Guidelines on Local Government Borrowing and Recent Developments in South East Europe
6. How to find and select the lender?


6.2. How could local governments increase their chances to borrow
6.2.1 Lenders' expectations from local governments


Financial institutions approaching local governments operations usually pursue a detailed qualitative and quantitative analysis of a wide range of financial, economic and institutional factors in order to assess creditworthiness. The depth of such analysis varies across financial institutions, depending on degree of specialization on local government segment.

As shown in Chapter 4, the economic conditions in which a local government operates have an important influence on its creditworthiness. Although some financial institutions may not put too much emphasis on this factor in their credit analysis, it is important for local governments to understand its importance for their future revenues and indebtedness capacity and take proactive measures. Such measures may include various tax facilities offered by the local governments to large local companies of systemic importance20 for the local economy aimed at stimulating investment and employment; local governments can also increase investment attractiveness of the region by providing large investors with real estate assets (land, buildings).

Example
Romanian experience in supporting the development of local economy
The Metropolitan Area of Oradea (MAO), which gathers the municipality of Oradea along with 11 neighboring communes, is in the process of creating a marketing strategy aimed at increasing attractiveness of the local economy among foreign investors.

In a first step MAO identifies from the pool of real estate assets (land, buildings) that belong to its members the ones which could be used to support new investments. Based on a detailed analysis of the local economy structure and growth perspectives, MAO selects the economic sectors which have the greatest development potential by taking into consideration the key strengths of the local economy. It then combines the results of the analysis with the available real estate assets for new investments into territorial sectoral offers, which are subsequently marketed to foreign investors.

For example, one of the identified investable assets is a piece of land owned by one commune in a touristic area. As tourism has been identified among one of the key industries with potential to drive the local economy forward, the territorial offer in this case would be addressed to potential investors interested in developing a tourist resort. MAO would provide the land and access to public infrastructure to the investors which are committed to build a resort in the area.

As previously explained (Chapter 4) when assessing budgetary performance of local governments, financial institutions also analyze the trend of the net operating result (balance).

The degree of financial flexibility, which local governments have at their disposal to adjust the budget in periods of financial and economic distress, is also important from the point of view of debt servicing capacity. If a local government has high financial flexibility, it will be able to effectively adjust its revenues or expenditures in the face of external shocks, so as to maintain its financial stability.

Related to the financial flexibility is the political flexibility – i.e. willingness to rationalize expenditures – to pursue austerity measures in case of financial distress. Thus, even if a local government has financial flexibility it may lack the readiness to implement adjustment measures to balance the budget due to political reasons.

Project management capacity of local governments represents another area of focus in banks' credit risk analysis. It emphasizes the sophistication of local government structures and practices and it evaluates the capacity to observe legal procedures for procurement and financial management. In this context banks may be interested to see how the implementation of previous investment projects succeeded, what were the main problems encountered and how the local officials dealt with them.

A high degree of transparency and disclosure is a key characteristic of good financial management. It is an important aspect of the relationship between local governments and financial institutions as it provides banks with the necessary information in their due diligence procedures and helps them to build an unbiased representation of the former's true financial position. In this context local leadership should be willing and able to communicate all required information to lending institutions.

The quality of the budgeting process belongs also to financial management capabilities. Budgeting should be accrual and program based. A consolidated approach to budget planning is desirable; budget should include all operations of local governments and subordinated related entities.

The existence of a debt management strategy at local government level with clear and strict indebtedness policies, besides those available at national level has a positive impact on creditworthiness. The debt policy should be explicitly formulated and observed. It should be stable and predictable across time, adequately disclosed, with no unplanned or sudden debt issues and correlated with the capital investment strategy. Debt limits imposed by national legislation should be respected at all times. Moreover, the local government should ensure an indebtedness level which can be sustained without putting too much burden on revenue streams.

Political changes in the local governments may determine in some cases a shift in the local development strategy which may have negative consequences on willingness and commitment to service debt contracted during the previous term. Local managers need to understand the importance of having a good track record in repaying financial debt and ensure continuity of investment projects, as they both represent preconditions for accessing future loans at reasonable costs. Lenders learn about non-compliant or distressed local governments from their peers or from national debt registers. Such behavior sheds a lasting negative light on the local governments, which results in difficulties in contracting new loans or higher risk-associated costs.

