93889 Intergovernmental Fiscal Relations and Local Financial Management February 24-March S, 1999 Novotel Hotel, Chiang Mai, Thailand Organized by the National Economic and Social Development Board of the Royal Thai Government and the World Bank Subnational Debt, Borrowing Process, and Creditworthiness by John E. Petenen Government Finance Group (A Division of ARD, Inc.) ©World Bank, 1999 Table of Contents 1. Why Borrow? 2 1.1 The Financing Choice 2 1.2 Linking Governments to the Credit Markets 3 2. Subnational Governmental Debt and Types of Security s 2.1 Prototype Credit Structures 6 2.2 General Obligation Debt 8 2.3 Limited Obligations 9 2.4 Enterprise or "Self-supporting" Financing 11 3. Debt Structures, Instruments, Transactions, and Markets 14 3.1 Maturity or Term of Debt 14 3.2 Debt Service and Interest Rate Structures -15 3.3 Types of Transactions: Methods of Sale 17 3.4 Market Operations 20 4. Documentation, Disclosure and Financial Reporting 21 4.1 Disclosure Requirements and Processes 22 4.3 Financial Disclosures 23 5. Creditworthiness, Analysis and Ratings 25 5.1 Sovereign and Subsovercign Ratings 26 5.2 Subsoverign Rating Factors 26 5.3 Role of Rating Agencies 28 5.4 Private Credit Enhancements 29 Note: Much of this paper draws from John Petersen and John Crihfield, Linkages Between Local Governments and Financial Markets: A Tool Kit to Developing Subsovereign Credit Markets in Emerging Economies (Draft, December 1998). 1. Why Borrow? The use of credit, raising funds today that will be repaid tomorrow with interest, is one of the fundamental issues governments at all levels face. Sovereigns, the usually superior national-level government, will have many more choices in this regard because they have control over the money supply and the operation of the banking system and credit markets. However, the more oi)en that national economies have become, the more even those options are curbed by the workings of the international economy. Subsovereign governments in many parts of the world are now facing the question of borrowing or, if they have borrowed in the past, doing so from the private capital markets as opposed to a governmental entity or local bank. In the past, many local government loans have been in effect mandated by the central government and the underlying borrower had little to say about the purpose or terms and conditions. Part of the process of devolution has meant an opening up more opportunities to decide at the local level if to borrow and if so, then from whom and using what kind of security. 1.1 The Financing Choice: The first choice is whether to borrow at all or simply pay for goods and services as you have sufficient funds to do so. Were there no investment or capital expenditures that provide services over several years, this decision would be an easy one to make. Where capital goods are present, however, the choice becomes more complicated. The arguments for and against borrowing and going into debt are repeatedly debated and the cogency of those competing viewpoints vary across time and places. Generally, however, the choice of using resources today versus waiting until tomorrow is one that entails a cost (interest) just like any other economic choice. In economies with adequate savings, stable political systems, health economies, sound financial institutions and good growth prospects the cost of borrowing tends to be lower. The reverse is true when these factors are absent. Everything else being equal, the arguments in favor of borrowing (if the credit markets permit it) are strongest in growing economies. There are three major reasons for this. First, on a pragmatic basis, the amount needed for the expenditure is too large to raise from current resources and because of the lumpy nature, all the spending must be done before there are nay benefits. Second, the infrastructure needed to accommodate future growth is needed today. To delay providing it Will slow the growth that will improve conditions including the abilty to repay debt But it is important to note that the debt must support productive growth and not be poured down a rat hole of unproductive uses. The third argument is that it is more equitable and economically efficient to have those that over time consume capital and get its benefits to contribute to the costs. When the technical problems of funding "lumpy expenditures" are combined with those of intergenerational equity and economic development, borrowing becomes favored where markets will accommodate it. 2 Arguments for "Pay-As-You-Go" versus Those for Debt Financing Arguments for "Pay-As-You-Go" Financing • No interest expense is incurred. Money not spent on interest costs can be. used to . fund additional projects. • Debt capacity is reserved for other, possibly more important future projects. • Future users/taxpayers have no say in whether debt is issued are not responsible for paying for projects approved by today's government. • Use of credit is too tempting and will lead to over-commitment of future resources. Arguments for Debt Financing • Current revenues are insufficient and too inflexible to fund "lumpy" cash needs on a pay-as-you-go basis. • Future increases in construction and acquisition costs can be avoided by funding and building projects today. • Future inflation reduces the cost of borrowing. Debt can be repaid with currency that is worth less than the value of that borrowed. • Payment of costs for use .of capital can be synchroniz.ed with the flow of benefits over the useful life of the asset being financed. This section begins with the premise that a decision to borrow bas been made and that it is now a question of how this borrowing is best done given the available options. For the most part, the peispcctives taken will be that of the subnational borrower and the lender or investor, although there are many places where the policy choices already made or to be made at the national level will have a bearing on the discussion. In most countries, subnational debt (to the degree it is reported) usually makes up but a small portion of total public and private debt. As noted in the introduction, that situation is likely to change with growing devolution of responsibility and decisionmaking to the local level. Growth depends on putting needed improvements in place as soon as possible. Going in debt will permit growth to occur and increase the means for its repayment in the future. 1.2 Linkages to the Credit Markets In most countries, even the smallest, least sophisticated governments have some linkage with the financial markets. The basic nexus is found in the relationship with the banking system and the county's payments mechanism. As the system matures, other financial institutions arise that beckon for the local unit's interest, such as insurers and various funds that may wish to attract the government's financial assets, such as 3 investment funds. A higher stage yet of development occurs when the local government begins itself to directly enter the securities markets, as either a lender, borrower, or both. In many countries the banking system was once under the control of the central govenunent or, perhaps, provincial governments and banks that traditionally served the local units may persist in that relationship. The banks will act as depositories for local funds, receiving and providing cash payments and holding balances in safekeeping. They also will provide checking and wiring services and act as the principal outlet for short term investments. Typically the larger governments become, the more services they may require of banks and the more options they have among potential bank vendors. With the privatization of commercial banking in much of the world, local governments may find themselves in a changing environment as regards to choices and growing linkages to the financial markets. The privatiz.ation of banks and the opening up of domestic banking to foreign competition has broadened the market for banking services and is likely to expand the alternatives that are available to individual units of all sizes. However, the greater the financial size and activity of the local unit, the more attractive it becomes to local banking service vendors. As is true with many other markets, banking services can offer economies of scale. Growing autonomy and size of operations at the local level will likely lead-to greater freedom of choice over how assets will be invested and liabilities created. Banks, for example, typically depend heavily on short term deposits for their capital base. The tenure of these deposits and how much interest must be paid by the bank to retain the accounts are increasingly subject to competitive forces. Banks, if managed and supervised according to prudential standards, have limits on the size and maturity of---- loans, how such loans are secured, and how much lending they can do to any given economic sector or any one borrower. Moreover, various borrowers are subject to credit standards that determine how much in the way of reserves banks must hold for a particular type of loan or borrower. A major attribute of the growth in privatiz.ation of assets and overall growth ;n economic activity has been the increase in the size of capital markets. Capital markJts are usually divided into two broad sectors: the credit market, which is concerned with debt obligations of various maturitites and the equity market, which deals in "shares' or "stocks," which deal in evidence of ownership. Within these two broad markets, many subdivisions can occur, depending on the nature of the issuer, the entity that is proving the instruments or securities that evidence debt or ownership, and the technical nature of the securities instrument being offered. In this paper, the focus is on borrowing and the management of debt. But, it is well to keep in mind that borrowing transactions may be related to other services to local governments that financial institutions can provide and may involve more than one financial service and financial market. 