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

4.4. Determining Local Government Borrowing Capacity

Local governments should be aware of their maximum borrowing capacity (i.e. how much money they can borrow) in order to be able to set and prioritize capital investment objectives.

Projecting the future financial position (revenues and expenditures) of a local government is key in determining the financial resources available to repay debt. The forecasting framework of local revenues and expenditures should incorporate the economic, political and financial risk factors that were described in the previous section.

Local governments usually repay debt (principal plus interest) from the operating surplus, which is the difference between operating revenues and expenditures. Maximum borrowing capacity of a local government can be estimated as the present value of its future net operating surpluses (operating surplus minus debt service on outstanding debt). The discount rate used in the present value calculation should be the interest rate charged by banks for m loans.

Local governments should be able to demonstrate that they are able to generate persistent positive net operating results in the future, as a precondition for borrowing. If a local government has a temporary structural deficit (negative net operating result) in the future, it can still take on new debt, provided that the financing agreement foresees a grace period at the time the deficit is recorded. Alternatively it can use capital revenues to finance the operating deficit. However, if a local government runs on persistent structural deficits, serious efforts must be made to rationalize operating expenditures and increase revenues before borrowing should even be considered1.

The ratio of expected net operating result to expected debt service is probably one of the most important indicators of local governments' debt carrying capacity. If the ratio is close to one, then any major fluctuation in a local government's operating revenues or expenditures could result in serious problems in meeting the debt service obligation. A ratio significantly higher than one indicates that the local government has a comfortable financial position relative to its debt obligations.