KNOWLEDGE PAPERS SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA Approaches to Attract Long-term Capital for Small-Scale Infrastucture Projects KNOWLEDGE PAPERS SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA Approaches to Attract Long-­term Capital for Small-Scale Infrastructure Projects Alessandra Campanaro Binyam Reja November 2017, No. 25 Urban Development Series Produced by the World Bank’s Social, Urban, Rural & Resilience Global Practice, the Urban Development Series discusses the challenge of urbanization and what it will mean for developing countries in the decades ahead. The Series aims to explore and delve more substantively into the core issues framed by the World Bank’s 2009 Urban Strategy Systems of Cities: Harnessing Urbanization for Growth and Poverty Alleviation. Across the five domains of the Urban Strategy, the Series provides a focal point for publications that seek to foster a better understanding of (i) the core elements of poor policies, (iii) city economies, (iv) urban land and housing markets, (v) the city system, (ii) pro-­ sustainable urban environment, and other urban issues germane to the urban development agenda for sustainable cities and communities. Copyright © World Bank, 2017 All rights reserved Global Programs Unit; Social, Urban, Rural & Resilience Global Practice World Bank 1818 H Street, NW Washington, DC 20433 USA http://www.worldbank.org/urban The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. 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Contents Foreword v Acknowledgements vii Acronyms viii Executive Summary 1 1 Introduction 3 2 China’s System of Municipal Financing and Its Evolution 4 3 Small Town Infrastructure Development and Finance in China 11 4 Proposed Infrastructure Financing Facilities (IFFs) 18 5 The Application of IFF in China 30 6 Next Steps: Implementation Considerations 40 References 43 Previous knowledge papers in this series 45 Foreword More than half of China’s population now lives in ening fiscal gap. Particularly, China’s traditional the cities and 70 percent is expected to do so by municipal financing system has left many small 2030, adding another 300 million urban inhabit- towns poorly served in terms of infrastructure. ants seeking jobs, housing, infrastructure and other Only a mere 9 percent of total fixed asset invest- services in cities and towns. Over the past three ment goes to towns, leading to disparities in the decades, China has experienced unparalleled ur- level infrastructure and quality of municipal ser- banization and economic development, successfully vices between cities and towns. Furthermore, the creating employment and improving living stan- traditional urban infrastructure financing model dards for its citizens. Although China has avoided has caused problems such as low density urban some common issues related to rapid urbanization, sprawl, maturity mismatch and inefficient resource such as urban poverty and unemployment, strains economic allocation. In order to realize its socio-­ are starting to show as its existing growth model is potential, small towns not only need to improve running out of steam with inefficient use of land, infrastructure and public services provision, but capital and labor. also avoid the common issues that larger cities have gone through in the past. Is there an alterna- In this context, China is embarking on a new model tive financing channel that can help small towns of urbanization. The central government recently in China address the above issues? This paper is launched the “New Urbanization Plan” to sustain contributing to this debate. the country’s economic growth by promoting fur- ther urbanization. This new model (or so-­ called In 2014, the World Bank has collaborated with the new normal) sees not only a shift from a resources National Development and Reform Commission mobilization strategy to increased efficiency and (NDRC) to carry out a study to identify various sustainability, but also an emphasize of small cities infrastructure financing strategies for small towns and towns’ role in the further urbanization and in China. This paper intends to further explore sustainable economic growth. The new path to the feasibility of establishing a subnational level sustainable growth implies financing challenges for infrastructure financing facility pilot. By review- different layers of governments. ing China’s municipal finance system including its evolving regulatory framework, the paper presents The decentralization has provided subnational the key challenges ahead and a preliminary road- governments certain flexibility and incentives in map for setting up a pooled infrastructure financing local economic development, but also create a wid- mechanisms at the subnational level. SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA vii Acknowledgements This report is a follow up to the Phase I Small Analyst, Consultant), Anita Shrestha (Transport Town Infrastructure Financing (P143473) Advisory Analyst), Wenting Wei (Consultant) and Hongye Fan Services and Analytics (ASA). This Phase II paper (Urban Transport Analyst, Consultant). was prepared by a team from the World Bank in collaboration with the National Development and Peer review comments from Jeffrey Delmon (Senior Reform Commission (NDRC), Ministry of Fi- Infrastructure Finance Specialist), Lili Liu (Lead nance (MoF), Shanghai Municipality Government Economist), and Min Zhao (Senior Economist) (SMG), and Shanghai Municipality Investment are gratefully acknowledged. Administrative as- (SMI) Corporation. sistance was provided by Inneke Herawati Ross (Senior Program Assistant) and Ruifeng Yuan (Pro- The main authors and co-­ task managers for this gram Assistant). Additional editorial support was report are Binyam Reja (Practice Manager, Cen- provided by Laura Lewis De Brular (Information tral and North East Asia Transport) and Alessandra Analyst) and Taotao Luo (Urban Analyst, Consul- Campanaro (Senior Urban Specialist). They worked tant). The report also benefitted from discussion under the overall guidance of Bert Hofman (Coun- with a team from the International Finance Corpo- try Director, China and Mongolia) and Abhas K. ration (IFC) and the Global Infrastructure Facility Jha (Practice Manager, East Asia and Pacific Region (GIF), including Simon Andrews (Manager, IFC Urban and Disaster Risk Management). The report China Office), Hao Sun (Senior Investment Offi- benefitted from consulting support from Daniel cer), Wenqin Zhu (Principal Country Officer, IFC Bond (Senior Infrastructure Consultant) and Zhi China Office), and Towfiqua Hoque (Sr. Infra- Liu (Lincoln Institute of Land Policy, Consultant). structure Finance Specialist). This report has also Additional inputs have been provided by Catalina benefited from insightful discussion and knowledge Garcia-­K ilroy (Lead Financial Sector Specialist), exchange with the industry and policy makers in Tuo Shi (Urban Economist), Jing Zhao (Finance Beijing and Shanghai. viii URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS Acronyms ADT Administratively designated towns NAO National Audit Office APL Adaptable Project Loans NBFI banking financial institutions non-­ ASA Advisory Services and Analytics NDRC National Development and Reform CAPEX capital expenditure Commission DFI Development Finance Institutions PPP public-­private partnership DFV District Financing Vehicle SME small and medium enterprise ERR Economic Rate of Return SMG Shanghai Municipality Government FIL Financial Intermediary Loan SMI Shanghai Municipal Investment FMDV Global Fund for Development of Cities SNG subnational governments GUIFF Green Urban Infrastructure Financing SOE state-­owned enterprises Facility SPV special purpose vehicle IFF Infrastructure Financing Facilities SRFs State Revolving Funds INCA Infrastructure Finance Corporation TA technical assistance Limited TSS Tax Sharing System IEG Independent Evaluation Group TNUDF Tamil Nadu Urban Development Fund IRR Internal Rate of Return UDIC Urban Development Investment LGFA Local Government Funding Agency Corporation MFA Municipal Finance Authority of British USAid United States Agency for International Columbia Development MoF Ministry of Finance WB World Bank SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 1 Executive Summary China has experienced rapid urbanization in the puts constraints and increased discipline on gov- past three decades, which has successfully brought ernment income and expenditure, providing both unparalleled economic growth, employment cre- opportunity and challenges to local government fi- ation and improvement in living standards. Over nance. On the one hand, it allows provincial level the next 20 years, there will be 65 to 70 percent of governments to issue debt themselves under control the population living in China’s cities and towns. by the legislature and the central government. On However, the existing municipal finance system the other hand, local governments cannot borrow has experienced an asymmetric assignment of fiscal through UDICs or other corporation channels, clos- power and expenditures, leaving a widening gap ing this traditional way of urban finance in China. between municipal budgetary revenues and expen- ditures: the ratio of subnational revenues remains slightly less than 50 percent of total government budgetary revenue, while the ratio of subnational expenditures has risen as high as 80 percent of the China has experienced rapid total expenditures. urbanization in the past three This paper is focused on exploring the feasibility decades, which has successfully of establishing a pooled Infrastructure Financing Facility (IFF) at the sub-­ national level to provide brought unparalleled economic sustainable long-­ term finance to infrastructure projects in small towns. The paper reviews China’s growth, employment creation and fiscal and infrastructure financing system, includ- ing the 2014 amendment of China’s Budget Law improvement in living standards. and associated regulations, presents an overview of pooled IFFs, and explores the potential application of a pooled financing facility in China, specifically Small towns, with expanding population and for urban infrastructure projects in the greater presence throughout the country, are expected Shanghai region. to play an important role in China’s new urban- ization strategy by settling large amount of newly Local governments in China have relied on land-­ urbanized population. The number of small towns based financing. and the use of urban development increased from 20,986 in 2005 to 21,826 in 2014, investment corporations (UDICs) for off-­ budget accounting for over 20 percent of national popu- borrowing for financing infrastructure and de- lation. Yet, small towns’ role has been constrained livering an unprecedented urban development in due to lagging infrastructure and less attractive history. However, a consensus has emerged that employment prospect compared to larger cities. the current system is unsustainable in the long term Unbalanced allocation of fixed asset investments and have triggered concerns at the national level. that favor cities over towns had led to disparities Of particular concern is the maturity mismatch of in the level and quality of infrastructure and mu- UDIC borrowing. Infrastructure projects normally nicipal services. Furthermore, small towns face require long repayment periods, while UDICs have several constraints on their creditworthiness as relied on short-­term financing from mostly banks they lack fiscal autonomy and limited capacity to and trusts. The Budget Law amendment in 2014 borrow. While the amended Budget Law starts to 2 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS allow local governments to issue bonds, the bor- ent small towns, issue marketable-­ size bonds and rowing has to be organized at provincial level and thus lower the cost of debt. Additional advantages mostly benefits larger municipal governments. As of a pooled financing mechanism can be achieved such, the small towns’ needs for long-­ term financ- due to scale and knowledge of the capital markets ing may remain underserved. Some innovations in as well as a longer tenure that can help address infrastructure financing in the recent years include maturity mismatch. General design considerations local government debt “swaps”, public-­ private-­ for IFFs include accountability, regulatory and tax partnerships (PPP) and infrastructure funds. The treatment, no exclusivity obligation, functions out- PPP approach is useful mostly for larger projects sourced, minimum level of participation and level and will not likely provide a viable approach for the of leverage. Cases from a mix of developed and financing of smaller projects in small towns. developing countries present existing practices and lessons of the IFFs. Despite the potential of using IFF for small-­town Small towns are expected to play infrastructure financing, IFFs has not been used in China in part due regulatory issues that need to an important role in China’s be considered for any IFF designs for small towns new urbanization strategy by in China, including: regulation of non-­ deposit taking financial institutions in making loans, use settling large amount of newly of a revenue stream as collateral, constraints for municipalities to borrow directly, and inadequate urbanized population. reporting and disclosure standards. Taking the existing regulatory framework, Shang- town In order to facilitate the ability of small-­ hai Municipal Government (SMG) is proposing to governments to obtain sustainable financing for develop an urban infrastructure financing facil- infrastructure projects from financial markets, town related projects in the greater ity for small-­ IFFs could be established to channel long-­ term Shanghai area. financing for projects sponsored by small towns. An IFF will pool the financing needs from differ- SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 3 Introduction This report is a product of the World Bank work domestic (and possibly international) capital mar- on local government infrastructure financing in lend into specific sub-­ kets, as well as to on-­ projects China. It presents the feasibility of establishing fi- with proper project appraisal and fiduciary over- nancing facilities to provide sustainable long-­term sight capacity. This proposal could be implemented debt to infrastructure projects in small towns, with fenced pilot experiment for China to find as a ring-­ a particular focus on the small towns in the Shang- sustainable long-­ term debt finance mechanisms up study to Phase I of a hai region. It is a follow-­ for small town infrastructure development. A suc- World Bank Advisory Services and Analytics (ASA) cessful pilot case in the Shanghai region could for Small Town Infrastructure Financing in China. potentially be replicated in a few other provinces to meet substantial infrastructure financing needs Phase I of the ASA was carried out in 2014 in col- in small towns. laboration with the National Development and Reform Commission (NDRC). It identified various Recent policy changes in China have created both infrastructure financing strategies for small towns challenges and opportunities for introducing sus- through financial intermediaries. As a result of this tainable infrastructure financing mechanisms. effort, a broad consensus was built on the benefits With the aim of better managing local govern- of establishing an Infrastructure Financing Facil- ment debts, the Chinese central government has ity (IFF) at the sub-­national level as a pilot project. introduced a series of new policies and amended The NDRC and the World Bank thus agreed to the 1994 Budget Law. Under the new framework, conduct a Phase II ASA Study to explore the fea- smaller cities still are not allowed to borrow directly sibility of establishing an IFF. Further discussions but are expected to leverage on the provincial-­ level with NDRC, the Ministry of Finance (MoF), and government borrowings. Hence financial innova- the Shanghai Municipality Government (SMG) led tions for small town infrastructure projects need to to the decision to focus on Shanghai municipality take this limitation into consideration. for this pilot project. The Shanghai Municipality consists of the cen- tral city of Shanghai and nine suburban districts/ Recent policy changes in China counties. A District Financing Vehicle (DFV) was established in 2005 under a World Bank-­ fi nanced have created both challenges and Shanghai Urban Environment Adaptable Program opportunities for introducing Loan (APL) Project Phase II, and it played an inno- vative role in appraising, managing and leveraging sustainable infrastructure private sources of financing in infrastructure proj- ects for small towns within Shanghai Municipality1. financing mechanisms. The SMG proposed to transform the DFV into a fledged Green Urban Infrastructure Financing full-­ The purpose of this paper is to explore the feasibil- Facility (GUIFF) with the capacity to raise funds in ity of establishing infrastructure financing facilities (IFFs) to provide sustainable long-­ term finance to 1  P075732, approved by the Board on Jul. 05, 2005 and closed on Mar. 31, 2015. The DFV continues to operate under Shanghai infrastructure projects in small towns and provide a APL3 (P096923, approved by the Board on Jun.25, 2009 and conceptual financial engineering design to the IFF. planned to close on Jun.30, 2017). 