A clear and coherent capital investment strategy represents the starting point of any investment project and provides the lender with a long-term perspective over any local government's investment plans and future financial position. To this end it is important for the local government to have multi-year financial planning with corresponding appropriations that enables them to roll out the planned investment projects. The strategy should include a prioritization of the major projects according to their importance and funding needs.

Financial institutions require borrowers to bring a form of eligible guarantees in order to secure debt repayment. In case of decentralized local governments, borrowing is usually guaranteed by own revenues. Theoretically revenue streams would be intercepted by lenders in compensation for overdue debt service. Other forms of guarantees such as physical assets may be also accepted by law in some countries. In many cases, where legislation on local public debt is not clear enough, financial institutions may consider own revenues guarantees offered by local governments as good as government guarantees. Thus, it is important for local governments to ensure that financial institutions understand the nature of guarantees and conditions under which they become exercisable. Guarantees from central governments are also practiced in some credit markets, but they are usually characteristic for the early stages of development, when financial institutions knowledge about local governments and willingness to lend them is low.

6.2.2. Characteristics of the south-eastern European countries

All lenders would like to work in ideal conditions: stable legislation, open and correct financial statements and accounts, stable flow of revenues, well developed investment plans, sufficient administrative capacity and political commitment to service debt regardless of the leadership changes. In many countries today such conditions are not present. Thus lenders operate in volatile environments fraught with risks; during recessions such risks are even greater. Chief among them are: unstable allocation of revenues as a consequence of changes in the national legislation, volatile tax revenues, poor revenue planning and management at local level, lack of transparency and administrative capacity.

In the countries surveyed for this paper the lending conditions are not perfect either. During this subchapter, we will go through the related findings on the local credit market conditions.

Although the majority of local governments are required to adopt debt management policies and multiannual capital investment plans, many others do not have to observe such a prerequisite. In the latter cases lenders cannot get the big picture of the local governments future actions nor can they find lasting political commitment for the projects they are financing.

Revenue stability has been largely achieved over the last years. However, there are cases when governments or parliaments suddenly changed regulations to the disadvantage of local governments. Moldova, Serbia and Romania can be cited in this respect21. Local governments must be aware that lenders, like any other investors, are driven by confidence; revenue fluctuations inhibit confidence in the borrower's ability to service debt.

Any lender requires guarantees. Local governments in most of the surveyed countries are providing such pledges. The most frequent is revenue interception. Unless the debtor pays its dues, the bank is entitled to takeover part of its revenues in exchange. However, a lender should know that local government accounts with the State Treasuries are usually very difficult to execute. Some countries allow local governments to provide assets as collateral for incurred debt. Such instruments are allowed in Albania, Bulgaria, Kosovo, Macedonia, Montenegro, Slovenia and Turkey. Even in such cases, foreclosures can be very difficult and procedure-laden when it comes to public assets. A special case can be found in Serbia, where local governments are forbidden to issue any guarantees in favor of their lenders.

Example
Forced execution of local government accounts held in State Treasury in Romania
In Romania a court has to confirm the existence of an unpaid debt and approve the interception of the debtor's revenues within the Treasury. To pay the debt, the debtor has to have cash in his accounts. Else, it has a respite of six months to find resources and clear off the debt. The main credit officers play a decisive role in securing the cash to repay the debt. Unless he (she) is well-intentioned the lender could spend many months trying in vain. Eventually, after the six-month term expires the lender can resort to the foreclosure of the debtor's assets. To this end, the applicable procedures are laid by the Fiscal Procedures Code.

State guarantees are also to the liking of lenders despite the moral hazard they induce to local governments. Some countries make explicit to local governments and lenders that state guarantees are not available in any circumstances. Albania, Bulgaria, Moldova, Romania and Slovenia fall into this category. There are countries which leave the door open for state guarantees in special cases: Croatia, Kosovo, Macedonia, Republika Srpska, Serbia and Turkey. The state guarantees are usually approved by Parliament (Undersecretariat of Treasury in Turkey's case), but the government plays a central role through the Ministry of Finance. Moldova is a special case in this respect; the central government does not issue state guarantees, but county governments may do it in favor of local governments.