1 1 For example, local depository banks may hold large cash balances for local governments during the course of normal operations, as a result of the proceeds of bond sales, or as sinking funds against outstanding debt How these 4 2. Subnational·Governmental Entities as Borrowers Subnational debt may be the obligation a local, regional, provincial, state government, or of projects that are sponsored by them, including projects involving the private sector through subsidies, partnerships, and concessions. The legal and financial relationships that subnational governments may enter into, including the type of debt they contract, can differ markedly among countries. In many places these relationships are evolving and even where they are established, they continue to be dynamic. Thus, the policymaker and the analyst alike must be prepared to look at a variety of factors and risk exposures when dealing with the debt transactions of subnational governments. Analysis of subnational government debt can have many elements in common with other borrower types such as public utilities and private sector firms. But, there are some special features relating to the powers, structure, and operation of the subnational governments themselves. For example, most local governments deal exclusively in the domestic currency for revenues and expenditures. Thus, except for certain types of facilities (electric power, ports, airports, telecommunications), they will not have much access to foreign currency payments. Also, governments typically have certain powers over the local market for services that approach monopoly status that may be enforced by regulation. On the other hand, governments are site-specific and unable to change the geographic locus of business or the fundamental nature of the services they provide. And, by that same token, they do not go out of business. A fundamental distinction in classifying debt is whether the obligor is the subnational government itself or if the obligor is some other, more limited legal entity. The obligor may be the subnational government itself, relying primarily on its taxing power and other genera.I governmental revenues to form the credit backing of the loan (i.e., general government borrower); or the obligation may be limited to a particular revenue source of an enterprise to which the general governmental credit is not pledged (a limited or non-guarantee obligation). This distinction is reasonably clear in the United States where a revenue-generating project or enterprise that is financed with a limited obligation is referred to as a revenue bond. In Europe, the term "ring-fenced• obligation is frequently used. However, the distinctions between general and limited pledges can be blurry. This can be the case in a project financing where there may be mixtures of public and private funds, service and off-take contracts, profit-sharing arrangements, concessions with guarantees of use, etc. This is especially so in those countries where · governments formerly carried on a variety of commercial, industrial activities that are funds arc invested, in what types of securities and at what rates of interest are very important to calculating the cost of borrowing. By the same token, when governments borrow from banks, there is often a requirement that sums regularly be set aside in a sinking fund to repay the principal at term. It is clear that unless the interest earned on the sinking fund is equal to that paid on the loan, the government should be repaying the loan by amortizing the principal in installments rather than investing in a sinking fund that is payable at the term of the loan. s now being totally or partially privatized. A major distinction is found in those "project finance" cases where the private sector is a direct investor in a project, an equity provider and/or the operator of the facility, and is actively engaged in its operation and management. In those cases, the analysis may become very complex and .involve a blend of risk factors involving both the public and private sectors. 2.1 Prototype Credit Structures The accompanying charts present simplified schematic illustrations of three prototype financing and credit structures involving subnational governments. For ease of exposition, we have assumed that the financing involves a project, which is typically the case. However, the borrowing might be used for other purposes, including relending. a. General Government Obligation (general revenue supported) · In this case the government uses its general revenues to support the debt service payments and owns and operates the project itself. In most countries, this would be the likely structure for public safety, public education, and health and welfare capital expenditures, which activities themselves are not revenue producing. The government issues the debt in its own name and pledges its general revenues. The proceeds of the borrowing are spent on a project. However, neither the project itself so financed or earnings from it are specifically tied to the repayment of the debt. An important variation on this theme is where the local government gets intergovernmental assistance, such as shared taxes or grants, which are pledged as part of the security. A. General Obligation Revenues Debt Government Project 6 b. Limited Obligation ("Revenue Bonds") In this case, the facility is an enterprise that produces revenues through charges and fees that are used to defray much or all of the costs of operation and debt service. The debt is secured primarily or exclusively on the project earnings, general revenues are typically not pledged directly, and there may be a prohibition against their use. Common subnational enterprises are public utilities, such as water and sewer, electric distribution, local toll facilities, public markets, harvest processing facilities and local ports and terminals, etc. The debt is issued either by the project itself (which may be a limited-purpose special district) or on behalf of the project by the general governmental sponsor. B. Revenue Obligation Revenues Government I ~ Debt Project c. Project Financings {public/private undertakings) In this third case, which is typically a "utility" type project, the government enters into arrangements with the private sector in the form of concessions or . partnership agreements to build, own, and/or operate the project. The government, either national'or local or perhaps both, may provide any number of inputs into the financial structure: equity interests, subsidies, and various forms of guarantees related to the demand for outputs or for supplying needed inputs. Likewise, the private sector, or international lending entities, may contribute debt, equity, and various enhancements to the financial mix . The obligations of, and returns to, the respective parties are determined by contract. The debt is typically issued in the name of the project and may be non-recourse, looking only to project earnings, ownership, and/or assets for security. 7 C.Project(Public/Private) Revenues Government Private I I \ I Debt Project Equity As outlined above, types ofdebt are defined by the kind of security given by the borrower. Security (that is, where the money will come from to repay the debt) typically runs to two questions (I) where the money is expected to come from if everything goes as planned and (2) where it might have to come from, which is the ultimate collateral and remedies in case of failure. Before investing, creditors want to know not only where the money is expected to come from, but also what are their remedies or security in the event of default. Unless the remedies and security are deemed adequate, the markets may set risk premiums that make credit unaffordable to many jurisdictions. Knowing the security on debt is important because uncertainty as to remedy and security builds inefficiencies into the market.2 2.2 General Obligation Debt General obligation debt typically is taken as the pledge of a governments taxing power and other assets, real and financial, to the payment of debt service. But while the 2 The question of what remedies should be available by law to creditors is critical. Any framework for subsovcreign borrowing needs to spell out what powers a jurisdiction has to pledge assets, revenue streams, and to exercise its powers to set taxes, tariffs, and other levies. It is also desirable to spell out how such security can be affected in the event of default or other financial emergency. 8 · concept seems pretty clear, the precise legal meaning of the definition is fraught with uncertainty. Most emerging countries, with the exception of the largest units, general purpose subsovereign debt has in the past carried some form of sovereign government backing. Increasingly, national governments are attempting to wean local governments off of. such backing and encouraging them to borrow on their own credit. The security offered by (and creditworthiness of) the subnational unit, without an explicit or implicit guarantee by the national government, is often not clear. Accordingly, expressions such as "general obligation" or "balance sheet" debt often mask an unresolved question of ultimate security: that is, just what remedies are available to an investor in case the unit fails to pay on time and in full. 3 Aside from the good faith of a jurisdiction and the prospect of national assistance if things get difficult, subsovereign general obligations have often been backed by the - ability of creditors to seize financial and physical assets. For a number of reasons, this physical collateral system is not a sound approach to securing credits. Local governments with physical assets that are unrelated to their municipal service responsibilities, e.g. a commercial enterprise, might be best advised to divest themselves of the asset so as not to divert scarce city management capacity to managing a potentially private activity. Municipal assets that are used directly or indirectly in the provision of vital services should not be risked as collateral. 2.3 Limited Obligations Governments need not in most cases pledge there full faith and credit and general taxing source to repaying a debt. Limited security can be given to secure subsovereign debt. Possible limited security arrangements include the following: • Pledging of physical or monetary assets. • Pledging the right to operate a facility or provide a service. • Pledging of selected revenues, such as: From tariffs, fares, or rentals. From particular taxes or special levies. From grants or shared taxes (intergovernmental transfers). • Pledging the power to set specific tax rates, utility tariffs, and other levies. • Pledging by the executive to budget for and recommend payment of future debt service, without an explicit binding pledge that those appropriations will be made.4 • Pledging to assign the payment of future intergovernmental revenue. 3 Thus, both new and existing holders of outstanding subsovcrcign debt where the sovereign guaranty find themselves asking what security stands behind general debt issues of local governments. A central question is what remedies arc available to enforce that promise. 4 This type of security is known in the U.S. as appropriation or moral obligation debt. It recognizes that debt is not a full faith and credit binding obligation but rather is subject to the will of successive legislatures. Its origins arc out lease rental debt that holds that the obligation only runs from fiscal year to fiscal year and is subject to reconsideration of the legislature each year. 9 A very common form of pledge backing debt in developed markets is one which is restricted to a particular revenue stream or a enumerated local government assets. Also possible is for the creditor, in case of default, to step in and perform the activity and recei~e the revenues. But, both the carving out of specific revenues and giving the creditors rights to assets and operational powers raises a host of operational and policy issues. A pledge of revenues from public utilities is appropriate for financing related to those utilities that benefit from the financed improvements. But, it raises concerns ifthe pledge of revenue-producing properties are used to secure unrelated financing. Part of the concern is simple economics. When a jurisdiction subsidizes general expenditures at the expense of utility charges, it results in a misapplication of resources. In economic theory, and usually in practice, the service that does the subsidizing is undercoated, and the service that is subsidized is over-allocated. Local revenue-raising powers may be limited in emerging economies. But, ·even where the powers of local governments to set rates and make levies do exist, there can be ambiguity as to whether local government can pledge to set tariffs, tax rat~s, or other charges at a level sufficient to service a debt. 5 There can be issues as to whether such covenants unlawfully bind future administrations and legislators in the exercise of their prerogatives. However, without such a forward-looking and binding-contract ability to pledge, the pledge is much less meaningful to the point of being worthless. Where the tariffs, rates, or charges can be increased or decreased at the discretion of the local authorities, a covenant to set and maintain those tariffs, rates, or charges at adequate levels to meet operating costs and pay debt service is a useful financing tool. The experience in many emerging market countries is that the primary cause of debt service default and payment arrears is failure to increase rates and charges that were planned to be the source of revenues. Subnational jurisdictions will benefit from clear legal authority to covenant future tariff or tax increases to secure debt. Jurisdictions may choose whether or not to use this mechanism, but they should have the legal authority to covenant, if possible. In many countries local jurisdictions can assign creditors their interest in specified revenue streams, such as shared taxes and grants, received from the national or other higher-level governments. Revenue intercepts are attractive to a creditor because they promise frequently stable and predictable revenue stream that can be easily accessed to pay debt service. Intercepts can be designed in various ways either to assure adequate funds are available to meet debt service payments prior to their coming due (an ex ante intercept) or to be tapped only in the event of a local government's default (an ex post intercept). Another variant is to have a bank credit facility standing by to advance money in case funds are not on hand to meet debt service payments and then have the loan repaid out of future intercept receipts. 