4 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS China’s System of Municipal Financing and Its Evolution 2.1 The Basic Fiscal Finance System While decentralization was essential in providing The basic system governing subnational and mu- flexibility and incentives to local governments to de- nicipal finance was established by the landmark velop their infrastructure needs, it has left a major Tax Sharing System (TSS) reform in 1994 and has fiscal revenue gap. The system is asymmetrical in generally stayed the same until it was amended in the assignment of fiscal revenue and expenditures. August 2014. The TSS broadly defines the responsi- The gap between municipal budgetary revenues bilities of the central and subnational governments. and expenditures has widened over time. The ratio Urban development is considered a local concern, of subnational revenues remains slightly less than and municipal governments assume primary 50 percent of total government budgetary revenue, responsibility—­ both functional and fiscal—­ for it. while the ratio of subnational expenditures has The responsibilities of the national government are risen as high as 80 percent of the total expenditures limited to the review and approval of urban master (Figure 1). plans and large urban infrastructure investment 2.1.1 Closing the Financing Gap projects, setting technical standards and policy guidance, promoting knowledge exchange, and Land Based Financing. For Chinese municipal facilitating capacity building and access to interna- governments, extra funds are needed to close the tional financing. financing gap between municipal budgetary rev- SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 5 enues and investments on urban infrastructure. tions that local governments capitalize by providing Land asset-­based revenues have played this func- them with land use rights, cash, and shares in state-­ tion in the past decades and have become a major owned enterprises. UDICs are treated as municipal source of funding for Chinese sub-­ sovereigns. state-­owned enterprises (SOEs) under China’s Com- Figure 2 shows the source of revenues used to fund pany Law. The UDICs mobilize financing for urban infrastructure development, where the land infrastructure investment via loans from banks and lease revenues account for 40 percent of revenues used to fund urban infrastructure. This percent- age is much higher in small towns and could reach FIGURE 2. Revenues Used to 70 percent of all revenues. Fund Urban Infrastructure Billion RMB Urban Development Investment Corporation (UDIC) Borrowing. In China, until the Budget Law 1500 Water Resource Fee was amended in 2014, subnational governments Land Transfer Revenue were not allowed to borrow from banks and other Other Revenues financial institutions or to issue bonds. They have 1250 User Fee/Fee for Use of gotten around this restriction in the past through Municipal Utilties the establishment of UDICs—­ municipal corpora- Fee for Expansion of Municipal Utilities Capacity 1000 Extra-charges for FIGURE 1. Expenditure and Revenue Public Utilities Percentage of Local Governments out of Total Urban Maintenance and Government Expenditure and Revenues Construction Tax Percent 750 Local Government General Budget 100 Central Government X (horizontal) axis General Budget Y (vertical) axis 90 Subnational expenditure 500 percentage Axis Header 80 70 250 60 Subnational revenue percentage 50 Figure 1 1990 1995 2000 2005 2010 2015 40 30 Source: China Urban Construction Statistic Yearbook. 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014 Note: Since 2013, “water resource fee” and “municipal special allocated budget” (which was an important part of the local gov- Source: World Bank and the Development Research Center of the ernment general budget before) were dropped from China Urban State Council of China (2014). Construction Statistic Yearbook due to change in methodology. 1,200 User Fee/Fee for Use of Municipal Utilties Fee for Expansion of 6 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS Municipal Utilities Capacity 1,000 Extra-charges for Public Utilities Urban Maintenance and Construction Tax the “shadow” banking system based on their land In800 light of these implicit and explicit guaran- Local Government use rights and future revenue from land develop- tees, banks are willing to lend General to UDICs whose Budget ment projects as security (World Bank, 2012).2 is linked creditworthiness Central with the related local Government government. Aside from borrowing General Budgetfrom banks, fi- The purpose, structure, and capacity of UDICs 600 nancing channels of UDICs also include mid-­ term differ widely across subnational governments notes, trust products, and enterprise bonds3. The (SNGs) in China. Many UDICs manage municipal enterprise bond is also widely known as “UDIC investment and maintenance operations in multi- bond” (Chentou zhai ). The scale of UDIC bonds ple sectors, such as in transport, power, and water 400 bourgeoned in 2009 and to a large extent replaced supply, beyond serving as financing platforms. Some bank loans in the period 2009 -­2014 due to stricter UDICs function as purely financing platforms and controls on banks’ lending to UDICs (Figure 3). do not undertake any revenue-­ generating activity. Some other UDICs have mixed public and com- China’s 200 system of municipal finance and gover- mercial business activities. nance has delivered and kept pace with a period 3  It is worth noting that UDICs’ borrowing is not limited to projects without cash flows (i.e., public goods/services). It can also support the company’s commercial/for-­ profit projects (e.g., real 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 China’s system of municipal estate). More often than not, UDICs will pack public and com- mercial projects together, forming a kind of cross-­ subsidization, finance and governance has to attain financing. delivered and kept pace with a FIGURE 3. The Annual Amount of UDIC Bond Issuance period of urban development Billion RMB unprecedented in history. 2,500 However, a consensus has 2,000 emerged that the current system is unsustainable over the long term. 1,500 1000 UDICs are able to obtain financing from commer- cial and/or policy banks for urban infrastructure 500 investments, some with revenue flows (such as toll roads) and others without (such as urban streets). 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 UDICs represent a large stream of business to com- mercial and policy banks; municipal governments Source: China Urban Construction Statistic Yearbook; WIND Data. are assumed to provide implicit guarantees, and collateral is offered in the form of land. Note: Authorities eased the control of UDIC bonds in later 2015 with the consideration that UDICs were still the main source of urban infrastructure finance for most local governments. Since No - 2  Some UDICs have also issued bonds on their balance sheet. vember 2016, regulation of local debt strengthened again, and it is See also footnote 4. projected that UDIC bonds in 2017 would slow down and return to the level slightly lower than 2015. 2013 SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 7 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 of urban development unprecedented in history. by the National People’s Congress, and it became However, a consensus has emerged that the current effective on January 1, 2015. The Amendment aims system is unsustainable over the long term. Rely- to legal constraints on government income and put RMB Billion ing on off-­budget funds such as land concessions spending, a move that is set to have a far-­ reaching 2,500 is not sustainable as the rate of urban expansion effect on the country’s fiscal balance and health. The cannot continue indefinitely. The rapid expansion revised law requires that all types of fiscal money of UDIC borrowing—­ especially since the global fi- should 2,000 be put under the unified budgetary system, nancial crisis of 2008—­ has also triggered concerns. and detailed budget information, including that of The rapid growth of UDIC borrowing has pushed the central government, the local governments and up land prices to levels that are likely unsustain- government 1,500 departments, must be open to public able in the longer term and has created conditions supervision and scrutiny. Another ramification of that could undermine the viability of many UDICs. the revision of the budget law is its clear control 1000 Of particular concern is the maturity mismatch of of government debt issuance. It starts to allow the UDIC borrowing. Infrastructure projects normally local governments to issue debt themselves, and the require long repayment periods to generate the rev- issuance 500 must be put under strict control by the leg- enues needed for their capital costs. Unfortunately, islature and the central government. the UDICs have relied on short-­ term financing 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 from banks and non-­ bank financial institutions issuing tap was turned on by the Since the debt-­ (the so-­called “shadow banking system”.)4 As is Amendment, an impending task is to clear the large highlighted in Figure 4, according to the audit of amounts of government financing vehicles and cut local governments’ debt carried out by the National Audit Office in 2013, 73 percent of total local gov- ernment debt was due to be paid off in less than 5 FIGURE 4. Repayment Schedule of Local years. This will be a serious challenge in that most Government Debt (as of June 2013) of the debt was used to finance long-­ term infra- structure projects (HSBC, 2014). The government recognizes the risks in implicit 2013 guarantees, as well as the maturity mismatch exist- 2018 18% ing in the system, and has taken significant steps and beyond and reforms to introduce alternative means of 26% infrastructure financing with proper credit risk al- location, as discussed below. 2014 2017 20% 8% 2.2 Recent Subnational Financing Reform in China 2016 2015 2.2.1 Budget Law Amendment 11% 17% On August 31, 2014, the Amendment of the Budget Law of the People’s Republic of China was passed Source: National Audit Office (2013); HSBC (2014). 4  The primary “shadow banking” sources used by the UDICs are wealth management products sold to retail customers, trust loans sold to high-net-worth investors and entrusted loans from large companies. See McKinsey & Company (2015). 8 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS the links between the local governments and such special local government debt. Local governments companies. In October, 2014, China’s State Council can apply to issue bonds to replace existing debt published the Guideline to Strengthen the Supervi- to lower interest payments and lengthen debt dura- sion and Management of Debts Incurred by Local tion. Local governments should also work to pay Governments (No. 43, 2014). The State Council down such debt, including via local asset disposals. required the establishment of an integrated man- agement mechanism for local governments’ debts to Based on the 2014 State Council Document No. 43, cover borrowing, use of funds, and repayment. Ac- the current local government finance vehicles are cording to this new guideline, governments of the separated from local government functions, and 32 provincial-­level regions are allowed to borrow the UDICs without financial revenues are closed. within a quota set by the State Council. The quota Debt borrowed by enterprises and institutions for needs to be approved by the National People’s Con- which local governments are not liable should be gress or its standing committee. Prefecture-­ level fi nanced) according to market rules, paid (and re-­ and county-­level governments can commission the having access to credit from commercial banks and provincial governments to borrow, if necessary. to the corporate bond markets. The guideline also requires that local governments no longer borrow money through UDICs or other Therefore, it is expected that the municipalities corporate channels. fi nancing of urban will have two channels for debt-­ infrastructure in the near future (see Table 1): A significant portion of the proceeds of such bond one is local government bonds through the pro- issuances are passed down to lower levels of govern- vincial governments, and the other is corporate ment to meet their infrastructure financing needs. bonds or commercial bank loans borrowed by This source of financing is of special importance in revenue-­earning utilities and infrastructure ser- that it supplements other forms of budgetary rev- vice providers. enue that can be used to finance projects that do not generate revenue from local user fees (Moody’s, In addition, local governments are encouraged to 2015). The provincial-­ level bond issuers expect the attract private sector/social capital for infrastruc- lower levels of local governments to repay, with in- ture development. This could be achieved through terest, the funds passed down to them. This will (i) public-­private partnership (PPP) arrange- then provide the provincial-­ level borrowers with ments with the private sector and (ii) establishing the funds they need to repay their bonds. Since the a government-­ owned enterprise for service provi- provincial-­ level governments can withhold normal sion, or converting an existing UDIC with revenue budgetary allocations to lower level governments from public service provision into a utility service/ if they fail to meet their payment obligations, they infrastructure company. The enterprises/special are in a very strong position to ensure that these purpose companies (both private and public) can payments are made. borrow from the market based on revenues from users and other operating revenues. If there are Following the new guideline, the Disposal Method shortfalls in revenues, the sponsoring local gov- of the Stock of Local Government Debt (2015, ernment can provide a pre-­ determined subsidy No.32) issued by the Ministry of Finance gives from the budget. In this regard, local governments more details on how to deal with the flow and stock would enter into concession contracts or service of local government debt. Debt borrowed by local agreements with the service providers and provide governments and agencies, or payable by local availability payment (or a similar form of operating governments, should be categorized as general or subsidy) during the service operation period. The SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 9 TABLE 1. Urban Infrastructure Debt-Finance Channels under the New Budget Law INFRASTRUCTURE UNDER THE MUNICIPAL GOVERNMENT RESPONSIBILITY INFRASTRUCTURE UNDER LOCAL UTILITY AND WITHOUT REVENUES WITH REVENUES INFRASTRUCTURE COMPANIES—ALL WITH REVENUES Corporate bonds Commercial bank loans General obligation bonds Revenue bonds Revenue-based Project Finance PPP Source: Authors’ own elaboration. service provider would be responsible for raising As of the end of March 2016, the National PPP the initial financing and would repay the loans from Information Platform Project Database had 7,721 operating revenue and/or government subsidies. projects (a total investment of RMB 8.78 trillion Projects are expected to be bankable with contract yuan), including 232 MoF demonstration projects terms, tariffs, and subsidies agreed between the (a total investment of RMB 803.5 billion yuan). De- sponsoring government and service provider. The spite the strong enthusiasm from local governments subsidy would be reflected in the annual local gov- on PPP, actual transactions that have reached fi- ernment budget, but there will be no government nancial close or implementation are few. Of the 232 guarantee for loan repayment. MoF demonstration projects announced in 2015, only 73 were under implementation (32 percent), 2.3 Other Recent Innovations in while 24 projects were still under identification, 93 Infrastructure Financing were under preparation, and 42 were under pro- 2.3.1 Public Private Partnerships curement (18 percent). The budgetary resources available to local gov- For the larger PPP projects in the PPP Center data- ernments, even with additional financing from base, the actual implementation progress was even provincial bond revenue sharing, is insufficient to slower. As of the end of March 2016, of the 7,721 local government needs for new infrastructure, as projects in the database, 1,051 projects were under well as the ongoing TABLE1 capital expenditures (BASIC). necessary This is table style Table1 with NO local paragraph, preparation, 277 were under procurement, and existing infrastructure. for upgrading character, Thus, or cell styles applied. local alternating Standard only 369 fill is 20% were under implementation (5 percent). governments still face a significant infrastructure DUMMY TABLE DUMMY TABLE DUMMY TABLE financing gap. One way that the Government of There are a variety of reasons why private sector China plans to Dummy gap is using Dummy Table fill this PPPs. Table Dummy Table up-­take has been low in the China PPP space, in- Dummy Table Dummy Table Dummy Table cluding still ambiguous/developing regulations and Dummy Table In late 2014 China’s State Council