Example
Loan guarantees to local governments in Moldova
In Moldova there is a hierarchical relationship between county governments (rayons) and local governments (communes and towns) stemming from the role of the former in providing intergovernmental transfers to the latter. As such, public authorities of level II (i.e. rayons) are entitled to grant local public authorities of level I, as well as municipal enterprises, guarantees for loans for capital expenditure from financial institutions and from other national or foreign lenders. The guarantees have been granted for full or partial coverage of expenditure regarding repair works (Rayon council of Orhei); repair and maintenance of local roads (Rayon council Ungheni); construction of water wells (Rayon Council Hînceşti) etc. The loans are guaranteed with the rayon transfers for financial support to town and commune budgets.


In most cases lenders perform their own due-diligence, with the notable exception of bond issues where due diligence is carried out by independent auditors. With a view to evaluation, as a general practice, lenders require financial statements over a number of years, books of accounts, debt balance and commitments, lists of assets, investment plans and project technical documentation.

Credit ratings are rather rare, given their cost and local lenders' reliance on legal provisions. However, there are notable exceptions; a credit rating by a major independent agency is a prerequisite for a local government borrowing directly from an International Financial Institution (e.g. the European Investment Bank); moreover, bond-issues have to be backed by credit ratings to gain investors' confidence. In Bulgaria there is an Agency for Credit Ratings and Analyses which provides ratings to interested entities, including local governments. The agency was formed in 2010 from the merger of two existing credit rating agencies of which one was a Moody's affiliate. Also, Macedonia provides an interesting example of a national program to carry out local government credits rating by international credit rating agencies. In Turkey, the three main credit rating agencies are active in analyzing and assigning credit ratings for local governments. Fitch Ratings even has a regional office in Istanbul.

Example
Macedonian local governments' credit rating assistance program
In 2009, USAID Macedonia Local Government Activity (MLGA), in cooperation with Macedonian Financial Excellence Center (MFEC) and Moody's Investor Service, launched an external financial audit in six municipalities whose findings would be in compliance with international public accounting standards. Since then three local governments have been rated, namely Skopje, Strumica and Veles.

On 11 February 2010 Moody's Investor Service published the municipal credit ratings of Veles and Strumica, reflecting solid overall budgetary performances and lack of any direct-debt exposure.

The costs of credit rating vary between EUR 14,000 to EUR 19,000 depending of the size of the local government and the rating agency.

Example
Local governments with rating across central and eastern European countries
Bulgaria – there is a locally established Credit Rating Agency which assigns ratings to LG. International rating agencies are also present. In 1999 Standard&Poor's rated Sofia and in 2000 Moody's rated Varna.

Croatia - Only City of Zagreb obtained a credit rating so far from Moody's.

Macedonia - Two municipalities Strumica and Veles as well as the City of Skopje have been rated.

Romania - on IFIs demand or prior to international bond issues - Bucharest 2005 – Standard&Poor's, Oradea 2009 – Fitch

Serbia - Three cities have been assigned with credit ratings in June 2010 by Moody's; Valjevo and Kraljevo obtained B1 and the City of Novi Sad Ba3.

Turkey - Most metropolitan municipalities are being rated by S&P, Moody's and Fitch. Istanbul, Ankara, Izmir and Bursa are some examples in Turkey. These municipalities are generally rated parallel to the sovereign grade. Istanbul, for instance, is rated as BB+ (Fitch Ratings), BB (S&P) and Ba2 (Moody's).

Annual fees show slight variations, changing between $30,000 and $36,000.

In the countries where State-funded banks and investment funds are present the interest rates and fees they charge to local governments tend to be lower than those of private lenders. As a rule, such market enhancing mechanisms may be welcome in less developed credit markets, but they must be temporary. Examples of this sort can be found in Montenegro (the State Development Investment Fund) and Turkey (the Bank of Provinces).

Last but not least, all lenders will be careful about the local governments' capacity to manage debt. In most countries in south-eastern Europe, rural and small local governments' financial departments are not staffed with adequately qualified personnel. In such cases lenders will keep close monitoring on the debt implementation.

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