noTE NO. 4 – july. 2012 SNTABriefs Sharing knowledge, experiences, and innovations in sub-sovereign financing for infrastructure 73643 Enabling Environment for Sub National Government1 Debt Benjamin Darche and Joshua Gallo T he enabling environment is the national impact on SNGs’ annual operating balance. government’s legal, regulatory, and institu- tional framework and debt market condi- The Implications of Decentralization tions that govern sub-national governments’ (SNGs) for SNG Borrowing borrowing. When planning to borrow, SNG finance directors should assess the borrowing constraints The influence of the nation’s decentralization laws imposed by the enabling environment. and policies constrains the types of revenues an SNG can use to repay a borrowing. The revenue source The most critical element of the enabling environ- must be eligible to repay debt; comply with any ment is the nation’s decentralization and fiscal restrictions on the amounts used for SNG’s operating laws governing the SNG revenues used to secure or capital budget; and comply with national govern- or guarantee debt repayment. Decentralization laws ment limits on SNG outstanding debt. The purpose determine SNG revenue raising capability and expen- of the borrowing and the selection of the revenue diture requirements to deliver local services. Laws and source for debt payments are influenced by national regulations also determine which revenues an SNG decentralization laws. uses to repay debt and the total outstanding debt, or debt capacity, an SNG can support with these A country’s decentralization laws and policies pertain- revenues. National government’s fiscal laws that ing to revenue and expenditure assignments also regulate SNG debt, commercial banks, and the stock have a significant impact on SNG ability to generate markets also contribute to the supply and demand an operating surplus and debt capacity. of SNG debt. • Revenue assignments between national and SNG Macroeconomic conditions also play a significant political jurisdictions, whether local taxes, inter- role in the supply and demand for SNG debt. The government transfers, or fees for service, provide most direct impact on the SNG debt market is the operating and capital budget support, in addition to central bank’s interest rate policy that shapes the repayment of SNG debt. government’s benchmark “yield curve�2. The bench- mark yield PPIAF curve sets Approved the interest Logo Usage rate floor for public • Expenditure assignments determine SNG operating (including SNG) and corporate debt. and investment costs that for SNG service delivery Logo - Black obligations. Government fiscal and monetary policy also contrib- utes to the enabling environment. In addition to the government yield curve, PUBLIC-PRIVATE INFRASTRUCTURE fiscal ADVISORY and monetary policy FACILITY Benjamin Darche is a Public Finance Consultant, and Joshua Gallo is drives the underlying economic base of SNG revenue Program Leader for PPIAF’s Sub-National Technical Assistance Program. collection, as well as inflation, which has a major Logo - 1-color usage (PMS 2955) PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FAC ILITY 2 Unless SNG revenue raising capability matches its Fiscal reforms introduced after the 1997 crisis seek required operating and capital expenditures, it may to control SNG debt through a variety of regulatory experience increased budget deficits, poorer service requirements and indicators, such as a maximum debt delivery, reduced debt capacity, and a deteriorating service to current revenues ratio, among others, as in credit rating. This inconsistency contributes to oper- Colombia and Peru 4. In other cases, national govern- ating budget pressure, leading to budget deficits ments must approve direct debt issued by states, as and SNG short-term borrowing, often by delaying in India. These SNG debt controls are an attempt by vendor payments. Budget pressure may also result national governments to avoid SNG bailouts and in high interest rates charged by commercial banks negative macroeconomic consequences. for SNG lines of credit and other forms of short-term financing. Another potential outcome of revenue and Sufficiently large SNG bailouts may contribute to expenditure assignment inconsistency is delayed SNG increasing inflation, as was the case in Brazil in the debt service payments on its long-term borrowing or early 1990s. To control SNG debt, Brazil passed the outright defaults. Finance directors should take these Fiscal Responsibility Law (2000) that does not allow factors into account in planning an SNG debt offer- SNGs to borrow. However in some Brazilian states ing, whether a commercial bank loan or local capital and some other countries, local governments have market bond issue. circumvented SNG legal borrowing restrictions and managed to issue debt in the local markets 5. In other cases SNGs have increased responsibility to deliver social services, but may lack the legal power Regulatory reforms and adequate monitoring of SNG to increase fees and charges for these services. This debt may help improve a country’s fiscal manage- contributes to greater budget deficits and reduces ment. But without coordinating debt management SNG debt capacity, and could lead to non-compliance with implementation of appropriate revenue and with the mandate. Required expenditure mandates expenditure assignments, SNG debt may grow and Government without concomitant revenue raising capability may create “moral hazard� problems for the central also have an impact on national and SNG government government. fiscal and debt management. monetary policy Moral hazard arises when investors of SNG debt (and contributes to SNG Debt Management and Moral rating agencies) believe that the national govern- the enabling Hazard ment will step-in to prevent SNG default, as was the case in Brazil in the late 1980s and early 1990s. environment Mandated SNG operating and capital expenditures In countries with mature capital markets and more may require SNGs to undertake additional borrow- closely