Guidelines on Local Government Borrowing and Recent Developments in South East Europe
7. How to manage the credit?

Local governments can tap external resources using a wide range of borrowing instruments. However, each instrument is suited to finance only certain types of activities. Short term financing instruments include: (i) working capital credit line – local government draws funds from the credit line, on which they pay interest, to finance temporary revenue shortages; principal is usually rolled over, (ii) bridge loans are a special type of short term loan where financing for a capital investment project is provided for a transitory period until the main (long term) financing is obtained. Medium and long-term borrowing should be pursued by local governments when financing capital investment projects. Long-term borrowing to cover current expenditures is usually prohibited by law and must be avoided anyway.

Planning the structure of a financing package should be in line with a local government’s debt management and capital investment strategy. When negotiating with the financial institution(s), local governments have to think at maturity, grace period, interest rates, fees, drawdown (loan disbursement), refinancing etc. After securing the financing package local governments have to generate enough revenues to pay for debt service and also allow for additional lending or direct investment. Unfortunately, when things do not go as planned, local communities must deal with loan restructuring and sometimes default.

Restructuring of a loan should be contemplated as an option when local governments enter a period of financial distress. Restructuring should be foreseen, whenever this is possible, from the beginning when the financing contract is signed with the bank. Restructuring of a bank loan usually involves the following elements: (i) refinancing, (ii) maturity extension, (iii) reshaping the debt service schedule to match the client’s projected cash-flows, (iv) writing off a portion of the debt (haircut).