5 Such provisions are known as rate covenants. 10 Intergovernmental Transfer Payments As Collateral Typically, in newly emerging economies, local governments are highly dependent on transfers from the central government. While these can be very volatile and untested for sustained periods of time, they form a major portion of revenues and are attractive for interception to cover debt service payments. Columbia offers an example of the widespread use of intercepts of central government payments to cover debt service through the Findetere program. · As a rule, if intergovernmental payments _are used for pledging, there should be . a coverage factor so that the historic and/or expected level of transfer covers the debt service payments by some fraction greater than one. In the Philippines, about 50% of · ~ revenues received by cities are through .intergovernmental transfers from the . national government, and for provinces the average figure is 75 %. The smaller and more rural the local government, the higher the proportion of transfers to total revenues. In that country, government owned banks (the de facto required-depositories for local governments) have· gotten deeds of assignment of transfer payments to cover bank loans 7 As aid is received, the banks have a right of offset against any loan amounts owed the banks prior to dispersal for other purposes. . •. Intercepts_can have a powerful impact on local borrowers, especially small and . remote units . . The assignment to bondholders of state payments to local school districts (which typically make up over 50 percent of revenues for the districts) is .very common in the Unitect States and is the basis for high credit ratings by local school districts covered by·such programs, which is usually only one full notch below that on the state's general obligation debt. 6 As a result of this amt other small-borrower preferences, local schools are among the lowest cost borrowers in the U.S. municipal bond market. · 2.4 Enterprise or "Self-supporting" Financing . A common use for special pledges of revenues and assets is for a self-supporting "enterprise" that generates its own means of repayment and does not rely on recourse to general revenues. 7 . This limited obligation involves the pledge of only specifled system or project revenues to repayment. In accounting terms, this implies the creation of a special fund to receive the specified revenues, which are expended to meet costs 6 One notch means if the state's general obligation is AAA, then the intercept protected debt will be rated AA. 1 This is the traditional notion of the enterprise revenue bond. There is a legion of variation on the idea, many of which have been designed in the U.S. to circumvent restrictions on tax-supported debt. This approach allows and encourages allocation of full costs of services to the beneficiaries. Economically, this is desirable because it leads to efficient allocation of scarce resources. 11 . associated with the enterprise, including the payment of debt. This concept focuses credit concerns on the viability of a particular project or system, rather than on the viability of the jurisdiction. Poor or unsound general purpose governments in theory can have viable enterprises, and vice versa.8 There are several advantages to this type of financing: • It establishes a relationship between the cost of service and service prices. This promotes more efficient operations. The cost/price relationship need not be absolute and can be modified in practice, but it has the benefit of assembling the costs and making any subsidy paid transparent. • If the utility has been run at a surplus to subsidize other governmental functions, then the added ''tax" burden resulting to utility users becomes evid~nt. • To the extent that general revenues have subsidized enterprise operations, the use of dedicated revenue structures will free up general revenues to pay other costs.9 • Management and operation of revenue-producing facilities tend to be more efficient and the facilities are better kept up since they need to be in shape to produce revenues. This can be encouraged by contractual provisions protecting income and value, paired with creditors' active interest in assets and their operation. • When there are legitimate reasons to use general revenues as well as specific revenues, it may be better to use general revenues to reduce the amount of debt incurred. For example, by making a municipal "equity" investment in the asset up front, and borrowing to build or acquire the rest of the asset, pledging only revenues produced by the asset, or even a part of the asset's operations, to meet debt service requirements. This practice is common in Western European countries for many municipal utility operations. There are also disadvantages to limited obligation, self-supporting financing. • The expressions "asset stripping" or "security dilution" convey the concern faced by existing creditors of jurisdictions that have relied on a utility to generate subsidies for the general fund, when those revenues are instead pledged to a utility-speCific purpose. 10 In other words, where prior lenders have looked to the overall revenue~ as a source of repayments, a subsequent sequestering or stripping away of revenue streams weakens the credit. 8 This will depend greatly on the operational and legal strength of the ring-fence between the enterprise and its governmental parent. 9 In some places, such as in South Africa, the subsidy runs from the utility to the general fund, rather than the other way. IO However, most economists would applaud this elimination of the cross-subsidy on efficiency grounds. 12 • Limited obligations may hinder redistribution of infrastructure and services among population groups (say, from rich sections to poor ones) by keeping potentially redistributable revenues for the benefit of an already privileged area. If there are to be preferential and redistributive policies they typically must be financed from the sponsoring unit's general funds. • Future financing options are restricted. Enterprise financing is a matter of contract between the public-sector sponsor, acting on behalf of the enterprise, and the investors. 11 Investors typically will require restrictions that reduce the options of borrowers in the future. For example, borrowers must meet certain conditions before they are able to issue more debt secured on the enterprise earnings (additional bond test), must conform to certain requirements regarding reserves and insurance, and must abide by a rate covenant, as was discussed above. The above discussion focuses on that enterprise financing associated with traditional "natural monopolies," public utilities provided by local governments. However, there are other potentially revenue-producing activities that are "semi- commercial" in character, such as transportation terminals, public markets, 'abattoirs, farm processing plants, and the like. In addition, industrial estates, tourism facilities (including hotels), toll roads and bridges, and a number of other revenue-producing facilities are candidates for complete or partial financing by the use of "revenue bonds.' Critical components of such proposals aie the ability to regulate the market (control competition), the reliability and growth of revenues, the technology used, the facilities' adequacy, firm construction dates and costs, and operating costs that are either fixed or controllable in the future. Depending on the nature of the facility, determining the nature of and risks in these technical and economic factors requires engineering studies and market demand studies. The objective of the studies, from the financial perspective, is to obtain objective estimates of what will be the net revenues available after operations to pay debt service on the loans or bonds and, if not, what steps might be taken to ameliorate the situation. Such studies are especially critical in new, free-standing projects where there is no experience.yet with operations. 11 For example, there may be requirements that the borrower not pledge the same asset to another lender, except under st8ted conditions (additional bonds test), that the revenues provide certain coverage of the debt service (rate covenant), and that revenues be retained for use on the facility and to the benefit of bond holders (closed loop). Negotiation of these restrictions and the associated tests is an integral part of the borrowing transaction. 13 . 3. Debt Structures, Instruments, and Methods of Sale Debt structure and instruments have to do with the mechanics of how the principal of debt is to be repaid, how long a debt will be outstanding and the how interest due on that d.ebt will be figured and paid. Method of sale has to do with the procedures by which debt is offered to the final investors and debt obligations exchanged for the bond proceeds. Beyond legal restrictions that may be placed on particular types of debt or issuers, these matters are usually determined by the market. That is as it should be, assuming that the market is competitive and that debtor, investor and banker are all equally well informed. The financial markets are fluid, and what might be attractive one day can be unattractive the next.. Inflexibility is costly. A major concern at the national level in many emerging economies is not to interfere with the flexibility of lenders and borrowers in structuring debt so as to suit both parties. This section describes debt structure and illustrates the range of instruments available to suit the profiles of issuers and investors. 3.1 Maturity or Term of Debt The maturity of a debt instrument should be no longer than and, better yet, matched to the economic life of the asset it is financing. Ideally, amortizing the liability on one side of the balance sheet is matched by the depreciation of the asset financed. Thus, infrastructure assets, such as water systems, roads, or municipal buildings, which typically have lives of 15 to 30 years, should, in principle, be financed with long-term bonds of similar duration. 