aligned revenue and expenditure assignments ing 3 to comply with existing social service delivery between national governments and SNGs, such as obligations resulting from decentralization reforms. the US, Canada, and France, central governments This increases not only SNG debt, but also a country’s will not intervene in transactions between subnational total outstanding public debt. governments and their creditors, relying on market discipline to control subnational debt. To avoid rapidly increasing SNG debt, whether created by unfunded mandates or for other reasons, Developing countries with SNG debt controls are many national governments have instituted fiscal moving in the direction of the mature capital markets reforms after the 1997 Asia financial crisis. However, to limit moral hazard and encourage sustainable SNG governments should recognize that inconsistent borrowing. However, unless the national govern- decentralization policies that do not provide SNGs ment’s fiscal decentralization policies concurrently with sufficient revenue raising capacity, in addition to removes inconsistencies in revenue and expenditure their expanded expenditure mandates, might result assignments between the different government tiers, in over-indebted SNGs and deteriorate a country’s creditors will continue to require explicit or implicit general macroeconomic conditions in the long term. national government guarantees, exacerbating moral hazard, and limit development of local capital markets. Enabling Environment for Sub National Government Debt 3 Macroeconomic Conditions, SNG ate revenue, such as construction of a new city hall. Economic Base and Debt Capacity If the SNG has a financial policy to recover all costs, A country’s general macroeconomic condition is the including debt, for a project that generates its own foundation of the economic base underlying SNG revenues, the project has to charge a tariff or fee revenue sources; inflation related to operating and sufficient to repay the debt and comply with service capital budget expenditures; and/ SNG’s cost of capi- delivery performance standards (full cost recovery). tal that drives interest rates. These macroeconomic enabling conditions are beyond the SNG’s control, but If the SNG determines the tariff is not affordable form the basis of an SNG’s annual operating and capi- and not sufficient to repay the debt and operate the tal budgeting process and SNG debt management. water supply service, it may have a policy to subsidize A country’s debt service payments with general budget oper- general SNG’s may repay debt from three general sources, ating revenues. However, if the SNG also wants to macroeconomic depending on the type of debt it issues: i) general build a new city hall, it must use general operating revenues to repay this debt. The SNG has to deter- condition is the obligation or issuer debt secured by all available SNG revenues, a “full faith and credit� pledge of the local mine if it has the capacity to support borrowing for foundation of government; ii) tax supported debt secured by a both the water supply and city hall investments. This the economic pledge of a specific tax, fee, or other revenue source, requires a financial analysis to decide if the SNG’s base underlying such as co-participation debt issued by provinces operating budget generates a sufficient surplus for and municipalities in Argentina 6 ; and iii) revenue future water and city hall debt service payments. SNG revenue or enterprise debt secured by tariffs or charges paid sources by the customer for services delivered by the SNG If the financial analysis shows that general budget and or an SNG owned enterprise, such as a water and project specific revenues are insufficient to pay SNG sewer company or department. The underlying cumulative debt service, the SNG has to either raise macroeconomic conditions that support the forecast existing tax rates and fees; introduce new tax and of revenues generated over the life of the debt are fee sources of revenue; increase existing SNG operat- fundamental criteria that credit rating agencies use to ing efficiency; or reduce the amount of investments. determine the SNGs ability to repay debt obligations. The national government’s fiscal and decentraliza- tion laws determine the SNG’s flexibility to change In addition to securing debt, SNG inter-governmental the rate basis to increase revenues and generate an transfers, own source revenue, and service fees and operating surplus. They also impact the extent to charges, fund operating expenditures. These oper- which an SNG can improve operating efficiencies, for ating expenses compete with creditor debt service example by outsourcing services and reducing labor payments over the life of outstanding SNG debt costs, assuming this approach is politically feasible. obligations. Therefore, it is crucial for SNG finance directors to insure that debt service payments over the Macroeconomic and financial system assumptions in life of its total outstanding debt do not result in future the financial planning analysis also contribute to the operating budget deficits. This requires the finance forecast of SNG debt capacity and effect a SNG’s cost director to simulate an SNG’s future operating budget of capital. SNG debt capacity is driven by the inter- and the SNG’s debt capacity 7. How much debt can est rate, price (together, the yield), and duration 8 an SNG support with the projected annual net oper- of its consolidated debt 9, among other factors. The ating balance over the maturity of any proposed national government establishes the “risk free� bench- borrowing? Macroeconomic assumptions underlying mark yield curve for all capital market debt, including the revenue projections, the purpose of a borrowing, debt issued by SNGs. The sovereign yield curve repre- and SNG implicit or explicit financial policies have a sents the lowest yielding fixed income securities in the significant impact on the SNG’s future financial health. domestic capital market. SNG yields are priced off the The purpose of