Dummy Table released an Dummy Table enforcement and arbitration rules; lack of credibil- investment and financing Source: guideline Looks like this. which empha- ity of local governments in contract enforcement, sized the significance of PPPs in mobilizing private incentives of local governments, local governments capital. The renewed 1. In any emphasis case where PPPsapply on cells gave tolocal multiple-entry subsequent unwillingness I locally cells, up to open ap- projects to profitable governments thepliedopportunity for continued financ cell style “Table1_Body - Cell, Centered Vertically. private sector, difficulty for privately owned en- ing their infrastructure investment needs at a time terprises to obtain finance, and entrenched and 2. In to when their access off-­ any balance case wheresheet borrowing a special left-column cell seemed powerful applicable, I locally ap- SOEs. through the UDICs being wasstyle plied cell curtailed. Cell, Centered Vertically. “Table1_Body 10 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS 2.3.2 Infrastructure Funds Infrastructure funds are still incipient products Infrastructure equity funds are starting to prolif- but could potentially develop into an unstable and erate in China to engage local governments and opaque financing vehicle unless improved regu- UDICs in infrastructure financing, including PPP lations are established There is a danger that the projects. These structures do not have clear super- infrastructure funds being promoted in China may visory and regulatory frameworks. However, they create unintended consequences if they are too pass appear to be designed to make it possible to by-­ broadly used to by-­ pass restrictions on UDIC’s fi- restrictions established by the central government, nancing of municipal projects. Infrastructure funds including borrowing through bond/loan instru- will not likely lead to greater transparency in munic- ments, which the funds circumvent by agreeing on ipal financing and may delay the process of moving a buy-­back date and fixed coupon and price on the municipal financing into the capital markets. equity investments of the fund. SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 11 Small Town Infrastructure Development and Finance in China 3.1 The Role of Small Towns Addressing poverty in small towns is critical for in China’s Urbanization achieving China’s 13th Five Year Plan develop- Small towns are an integral part of China’s urban ment goals, as well as the World Bank’s twin goals system. China’s urban hierarchy consists of cities of ending extreme poverty and promoting shared (municipalities) and towns at four administrative prosperity. Empirical evidence shows that income levels below the central government: provincial-­ (and poverty rates) is significantly lower (and higher) level cities, prefecture-­ level cities, county-­ level in small towns than big cities (Ferré et al, 2012). cities (district/county), and “small towns” (village/ In China, the per capita incomes of small towns township). The so-­ called small towns comprise of around major cities, such as Beijing and Shanghai, all administratively designated towns (ADTs), in- are often much lower than in cities in low-­ income cluding those that serve as the county seat. This central provinces. For example, Chicheng County, hierarchy corresponds to the government hierarchy. located near Beijing municipality, had an urban household income per capita of RMB 12,726 in The number of small towns has remained relatively 2010, while Chengdu, a big city in the West, had stable over the last ten years, despite small changes RMB 20,835. Other international data also con- due to mergers into larger cities or consolidation firms the income disparities between small towns with nearby towns. According to official statistics and big cities. In India, for example, among urban from National Statistics Bureau, in 2005 there were areas, the poverty rate in small towns (population 20,986 small towns, of which 1,464 were county seats less than 50,000) was double the rate in large towns and 19,522 other ADTs; in 2014 there were 21,826 with a population of 1 million or more (30 percent small towns, of which 1,425 were county seats and to 15 percent). In Vietnam, the 634 smallest towns, 20,401 other ADTs. The number of county seats has with an average population of about 10,000, are been declining slowly, mainly due to the fact that home to more than 55 percent of the urban poor some suburban counties under the prefecture-­or (Lanjouw & Marra, 2012). Small towns can play an provincial-­level municipalities are converted into important role in reducing poverty in peri-­ urban a district of the municipality as a result of urban areas if policies that nurture economic activity and built-­ up area expansion. As the data over the last improve residents’ access to basic services and jobs ten years indicates, small towns continue to be an important component of China’s urban system de- spite rapid urbanization and metropolitan growth. The total population living in small towns is gen- Addressing poverty in small towns erally believed to be over 200 million, accounting for at least 15 percent of the national population. is critical for achieving China’s 13th The total population living in town districts—­ the Five Year Plan development goals, urban core of towns—­ reached 312 million in 2014, accounting for about 42 percent of China’s urban as well as the World Bank’s twin population and 23 percent of the national popula- tion (Campanaro & Masic, 2017). goals of ending extreme poverty and promoting shared prosperity. 12 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS are implemented. Policies that improve service de- In reality, small towns do have specific roles to livery and foster non-­agricultural job creation in play in the urban system and urbanization pro- small towns and peri-­ urban areas can offer rural cess. First, many small towns can serve as a nodal migrants better livelihoods, thus helping to reduce point between urban and rural areas for the flows both urban and rural poverty. In countries where of goods and materials going to the rural areas. population density is high in smaller towns, such Second, they can serve as the first level of ur- as China, the scale economies may be sufficiently banized areas that provide public services to the large enough to make service delivery, including in- surrounding rural areas, such as schools and health effective (World frastructure related services, cost-­ clinics. Many migrant workers purchase homes in Bank, 2013). small towns near their countryside for their left-­ behind children and elderlies. Third, small towns Small towns have long been expected to play a are increasingly becoming the home of many rural buffer role in China’s urbanization management households who no longer engage in farming. Most policy. Policy makers and city planners have long recently, the government promotes targeted inter- attempted to have small towns serve as a buffer for ventions to protect and improve the small towns rural-­ urban migration, through policy interven- to-­ with unique values of long history, cultural heri- tions. The expectation is that some migrants can be tage, and environment amenities. absorbed by the small towns instead of jamming to the larger cities. This policy has never been success- From a socio-­ economic standpoint, small towns ful for various reasons. The most significant reason will continue to hold their place in the function- is that urban employment prospect in small towns ing of China’s urban system. Despite the general is not as attractive as that of larger cities. Another trends of urbanization toward larger cities, there is key reason is that the urban services provided by no obvious reason that small towns will decline in small towns are generally much less desirable. the future. They offer attractive features, such as SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 13 low cost of living, slow pace of lifestyle, quiet living China. This effort is expected to influence the fur- environment, better air quality, in most cases, and ther development of small towns. proximity to rural areas that appeal to certain groups of households, especially the rural house- 3.2 Current Status of Infrastructure holds leaving the farmland from the surrounding Development in Small Towns areas. Some of the small towns may attract urban Infrastructure development in small towns lags households that seek a quiet, less crowded lifestyle. considerably behind cities. Nation-­ w ide data on Therefore, the majority of small towns will continue the levels of infrastructure services across small to exist and to be viable for the foreseeable future. towns is not available. However, some available local data and anecdotal evidence shows that in- Moreover, small town development is considered frastructure services in small towns are generally an important component of China’s New Urban- inadequate and of poorer quality than the national ization Strategy. The Decision on Major Issues average. In 2014, for example, the average per Concerning Comprehensively Deepening Reforms capita investment for basic urban infrastructure issued by the government in November 2013 called in Shaanxi Province’s small cities and towns was for the relaxation of household registration control only 68 percent of the national level. The percent- of farmers settling in towns and small cities. Thus, age of population with access to water supply, road small towns were expected to play an important space per resident, and length of drainage pipes role in becoming settlements for the newly urban- per square kilometer of built-­up area were respec- ized population. The 13th National Economic and tively 89, 74 and 67 percent of the national average. Social Development Five-­ Year Plan called for effort Operations and maintenance expenditures were to encourage in-­ situ urbanization of 100 million minimal (World Bank, 2014). According to a study rural population especially in central and western by World Bank (2012), in 2009, the gas coverage rate was 91 percent in cities but only 62 percent 14 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS for county towns; for wastewater treatment, the fiscal transfers, land sale revenues, bank loans, and coverage rate was 75 percent in cities but only 42 self-­raised funds (mainly charges) for infrastructure percent for county towns; and water coverage rate financing. Also, similar to the approach commonly was 96 percent in cities as compared to 84 percent adopted by cities, debt financing by small towns in county towns. The lower level of urban infra- has primarily been taking place through UDICs. structure services in small towns is not a surprising While almost all cities have created their own phenomenon. All around the developing world, UDICs for borrowing commercial loans with land small towns generally have poorer infrastructure as collateral, only a small number of better-­ off services mainly because of their poorer economic small towns have the capacity and development status, although towns enjoy better infrastructure potential to do so. services than rural villages. Urban development potential of small towns varies Inadequate infrastructure services in small towns significantly across China. Small towns with urban are mainly due to inadequate public investment for development potential are mainly those located in infrastructure. According to the World Bank (2012) the more affluent eastern region of China or within study, investments and public resources had been major urban areas. For example, small towns in mostly directed to the highly urbanized big cities, the Shanghai Municipality region provide land for leaving the less urbanized towns underfunded. industrial and urban development to the rapidly expanding urban areas. Some small towns in the provinces of Jiangsu, Zhejiang, Fujian, and Guang- dong have better fiscal and financial capacity than some county-­ level cities in level or even prefecture-­ Infrastructure development the less developed western provinces. Unlike cities, in small towns lags small towns lack administrative status and face higher hurdles to access commercial bank loans. considerably behind cities. 3.4 Constraints in Small Town Infrastructure Finance The sustainability of traditional small town infra- Towns received a mere 9 percent of total fixed asset structure finance can be measured in different ways. investment. Unbalanced allocation of fixed asset The credit rating of a sub-­ national government investments that favor cities over towns had led to national gov- represents a formal opinion of the sub-­ disparities in the level of infrastructure and quality ernment’s capacity and willingness to repay debt in of municipal services. The socio-­ economic potential time. The commonly practiced rating analysis is of small towns has been constrained by underdevel- a matrix of political, economic, budgetary, finan- oped infrastructure and sub-­ optimal provision of cial, and institutional variables deemed relevant to public services as compared to larger cities. the sub-­national government’s creditworthiness. In general, the sustainability of Chinese local gov- 3.3 Current Practices of Small Town ernment debts is dubious if being judged by these Infrastructure Financing measurements. The sustainability of small town In general, small towns have very limited capacity government debts would be more dubious. to raise funds for infrastructure investment proj- ects. Similar to larger cities, small towns rely on SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 15 Small towns face several constraints on their cred- without a robust revenue from users or the ad- itworthiness as they lack the ability to adjust both equate fiscal space to support the project, projects revenue and expenditure. In China’s vertical fiscal in small towns are likely to elicit limited private system, the lower the level of government is the less sector interest. fiscal autonomy it has. The financial resources of China’s small town government are limited, and most township governments do not have independent budget. The China’s National Audit Office released the audit result of 54 counties in 2012 and found that In general, small towns have very 49 percent of counties’ public expenditure relied on upper government transfers. In 45 western counties, limited capacity to raise funds for the share of transfer was 62 percent. And only three infrastructure investment projects. counties had primary budgetary surplus to meet the needs of public expenditure (NAO, 2012). Over the last ten years, many third-­t ier and fourth-­ 3.5 A Case for Specialized Financial tier municipalities have excessively developed land Intermediaries for Small Town for overly ambitious real estate development. As a Infrastructure Development result, housing supply in some of these cities is al- The Amended Budget Law gives local governments ready in excess of demand. Without continuing real limited rights to issue bonds for infrastructure in- estate development, land-­ based financing will not vestment. This does not apply to the level of small work. Without land-­ based financing, these cities towns. Nowadays, the State Council allows only will not be able to borrow. provincial level governments to issue bonds, al- though it is anticipated some of the bond proceeds With the cooling down of the real estate market are expected to go to lower level governments. It is and consequentially of land markets, many cities reasonable to expect some conflicting priorities in would find little fiscal space for borrowing. There such as the provincial governments have their own is no attractive alternative source of municipal fi- infrastructure investment priorities which they may nance. Property tax has not yet been introduced. wish to finance through government bonds, thus The central government is in the process of draft- leaving little room for municipalities to get a share ing the first national property tax law. It may take of the bond tranches under the limit set by the State possibly some years before the law is passed by the Council. There are a total of 661 municipalities in National People’s Congress. It would take a few China, of which 4 are at the provincial rank, 282 more years for cities to establish a workable prop- at the prefectural rank, and 375 at the county level. erty tax assessment and administration capacity. For most municipalities and all small towns, local Therefore, it is fair to expect that property tax will government bonds will be most likely beyond their not become a major source of municipal finance in reach for at least the next few years. the foreseeable in China. While the amended Budget Law is a step forward The Ministry of Finance has been actively promot- in terms of allowing local governments to access the ing public-­ private partnership in infrastructure capital market directly, it does not allow local gov- financing even at the local level. Most provincial ernments to borrow from commercial banks and governments respond by coming up with a long other financial institutions. The chance for small list of projects offered for PPP financing. However, 16 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS town governments to access capital markets could projects that cannot