

Per Capita Income and its volatility

Real Annual Local GDP Growth

Composition of Local GDP

Natural Resources

Employment Growth & Quality of Workforce

Economic Policies

Furthermore, the assessment should focus on the availability of basic economic infrastructure, relevant to the quality of life. This includes reliable electricity supply, transport system, health, water and wastewater treatment facilities, telecommunication system etc. Demographic indicators such as per-capita income, poverty levels, degree of urbanization, employment rate etc. are also very important. Favorable demographics significantly improve a local government growth potential while at the same time relaxing budgetary constraints related to high social expenditure allocations.

4.1.1 Political Risk

The objective of political risk assessment is to provide a means of evaluating the political stability of local governments on a comparable basis. Political stability is vital to continuity in economic decision making and growth as political consensus enables economic reforms. Political risk is a judgmental factor. It should be quantified by considering the (political) stability of the local government in the past and the attitudes of major political parties towards important issues for the local community.

The political relationship between the central and local governments has to be also taken into account as this may have an impact on transfers (grants) from the central government and direction of investments in new projects. Therefore it may have an impact on the local economic development.

4.1.2 Financial Risk12

The financial situation of a local government is crucial for its creditworthiness, as it determines the ability to meet current obligations and debt service. Factors that have an impact on the financial position of local governments include:

revenue and expenditure structure and dynamics

net operating result

ongoing liquidity and cash flow management

financial flexibility – autonomy to raise taxes and fees,

the ability to balance financial operations over the economic cycle

willingness and ability to control expenses

indebtedness – both on and off-balance sheet debt

Municipal senior management must be well prepared to identify, evaluate and mitigate the main sources of risk for the financial situation of the local government (currency, interest rate, maturity mismatch risk). The materialization of such risks would negatively impact cash flows: consequently, municipalities may be exposed to insolvency or default scenarios.

When assessing financial risk of a local government, each of the above mentioned factors have to be compared with relevant benchmark values established for a group of similar local governments. Such an approach must be supported by adequate technical and accounting expertise as well as by the establishment of reliable local statistics database.