a borrowing determines whether an sovereign yield curve benchmark. The “spread� above investment will generate a fee for service, such as the sovereign yield is the creditor’s perception of the water tariffs charged to customers, or does not gener- SNG’s risk relative to the risk-free sovereign. An SNG’s 4 Notes The Sub-National Technical 1 For purposes of this paper, any political jurisdiction below the national govern- Assistance (SNTA) Program ment, such as states, regions, province, cities, districts, etc., defined in the national constitution are considered as an SNG. As more and more countries decentralize, the 2 A line that plots the interest rates, at a set point in time, of government bonds with different maturity dates. This yield curve is used as a benchmark to price provision of infrastructure is increasingly becom- other “risky� debt in the market, such as mortgage rates or bank lending rates. ing the responsibility of sub-national authorities 3 Short-term borrowing, less than one year, for operating deficits and long-term (local governments and public utilities). These borrowing for capital program investments. authorities are finding it necessary to seek long 4 Regulation 955 of the Fiscal Decentralization Law requires the Ministry of term private financing for their infrastructure Finance in Peru to monitor seven SNG debt indicators. The Ministry can stop an projects. Using annual budget allocations to SNG borrowing if it does not comply with the following indicators: build infrastructure is difficult to manage because the funds required vary greatly from year to year. •Total Outstanding Debt Stock cannot exceed 100% of Current Revenues Long term debt financing allows sub-national • Total Debt Service Payments cannot exceed 25% of Current Revenues authorities to smooth out the annual funding • Average Primary Budget Result over 3 years must be greater than 0; requirement by borrowing a large amount of • Short Term Debt must be less than or equal to Current Revenues/12; capital at one time and then repaying the debt in • Stock of Debt without a National Government Guarantee must be less than 40% of Current Revenues predictable annual increments small enough to • Total Debt Service without a National Government Guarantee cannot exceed make the project affordable to the people served. 10% of Current Revenues The Public Private Infrastructure Advisory Facil- • Year over year Real net financial expenditure growth cannot exceed 3% ity (PPIAF) works with sub-national authorities to enable access to private financing on the best 5 The State of Rio de Janeiro issued asset backed securities (ABS) through the sale of its oil royalties in the local market. The ABS was not considered “debt� possible terms, and shares the lessons learned by regulators, but a sale of assets. Similarly in China, local governments have from its global experience. issued debt by municipal owned corporations and special entities that are not considered as direct municipal debt by the national government. However, in China’s case, the national government recognized the need to stimulate the local economy as a result of the 2008/09 global financial crisis and allowed SNGs to relative risk is a function of the type and amount issue several hundred billion dollars of debt. Some analysts consider this debt of revenues used to support debt service payments, unsustainable that may lead to a local government debt crisis. among other key criteria used by rating agencies to 6 Co-participation revenues are constitutionally mandated transfers from central determine the credit rating for the SNG debt issue government, on a formula basis, to the provinces and municipalities in Argen- (see Credit Rating Briefing). Relative risk is also driven tina. Many other countries have similar revenue transfers from national to local governments that are also used to secure SNG debt obligations. by the extent to which investors view SNG debt with an implicit or explicit national government guarantee. 7 Other financial policies to protect annual operating balance include a “rainy National government guarantee of SNG debt requires day reserve fund�; prohibitions on incurring debt denominated in a foreign currency; debt maturity structure that does not allow a large portion of all a smaller spread than debt issued by SNGs that do outstanding debt to come due in the same year; restrictions on the amount not have a guarantee. This perception may be of short-term debt to total outstanding debt; maintaining, at a minimum, an investment grade credit rating; investment of surplus SNG funds in fixed income driven by the investor’s understanding of securities rated investment grade or higher, etc. the status of decentralization and politi- SNTAbRIEFS PPIAF Approved Logo Usage cal relationships of SNG officials to 8 Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as SNTAbriefs share emerging knowledge on national officials. a number of years. Rising interest rates mean falling bond prices, while declin- sub-sovereign financing and give an overview Logo - Black ing interest rates mean rising bond prices. (See http://www.investopedia.com/ of a wide selection of projects from various terms/d/duration.asp#axzz1oMrUZQ4W). regions of the world. Related notes can be found at www. ppiaf.org. SNTAbriefs are a publication of PUBLIC-PRIVATE IN F R A S T R U C T U R E A D V IS O RY FA C IL IT Y 9 Many SNGs own enterprises that deliver services, such as water, sewer and PPIAF (Public-Private Infrastructure Advisory Facility), a solid waste companies. The debt of these companies, although reported in inde- multidonor technical assistance facility. pendent financial statements, is a legal liability of the SNG. Investors consolidate the debt of the enterprises with the SNGs debt to determine total outstanding The views are those of the authors and do not necessarily SNG debt and cumulative debt service payments. reflect the views or the policy of PPIAF, the World Bank, or any other affiliated organization. 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