be structured in a way that fits be close to zero. Therefore, small town govern- the PPP structure. Therefore, other channels for fi- ments will remain unserved by the capital market earning nancing infrastructure for smaller revenue-­ for many years to come if no reform action is taken. projects need to be explored. At the same time, the amended Budget Law has Specialized financial intermediaries may offer an closed the door for local governments to borrow alternative source of debt-­fi nancing for the util- from other financial institutions through their fi- ity and infrastructure service companies of small nancing platforms. It can be expected that many towns and municipalities. Some utility companies municipal governments and all small town govern- may not operate in full cost recovery and thus ments will not have access to other debt-­ fi nance require government subsidy support. Their borrow- unless further amendment is made to relax the ing from IFF would still be possible if they receive strict control. Their infrastructure financing needs stable government subsidies to cover the deficits. will be largely unserved by the financial sector or they will rely on risky shadow banking system. Instead of waiting for further amendments of the Budget Law, it would make sense to explore alter- The pass through of funds from provincial-­ level financing for small-­ native debt-­ town governments bond issuances are to be used to finance public through a pilot experiment of IFF in a carefully projects that generate insufficient revenue to cover selected province. IFFs can serve the public utility all their capital costs. The PPP approach is useful companies of small towns. It would require a special for larger projects but will not likely provide a viable endorsement from a relevant competent authority approach for the financing of smaller projects or to experiment with IFF for small town government. SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 17 There are several preconditions and considerations OO Better functioning bond markets would gener- that would need to be taken into account in the ally be needed (e.g., liquidity, pricing, market planned shift to bond market financing. The stated segmentation, long term government bond yield rationale for the shift is that bond markets allow curve, etc.); transparency and accountability that is not so easy to achieve under bank lending or UDIC-­ based fi- OO Reliable regulatory structures for new fixed-­ nancing. It is not clear, yet, if all the implications of income market structures would need to be this measure have been considered, including the developed (e.g., project finance and securitiza- pace of this change. Preconditions and consider- tion frameworks); ations related to bond market development more broadly that would need to be discussed include OO Not all infrastructure can be financed through the following: bond markets in a cost-­effective way (e.g., bank loans may be more suitable for financing the OO There is not a long-­ term finance market, nor construction phase of many infrastructure proj- on the side of investors, instruments or overall ects); and framework; OO Lingering tax and regulatory framework that OO There is too much guidance on direct issuance favors hold to maturity rather than secondary on municipal debt (e.g., established maturity market trading for banks and other bond holders. structure and caps on maximum rates); 18 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS Proposed Infrastructure Financing Facilities (IFFs) Since local governments in China need long-­ term, In order to promote the ability of small-­ town gov- low-­cost financing, it would be most suitable if they ernments to obtain financing for infrastructure had access to long-­ term institutional investors, projects from financial markets, specialized finan- such as pension funds and life insurance compa- cial intermediaries (or infrastructure financing nies. However, obtaining low-­ cost bond financing facility, IFF) could be established to channel long-­ requires that bonds be highly rated and issued term financing to infrastructure projects in small at a scale and frequency that will generate ready towns. Many developed countries adopt the prac- demand for the bonds based on their liquidity and tice of specialized financial intermediation for small creditworthiness. According to international expe- town’s debt financing. Different countries adopted rience, capital markets are more suitable for large different types of structures and institutions for and medium-­ sized cities, less so for small cities and the same purpose of linking projects (or groups of towns. Small towns are faced with the problem that projects) to the markets, such as bond banks, infra- individually their financing needs are too small, structure funds, and regional development funds. their stand-­alone credit-­ worthiness too weak, and Examples include local government financial inter- their expertise too limited to allow them to do so mediaries in Belgium, Finland, France, Spain, and on their own. Sweden; municipal finance corporations in Canada (mostly provincial agencies operating at the provin- SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 19 cial level)5; and municipal bond banks in the USA ing would be crucial. See chapter 9 for an analysis (state instrumentalities operating at the state level)6. of the key regulatory barriers. In current market conditions in China, there is likely 4.1 Structure of IFFs to be a strong demand for low-­ r isk government or The focus of an IFF7 is the financing of small mu- quasi-­government instruments. A pooling vehicle nicipal projects. By combining small town, SOEs, would be able to satisfy such demand by issuing utility or project borrowings into larger “pools”, bonds into the capital markets and on-­ lending the IFFs can achieve various economies of scale.8 IFFs proceeds to participating small local governments. issue large bonds on a regular basis and with stan- Such instruments could provide critically needed dard documentation. This makes the bonds more diversification opportunities to institutional inves- marketable, attracting more bidders, and thus tors, many of which may have investment portfolios lowering the cost of debt. Underwriting, listing, that are excessively concentrated on national gov- and rating agency expenses are also less than they ernment securities. IFFs will normally issue bonds would be if each pool member issued bonds on their with longer tenures than most corporate debt, own. Additional advantages can be achieved due to which can be an additional feature attractive to scale and knowledge of the capital markets as well portfolio managers who are attempting to do asset-­ as credit rating arbitrage. The latter allows lending liability management of their portfolios. funds obtained using their better credit rating to more poorly rated members. Finally, pooling brings There are no clear rules that prohibit or restrict the a reduction in risk through portfolio diversification establishment of special financial intermediaries in and structuring. China, but the introduction of specialized financial intermediaries for small towns must be synchro- Various forms of such facilities have been developed nized with the changes in the Amended Budget in a number of countries and they have proven to Law and other related regulations, particularly for be efficient in providing bond market access for what relates to an on-­lending licensing, capacity to small public bodies or revenue-­ earning projects. issue debt, and an adequate prudential supervision. IFFs allow the issuances of bonds, which would Additionally, fiscal and financial reforms address- in turn be on-­ lent to individual, small borrowers ing and guiding small towns in debt management collectively rather than individually. An IFF is typi- practices as well as financial management report- cally structured as is shown in Figure 5. 4.2 Key components of an IFF 5  In Canada there are several bond banks that operate at the provincial level. (In Canada these are referred to as municipal IFF SPV: A Special Purpose Vehicle (SPV) is cre- finance corporations.) All of these but one have their debts guar- anteed of their provincial governments. They were established ated to borrow, usually in the bond market to by the provincial governments, which retain the control and resultant benefit of their consolidated borrowing efforts. The ex- ception is the Municipal Finance Authority of British Columbia 7  The term “infrastructure financing facility” is used here to (MFA), which was established in 1970. The MFA’s debt is not denote any form of specialized financial intermediary used to guaranteed by the provincial government of British Columbia finance infrastructure. -­rather all borrowing has a “ joint & several” payment obligation from the MFA’s members, in effect guaranteeing that all debts 8  A study for the US compares the results of bond bank issues undertaken by the MFA have the full backing of every unit of from Maine, Indiana, and Illinois in 1999 to a sample of issues local government in the province. It is this type of IFF that is sold throughout the country (but not by bond banks) during discussed here. the same period. On average, two of these programs appear to borrow at costs significantly lower than the national average (32 6  For examples of these see FMDV (2015). Also see Council of basis points for Maine, 58 basis points for Illinois). See Robbins Infrastructure Financing Authorities (1997). & Kim (2003). 20 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS FIGURE 5. Structure of an IFF Equity investors Capital Member municipalities National government DFIs Non/For-profits investors IFF SPV Bond financing TA Loan lending Debt servicing Capital markets Borrowers Repayment Pool Member municipalities Utility companies Projects carried out by the private sector to provide services to a municipality (usually under a concession aggreement or PPP) and that are financed on a non-recourse basis (i.e., debt servicing comes from project revenues) Outsource functions to Projects or companies that provide services to the municipality and borrow on their private sector own balance sheet but also have some financial support from the municipality Source: Authors’ own elaboration. on-­ lend to municipalities/utilities/projects. The The utilities companies and projects can borrow legal structure uses various entity nature (e.g., cor- with their own revenues or together with govern- poration, government agency, non-­ deposit financial ment guarantees if necessary. institution). The IFF then lends the funds that it Equity investors has raised to finance infrastructure benefiting the Equity Investors: The IFF is established with members of the pool. The IFF repays its debt pri- initial equity by its owners. The equity is used to Capital Member municipalities National government DFIs Non/For-profits investors marily using the debt service charges on its loans to cover startup expenses and for capital reserves. The its sub-­borrowers. However, the facility would also equity investors often include public bodies (e.g., SPVits own equity IFF and use reserves, liquidity facilities, Bond financing national/regional governments or development to make sure that such repayments are made on a finance institutions or non-­ profit organizations) TA Loan lending Debt servicing timely basis and in full. and private investors who a financial return expect markets Capital from equity investments in the IFF. Equity invest- Borrowers Repayment Borrowers: The borrowers are the municipalities, ments can be both paid-­ in and contingent. In some utility companies, or projects. Municipal borrow- cases, the borrowing municipalities also provide Member municipalities Utility companies ing is usually in thePool form of “general obligation” equity and are part of the shareholding structure. the municipality borrowing in whichProjects the private to carried out by commits sector to provide services to a municipality (usually under using all its financial to repay or resources agreement a concession the loans. PPP) and that are financed on a non-recourse basis (i.e. debt servicing comes from project revenues) Outsource functions to Projects or companies that provide services to the municipality and borrow on their own private balance sheet but also have some financial support from municipality sector SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 21 4.3 Key Functions/Features of IFFs revenue streams or have adequate cash flows from An IFF would have four primary functions: fund the project to repay the loan. Borrowers include raising, lending, supporting liquidity and credit road development corporations with secured rev- quality, and providing advisory services. enues from tolls or fuel levy transfers, water utility companies that have adequate cost recovery (and/ Fund raising by IFF. The IFF would pool and or dedicated subsidy), and metro/bus companies. aggregate the borrowing needs of many small mu- Private sector developers that have PPP concession nicipalities or projects to create marketable-­ size agreements with a local government to develop bonds and issue such bonds into the capital markets and operate/maintain an infrastructure facility on a regular basis. The pooling can realize various or utility service would also be eligible to borrow economies of scale and reduce risks through port- from the IFF. In this regard, the IFF can serve folio diversification, which therefore allows smaller to promote the PPP agenda in China by making projects and municipalities to have wider access to longer-­term finance available to potential private finance at a lower cost. sector developers. An IFF needs to maintain a sufficiently high credit The IFF may also be used as a vehicle to assist rating to be able to issue long-­ term bonds with at- local governments to restructure and refinance tractive pricing. An IFF’s creditworthiness is built their “shadow banking” debt in the domestic upon that of equity investors and the underlying bond market to help reduce the risk of a local gov- projects it supports. It is essential that the IFF issue ernment credit crisis and contamination of the comprehensive and regular reports of its activities. banking system. IFF loans can include refinancing This means that an IFF needs to be highly trans- and restructuring of outstanding local government parent. IFF obligations are usually not guaranteed debt, in addition to providing new money for new by the national government or higher level sub-­ infrastructure investments. national governments. Supporting liquidity and credit quality. The liquid- lending to IFF borrowers. The funds raised by On-­ ity of the securities issued by an IFF is an important the IFF would be held by the entity for the purpose consideration, and it affects the appetite for, and of on-­lending to infrastructure projects based on pricing of, those products. IFF liquidity manage- their demand while maintaining adequate reserves ment would require sustaining sufficient volumes of to meet the IFF’s liquidity requirements and cov- ‘benchmark’ securities in the market. The implicit ering operating expenses. The IFF would provide assumption made is that the debt requirements of targeted debt products to finance infrastructure at the local government sector are large enough to cost-­ effective interest rates and with flexible terms. support a market for such debt instruments. The interest rates for on-­ lending from the IFF to its borrowers would need to have a margin that Moreover, adequate credit support arrangements reflects the cost of funds and return expectation would be required to satisfy the concerns of in- of the IFF to ensure that it can operate in a self-­ vestors around the ability of the IFF to meet its sustaining manner. liabilities over the short and long run. It is antici- pated that the IFF’s liabilities will be secured by The IFF would primarily lend to public service debentures providing a claim over its members’ utilities and infrastructure development corpora- local government general and project revenues. tions. Borrowers would need to commit specific Additional credit enhancement could come from partial credit guarantees for other tiers of govern- 22 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS ment or from Development Finance Institutions there should be potential for partial ownership and (DFIs) on specific loans made to the IFF’s members. a role in governance by higher-­ level governmental bodies and possibly the private sector, which will Providing advisory services. The IFF often pro- reduce the financial risks in terms of credit rating.9 vides advisory services and training to its members In China, IFF would be established by provincial in areas such as financial structuring of infrastruc- government to serve the needs of small towns. In ture projects, risk assessments, debt and liquidity the US, the lower-­ level government are sharehold- management, and a selection of financial products. ers in IFF-­ t ype institutions. This may be more This will be in the IFF’s own interests as it will complicated to apply in China given the adminis- benefit from improved budgetary discipline and fi- trative structure and may encounter political and nancial sustainability on