12 In many emerging markets this matching is impossible to accomplish as investors are unwilling to extend loans beyond a few years and even then, the rates of interest may be exorbitant because either there is large perceived risk beyond a few years and/or capital can be committed at short maturities at substantial returns. Even if longer term capital is available, the shape of the yield curve may make borrowers prefer the use of shorter term debt. 13 Typically, the yield curve is upward sloping, i.e., the longer the term of the debt, the higher the interest rate payable. The upward slope is caused because investor5 want extra compensation for the lack of liquidity of long-term lending. They have increasing uncertainty as to what economic conditions, price levels and interest rates will be in the future. But that is not always the case. Short-term rates may be temporarily driven up by liquidity shortages and efforts to defend the currency. Moreover, if expectations are that the prevailing level of interest rates is unsustainably high, and that rates are expected to fall, then the yield curve may be inverted, with short-term rates higher than long-term rates. In such cases some borrowers 12 Matching asset life to debt tennis also sound public policy because facilities can be paid for by those who use them. 13 The yield curve is sometimes called the tenn structure of rates and relates the interest rate to the term of the debt (the years it will be outstanding). 14 . may borrow short, if they believe long-term rates will fall. Others may choose ·to lock in the relatively lower long-term rates. There is also a trade-off between the lower rates typical of short-term debt and refinancing risk. If the debt is shorter in maturity than the life of the asset, the issuer is exposed to refinancing risk, i.e., new debt may have to be raised during the life of the asset at a higher rate than the original loan. If the borrower's credit risk has worsened, it may not be possible to refinance. Refinancing can, of course, work in favor of the borrower. That happens if the general level of interest rates declines or where the issuer's credit has improved relative to that of the others in general. In the case of general obligation bonds, the latter situation could happen as a result of improved general creditworthiness of the jurisdiction. In the case of project finance, the construction and initial phases of operation are riskier than later phases in a mature project, and it may be possible as time goes by to refinance at lower rates. However, financiers are aware of this, and rely on the later phases to provide some compensation for the additional risk taken at the outset, so would probably reserve the right to refinance for themselves. 3.2 Debt Service (Repayment) Struc~es The cash flow profile of debt refers to the way in which the borrower pays and the lender receives interest and principal over the life of the liability. Several common profiles as found in the bond markets are described below. A term bond typically has a fixed interest rate and maturity or term, and pays a semiannual interest payment or coupon with all of the principal due at the end of the life of the loan. On the other hand, a serial bond has the principal repaid in installments over the term of the debt. These repayments of principal, known as the amortization ofprincipal, may be variously structured. Principal may be repaid in equal increments, which is called a level principal structure and leads to progressively smaller debt service payments ("front-end loaded'). This conservative approach leads to rapid repayment of debt and frees up future borrowing capacity quickly. On the other hand, if the debt service payments are level, then the earlier year payments contain proportionately more interest than principal. These are called a level debt service structure. Alternatively, the debt service schedule may be structured to increase over time. Use of the increasing debt service structure ("back-end loaded") in municipal bonds is increasing in the United States and elsewhere in those cases where growing revenues are believed very likely to occur. Bonds may carry options that are of value to the issuer and investor. One that is prevalent in the U.S. market is the call option which allows an issuer to shorten the life of the debt if it chooses. This option usually is not available for the early years of the debt and then carries a cost to effectuate. The counterpart to the borrower's call option is the put option, which allows the investor to put or tender the bonds back to the issuer before their stated or nominal maturity, usually at pre-stated dates and for the par value of the bonds. 15 Original discount bonds, called "zeros" when they fully discount future interest payments, pay no or reduced interest coupons. The investor realizes interest return by buying the bond substantially below its principal value. Such bonds can be originally issued at discount or may be created synthetically by investment banks by stripping the coupon off a standard term or serial bond. Zeros are attractive to parties who wish to secure a fixed amount of capital in the. future without being exposed to reinvestment risk. When the zero bonds are created synthetically, the coupon stream from a stripped bond can be sold to an investor who is primarily interested in an annuity flow. Cash flow profiles can be engineered to match the cash flows generated by the activity that is being financed. Liabilities can be index-linked, where the revenue flows are expected to vary with an index, such as inflation or an input cost. In this case, interest payments can go up or down, depending on the movement of the index. As noted, amortizing payments can be structured with an escalating profile, with lower debt service in the early years. This is common in commercial property finance, for example, where there is a "ramp-up" period when rentals are expected to escalate, and can be appropriate for certain municipal assets. Similarly, interest payments for initial periods can be deferred by using bond proceeds to pay interest costs in early periods (capitalized interest). Bank loans or municipal bonds may be made at either fixed or floating rates of interest. Floating or variable-rates as they are also called are interest payment mechanisms wherein the interest rate is reset from time to time. 14 In emerging markets, the variable rate may be the only interest payment structure available for obligations beyond a short maturity. The relative advantages of fixed versus floating rate debt are similar to those regarding short term versus long term debt. Floating rate debt implies continuous uncertainty about the cost of debt, but it can be appropriate where revenues are expected to vary in concert with changes in interest rates. However, this is not usually the case for municipalities. Financial flexibility and access to liquidity are very important considerations for floating-rate borrowers. If there is limited ability to change taxes or rates to respond to rising interest rates, then over-reliance on variable rate debt is worrisome. The rating company Standard and Poors generally recommends that the combined short-term debt and variable rate debt not exceed 20 % of total debt but it depends on the circumstances . (degree of flexibility) and matching of revenues versus debt service. 1s Bonds also may pay interest on a variety of interest payment or "coupon" dates. Although the semi-annual is the most common, structured loans can have varying coupon 14 The interest rate may be mechanically pegged to some market index or may be set by a repricing agent that declares the rate needed to place the securities. 15 In the United States, where there is an upward sloping yield curve from short-term to long-term tenor, there has been a reward of between l 00 and 200 basis points for using variable rate instead of fixed-rate debt The structure allows flexibility to restructure debt, since it typically can be called at the reset date to restructure debt 16 profiles (semiannual, quarterly, even monthly) to suit the cash flows requirements of the borrower and the capacities of the issuer. There are several caveats to make in considering the cash flow of bonds. It is unlikely that the repayment structure of bonds should be regulated aside from confining borrowing to capital expenditures and having maturities not exceed the useful economic life. Most municipal bonds in emerging markets have had short maturities and frequently have had term bond or bullet maturity structures. This, in effect, has meant that the loans to local governments were for the construction and start-up period. Then, implicit in the repayment structure, they have required the borrower to "roll over" the loan into another one at maturity or to come up with alternative means of long-term financing. Such an approach subjects the issuers and lenders to great uncertainty regarding future debt service requirements and effectively holds borrowers hostage to future changes that may be forced upon them when they again come to market to renew the loan. The dependency of many emerging country borrowers on variable rate and end- of -the-loan term maturities are major factors in increasing the riskiness of their obligations. A final area of policy regarding the structure of instruments is that of the restrictions that may be placed on 4tterest rates or on the maximum maturity of bonds. Interest rates may be capped by "usury rates" that set an absolute ceiling on the rates the issuer will pay. While this was once common practice in the United States, the restriction has disappeared for all practical purposes over the last twenty years. The effect of limiting interest rates is to ration capital away from governments during periods of high interest rates. Such restrictions continue to be seen, however, as a matter of contract in the case of variable rate instruments, where a cap is either introduced or a borro'wer may purchase a rate cap contract from a commercial bank that will agree to pay the excess interest for a fee. The other common restriction is on maximum maturity, which is often specified in conjunction with the expected useful life of the improvement being financed. Again, these are seldom effective and the market itself provides the limitation on how far it will extend debt, especially at fixed interest rates. 3.3 Methods of Sale Municipal securities can be sold to investors in a number of ways, ranging from the competitive auctioning of bonds to the highest bidder to a placement of them with the final investor, much as a direct loan is made from a bank. In most emerging markets, the sale is done through a process called negotiation, in which the borrower procures the services of a financial services firm (such as an investment banking firm) to sell its bonds to the final investors. 16 The firm either will underwrite the issue, in which it agrees to buy the bonds at a certain price, or act as placement agent and which it does not agree to 16 For larger bond issues, a combination of firms, called a syndicate, may band together to underwrite and distribute the issue. 17 . buy the bonds but rather makes a "best effort" to sell them and for which it receives a commission on the bonds sold. The various methods of sale have their advantages and disadvantages. Generally a competitive sale environment requires there be a very active market with a large number of issuers offering fairly standardized securities and a large number of investors interested in owning them. The large volume of activity results in a number of bankers that follow the market, make bids, and place bonds to investors. It also means there are other professionals that help with the design of the issues, preparing documents, and running the auctions. 