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

7.1. Types of loans and their recommended uses

As described in Chapter 3, local governments can tap external resources using a wide range of borrowing instruments. Each instrument is suited to finance certain types of activities and may be allowed or prohibited by national legislation.

National legislation in surveyed territories covered by NALAS members differentiates between short term and long term borrowing. Local governments can issue short term debt in most of the target territories covered by NALAS members to cover temporary shortages in revenues, in order to finance current expenditures (and ensure continuity in public services), refinance maturing loans, provide intermediary (bridge) financing for major investment projects, pre-financing loans for EU funded projects, or in some cases to fund capital expenditures (from within the fiscal year when the shortage is incurred). Short term loans have to be repaid by local governments usually before the year end from own funds or alternatively through a longer term credit facility.

The most frequent short term instrument is the working capital credit line. The local government can draw funds from the credit line based on their liquidity needs, on which they pay interest; depending on how the product is structured, local governments may be required to repay the utilized amount within one year or alternatively the drawn amount can be rolled over. Amortizing loans can also be used to finance short term deficits. 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. Loans for investment should be structured according to each project’s characteristics and economic life. In this context, a local government can either apply for a long term loan or approach a bond issue. The loan should be structured to enable maximum financial flexibility for the local government at a competitive cost (long grace periods, customized debt repayment schedule to avoid overlapping peaks in debt service with previously contracted debt). Bonds can be more attractive than loans to finance long-term investments, as they have usually longer maturities than plain vanilla loans. However, bond issues should in general be structured with an amortizing repayment schedule; as a result of legal debt thresholds bullet bonds do not allow local governments to issue a significant amount of debt.