the part of its members. practical challenges. It will also likely provide inside information on each municipality’s management capabilities and 9  More fundamental than ownership structure for governance is financial situation that will be useful for the IFF’s the integrity and independence of the IFF’s management, and the assessment of the municipality’s creditworthiness. transparency and accountability of its operations. The ownership structure must provide strong incentives for efficient management. Standard tools in corporate management are independent external 4.4 General IFF design Considerations audits that are publicly released, public reporting of audited ac- counts, and boards of directors that are independent of day-­ to-­day Accountability: Local governments in an IFF management and effectively oversee it. Another approach is to hire sector asset manager that reports to the bond bank’s gov- a private-­ should remain focused on managing their levels of erning board. Last, and very important, is the fact that the bond financial risk. Regardless of how it is capitalized, bank will itself be entering and reporting to the private capital the IFF should be accountable first and foremost market. Its securities will be rated and scrutinized by prospective bondholders. A good discussion of various ownership structures is to the participating government entities. However, provided in Peterson (2006a). SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 23 Regulatory and tax treatment:Another important as only after a critical mass is achieved can an IFF consideration is how the IFF’s securities will be become attractive for inward investors. This re- evaluated by banks (capital adequacy requirements quires stakeholders to access the facility for credit and their potential use as repo collateral) and other in a consistent manner. Securing sufficient initial institutional investors (portfolio restrictions and re- participation will be one of the major challenges to quirements). The tax treatments of IFF securities create an IFF. will affect their attractiveness to institutional inves- tors and thus their pricing. Clear legislation and Leverage: One of the key issues that needs to be regulation can help to solve these issues. However, considered in the design of an IFF’s financing this may be more difficult when there is private structure is the level of leverage that it will able to ownership of the IFF, which requires dividend pay- achieve. The primary consideration is the prob- ments or other forms of return. ability that the debt service payments received by the IFF from its loans will fully cover, on a timely No exclusivity obligation: Membership in the IFF basis, the scheduled debt service payments due by should not require an obligation to use the IFF the IFF on its outstanding bonds. The IFF also loans exclusively (as this may discourage partici- must have ready access to funds that can be used to pation and cause market distortion), and members cover debt service payment obligations on its own could retain the right to gain services and finance debt even if there are shortfalls in payments on the from other entities including banks. Some specific portfolio of loans to its members. While leverage infrastructure projects (especially PPP projects) is often measured by the total amount of funds the may be large enough and have sufficiently high IFF has borrowed relative to paid-­ in equity capi- credit. In this case, a municipality would benefit if tal, the actual calculation used by regulators and such projects are financed by issuing its own bonds rating agencies is more complicated. An IFF’s instead of going through the IFF. capital base (or “claims paying basis”) can consist of paid-­ in equity capital, contingent equity capital Some functions outsourced: IFFs often outsource (i.e., capital that will be made available by investors functions like payment collections and credit anal- as needed and under specific conditions), accumu- ysis to specialized private sector firms or other lated reserves from retained earnings, any “sinking government bodies both to obtain the necessary funds” it has established, grants from governments expertise and to reduce operating costs10. or non-­ profits, and funds that have been borrowed (or are available for borrowing) on a long-­ term Minimum level of participation: It is necessary to basis.11 In addition there will be funds available to require a minimum level of participation in an IFF 10  An important design question is which services will be provided by the bond bank’s permanent staff, and which will be procured by contract. Most bond banks in the United States have very small staffs. Many contract with private sector asset 11  Initially the New Zealand (Local Government Funding managers for day-­ day operations. Bond banks may approve to-­ Agency) LGFA had 45 million ordinary shares on issue, 20 mil- individual loans, but contract with commercial banks for loan lion of which remain uncalled. All ordinary shares rank equally origination and servicing. In such cases, the bond bank acts as with one vote attached to each ordinary share. It also uses an “apex bank” selling its own securities and using the proceeds Borrower Notes for financing—­ T hese are subordinate debt in- to purchase loans from originating banks. Banks may be paid a struments (which are required to be held by each local authority fee, or may markup the interest rate. The bond bank may also that borrows from LGFA in an amount equal to 1.6% of the ag- use the contract to share risk with originators, either through gregate borrowings by that local authority). LGFA may convert partial guarantees from the originating bank, or by having the borrower notes into redeemable shares if it has made calls for all originator retain a fractional interest in the individual loans unpaid capital to be paid in full and the LGFA Board determines (Peterson, 2006a). it is still at risk of imminent default. 24 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS the IFF on a short-­ term basis from various liquidity cash flow problems serious enough to cause debt facilities.12 See Figure 6 below. service problems. The role of the IFF, as a pooled financing structure, is to protect lenders to the IFF The amount of leverage that is prudent for an IFF from being affected by such cash flow problems. to operate depends on the frequency of expected Thus the IFF needs sufficient funds available to defaults in the pool of loans, expected losses in the meet all debt service deficiencies in its pool of loans event of defaults, and the duration of periods when to municipalities at all times. the IFF will have to replace or supplement debt service payments for portfolio loans. Very high le- In summary, the following factors are critical to the verage is possible if most debt servicing problems design of an IFF: are temporary, requiring the IFF to serve essen- providing temporary tially as a liquidity facility—­ OO The preferred IFF model needs to achieve lower “topping” up on debt service payments from mu- financing costs for its participants as compared nicipal projects. In most cases public infrastructure with the estimated current borrowing costs of projects, once they have completed construction town, local governments. most small-­ and been put into operation, should eventually be able to repay all capital expenditures and operating OO The preferred model does not require explicit expenditures. However, there may be temporary credit support from other tiers of government and is unlikely to require substantial legislative change. These are important factors in measuring 12  For example, Municipal Financing Authority of British Co- lumbia’s available liquidity to respond to temporary payment in- the costs (including time costs) and risks inherent terruptions included in 2014 a modest debt reserve fund of C$104 in the subsequent implementation process. million, C$2.5 billion from sinking fund set aside and unrestrict- ed retained earnings of C$40 million. The authority also had a C$200 million line of credit available. In total these exceeded its annual debt service obligations (Fitch Ratings, 2015). FIGURE 6. Determinants of IFF Leverage Contingent Paid-In Equity Equity Capital Capital Present Value of Expected Reserves Losses Long-Term from Loans Debt Retained and Earnings Guarantees Required Payments to Cover Defaults Liquidity Facility Source: Authors’ own elaboration. SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 25 OO The preferred model should contribute positively Kenya, Mexico and Colombia also provide some to promoting a culture of sustainable debt use. relevant lessons13. 4.5 Use of IFFs in Various Countries Table 2 lists some examples of existing IFFs in Pooled infrastructure financing facilities have the developed countries, which include a number been used in a number of OECD countries as well of highly rated facilities. In other countries where as developing countries. Examples include local they do not currently exist, notably Australia government financial intermediaries in Belgium, and the U.K., planning for such vehicles is rela- Finland, France, Spain and Sweden; municipal tively advanced. finance corporations in Canada (mostly provin- cial agencies operating at the provincial level); and The first pooled local government finance agency municipal bond banks in the USA (state instru- was found in Denmark in 1898. Kommunekredit is mentalities operating at the state level). Developing a cooperative society in which all Danish local au- countries such as India, Philippines, South Africa, thorities have voluntarily joined. The agency issues 13  See Bond et al (2012) and Platz (2009). TABLE 2. Examples of Existing IFFs NAME OF DATE OF CREDIT COUNTRY ORGANIZATION FORMATION MEMBERSHIP OWNERSHIP RATING* WEBSITE Denmark Kommunekredit 1898 All Danish local authori- 100% by local authorities Aaa/ www.kommunekredit.com ties AAA/- Netherlands Bank Nederlandse 1914 11 provinces and 406 50% by national govern- AAA www.bngbank.nl Gemeenten municipalities ment and 50% by local governments Norway Kommunalbanken 1926 All Norwegian municipali- 100% by national govern- Aaa/ www.kommunalbanken.no/en ties and counties ment AAA/- Canada Municipal Finance 1970 All districts and munici- Non-share capital Aaa/AAA/ www.mfa.bc.ca Authority of British palities in BC AAA Columbia United States Vermont Municipal Bond 1970 Most cities, towns, school Non-share capital AA+ www.vmbb.org Bank (this was the first systems, water and bond bank—a number of sewer districts, and other other states now have governmental entities in them) the state Sweden Kommuninvest 1986 90 % of all regional and 100% by local authorities Aaa/ www.kommuninvest.se/en local authorities AAA/- Finland Munifin 1990 303 municipalities 16% by national gov- Aaa/AA+/- www.munifin.fi ernment, 53% by municipalities, 31% by local government pension funds New Zealand Local Government Fund- 2011 30 local governments 11% by national government -/AA+/AA www.lgfa.co.nz ing Agency and remainder by partici- pating councils France Agence France Locale 2014 103 local governments 100% by local authorities Aa3 www.agence-france-locale.fr Source: Author’s own elaboration. *Moody’s/S&P/Fitch. 26 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS bonds in various capital markets and then on-­ lends A similar approach is followed by the New Zealand the proceeds to the local authorities. The bond issu- Local Government Funding Agency (LGFA) and ance is supported by a joint guarantee signed by the was adopted by the original Danish agency. This members, which has been in force since the creation model is interesting as it is based on mutual con- of Kommunekredit but has never been used. Now trol and co-­ g uarantee by its members. This latest the agency is dominating the local government model may not necessarily be the easiest to apply credits market in Denmark. Similar examples were in China due to the rich layering of administrative found in Nordic countries like Sweden. Nowadays, territorial entities and the difficulty that may ensue this is a model still widely adopted. For instance, from coordination. the newly set up French Local Agency (Agence France Locale) goes in the same direction. Bond banks were created in the U.S. for three dis- tinct purposes; first, to provide access to the capital In Canada, there are several bond banks that op- markets for small municipal governments, second, erate at the provincial level and are referred to as to reduce transaction costs through the pooling of municipal finance corporations. They were estab- projects and third to raise domestic debts at the lished by the provincial governments, which retain lowest possible cost to borrowers and hence taxpay- the control and resultant benefit of their consoli- ers. Complementing the bond banks are the State dated borrowing efforts. All of these but one has Revolving Funds (SRF’s) designed as the financing their debts guaranteed by their provincial govern- tools to assist local governments finance water and ments. The exception is the Municipal Finance sanitation by leveraging state grants with domestic Authority of British Columbia (MFA), which was debt. In the US model, there are no shareholders as established in 1970. The MFA’s borrowing has bond banks are created by state law to link capital a “ joint & several” payment obligation from the markets and smaller municipal projects. The key MFA’s members, in effect guaranteeing that all feature of the financing is the legal structure of the debts undertaken by the MFA have the full backing transaction and not the balance sheet of the issuer. of every unit of local government in the province. Different security structures have been developed for the more than 25 pooled lending programs in the United States. The attractiveness of this model, SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 27 for the Chinese situation is that the Bond banks are The World Bank has extensive experience in set- at the state level, allowing for regional differences, ting up and financing financial intermediaries, appropriate in a large federal country. Further, including those devoted to sub-­ nationals. The track the Bond Bank structure has some near-­ universal record has been mixed over the years, but overall features which are essential for the urban environ- the Independent Evaluation Group’s (IEG) special ment sector: the linkage they provide to long term study on the subject is positive. The Bank has fi- financing sources (insurance and pension) and the nanced IFFs led to stronger own-­ revenue flows by low-­cost loans made possible by a low capital base. the financed entities, better financial management, improved local information systems, and local The Tamil Nadu Urban Development Fund management of procurement. Weaker results were (TNUDF) was established in India as a Trust in found to be common in monitoring and evaluation, 1996, a legal structure that allowed borrowings operations and maintenance, leveraging private from markets and also increased in its own equity finance and poverty focus. All these areas can im- capital as the business demands grew. TNUDF dis- prove and yield better results. IFFs generally set up bursed around USD 100 million in its first three as wholesale mechanisms (thus serving many mu- years to around 120 local governments for envi- nicipalities) have had better outcomes than retail ronment and other infrastructures, with water and IFFs which served just a few (IEG, 2009). See fol- sanitation constituting a rising share of the port- lowing table some selected example with related folio. This trust, with little recourse to the capital, lesson. relied on credit enhancements of a debt service reserve fund and repayment from borrower’s taxes and fees. The success of TNUDF was facilitated by World Bank capital used for blending with local fi- nance and the set-­ up of a credit enhancement for debt issued by USAid. Infrastructure Finance Corporation Limited (INCA) is a private debt fund, and was created in South Africa after the new national govern- ment took over after the apartheid regime, as a consortium of major private sector banks with the objective to support the South African mu- nicipal bond market, and provide debt finance for local government units, parastatals and private companies involved in infrastructure. INCA is an example of open-­ access intermediary serving smaller municipalities, based on strict lending cri- teria. The significant points of differences with the DFV/ GUIFF situation are the legal framework for debt recovery, entity financing as opposed to fi- nancing concessions, and the pricing freedom that INCA enjoys. TABLE 3. Selected Examples of IFFs Financed by the World Bank PROJECT APP. WORLD BANK COUNTRY NAME OF FI NUMBER TIME CONTRIBUTION KEY FEATURE LESSONS USD 16 ml: 15 ml line of O Full-fledged specialized municipal bank P005406 1983 credit and 1 ml for TA subject to Central Bank regulation, financed USD 177.3 ml, 176.5 ml line with bond issuance, bank loans, purchasing P005517 1993 certificates of deposits and credit lines from of credit and 0.8 ml for TA Lending loans to Communal Infra- MDBs. urban and rural local Morocco structure Fund authorities for urban O First bond issuance backed by governmental (FEC)* USD 110.3 ml, 110 ml line infrastructure (Retail) guarantee but later not needed. P005523 1997 of credit, 0.3 ml for FEC O Loan ceilings to reduce credit risk: projecting institutional development municipalities’ budget surplus and limiting new municipal debt within this surplus. USD 300.2 ml, 102.3 ml O A Trust with participation of 3 private FIs and P009872 1988 went to FI: line of credit state gov’t, all guaranteeing its debt. Lending loans to small and medium cities & O Self-sustained with bond issuance and sub- Tamil Nadu Urban USD 105 ml, 80.5 ml went corporations building ordinate loans from other funding agencies. development fund to FI: 80 ml line of credit P050637 1999 urban infrastructure and 0.5 ml for bond issu- O Availability of WB’s credit and USAID’s credit (Retail) India ance TA guarantee facilitated blending with local finance. USD 43 ml: 12 ml for par- O Half of the funds support lending operations; India Partial Risk Providing sub-guaran- tial risk sharing facility, 6 the other half support a sub-account window Sharing Facility for P128921 2015 tee to sub-financers of ml for TA, and 25 ml from for partial risk sharing facility, backed by the Energy Efficiency* EE projects (Wholesale) Clean Technology Fund CTF guarantee. O Revolve based on WB loan, IDB loan, state gov’t budget, retaining earnings from opera- tions. Lending loans to Urban Develop- USD 100 ml, 92.1 ml went Municipalities and O Intensive and early marketing of project Brazil P006435 1989 ment Fund (FDU)* to FI: line of credit public utilities for urban ideas. infrastructure (Retail) O Private lenders can’t use intercept mecha- nism thus limiting municipal lending only to state sponsored MDF. O Second-tier FI: using WB loans to rediscount USD 60 ml, 40 ml went to Lending to mu- commercial banks’ loans to municipalities P006852 1991 nicipalities through FI: line of credit to incentivize municipal lending. The banks commercial banks, absorb 100% credit risk. Colombia FINDETER* for urban infrastruc- ture such as water, O Voluntary intercept agreements increase USD 49 ml line of credit the willingness of private sector to make P006861 1998 sanitation, transport (75 ml was approved) municipal lending. However, this intercept (Wholesale) mechanism lacks legal basis in China. O A top-down, pre-selected beneficiary ap- USD 35.8 ml (40 ml was Lending loans to proach caused delay in implementation and Municipal Develop- Philippines P004501 1992 approved), 24 ml went to municipalities for urban cost-recovery problems. A demand-driven, ment Fund FI: line of credit infrastructure (Retail) competition selection process is recom- mended. O Precaution for future O&M: sub-borrowers Lending loans to guarantee availability of budgetary resources USD 19.5 ml (20.9 ml was municipalities for for infrastructure O&M after projects hand- Municipal Develop- over Georgia P050910 1997 approved), 16.1 ml went to urban infrastructure ment Fund FI: line of credit in Priority Investment O Use of management information system Plan (Retail) (MIS): provide data & information for timely monitoring * FIs that mainly lend to green/environmental urban infrastructure. Source: Authors’ own elaboration; information on projects sourced from WB project documents. SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 29 PROJECT APP. WORLD BANK COUNTRY NAME OF FI NUMBER TIME CONTRIBUTION KEY FEATURE LESSONS O Use of Fund Manager under a performance based contract; weighting should be further Lending loans to indus- towards performance instead of retainer USD 10 ml: 8 ml line of trial and other energy part. Romania FREE* P068062 2002 credit and 2 ml for TA consumers using EE technologies (Retail) O Transaction costs at project level still high and need pre-investment TA support to sub- borrowers. Lending to utilities / O Failed to attract co-finance with commercial USD 10 ml: 4.5 ml for municipalities using banks during implementation since the partial credit guarantees, Bulgaria BEEF* P084831 2005 EE technology (Retail); size of EE projects was typically small and 4 ml line of credit and 1.5 Partial credit guarantee increased the transaction costs per loan ml for TA. (Wholesale) amount for commercial banks. O Gov’t established a vehicle SMI to channel its i) USD 100 ml WB line of Indonesia loans and equity investments to IIFF. credit (subordinated debt) Lending to infrastruc- Infrastructure P092218 2009 Self-sustained by bond issuance. Products ii) USD 40 ml IFC equity ture projects (Retail) O Financing Facility include loans, guarantees, equity investment investment and advisory services. O A single window for all gov’t guarantees for infrastructure PPPs, mainstreaming WB Indonesia USD 29.6 ml: 25 ml for policies. Indonesia Lending to infrastruc- Infrastructure P118916 2012 issuing IIGF guarantees, Optimal usage of all guarantee types (IIGF ture PPPs (Retail) O Guarantee Fund 4.6 ml for TA capital, WB funds, and MOF guarantees) based on what risks the underlying funding can cover. O Limited liability SOE set up with equity from Regional Lending loans to Gov’t of Indonesia and long-term low-cost USD 200 ml, all for FI: line Infrastructure P154947 2017 subnational gov’t for debts from other institutions. of credit and TA Development Fund infrastructure (Retail) O Will borrow through bond issuance in future. i) USD 5 ml DGF funds: 0.5 Providing debt, equity O The TA window ensure a significant pipeline Middle East ml for initial cost of Facil- of viable projects to attract funding from Arab Financing investments, guaran- and North ity Manager and 4.5 ml for third parties, in form of Shariah-compliant Facility for Infra- P121173 2010 tees to infrastructure Africa TA window (Islamic finance) and conventional funds. structure (AFFI) projects in MENA (MENA) ii) USD 50 ml IFC equity countries (Retail) O May finance through issuing bonds in future. Providing loans and Wholesale Develop- USD 500 ml: 445 ml line O Partial credit guarantees (50%) on PFI loans guarantees to PFIs Nigeria ment Finance P146319 2014 of credit, 35 ml for credit reduce moral hazard and risk of defaults financing MSMEs Institution guarantee, 12 ml for TA while incentivizing PFIs to lend to MSMEs. (Wholesale) O Cover management fees of the Pilot VC Fund Seed Co-invest- USD 22 ml: 17.2 ml line of Providing equity or with WB loans to lower the cost to private ment Fund & Pilot credit for VC Fund, 2.7 semi-equity invest- investors and ensure structure viability. Croatia P152130 2015 Venture Capital ml line of credit for Seed ments to innovative Fund Fund, 2.1 ml for TA SMEs (Retail) O Undertake Co-investment Fund and TA first to develop market for the VC Fund. O Revolve fund leveraging government budget and MDBs loans to attract commercial capital. USD 0.2 ml WB Budget and Providing finance to O Various financial products: equity invest- Green Energy Trust Fund, for a study EE RE and air pollution ment, debt financing in form of equity, China P152109 2016 Fund* on establishing potential reduction projects mezzanine, entrusted loans Green Funds in China (Retail) O A market-based energy savings measurement and verification system is critical to imple- ment innovative EE financing. 30 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS The Application of IFF in China 5.1 Regulatory Constraints for IFF governments for infrastructure investment and Establishment in China land development and expect repayment from the Despite the potential of using IFF for small-­ town land concession revenues of the borrowers. Poten- infrastructure financing, there are regulatory issues tial reform in the regulation of NBFI implies that that need to be taken into account for any IFF de- the government is seriously considering opening up signs for small towns in China as discussed below. the financial market for NBFI to lend under a reg- ulated framework. This may open a door for IFF Regulation of non-­ deposit taking financial institu- into the urban infrastructure financing business. tions. IFFs are likely to be classified as non-­ deposit However, in the near future, a potential IFF needs financial institutions and, as such, will need to to take into account the current barrier in direct obtain a permit to make loans to small munici- issuance of loans. palities for infrastructure projects. In China, banks lending. Currently IFFs would not be allowed On-­ are lending institutions that are licensed to take individual deposits. The Chinese banking regula- to issue loans, and thus have to work through a tions do not allow other financial intermediaries to trustee bank for issuing loans, or make equity in- lend. Recently, however, the Chinese government vestments (like any other infrastructure funds in authorities in charge of banking regulations are the market). This has implications to the design of considering a new regulation for non-­ banking fi- the IFF that differ from the practice in other coun- nancial institutions (NBFI). tries. As a result: This consideration arises from the fact that a OO Municipal borrowing from the IFF on a “gen- number of non-­ deposit financial institutions (such eral obligation” basis will not be possible. as trust companies and private equity funds) have Instead the IFF lending would be directly to already engaged in lending or quasi-­ lending activi- recourse basis) and municipal projects (on a non-­ ties. Some of these institutions actually lend to local utility companies . Non-­ 14 recourse project and utility company financing is risker than lending to municipalities. The creditworthiness of the project usually cannot be higher than that of the Despite the potential of using IFF 14  The fact that the IFF would be lending primarily to munici- for small-town infrastructure pal projects and utility companies means that the credit analysis skills of its staff would need to be different. Typically an IFF would focus on evaluation of municipal finances. While this can financing, there are regulatory be challenging, especially if the municipality does not have good financial accounting and stable revenue sources, it does have the issues that need to be taken into benefit that over time there would be a steady accumulation of knowledge about each municipality since each would likely be borrowing from the IFF in order to finance a number of projects. account for any IFF designs In contrast, when lending to projects on a non-­ recourse basis each will need to be evaluated “from scratch”, i.e., without utiliz- for small towns in China ing or relying on any previous work for assistance. While lending to utilities might be repetitive, it will be less so than for munici- palities. Thus the credit review process for the IFF will likely be more complex and time consuming than is typical for an IFF that lends only to municipalities. SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 31 municipality. If the IFF also lends to companies ments and the subsidies and transfer payment from (such as construction companies that might use higher-­ level governments are primarily used for the funds as bridge financing for infrastructure basic public services, which cannot be used as a projects) and takes unsecured corporate credit guarantee to repay the debt of local governments. risk, the impact on the IFF’s rating will be even Only extra-­ budgetary revenue minus the extra-­ more pronounced. budgetary expenditure can be used to mediate the local debt deficit. In China, using transfer payment OO Given the higher risk involved in lending to proj- intercept mechanisms to improve local-­ government ects and utilities, the degree of leverage the IFF credit is still a lack of relevant legal basis. However, could use would be lower than is typical for IFFs it is arguable that the transfer payment intercept is that lend to municipalities. not designed as a kind of financial guarantee but as a set-­up to enable debt-­ fi nancing to flow to basic OO Since the IFF would not be lending to the smaller public infrastructure services. It is ultimately used cities, the use of a transfer payment “lock box” for the right purpose. structure, another important risk mitigation, could not be used to reduce the IFF’s credit risk. Inadequate reporting and disclosure standards. Public information is the precondition of effective Use of a revenue stream as collateral. The risk assessment and management, but currently in Amendment of Budget Law prescribes in para- China, the debt information is not transparently graph 1 of article 16 that fiscal transfer payments accounted for and reported. Previously, budget should be used to promote equal basic public ser- information provided by some government depart- vices between regions as the main target. In other ments were often too vague for legislators and the words, in the current Chinese fiscal system, the public to supervise. After the State Council issuance fiscal revenue of the corresponding local govern- of the government comprehensive, financial report 32 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS system reform program in 2014, it is expected that Urban Infrastructure Financing Facility (GUIFF) in 2020, local government will start to release their town related projects but also larger green for small-­ balance sheets to the public. A pending issue, how- projects in other provinces. ever, remains the fact that in China, accounting is done on a cash basis and not according to ac- The Facility plans to invest in urban environmental crual accounting criteria. Some pilot activity at the infrastructure projects, mostly public utilities and central-­government level is taking place to explore PPPs. The initial focus will be the Shanghai region, a transition to international accounting standards, but the Facility is expected to expand to Yangtze however, this is a long journey and far from being River Delta Region and ultimately cover Yangtze accomplished, either at the central level, and much River Economic Belt in the future. The Facility less at the local level. The implication for the IFF will invest primarily revenue-­ earning projects, is that unless clarity and transparency are adopted which are bankable with contract terms, tariffs and by the participating stakeholders regarding the un- subsidies agreed between the sponsoring govern- derlying projects, pricing of the debt instruments ments and service providers. Any subsidy would be issued will be higher and their overall marketability reflected in the annual local government budget, and attractiveness much lower. but there will be no government guarantee for loan repayment. SMI has put together an initial pipeline Only revenue earning utilities and infrastructure of projects (see in Box 5.3.1). projects are allowed to borrow. In other words, towns cannot borrow on their budget; only their Given SMI’s strong capabilities as an infrastructure revenue-­ earning utilities and infrastructure projects project developer and its financial strength, such a can. Therefore, the specialized financial interme- Facility should be able to help mobilize infrastruc- diary will be able to serve only revenue-­ earning ture projects that might otherwise find it difficult standing infrastructure projects. utilities and self-­ to attract financing on their own. The aggregate impact in terms of scale will be constrained by the The cumulative impact of these regulatory con- limited financial leverage the Facility would have, straints will have a significant impact on the IFF, which will mostly depend on the frequency of ex- which will be reflected primarily in its creditwor- pected defaults in the pool of loans, the expected thiness (and thus its rating). IFF’s in other countries losses in the event of defaults, and the duration of that lend to municipalities are rated highly in large periods when the IFF will have to replace or supple- part due to the relatively high creditworthiness of ment debt service payments for portfolio loans. the municipalities that borrow from it. It is possible that the Facility’s investment in proj- Town Infrastructure 5.2 An IFF for Small-­ ects will provide sufficient credit enhancement—­ v ia Financing in the Shanghai Region equity and mezzanine debt—­ that project bonds SMG is proposing to transform its DFV into a full-­ might then be used to attract longer-­ term, lower-­ fledged infrastructure financing facility with the cost financing from institutional investors (both capacity to raise funds in domestic capital mar- domestically and internationally). lend into specific sub-­ kets, as well as to on-­ projects with proper project appraisal and fiduciary over- SMI’s effort could serve to demonstrate the vi- sight capacity. Shanghai Municipal Investment ability of such a facility. This could then lead to (SMI) Group is the main sponsor of the IFF and other financially strong UDICs in China, setting has proposed the creation of a Shanghai Green up a similar infrastructure financing facility rather than the current practice of shadowy infrastructure SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 33 BOX 5.3.1. Initial Pipeline for the GUIFF Outside SMI Outside has put together an initial pipeline of projects, as illustrated below by capital expenditure (CAPEX) required, sectors Shanghai and sources of public support: Shanghai 5 5 FIGURE 5.3.1. Total Number of Potential Projects in Pipeline in the Region Outside Outside Outside NO. OF CAPEX Shanghai 11 NO. OF Shanghai PROJECT W/O REQUIRED Shanghai Outside 11 