17 The competitive auction, with Several underwriters bidding on a bond issue, as commonly seen in the United States municipal bond is a rarity in other markets. Where bond markets are less homogenous and sales are irregular, issuers typically require that an underwriter be hired to help prepare the issue and to seek out possible investors. This technique is called a negotiated sale in which the underwriter is selected before the sale of the issue to final investors. The negotiations can be made competitive by injecting elements of competition among firms into the underwriting selection process and subsequently by holding underwriters to the projected terms of the issue. To help achieve competition, the issuer may employ the services of a financial advisor that is knowledgeable in the design of transactions and the process of marketing of securities to assist it. The advisor can perform a variety of functions but in the negotiated transaction its primary duty is to assure the issuer that it is being dealt with fairly by the underwriter and is holding up its end of the transaction. The advisor usually helps the issuer in the process of selecting the underwriters. See the box on Krakow Selects An Underwriter. The underwriting process, as opposed to the use of a best effort marketing arrangement, has the advantage of guaranteeing the issuer that sufficient funds will be borrowed. However, the investment banker undertakes the risk of reselling the issue and will demand more remuneration in the process of underwriting than simply acting as a placement agent. To make their profit and to cover expenses, the underwriters buy the bonds at a discount, which means that they buy the issue for less than the value at -,Wch it is reoffered to the final investors. · The mechanics of selling of the bonds and the setting of interest rates and other terms differ among the various domestic securities markets. In some countries with relatively small inactive markets, the terms of the bond offering may be set well in advance of the sale date. The bonds may then be sold on a given day with a discount or premium to make returns competitive with prevailing interest rate conditions. The technique of fixing terms will before the sale date tends to put the underwriter firms at most risk and issuers pay an interest rate premium in fixing the rates. Another approach 17 Other professionals include financial advisors, legal counsel, auditing firms, and printers to produce the documents. There may also be banks to handle the investment of proceeds and to oversee the payments under the debt contract (trustees and paying agents). 18 . is to commit to have the bonds underwritten at a certain mark-up or in relation5hip to some regularly published interest-rate index, usually that on government bonds. Finally, the terms can be determined by offering the bonds at a proposed structure and then changing the terms to meet the effective demand from investors in what amounts to an "infoi:mal" auction. The key point is that the terms and their acceptability to the issuer remain open until the sales contract ~th the underwriter is signed (the bond purchase agreement). Selecting and Underwriter by Competitive Negotiation The gmina (city) of Krakow Poland proposed a bond issue for 15 million Polish zlotys in 1996. The city, assisted by a financial advisor, sent an RFP to a large number of investment banking and commercial banking firms. the solicitation described the project and needed funds, provided information about the city and asked for proposals from interested firms. The RFP and selection process contained several elements designed to make the choice of firms transparent and competitive. The RFP contained a tentative maturity structure for the issue and asked responded to price the bonds (provide interest rates) and to indicate their gross profit, assuming that the bonds had been sold on a given day. In addition, the respondents were asked to estimate an itemized list of costs and to indicate which .c osts would be met from their profits and which would be paid by the City. Respondents were also asked to critique the structure and suggest alternatives of their own. Finns were also asked about their experience and financial capacity. The combination of factors were used in selecting the finalists, but all-in cost of borrowing was the most important. All costs, including future interest payments and fees paid by the city, weie mad comparable terms using a all-in-cost internal rate of return calculation. After the responses were analyz.ed by a committee, individual firms were contacted to clear up any questions (all responses were kept confidential). Of the eight firms (and syndicates of firms) that responded, the best three were invited to make presentations and to make their best and final offer. A syndicate made up in part of the local representative bank was selected. The final offer committed the underwriting syndicate to price the proposed bonds on a par with Polish Treasury bonds of the same maturity, a highly aggressive bid. Subsequently, Krakow received an investment grade credit rating from Standard & Poors and sold bonds (Duestchmark denominated) in the Euromarket in late i 997, the first Polish city to do so. The bond instruments or other evidence of ownership are delivered (physically or electronically, depending on prevailing market practice) and money is exchanged for them (settlement) from the day of sale or up to two weeks after the sale. Depending on market conventions and the nature of the security, the borrower (or the underwriter) may 19 . have selected a paying agent and/or a trustee that receives funds from the issuer and makes the periodic payment of interest and principal. The trustee, if one is used in the transaction, has the additional duty of overseeing the bond contract between the borrower and ultimate buyers and is responsible for looking after the interests of the investors. The important thing to remember is that beyond the procedures set down by enabling laws at the national level, the specifics of the bond offering are a matter of contract among the underwriter, the ultim3.te investor and the issuer. This puts a premium on the issuer getting good legal and financial advice independent from that given by the underwriter and the final investor. 3.4 The Securities Marketplace Bonds are attractive because they potentially can provide greater diversification and liquidity to investors than can direct loans. That is, unless the bond is in some way restricted in secondary market trading, it can be put up for sale, thereby giving the holder · liquidity before its maturity or enactment date. Ideally, there is a marketplace in existence that provides quotes of the prices at which holders are willing to sell or purchasers are willing to buy. Domestic securities markets in emerging nations are in various stages of development and reflect differing philosophies regarding regulation, intensities of competition and technological development. There has been a tendency for regulators in emerging markets to force all securities (equity and private debt) to trade on the formal exchanges in order to develop the exchange. But formal exchange listing requirements, which typically are copied from those in developed countries, can be burdensome and the related fees, costly. That burden and cost can be unfair to new companies and to those that are small. One answer has been to create a separate bracket for smaller, higher risk companies. (Japan, for example, has a corner of its exchange set aside for small, higher- risk companies). Another approach is to allow the development of an OTC or dealer-to-dealer market. The OTC is a ''telephone" market where there are dealer to dealer trades in securities that are not listed on the exchange or that can be traded off the exchange as well as on it. or the restriction of certain classes of offerings to sophisticated institutions and individuals. This approach provides trading liquidity to otherwise less liquid shares without exposing the general public to undue risk. New credits can season and then graduate to either ~estricted OTC trading or an exchange listing at a later time. Regulations that permit the creation of a number of separate markets can be uneconomic and lead to an undesirable diffusion of resources. The most recent moves have been toward fewer organized exchanges and towards a screen-based, fully reported trading as opposed to the open-cry , single-place market. 18 The more integrated and 18 A recent article on future of the exchanges indicates that the number is likely to decline rapidly and a few large international exchanges will dominate activity. See "Survey: Financial Centers" The Economist (May 9th - I 5th 1998) 20 transparent a market's operation, the better defined the market's participants artd scope, the more likely that market competition, on the basis of price and quality of service, will discipline the market behavior without direct regulatory involvement. 19 The more these conditions are met, the more securities regulation can rely on self-regulation through self- regul~tory bodies as opposed to direct regulation for setting the detailed market rules and enforcement. pp. 54 et.seq. The exchanges may be fewer, but their physical location may be less relevant as trading can occur wherever a computer can be plugged in. 19 A major factor in enlarging market competition is permitting the entry of foreign firms into the market. 21 . 4. Disclosure and Financial Reporting2° Complete and timely disclosure of information about issuers is a necessary, if not a always sufficient, condition for the effective operation of any securities market. That inclu~es one for municipal securities where the subsovereign borrowers themselves provide the ultimate security. Information-consistent, complete, timely and comparable- -is at the heart of judging the risks and rewards of investments. While information will not always answer all the questions (and bad information can give the wrong answers), an absence of information makes even knowing the right questions to ask difficult. Emerging and transitioning markets face particular difficult problems with disclosure. Many emerging economy countries are undergoing dramatic changes in their fiscal structure, as are the financial markets structure and regulation themselves rapidly changing. As we have noted, the vague basis for local security or the former direct guarantee by the sovereign is being replaced by more specific pledges of assets and ·revenues. Some countries, such as South Africa, have been and will continue to be highly reliant for revenues on commercial public utility operations (water and electric) and other emerging countries, for a variety of reasons, may wish to restrict long-term debt to self- supporting commercial operations. The ability of these governmental operations to generate resources to support themselves, or to generate surplus for general revenue purposes, depends on efficient · technical and managerial operations. Even where there is primary reliance on local taxes or on intergovernmental transfer payments, information on trends in these compared to local expenses becomes vital to determining relative credit quality. 