5 PROJECTS CAPEX* (RMB BILLION) Shanghai 5 5 In Shanghai 11 3 Shanghai 34.37 5 Shanghai Outside Shanghai 5 2 19.90 11 11 11 Total 16 5 54.37 11 Shanghai *The required CAPEX is not yet decided. Shanghai Shanghai Shanghai FIGURE 5.3.2. Potential projects sponsored by: FIGURE 5.3.3. Source of direct project revenue Solid waste Drainage Solid waste Drainage Rejuvenation New management Landscaping, roads Rejuvenation New management 2 1 Landscaping, roads Stormwater Solid waste 1 1 Solid Power generation waste Drainage Solid waste 2 Drainageinfrastructure infrastructure Stormwater 1 2 1 1 Power generation Drainage Rejuvenation management 2 Rejuvenation Landscaping, roads Wastewater management managementLandscaping, roads Landscaping, roads New New Wastewater 1 1 Solid waste 1 1 Drainage2 1 1 Power generation Stormwater 2 2 1 1 Power generation infrastructure treatment Stormwater 2Stormwater 1 management 1 Power generationroads Landscaping, Rejuvenation 2 1 infrastructure New 1 treatment Wastewater 1 Wastewater 11 1 1 Rehabilitation/expansion Wastewater 5 8 Stormwater 1 2 11 Power generation Rehabilitation/expansion treatment 2 5 1 8 infrastructure treatment treatment 1 of existing Wastewater 1 Rehabilitation/expansion 8 8 Reha Rehabilitation/expansion of existing 5 5 treatment 1 infrastructure of existing 12 of existing infrastructure Rehabilitation/expansion 5 8 12 12 infrastructure infrastructure 12 of existing 2 12 1 infrastructure 2 2 21 1 12 Not mentioned1 Sewer Not mentioned Not mentioned New preliminary Sewer Sewer Sewer Not mentioned 2New 1 preliminary New preliminary New Sewer preliminary treatment facility treatment facility Sewer Not mentioned treatment New facilitytreatment facility preliminary treatment facility FIGURE 5.3.4. Potential Projects will be sponsored by FIGURE 5.3.5. Type of Proposed Projects Local government Local government Local government Local government 2 government 2 Local Local government Not provided Not provided 2 SOF SOF 2 2 Not provided 7 SOF 7 Waste water SOF 2 7 Not provided Not provided Waste water 8 7SOF 8 treatment fee treatment fee SOF 5 7 7 7 Waste water Waste water 7 7 5 Local Local 7 8 8 5 fee treatment Waste water 7 government, PPP 8 Local treatment fee Local PPP government, 5 treatment fee PPP 5 Local 1 1 government, 2 5 2 government, PPP Local government, PPP Power generation 1 generation 2 Power PPP 2 government, PPP PPP 1 2 Power generation 1 PPP 2 PPP Power generation PPP FIGURE 5.3.6. SourcesLabel Label to come and Type to come Power of the Public generation Sector Support PPP 1 Shanghai Jinshan District Government Label to come 1 Label to come Shanghai Jinshan2 District Government 2 1 1 Shanghai Jinshan District Government 2 Label to come Label to come 1 Shanghai Shanghai 1 Jinshan Nanhul District Nanhul District Government Government 1 Shanghai District Government 1 2 Shanghai Jinshan Shanghai Nanhul District District Government Government 5 Government Shanghai Municipal 5 21 Shanghai Municipal Government 5 Shanghai Municipal Government 5 Shanghai Municipal Government 1 Shanghai Nanhul District Government 1 Shanghai Nanhul District Government Source: SMI Shanghai Municipal Government 5 Shanghai Municipal Government 5 34 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS Contingent Paid-In Equity Equity Capital Capital Present Value of 5.2.1 Potential structure for the Shanghai funds. As a result, the overall impact could be to Expected develop a new source of financingReserves for infrastructure GUIFF: Lending via a Trustee Bank Losses Long-Term from projects that would not Debt create additional Retained debt for Due to the potential regulatoryLoans constraints on a local governments or for the UDICs. and Earnings (as discussed above), a newly formed IFF lendingGuarantees Required possible GUIFF structure consists of lending via a There is a danger that the current infrastructure Payments trustee bank (see figure 7). Such “Entrusted Loan” to Cover funds being established in China may create unin- approach might circumvent some issues posed by Defaults tended consequences if they are too broadly used the current regulatory framework related to on-­ Liquidity pass restrictions on UDICsFacility to by-­ financing of mu- lending restrictions. Such an approach will increase nicipal projects. Infrastructure funds will not likely the financial cost of financing to projects because a lead to greater transparency in municipal financ- bank will likely charge a fee for this service. The ing and may delay the process of moving municipal GUIFF might seek a long-­ term entrustment coop- financing into the capital markets. Experience in eration agreement with one of China’s development other countries has shown that infrastructure funds banks, for example China Development Bank, and are also costly, both in terms of the cost of financing obtain a lower rate for the administrative fee that to municipalities and the returns going to institu- would not have a significant impact on the cost of tional investors. financing. This could be a transitional option for an FIGURE 7. GUIFF Structure 1 FI Loans The World Bank MOF/SMG SMI + Other Shareholders Report Fund Mgt Project Guarantee, Credit Pipeline, TA Enhancement TA On-lending Institutional Investors Financial Market GUIFF (commercial banks, (Corporate FI, issue bonds Debt Financing evolved by DFV Equity Investment Project Development Equity Investment Sub-fund of GUIFF Project Screening Project Assessment Capacity Building Financial Advisor Trustee Bank Debt Financing Project 1 Project 2 Project n Source: Authors’ own elaboration. SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 35 IFF until it can establish itself and obtain a permit ies currently considered by Chinese law, albeit not or the regulations are changed to allow IFFs to lend perfectly fitting with its mandate and nature. The to municipalities. Also, unless there is a change in most adequate structure would have to be studied the prohibition against municipalities borrowing in depth by a legal team during preparation. This from banks, the trustee bank would be limited to solution would also be a sub-­standard solution since lending to projects or utilities. capital adequacy and other prudential aspects may be driven by serving the requirements of the China 5.2.2 Potential structure for the Shanghai Banking and Regulatory Commission which may GUIFF: Lending directly to Projects not be suitable for the purpose of the GUIFF. Also, Future reforms of regulation on NBFI may remove there is no guarantee at this point that such strat- the barrier for IFFs to make loans directly to egy would be successful (i.e., that the license would projects and utility companies. In this case there indeed be granted). would be no need to involve a trustee bank and the structure would look like that shown below in Under this structure, the IFF would lend directly figure 8. Alternatively, it is possible that the GUIFF to projects or utility companies (see figure 8). This seek lending licensing at set up, according to one might be a useful interim solution while smaller of the existing umbrellas of financial intermediar- cities build up their own capacities to structure and monitor projects and establish their credit FIGURE 8. GUIFF Structure 2 FI Loans The World Bank MOF/SMG SMI + Other Shareholders Report Fund Mgt Project Guarantee, Credit Pipeline, TA Enhancement TA On-lending Institutional Investors Financial Market GUIFF (commercial banks, (Corporate FI, issue bonds Debt Financing evolved by DFV Equity Investment Project Development Equity Investment Project Screening Sub-fund of GUIFF Project Assessment Capacity Building Debt Financing Financial Advisor Project 1 Project 2 Project n Source: Authors’ own elaboration. 36 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS ratings. However, the long-­ term objective should funding. To accelerate its start-­ up, the GUIFF be for the smaller cities to be able to structure and would greatly benefit from World Bank initial manage projects themselves and to take responsi- funding via a Financial Intermediary Loan (FIL)16, bility for financing their infrastructure using all mainly to cover construction risks. Once it has a their fiscal resources. portfolio of performing projects, the GUIFF could then easily begin issuing bonds to match the debt 5.2.3 How a GUIFF Would Operate service payments it receives to the payments on Project solicitation: The GUIFF would solicit the bonds it issues, raising funds from the capital projects from the cities/towns—­ possibly with the market. These funds will in turn be on-­ lent to the assistance of MoF and the Shanghai Municipality.15 projects under a revolving fund mechanism. The projects could include self-­ fi nancing projects, Bond issuance:The GUIFF bonds should be rated projects dependent on future government payments for services or availability, and projects that com- by one or more qualified credit rating agency to bine both sources of funding. facilitate their purchase by as many domestic and international investors as possible. While a prop- Project evaluation: The GUIFF would evaluate erly structured GUIFF should be able to issue proposed projects for their feasibility, “value for bonds with relatively high ratings, it may be useful money”, and creditworthiness. A creditworthiness for the GUIFF to issue two tranches of bonds—­ assessment tool that evaluates borrowers’ debt ser- senior and subordinated. The subordinated debt vice capacity, indebtedness and overall financial tranche would provide first loss protection to senior position should be developed to facilitate project debt tranche. The subordinated debt bonds would and borrower selection. receive lower ratings than the senior debt bonds. These bonds should be attractive for infrastruc- Project structuring:Various types of project struc- ture fund investment. Such funds should have the tures could be considered. Some projects might be expertise to evaluate the risks of the GUIFF’s in- structured in the form of public-­ private partnership frastructure projects and typically seek the higher (PPP), with non-­recourse financing made to a proj- returns of subordinated debt. The senior debt ect SPV. Some projects can be operated by utility would likely need to obtain credit ratings and have companies or state-­ owned enterprises (SOEs) that a high enough rating to be attractive to banks and would secure payment based on project revenues or institutional investors.17 on corporate guarantees. Interest rates charged by GUIFF credit rating: In order to issue bonds, the the GUIFF could also vary depending on the credit risk of each lower-­ t ier government and/or project it GUIFF (independently of the structure it uses) will sponsored. This will help the GUIFF to avoid “ad- likely need to obtain a credit rating from one or verse selection” problems. more credit rating agency. If properly structured and capitalized, the GUIFF will likely have a rela- Initial external funding: Once the GUIFF selects tively high rating. Its association with the Ministry the projects to be financed, it will need to obtain of Finance and Shanghai Municipality would pro- 16  World Bank FIL would be made to the Ministry of Finance, 15  As noted above, under the new Government guidelines the which could then channel the funds to the IFF. MoF will vet on-­lending between upper-­and lower-­ t ier govern- ments. The MoF will also assess each local government’s debt 17  The total costs of using a combination of mezzanine and performance, using metrics such as debt to revenue and repay- senior debt could be held down if the mezzanine debt is provided ment ratios, and will issue warnings to local governments that by a DFI or government policy bank that is willing to make this become over-­indebted. investment in order to promote the development of IFFs in China. SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 37 vide some assurance to investors and likely give a include, among others, the potential eligible proj- boost to its “stand-­alone” rating by credit rating ects, the minimum and maximum funding limits, agencies. Over time as it develops experiences and required stage of project preparation, minimum records in selecting good projects and proper debt fi nancing, etc. degree of self-­ servicing, its ratings will improve. This is impor- tant, as it will then be able to secure lower-­ cost Selection and evaluation of the potential projects bonds and pass some of this savings on through its should follow an approach combining both indi- loans. Guarantee for bond issuance provided by a vidual analysis and portfolio management. The third party may also help to obtain a sufficiently purpose of the individual analysis is to ensure that high credit rating, supporting GUIFF to issue the project itself meets the selection criteria by medium to long-­ term bonds with attractive pricing. GUIFF and assesses whether the project is a good underlying asset for the GUIFF. In addition to the External guarantees: Ideally, the GUIFF should common project evaluation about commercial and have no explicit guarantee from national or pro- operational viability, economic value of the project vincial government or corporate (SMI) guarantee should also be taken into consideration. for the repayment of its bonds. Bond purchasers would essentially take the credit risk of a pool of However, the nature of pooling in the GUIFF projects, with the additional protection provided means that project evaluation should also follow by GUIFF’s debt service reserve accounts and li- a “portfolio management” approach to optimize quidity facilities that will help to ensure timely debt the structure of the project portfolio and mini- service payment, as well as GUIFF’s capital which mize potential risks. The IFF should try to develop would provide some first loss credit enhancement. a portfolio of projects that diversifies risks while Thus, bond buyers will need to evaluate (or rely on maximizing the usage of the financing resources. credit rating agencies to evaluate) the risk of the For such a portfolio, it is necessary to take into con- IFF’s degree of leverage and the ability of GUIFF sideration features of a project, such as sub-­ sector in selecting appropriate projects and efficiently (water and wastewater treatment, landscaping, managing the disbursement flows and collections to power and etc.), geographic location, type (new ensure timely debt servicing. This has potential to projects, rehabilitation, expansion of existing in- provide significant market discipline for small-­ town frastructure, or rejuvenation), and size. In addition, infrastructure financing. If a guarantee is used, for the GUIFF needs to balance project allocation instance to support bond issuance, GUIFF should among its stakeholders’ cities/small towns. Table 4 avoid full guarantees as they generally cause inves- provides some recommendations for project evalu- tors to focus only on the rating of the guarantor, not ation and selection. on the underlying credit structure of the transac- tion and the credit strength of the borrowers. The sectors eligible for GUIFF funding include transportation assets and services (including re- 5.3 Pipeline and Considerations habilitation of existing roads, reconstruction or for Projects Selection construction of new roads, landscaping, public Once the counties’ public utilities and SOEs and transportation facilities, ports, and urban trans- towns express an interest to participate in the portation), water and sanitation (water supply, GUIFF, it is then necessary to assess the demand sewerage, wastewater treatment, drainage, and for projects and their potential pipeline. The crite- erosion), solid waste management, electricity gener- ria for selecting qualified projects to finance might ation, transmission and distribution, and municipal 38 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS TABLE 4. Considerations for GUIFF Portfolio Selection ASPECTS SELECTION CRITERIA AND CONSIDERATIONS O A balanced portfolio of infrastructure subsectors and project types is desirable to reduce correlation of risks in the loan portfolio Sector and type O However, it may be necessary to initially focus on specific sectors so as to limit the project evaluation and management skills needed O Higher concentration risks and less efficient use of pooled resources if individuals are very large Size O Lower cost efficiency if the project size is too small O Target range of CAPEX required: RMB [1~10] billion O The expected Internal Rate of Return (IRR) (estimated by forecasting future costs and revenue flows) should be above a defined level Projected outcomes O The expected Economic Rate of Return (ERR) (i.e., including social returns such as job creation, improvement in public health, and etc. taken into consideration) should be above a defined level Local government O There should be public support for the project to be financed by the GUIFF Source: Authors’ own elaboration. TABLE 5. Considerations for Specific GUIFF Project Selection CRITERION DESCRIPTION The sub-project shall contribute to national/provincial priorities and contribute to sustainable Strategic relevance economic growth. Identify the governmental authorities and agencies involved in the design and implementation of Government ownership and the sub-project. institutional framework Explain the