21 Disclosures to the securities market are originated by the underlying borrowers themselves, the local governments. The borrowers may be assisted (or even superseded) by the central government or provincial government authorities in accumulating information, but the idea is that the party financially responsible for timely and full payment of debt service is the party responsible to make disclosures. A closely related concept is that the party that is in control of decisions as to honor obligations and that has control over the relevant information is the one responsible for information.22 Except in the cases where the issuer is only a "conduit" borrowing on behalf of another entity that is responsible for the debt, the issuer is the controlling party and obligated to report the information. · 20 A companion to this paper dealing in greater detail with securities market disclosure and its role in subnational government credit access is being prepared by the authors of this paper. 21 Aside from the immediate needs of the bond market, it would appear that effective democratic government will depend on reporting on a consistent format of the operating results of governments. 22 For example, a guaranty by a third party (such as the national government) has been seen as a reason to require less disclosure on the part of the actual borrower. That concept, however, has been rejected in U.S. practice where a guarantee or insurance) does mot obviate the need the need for full disclosure by the borrower. in South Africa (as elsewhere) the custom evidently has~ to lessen or relax requirements where the national government is the guarantor. As noted above, the change is the fiscal climate will supersede that doctrine. 22 . 4.1 Disclosure Requirements and Processes Disclosure can be required by central governmental fiat, by securities market regulation, or as a byproduct of the operation of the market through contract and market practic;:e and convention. Market-dictated disclosure is realized through meeting investor expectations, habitual procedure, and, most importantly under fear of anti-fraud provisions in the securities law (or similar legal obligations related to fair-dealing and fraud).23 In the securities markets, disclosure is aimed at the investor for the purpose of informing the investor so that it can make informed investment decisions. However, an often overlooked but very practical byproduct of securities disclosure is that the performance, condition and prospects of borrowers are reported. These economic and financial factors are of material interest to those other than investors in the market. Also, the concept of disclosure reaches beyond investor "protection" to investors (avoidance of fraudulent behavior) to supporting the rationale allocation of resources and being able to effective cost risk, whatever its level may be.24 Generally, formal disclosure requirements are met when the issuer sends published reports to the marketplace. The timing and scope of reporting information are important and technology is changing the process of publishing, as may be seen in the box on the Internet. There often are recipients of the information that in tum "translate" or re-communicate the disclosure and their opinions of it to existing and potential investors. The most important of these are the rating agencies, and the agencies, as will be discussed below, are often seen as a surrogate for disclosure. The policy objective of securities market development argues that investor protection needs to be counter-balance with the needs to reduce burdens are certain classes of borrowers to accommodate their access to the securities market. Lessened standards often are applied to smaller issuers or those classes of securities that are believed to represent less risk. 25 The content of disclosure can either be determined in either of two ways: (1) by a regulator's detailed listing of contents of documents and a sequence of presentation of various times, or (2) by a "flexible" standard that depends in its application on what the issuer and its advisors and agents perceive as information that investors should find useful in reaching an investment decisions. In practice there is usually a combination of 23 The nature of the securities laws and effectiveness of anti-fraud provisions arc critical to effectuating good disclosure through a market-based mechanism. 24 this is not just an academic distinction but goes to the heart of market regulation. If the primary purpose is avoid fraud and investor loss, then the emphasis on a screening out high-risk securities that regulators feel might cause loss to the investors. that substitutes a bureaucratic decision of that of the market place} The other approach, and the one stressed in the U.S. philosophy is to regulate to requiring full disclosure, and then let the market decide on the appropriate rate of return that is required to offset the level of risk, no matter what its magnitude. 25 Traditionally, government securities have belonged to this lower disclosure requirement, although that tradition has been eroded in the united states and elsewhere and the exceptions arc less likely. 23 . the two approaches, with a listing of generic types of information, leaving the particulars to those responsible for the deal. Since the scope and detail of meaningful disclosure can vary markedly both among and within markets, issuers and debt issues, the modem trend is to rely on market forces and self-regulatory bodies to specify the details of content. Disclc;>sure documents can also be available from a central source, (a depository) using information received on a recurring or event-driven basis.26 4.2 Financial Disclosure Fundamental to disclosure is the timely production of financial statements that follow consistent accounting standards and that are readily available to investors on a timely basis. Uniform accounting standards for local governments are critical to disclosure. In many countries, accounting systems are in transition and under review for improving their timeliness, conceptual consistency and transparency. 27 International bodies are also active in trying to achieve cross-country comparability. Strong accounting practices are central to improved financial management. In that regard, it should be noted that were the adoption of accounting standards required in order for any borrower to sell bonds or undertake a loan (perhaps with the exception in certain de minimus borrowers), the adoption of the standards would be accelerated. 28 Accounting standards and their applications vary greatly among countries and between the private sector and public sector. Most governments come from an orientation of controlling expenditures and revenues, stressing the legality of their actions and reporting their conformance with adopted legislation. This has frequently led to the use of cash accounting techniques in the recognition of receipts and outlays and :frequently obscured the economic purpose or life of the expenditures. On the other hand, much of credit analysis does indeed focus on cash flows and particularly those that relate to the availability of cash to pay debt service in full and on time. 29 Another common distinction is where the government borrower is involved in an enterprise activity. In those cases, there may be use of accrual accounting techniques that conform with those used in the private sector. While the use of accrual accounting has sound economic rationale for determining the worth and period income performance of an activity, credit analysis will typically require conversion to a cash basis to assure that 26 Jn the U.S. that role is played in the municipal market by a limited number of officially sanctioned (but privately owned) repositories as well as a central repository operated by an SRO (the Municipal Securities Rulemaking Board, MSRB). 27 One team of investigators reviewing the Latin American markets stress the problem of financial information: "The first problem is the quality of municipal or subnational management and accounting, which is often poor and incomplete." M. Freire, M. Huertas, B. Darche, Sub-national Access to the Capital Markets: The Latin American Experience First World Bank Conference on Capital Markets Development at the Subnational Level (Santander, Spain, October, 1998) 28 International Federation of Accounting (IFAC) Guideline for Governmental Financial &porting. The IFAC is attempting to develop widespread adoption of generally accepted accounting standards. 29 In credit analysis, it is customary for analysts to restate accounting reports to a cash basis to examine the availability of cash to meet debt service payments. Revenue bond contract indentures are expressed in terms of minimums of available current revenues after meeting expenses (cash outlays) in relationship to debt service needs. 24 the timing and magnitude of cash is available to meet debt service requirementS.30 The biggest concerns with cash accounting techniques are with its focus on short -term assets and liabilities and the ability of the obligor to change results by accelerating or delaying the timing of payments and receipts. The frequency and independence of audits are important issues. Most governments rely on audits performed by auditors from senior levels of government. Such audits often check for compliance with various program requirements as opposed to reflecting financial condition or assigning costs to activities. In some countries, governmental financial records are not publicly available and bank secrecy laws are an impediment to reporting fully the financial statement. Unavailability of financial data for these or other reasons is a disclosure in and of itself, and a warning flag that the one's ability to assess financial risk is nil and that political and legal risks are particularly important. In addition to financial statements, and depending on the nature and characteristics of the project being financed and the nature of the security pledged, added information having to do with operations and characteristics of the service provided and market served may be required in order to obtain appropriate disclosure.31 For example, investors in limited obligation or enterprise security that can look only to cash available after operating expenditures to repay debt want to know about the operating · characteristics of the enterprise and the market it serves. They need this information in order to judge how efficiently it was being operated and if there were any concerns about future the strength ·of demand, supplies, labor relations, environmental matters, lawsuits and the like. The list of potential items worthy of disclosure can be long and the particulars will be dictated by the nature of the operation and the security pledged.32 Thus, an important initial disclosure will be the intention or contractual commitment of the issuer to provide information on a recurring basis in the future. An important caveat, and one that is adjunct to this subject, is where disclosure requirements are made stringent and the regulators of the security markets then choose to 30 Asset valuation techniques differ among countries. Those that use a historical basis can greatly understate the replacement value of plant and equipment in periods of high inflation. For example, water utilities with much iftheir investment in underground piping and reservoirs may have major assets that have expected useful lives of from 40 to I 00 years. Utilities that use current market values for assets will appear to be much less leveraged i,n terms of debt as a proportion of total assets, than those that do not However, their current depreciation charges will likely be higher, which makes them appear less profitable. 