institutional framework to which the sub-project will be subject. A review of the laws and regulations which will impact the sub-project’s design, implementation Legal and regulatory framework and operation. Feasibility Analyze the sub-project’s technical feasibility and the key risks. Assess the financial viability of the sub-project. The assessment will include but not limited to revenue forecast, sources of financing, and maintenance costs over the project life cycle, payback Financial and economic period, return on investment. Assess the economic viability of the sub-project. This includes economic rate of return. Public sector considerations Describe the public sector support that need to be provided to make the sub-project bankable. Assess the interest of the private sector in the sub-project and why the sub-project would be Attractiveness as a PPP attractive as a PPP. Assess type of procurement and whether or not the procurement will be in compliance with World Procurement Bank (WB) procurement requirements. Assess whether or not the sub-project will have a positive environmental impact and is in compli- Safeguards ance with WB environmental and social safeguards. Source: Authors’ own elaboration. SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 39 infrastructure (paving, street lighting, rehabilita- TABLE 6. Prioritization Screening tion/expansion of existing infrastructure). Criteria for Individual Projects Scoring from 0 to 5 (0 = None, 1 = Poor, 2 = Fair, 3 = Average, projects. Each Screening Criteria for Eligible Sub-­ 4 = Good, 5 = Excellent) project will be assessed through a set of screen- sub-­ SCREENING CRITERIA (WEIGHT) SCORE ing criteria for financing under the Facility. Table 5 below lists a possible list. 1. Strategic Fit (20%) Weighted Score of Strategic Fit Prioritization screening criteria. Once the sub-­ 2. Readiness of Project (20%) projects are selected for appraisal, a priority list of O Degree of preparation and development of projects can be ranked according to a weighted sub-­ projects matrix in case the demand for financing is larger O Level of information available, including feasi- than the current capacity to fund/on-­ lend. Table bilities studies and other project preparation documents 6 highlights a possible prioritization matrix that could be adopted. Weighted Score of Readiness 3. Complexity of Implementation (60%) list of projects. A short-­ Selection of Eligible Sub-­ O Ease of moving to project implementation, potential eligible sub-­projects would be prepared including procurement, financing, safeguards based on the screening results. Strong sub-­ projects O Ability of the sub-project to generate sufficient will be selected for appraisal. Figure 9 shows a deci- cash flows to meet its financial obligations sion tree on the selection process. O Bankability of sub-project Weighted Score of Complexity of Implementation Total weighted score Source: Authors’ own elaboration. FIGURE 9. Decision Making Tree for Project Election Satisfactory as Go to apprisal a sub-project Not satisfactory Screening Results Drop as a sub-project Inadequate Request additional information information Source: Authors’ own elaboration. 40 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS Next Steps: Implementation Considerations Moving to the next stage of development and imple- evaluations in several areas, which have not been mentation will need a concerted effort by all tiers consulted with stakeholders. In particular, the com- of government.18 Broadly, the next steps for this mercial structure of the preferred option(s) needs to initiative should be: policy consultation with na- be further developed, with special attention to the tional, provincial, prefectural, county, and small role and function of the entity; the risk allocation towns stakeholders; further commercial and legal between investors, intermediaries, and borrowers; investigation of the preferred option, including and the credit risk related to lending to the GUIFF. consultation with the local government sector to Further assessments are needed for the following test demand; identifying commitments, costs, and aspects detailed below. resources to move into the ‘build’ phase; and assess- ment of demand for projects and potential pipeline Role and functions of the GUIFF: The role of a (Ernst & Young, 2013). collective vehicle is to meet the needs of local gov- ernments by securing long-­ term, low-­ cost debt Developing the momentum for the GUIFF will finance and conducting credit risk assessments of require consensus among the various levels of infrastructure projects. But the functions of GUIFF government that are involved—­ the national gov- could be more broadly defined to include an educa- ernment, the Shanghai government, and the local tive function and ad-­ hoc financial advice related to small-­town governments. This consensus primarily borrowing. The value of these services, and a more relates to accepting the case for action and the sub- precise understanding of need, could be further stance of the solution. tested with local governments. A well-­motivated coordinating body is needed to Credit risk enhancement: The credit risk of IFF launch the GUIFF. This body will organize and can be mitigated by issuing financial instruments manage the GUIFF, but it will also need to have enhanced by protection against arrears or de- the political and financial clout to determine which faults on loans to its individual members. There divisions will be allowed to participate political sub-­ are many possible forms of credit enhancement, in the GUIFF. including the transfer payment “lock-­ box” and reserve accounts mentioned above. It is also pos- This suggests that utilities at the county level may sible for some creditworthy third party to provide be the appropriate level of stakeholders to partici- a partial credit guarantee.19 The implementation pate in the GUIFF, with some small towns to be process would benefit from testing perceptions of considered, which demonstrate sufficient budgetary the strength of the protection implied in the pre- control and management capacity. ferred option with potential investors. It is assumed that an appropriately-­ structured IFF would be The assessment in this study about possible options received and there would be appetite for bonds well-­ should be validated with updated information and issued by it. However, it would be worth testing discussion. This study provides only preliminary this further as the preferred model is developed, 18  In New Zealand, where it could be argued that the political 19  The Tamil Nadu’s Municipal Urban Development Fund t ier system, landscape is easier to navigate on account of its two-­ in India issued pooled bonds for water and sanitation projects three years were needed to progress the Local Government of participating urban local bodies, with a partial (50%) credit Funding Agency from a concept to reality. guarantee from U.S. AID’s Development Credit Authority. SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 41 possibly through a structured questionnaire and Accounting treatment: The accounting treatment interview process. of participation by small utilities in the GUIFF will ultimately reflect the substance of the commercial Credit rating: A preliminary credit rating exer- arrangements attached to accessing credit through cise could be very useful, assuming there is a level the facility. Without knowing the precise nature of of consensus about the preferred option and a those commercial arrangements, it is too early to broad—­ a lbeit indicative—­ level of interest within offer a view on the impacts for financial reporting small local governments.20 Such a rating would by small local governments and related entities. add substantially to the level of confidence in the However, some important considerations are: level of demand for IFF bonds. It would also help to estimate the potential “risk arbitrage” savings OO Each stakeholder will be responsible for repay- that financing through the IFF would have over ing its own debts, meaning these amounts are small towns obtaining financing on their own. (It likely to be recognized as debt on their balance should be kept in mind that the rating of these sheet. It is important to be clear that the GUIFF bonds would improve gradually over time if the is not a means of shifting recognition of debts IFF builds credibility and demonstrates the robust- from local government. ness of its credit fundamentals.) OO The treatment of the mutual guarantee in the 20  For example, the New Zealand Local Government Fund- preferred option would depend, among other ing Agency engaged the major international ratings agencies to assign a “shadow” credit rating prior to going live, and this was factors, on the likelihood of it being exercised. an important step in building market presence and credibility. 42 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS Depending on the terms of a general guarantee, be identified at an early point. A contribution it could be treated as a provision on balance sheet across various tiers of government may, for exam- or, where payment is considered remote, it could ple, be part of the process of reaching consensus on be treated as a contingent liability requiring a way forward. disclosure only. Guaranteeing the performance of a specified debt—­ as opposed to a GUIFF’s Early considerations about how to fund establish- obligations—­ could be a financial guarantee and ment costs are also important because it could recorded as liabilities. impact appetite and patronage. For example, to the extent that these costs are to be recovered from OO The consolidation of a GUIFF is also important participants, there may be a perception that ‘early to consider from a balance sheet perspective. movers’ would pay a disproportionately larger Again, depending on the final structure of the share, which could deter participation. Further, entity, it is possible that members would need to there may be a case of creating incentives for par- consolidate parts of the GUIFF’s obligations. A ticipation by shifting or deferring the owners’ share key test in this respect is who has management of establishment costs (if others than SMI). power for the GUIFF and who benefits from the variable returns from operations. If there is no requirement for consolidation, then mem- bership could be considered a joint venture. A key test with respect to joint ventures is whether management and decision-­ making powers are contractually shared. Legal considerations: A critical part of the legal review is likely to be an analysis of the necessary amendments to legislation which will allow small local governments to establish and participate in a collective vehicle and allow the GUIFF to both borrow and lend directly. The scope of the review could be tailored to the level of definition of the commercial structure of a preferred option. There are clear benefits in avoiding substantial amend- ments to the extent possible because it is less likely the venture would be delayed in political processes. Costs associated with the set up: The costs of es- tablishing the entity would be substantial, and it is necessary to have early consideration of how to fund them. The costs include management, op- erational and advisory personnel and training, systems and equipment, and transaction costs. Precedent models suggest these costs could be sev- eral million dollars. There are several ways to fund the establishment costs, and these options should SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 43 References Azuma, Y. and Kurihara, J., 2011. Examining China’s FMDV (Global Fund for Development of Cities), 2015. Local Government Fiscal Dynamics: With a Special The Potential Catalytic Role of Subnational Pooled Fi- Emphasis on Local Investment Companies (LICs). Po- nancing Mechanisms. 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SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 45 Previous knowledge papers in this series Lessons and Experiences from Mainstreaming HIV/AIDS into Urban/Water (AFTU1 & AFTU2) Projects Nina Schuler, Alicia Casalis, Sylvie Debomy, Christianna Johnnides, and Kate Kuper, September 2005, No. 1 Occupational and Environmental Health Issues of Solid Waste Management: Special Emphasis on Middle and Lower-­ Income Countries Sandra Cointreau, July 2006, No. 2 A Review of Urban Development Issues in Poverty Reduction Strategies Judy L. Baker and Iwona Reichardt, June 2007, No. 3 Faceted and Spatial Perspective Urban Poverty in Ethiopia: A Multi-­ Elisa Muzzini, January 2008, No. 4 Urban Poverty: A Global View Judy L. Baker, January 2008, No. 5 Preparing Surveys for Urban Upgrading Interventions: Prototype Survey Instrument and User Guide Ana Goicoechea, April 2008, No. 6 Exploring Urban Growth Management: Insights from Three Cities Mila Freire, Douglas Webster, and Christopher Rose, June 2008, No. 7 Private Sector Initiatives in Slum Upgrading Judy L. Baker and Kim McClain, May 2009, No. 8 The Urban Rehabilitation of the Medinas: The World Bank Experience in the Middle East and North Africa Anthony G. Bigio and Guido Licciardi, May 2010, No. 9 Cities and Climate Change: An Urgent Agenda Daniel Hoornweg, December 2010, No. 10 ­ ulfilling the Promise Memo to the Mayor: Improving Access to Urban Land for All Residents — F Barbara Lipman, with Robin Rajack, June 2011, No. 11 Conserving the Past as a Foundation for the Future: China-­ World Bank Partnership on Cultural Heritage Conservation Katrinka Ebbe, Guido Licciardi, and Axel Baeumler, September 2011, No. 12 Guidebook on Capital Investment Planning for Local Governments Olga Kaganova, October 2011, No. 13 Financing the Urban Expansion in Tanzania Zara Sarzin and Uri Raich, January 2012, No. 14 46 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS What a Waste: A Global Review of Solid Waste Management Tata, March 2012, No. 15 Daniel Hoornweg and Perinaz Bhada-­ Investment in Urban Heritage: Economic Impacts of Cultural Heritage Projects in FYR Macedo- nia and Georgia David Throsby, Macquarie University, Sydney, September 2012, No. 16 Building Sustainability in an Urbanizing World: A Partnership Report Gallegos, and Artessa Saldivar-­ Daniel Hoornweg, Mila Freire, Julianne Baker-­ Sali, eds., July 2013, No. 17 Urban Agriculture: Findings from Four City Case Studies July 2013, No. 18 resilient, Climate-­ Climate-­ friendly World Heritage Cities Anthony Gad Bigio, Maria Catalina Ochoa, and Rana Amirtahmasebi, June 2014, No. 19 Results-­Based Financing for Municipal Solid Waste July 2014, No. 20 On the Engagement of Excluded Groups in Inclusive Cities: Highlighting Good Practices and Key Challenges in the Global South Diana Mitlin and David Satterthwaite, February 2016, No. 21 Based Financing for Municipal Solid Waste Results-­ Mona Serageldin, with Sheelah Gobar, Warren Hagist, and Maren Larsen, February 2016, No. 22 Financing Landfill Gas Projects in Developing Countries Claire Markgraf, September 2016, No. 23 Sustainable Financing and Policy: Models for Municipal Composting Silpa Kaza, Lisa Yao, and Andrea Stowell, February 2016, No. 24 SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 47 Photo Credits Cover “Lijiang | katused” by Tauno Tõhk is licensed under CC BY 2.0 Inside front cover “Lijiang | katused” by Tauno Tõhk is licensed under CC BY 2.0 / Converted to duotone from original Page iii “Xiamen Sunrise” by Jay Huang is licensed under CC BY 2.0 Page v “Impression of The Lijiang Old Town” by Xianyi Shen is licensed under CC BY-NC-ND 2.0 Page vii China. Photo: © Curt Carnemark / World Bank Page viii “Sunset scenery of ancienttownin Taicang, Shaxi” by HelloRF Zcool, at Shutterstock. Page 2 “Wuxi, Jiangsu, China” by Thomas Depenbusch is licensed under CC BY 2.0 Page 4 “Discomfort due to squishy feet, but the ran soaked ancient street is a delight!” by shankar s., at Flickr is licensed under CC BY 2.0. Page 10 “Construction Worker”. Photo: © Curt Carnemark / World Bank, at Flickr is licensed under CC BY-NC-ND 2.0. Page 12 China. Photo: © Steve Harris / World Bank Page 13 “Town life in Zhejiang Province, South China. This is the central street of that small town” by Yanfei Sun, at Shutterstock. Page 16 “Guilin Skyline Panorama” by cliff hellis is licensed under CC BY-NC-ND 2.0 Page 18 “Yuyuan Garden District Shanghai” by Bernd Thaller is licensed under CC BY-NC 2.0 Page 22 “The scenery of Wuzhen, one of the Chinese ancient town” by XIE CHENGXIN, at Shutterstock. Page 26 “Ancient Village - Li Keng” by Laurence & Annie is licensed under CC BY-NC-ND 2.0 Page 31 China. Photo: © Curt Carnemark / World Bank Page 41 “Beijing Hutong at Night” by Roman Boed is licensed under CC BY 2.0 Page 42 “Knock knock” by Ken Douglas is licensed under CC BY-NC-ND 2.0 Page 43 “Hongcun” by Xianyi Shen is licensed under CC BY-NC-ND 2.0 Page 46 “Pingjiang Road, Suzhou China” by Russ Bowling is licensed under CC BY 2.0 48 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS SUSTAINABLE INFRASTRUCTURE FINANCING FOR SMALL TOWNS IN CHINA 49 50 URBAN DEVELOPMENT SERIES – KNOWLEDGE PAPERS For more information about the Urban Development Series, contact: Global Programs Unit Social, Urban, Rural & Resilience Global Practice The World Bank 1818 H Street, NW Washington, DC, 20433 USA Email: gpsurrkl@worldbank.org Website: www.worldbank.org/urban