31 the word "appropriate" is used because once beyond a simple general government balance sheet pledge (and likely even in that case), the information needed to assess risk will be situational to a particular local government, For example, a government that relics heavily on utility operations such as electric and water systems, will find its ability to pay debt heavily influenced by the operations of those utilities. If the cost of raw materials or labor costs are rising rapidly and /or user are not paying their bills, then cash will be short and may lead to inability to make timely debt service payments. 32 The listing of items to consider are found in various trade and professional publications. A good starting point for generic items is continued in the GFOA Disclosure Guidelines for State and local securities (Chicago, 1991). 25 . promote reliance on private sector advisory and information services to examine disclosures and make informed judgments. Disclosure requirements need not assume that every investor is to read every document and understand every nuance of every deal. Rather, a limited number of qualified professionals are doing the examining and forming opinin of GO bonds to revenue bonds in terms of creditworthiness is not straightforward as a number of factors come into play. On the one hand, the attractiveness of financing capital projects through user fees rather than broad-based taxes has, since the 1970's, reduced the capital market dominance of GO financing over revenue bonds. This is due to the: (i) limited and uncertain legal capacity of governments to carry ever larger debt burdens; and (ii) continuing market innovations which favor revenue bond issuance. Moreover, as strong as a tax- backed GO pledge might be, it is no absolute guarantee of repayment. In fact some investors might view a dedicated stream of revenues from services by a government utility as a more flexible and reliable security allowing for an increase in user fees as opposed to tax rates/bases subject to voter authorization, restriction or repeal. On the other hand, the security for revenue bonds remains narrower than broad-based GO bonds which can call on property, income and sales taxes to meet debt service requirements. In addition, the competition which may exist among providers of services may squeeze profitability and market share and introduce uncertainty as regards repayment ability-compared to GO tax-backed obligations. ( Short-term Municipal Instruments and Other Features ofMunicipal Debt While municipal markets mainly consist of long-dated issues, there are also short-term municipal instruments such as municipal notes and commercial paper. Although commercial paper (CP) is issued for periods ranging from 30 to 270 days, a CP "program" itself could be rolled-over for several years so as to exhibit a strong relationship to long-term debt. For instance, short-term "revenue anticipation notes" and in particular "tax anticipation notes" are issued to address seasonal mismatches between expenditures for ongoing operations and lump sum receipts. Municipalities also use debt instruments with features aimed at minimizing initial cash outlays or interest costs. For instance municipalities may issue "zero coupon" bonds with no coupon payment to bondholders. Instead the bond is issued at a deep discount and matures at par-the advantage being the smaller initial cash outlay by the issuing municipality. The difference between par value and the original discount price could be translated into a specified annual yield. A variant is the "municipal multiplier" which is a bond issued at par and does provide for interest payments; however interest accruals are only paid at maturity assuming that the undistributed payments had been re-invested at an agreed yield (usually the bond yield-to- maturity at issue). "Variable-rate demand obligations" are interest-bearing notes with "put" features tied to specific short-term indices, sold by municipalities to finance capital projects. These are part of the "structured" finance products. ( Structured Municipal Finance "Structured" financings have become part of the municipal debt markets. These are conventional debt instruments combined with derivative products such as futures, options and swaps. (Futures are contracts where financial commitments between two parties are "settled" at a future agreed date. Options are buy/sell agreements where, against an up-front fee, one party acquires the discretionary right-with no obligation-to settle a financial contract at an agreed price and time.· Swaps are contracts whereby two parties agree to assume each other's financial liabilities as these come due.) While derivatives may be used for speculative pmposes, they also are powerful instruments for "hedging" risk-i.e., for protecting a financial position against unwanted mark.et price movements. Structured financings may thus entail risk mitigating and credit enhancement features embedded in the debt instruments. A "putable" bond for instance gives investors the right to sell back-if they so elect-the security to the issuer at an agreed price (usually the par value) at designated dates or within specified periods. Bondholders may elect to "exercise" such a right should they become concerned about the deteriorating credit standing of an issuer. Put options also provide bondholders with mark.et protection in an environment of rising interest rates, as they could redeem their investment at par-though the market value of their bonds might have fallen below par-and re-invest the proceeds in higher yield instruments. Conversely, from the issuers' stand- point, municipal bonds may entail a "call option", an arrangement which permits an issuing municipality to redeem-at its option under specified conditions-the bond before the scheduled maturity. An issuer would elect to exercise such a right if, in an environment of declining interest rates, the outstanding debt-which carries a high fixed coupon rate-could be replaced by lower cost borrowings. Derivative products which extend market and credit risk protection to investors (e.g., put options) and market hedge to issuers (e.g., call options) are provided at a price paid for by the beneficiary of the derivative instrument. For instance a municipal debt issue with an embedde.d call option should carry a higher yield than a conventional issue-a "premium" that compensates the bondholder as to the uncertain maturity of his holding. Other derivatives, such as interest rate swaps or forward contracts, may allow municipal issuers to hedge their financial position in altering the risk profile of their liabilities say from variable to fixed rates, or setting a cap on the potential cost of borrowing. Swaps are also used by bondholders to similar ends. Structured products entail though a number of risks, and in particular credit risk. State Revolving Funds The US "State Revolving Funds" (SRFs) are pool finance arrangements that provide low-cost loans to local entities for projects that comply with national regulations. These were introduced in connection with the 1984 "Federal Clean Water Act" on environmental regulations. They involve capital grants from the federal government to the state, matched by a contribution from the state (currently 200/o). Matching contributions are primarily funded with proceeds of state ( general obligation, and less frequently revenue, bonds. SRF lending is mostly accomplished in leveraging central capital grants and state matching funds through bond issuance. The size, composition and diversification of the loans extended by the fund enhance the quality of the overall portfolio above the pool's weakest credit. Mechanisms enhancing the credit of the bonds issued by the fund can also be considered, for instance in subordinating one class of debt to. the rights of senior creditors. CREDIT RISK ISSUES Unlike US Government securities, municipal debt obligations are not immune to default. In the mid-70's, New York City had to default on its debt obligations rather than disrupt the provision of basic city services. (Note that this default did not result in liabilities for, nor prompt a rescue by, the Federal Government-a reflection of the maturity of'the US municipal bond markets.) Credit ratings which allow investors to gauge the creditworthiness of municipal issuers, and financial and legal mechanisms (such as options or guarantees) that enhance the credit quality of municipal debt have become important factors in investment choices. Credit Rating. The capability of rating agencies to assess the creditworthiness of municipal and other issuers has considerably evolved since the time of the Great Depression. Indeed, "of the municipal debt issues that were rated by a commercial rating company in 1929 and plunged into default in 1932, 78 percent had been rated AA or better, and 48 percent had been rated AAA". Credit ratings have now achieved "wide investor acceptance as easily usable tools for differentiating credit quality". They have become important parameters in investment decisions, particularly in the US municipal bond markets which have a strong individual investor base averse to, and ill-equipped to assess, credit risk. It is no surprise thus that most US municipal debt issuers have secured a credit rating by one or more of the leading rating agencies. The stamp of a rating agency is however no guarantee against default as the financial condition of a rated entity may change, sometimes rapidly-as shown by the example of "Orange County" in California w~ich despite its high quality rating had to file for bankruptcy protection as a result of speculative financial management. Another example is "Washington Public Power Supply System" which defaulted on its debt obligations in 1990 while these had high quality ratings. Outstanding debt ratings may thus be subject to downgrade/upgrade should a rating agency consider, in the course of its surveillance process, that material changes in the financial condition of an issuing entity do warrant a rating review. The issuer rating may be put under "credit watch" until such time as a revised rating is announced. Credit Enhancement Mechanisms. The creditworthiness of municipal debt issues may be enhanced by special features which confer preferential status on debt obligations. These include seniority, collateral security, guarantees, put options, joint and several liability of a number of entities, and bank letters of credit for short-term debt. Municipal debt can also have the legal provisions of ''public credit enhancements" which may entail state insurance programs, central/state guarantees, and automatic withholding and use of state aid-most common in the US-to meet defaulted debt service. Such programs may be used both to increase market ( acceptance of bond issues and lower interest costs. Securitization is another credit enhancement tool. [Mortgage-backed securities, though not related to local government finance, provide an example of securitiz.ation which has considerably strengthened the housing finance market-its essential pillar being the diversified residential housing stock that backs the debt issues. Added to the physical asset, is the "public credit enhancement" resulting from the implied sovereign guarantee for the federal housing agencies (FNMA, GNMA) in the case of "pass-through" mortgage .securities]. Other forms of municipal credit enhancements may use separately capitalized subsidiaries which could be made "bankruptcy-remote". Finally, a potent form of municipal credit enhancement is bond insurance. Bond Insurance. Bond insurance has played in the past 15-20 years an important role in the growth of the US municipal bond markets. Indeed, individual investors rely on bond insurance to enhance the quality of the assets they are willing to hold. Yet, bond insurance in the US has not been a vehicle for allowing non-creditworthy issuers to have market access. Rathc;r, the insurance by "AAA" rated insurance companies allows small issuers at the lower end of the investment grade ("BBB" and "Aj to access the national market for high investment grade debt. This enhances the liquidity of the issues which can then trade on secondary markets. Close to 500/o of total US municipal bond (75% of "BBB" and "Aj issues are covered by bond insurance. Providing insurance coverage only to investment grade (i.e., low default risk) credits while charging low premia makes the economics "of insurance attractive to issuers. (Insurance firms further enhance their profitability through high leverage and investment income.) PRICING OF MUNICIPAL DEBT Debt by non-sovereign, including municipal, borrowers is priced in reference to the government securities yield curve, where spreads reflect issuers' parameters in terms of creditworthiness, liquidity and size. Given the tax-exempt features of municipal debt, the true reference for investors in US municipal securities would be the "taxable equivalent yield" which must be earned on taxable treasury bonds to produce the same yield as a tax-exempt municipal bond. CONCLUSION Municipal bonds, an important segment of the US securities markets, have been a primary source of local infrastructure finance. The challenge would be to develop these markets in developing countries, where local government borrowings have been largely confined to bank loans often with central government guarantees. SUMMARY FRAMEWORK FOR ENHANCING FINANCIAL MANAGEMENT, CREDITWORTHINESS AND ACCESS TO CAPITAL MARKETS Intergovernmental Fiscal Relations and Local ·Financial Management Course September 13-19, 1998 Council of Europe C~nference Center Budapest, Hungary Organized by the Council of Europe, Economic Development Institute of the World Bank, and Fiscal Affairs Division of the Organisation for Economic Cooperation and Development Mr Samir El Daher World Bank d Intergovernmental Fiscal Relations an_ Local Financial Management Framework for Enhancing Financial Management, Creditworthiness and Access to Capital Markets Samir El Daher · The World Bank September 1998 .-.. ------ - - - - . -~ Background • Increased decentralization in provision/financing of services • Expanded local government role requir. ing improved fiscal, institutional and regulatory . framework . • ,~xpanded local government role not matche'd by financial management and resource generation/mobilization capability 2 A Simplified Model • Assigning responsibilities among tiers of government • Defining net inflows (tax sharing/transfers) · •· ,Defining own-source revenues (taxes/fees) ~ • Defining institutional and resource gaps • Meeting institutional/financial challenge to: » Deliver services in m·ost efficient way » Fill resource gap in optimal" way including debt · ~ 3 - - - -----------· Decentralization and Responsibilities Assignment • Rationalizing revenue/expenditure . assignments among tiers of government • AHocating clear planning, investment and operating responsibilities • Promoting private participation/competition in provision of local services ==> increasing. efficiency and reducing resource gap 4 Fiscal Decentralization - Intergovernmental Relations • . Rationalizing intergovernmental fiscal relations • Streamlining revenue sharing policies among tiers of government • Setting predictable rules for central government transfers/grants • Removing disincentives from transfer rules and reducing moral hazard m{~ 5 4 ...... - - - - - - -""·- . Fiscal Decentralization Own-source Finance .. • Rationali.zing local tax bases and rates • Improving local tax collection levels • Improving local capacity for strong!stable own-source generation· • (Improving pricing of local services ==> institutional capacity issues) 6 Local Government Ins.titutio~al Capacity • Strengthening local government organizational setting for service delivery • Building local governryient staff capabilities • Improving efficiency of municipal assets management 7 ----------· Local Government Institutional .. Capacity • Strengthening autonomy and accountability of local public entities · • Strengthening planning and operating capability of local public entities • Setting performance criteria for monopoly . services 8 Local Government Institutional Capacity .· • · Developing rational pricing policies for local services • Differentiating between: » revenue generating services (revenue-based funding) » public goods (externalities, tax-based financing) • Improving local user fees collection levels 9 - -·- -·- - - - - . ........ Local Government Institutional Capacity • • Strengthening review process for local public investment programs • Improving screening/selection criteria for local investments • Implementing programs/projects that enhance potential access to private resources 10 Local Government Budgetary Planning ~nd Control • Improving local government budgeting processes • Strengthening capital budgeting (project finance) • Developing credible accounting systems • Implementing independent audits 11 ------· Local Government Budgetary Planning and Control ·, • Improving local government payment systems • Improving Cash management systems • Improving financial control systems 12 Local Government Disclosure Standards • Developing financial disclosure standards that provide investors/lenders with reliable information on local government entities and provide reliable basis for credit rating • Building data and indicators on local government finance (e.g. current revenues to current expenditures, local taxes to local · · revenues, local taxes to total revenues, ratios of.debt service to revenues, .. .) - q _____ - - 13 - - - - - ·- • Local Financial Management and Resource.. Mobilization • Strengthening local financial management and creditworthiness • Strengthening local government resource mobilization/access to capital markets • Accessing credit markets to fill resource gap » in manner consistent with macroeconomic stability . » without c,;reating explicit or impJicit_contingent liabilities at sovereign level (moral hazard) 14 Regulatory Framework on Local Governmet:tt Borrowing • Clarifying regulations on borrowing · authority and access to credit by local governments • . Improving_ local government credit re.gµlatiqns in respect to municipal collateral (legal issues/risks related to .Pledging inter-gove~nmental transfers), . bankruptcy and credit workouts, ... 15 ------· Local Government Financial Management • Improving local government financial planning .m proving local government • -_ 1 assets/liabilities management • Improving local government liquidity management • Improving local government infrastructure funding strategies 16 Local Government Infrastructure .Funding Strategy • Assessing alternative funding strategies .for infrastructure investments • Devising non-recourse project/corporate finance options that reduce claims on fiscal resources • Defining project return benchmarks and risk/return profiles 17 - --- ----. Local Government Finance and Access to Capital Markets • ·Assessing potential for direct access to private credit markets to finance local government investments/operations • Assessing role of financial intermediaries a s a means to raise private resources to . finance local infrastructure investments • f:\ddressing links with capital market infrastructu re/issues 18 Local Government Finance and . Access to C'1:pital Markets • Mobilizing debt funding backed by local government taxing powers (general obligation bonds) • Mobilizing debt funding secured by user fees and other dedicated income streams (revenue bonds) • Mobilizing debt funding on a corporate finance basis (balance sheet finance) 19 - - - ---- ----. . . Local Government Finance and · · ·A.ccess . . to Capital Markets • Using short-term municipal instruments (municipal notes, commercial paper, other special instruments .. ) to improve cash-flow profiles and respond to seasonal expenditures/revenues mismatches • Establishing "special purpose districts" to provide services to developing areas • Establishing "tax increment districts" to fund development of rundown areas 20 Local Government Finance and Access to Capital Markets '. . • Using financial/legal credit enhancement structures (securitization, guarantees, bond insurance, bank letters of credit, convertible debt, derivative products, .. ) • Conferring preferential credit status on debt obligations to diversify/transfer risks • Increasing market acceptance and . . lowering interest costs of local borrowing 21 Role ·o f Financial Intermediaries for Local Governments .. • Using pool financing arrangements for local infrastructure investments • Leveraging the intermediary's equity through bond issuance in credit market.s to lend mostly for viable, revenue-generating, projects •. Mobilizing credit on private markets without government guarantees 22 Criteria for Market-based Financial Intermediaries " • Defining structural and regulatory conditions needed to establish market- based financial intermediaries • Defining elements of public support (such as central capital grants) initially needed/acceptable to assist intermediaries in leveraging their equity resources through bond issuance on private credit markets 23 Criteria for Market-based Financial Intermediaries • Defining strategic objectives and main institutional parameters • Defining products range (loans, guarantees, equity participation, ... ) offered by intermediaries • Defining operational features including guidelines for portfolio diver~ification amongst sectors/borrowers 24 Criteria for Market-based Financial Intermediaries· • Defining main financial parameters related to intermediaries' funding, lending and product pricing policies • Defining main parameters related to the intermediary's market, credit and currency risk management policies • Defi~ing steps to transfor.m existing intermediaries into market-based operations 25 Links to Capital Market Development Issues .; • Developing local government markets as a sub-set of domestic credit markets - ·importance of local currency crediUfinance . • Developing local government credit markets/financial transactions requires effective financial regulations, ins~itutions and instruments • Building local government ability.to deal with regulations, institutions & instruments 26 Links to Capital Market Development Issues ~ • Using/improving domestic financial market infrastructure to tap .upstream long-term funding pool for local investments • Defining benchmarks for pricing debt obligations of sub-sovereign entities • Improving compliance with regulations . on issuance, registration, settlement, custody and repayment of local ·government debt 27 Links to Capital Market Development Issues · .. . . • Outlining, from debt issuer perspective, measures that bridge gap between demand and supply of local government securities so as to increase flow of long-term institutional funds into local investments • Outlining, from debt issuer perspective, requirements related to underwriting, distribution and market-making capabilities of local government securities 28 · .Partnership Building • Building financial partnerships between local governments and providers of services and capital to expand flows of domestic and foreign private finance into local infrastructure investments • Bringing together complementary financial interests (e.g. commercial banks, securities firms, institutional investors, rating agencies, bond insurers, utilities operators) 29