noTE NO. 3 – july. 2012 SNTABriefs 73642 Sharing knowledge, experiences, and innovations in sub-sovereign financing for infrastructure Importance of a National Scale Credit Ratings for Sub-National Authorities that Borrow Long term David Painter and Joshua Gallo The Cost of Borrowing a result, most have not developed the capacity to assess an authority’s creditworthiness. Since the L ong term financing for infrastructure proj- creditworthiness of this class of potential borrowers ects can be costly for sub-national authori- is not well understood, financial institutions often ties. However, some authorities obtain better choose not to provide long term financing for their terms for their financing than others from finan- infrastructure projects. Even when lenders want to cial institutions. Since every authority would like offer infrastructure financing, they may have diffi- to lower its cost of borrowing, it is important to culty differentiating between more creditworthy and understand why some pay less than others. less creditworthy borrowers and therefore have no basis for establishing lending terms that balance risk The cost of long term financing for infrastructure and return. Under such conditions, lenders impose development depends on the level of confidence costly lending terms to protect themselves against that financial institutions have that a sub-national unknown risks. authority will repay its debts. The term creditwor- thiness is actually a way of describing that level of Sub-National Public Finance Credit confidence. It is a relative term since some authorities Ratings are more creditworthy than others. The more credit- worthy authorities obtain financing for their projects Fortunately, in most countries, internationally at less cost than the less creditworthy. So, what can respected credit rating agencies can provide financial a sub-national authority do to minimize its cost of institutions with a substitute or supplement to their financing? Ultimately, it is the institutionalization of own creditworthiness assessment capacity. It comes good financial management practices that enables in the form of a sub-national public finance credit a local authority to achieve the highest feasible level rating. The agencies’ credit ratings are based on an of creditworthiness. However, it is also essential that objective external analysis of a sub-national authority financial institutions recognize and understand the in terms of carefully selected risk factors affecting its quality of an authority’s finances so that their level of ability and willingness to repay its debts. confidence increases and they offer the best possible PPIAF Approved Logo Usage Because the agencies’ principal business is assessing terms for the borrowing. risk, they have a depth of analytic expertise that most Logo - Black Creditworthiness to Demonstrating financial institutions cannot match. For this reason, Lenders PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY David Painter is a Development Finance Consultant, and Joshua Gallo is In many countries, financial institutions have little Program Leader for PPIAF’s Sub-National Technical Assistance Program. experience lending to sub-national authorities. As Logo - 1-color usage (PMS 2955) PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FAC ILITY 2 A simplified example • The credit rating agency reviews the partial risk guarantee structure and determines that it reduces Let’s imagine that a sub-national authority the risk of default enough to qualify the total borrow- wants to borrow local currency (LC) to finance ing for a AA+(ns) rating which would enable the an LC 100 million infrastructure project. In authority to borrow at an interest rate of 7%. this example, the credit rating agency gives the authority a national scale rating of A+(ns) which • The authority successfully borrows LC 100 million is investment grade, but below the national for a 15 year term at an interest rate of 7% and pays government’s bond rating of AAA(ns). Further another 0.5% per year for the partial risk guaranty. imagine that research by the authority’s public As a result, the annual cost of the borrowing to the finance advisor shows that national government authority is LC 11.3 million but this is expected to be bonds with a 15 year term carry an interest rate covered from the LC 11.5 million annual net revenue of 5%, but meetings with potential lenders and available from the project. investors reveal that a 15 year borrowing by an authority rated A+(ns) has to pay 10% interest to attract financial institutions into lending LC 100 million. obtaining a public finance credit rating is an excel- lent way for sub-national authorities to convincingly Now imagine the following scenario… demonstrate their level of creditworthiness to finan- cial institutions. • The infrastructure project is expected to gener- ate user fees of LC 20 million annually with a Each credit rating agency has its own methodology total operating & maintenance cost of LC 8.5 for assessing the risk that a sub-national authority million per year. will default on its debt. However, the essential factors • The credit rating agency reviews the project analyzed by these methodologies are virtually the More and determines that, due to a variety of project same. The agencies analyze and assess: risks, a borrowing based solely on repayment creditworthy from user fees would be rated BBB(ns) and 1. The institutional framework surrounding authorities would have to offer 15% interest to raise LC the sub-national authority including: central- 100 million, and this would increase annual debt obtain financing ized/decentralized governance; degree of fiscal service to LC 17.1 million. This would make the project financially unviable. autonomy; formal responsibilities of the author- for their projects ity; legally mandated annual expenditures; and at less cost • At the authority’s direction, the public finance the characteristics of any funding provided from than the less advisor designs a structured obligation based on the national government. a 50% partial risk guarantee purchased from a creditworthy guarantor that has a AAA rating. 2. The economic outlook for the sub-national o The structure makes 50% of the borrowing authority including trends in: the economic base; “risk free� and equivalent to AAA(ns) while the local revenue based; employment conditions; the other 50% of the borrowing remains an local income and wealth; demographics; and the A+(ns) risk. per capita tax/fee burden compared to other similar sub-national authorities and the national o The partial risk guarantee requires the authority to pay the guarantor an annual fee average. of 0.5% on the outstanding balance of the borrowing. 3. The sub-national authority’s debts and other liabilities including: current debt (long or short o The guarantor pledges to reimburse the term, fixed or variable interest rate, to be paid authority’s lenders/investors 50% of any in local currency or foreign currency); the debt principal lost in the event that the authority service burden; the needs for future debt financ- defaults on its debt. ing; other liabilities and contingent liabilities and how they are funded. Importance of a National Scale Credit Ratings for Sub-National Authorities 3 4. The sub-national authority’s finances includ- rating compares the sub-national authority to the best ing trends in: total revenues (their volatility, their credit risk in their own country: the national govern- diversity, their predictability); total expenditure; ment. The purpose is to provide local investors with the balance (surplus or deficit) between recur- a way to measure the risk of lending to the authority rent operating revenues and recurrent operating compared to investing in risk free national govern- expenditures; reserves; and liquidity. ment bonds. On any national scale, bonds issued to local investors by the national government are always 5. The management and administration of rated AAA(ns). the sub-national authority including: insti- tutionalized financial policies and procedures; To avoid foreign exchange risk, sub-national authori- management of the budget; accounting and ties borrow in local currency from investors that are Creditworthiness financial reporting; independent external audits; local financial institutions. Therefore, the authority’s is the level of the affects of politics, labor issues, or citizen initia- national scale rating is the one that is most useful for confidence tives; and the degree of revenue and expenditure demonstrating their creditworthiness to lenders. The financial flexibility. difference between a sub-national authority’s rating on international and national scale is typically very institutions Credit rating agencies assign a rating to a sub-national substantial. For example, one metropolitan govern- have that a authority based on detailed information about that ment in an emerging market country has been rated sub-national authority, and analysis of the factors above to predict BB+ on the international scale (i.e. not investment the likelihood the authority will fail to repay its debts. grade for international investors), but the same rating authority will Although each credit rating agency has its own agency rates the authority AA+(ns) on the national repay its debts system of letter grades, generally the ratings range scale (i.e. a very good credit risk for local investors). from AAA (highest credit quality) through BBB (credit quality good enough to be considered “investment Sub-national authorities which achieve an “invest- grade�) to C (exceptionally high levels of credit risk) ment grade� rating of BBB– (ns) or better on their on a scale that progresses: AAA, AA, A, BBB, BB, B, national scale are considered by most financial institu- CCC, CC, C with “+� and “-� to signal degrees of risk tions to be creditworthy. Those with lower ratings are between the letter ratings. The Rating Report that generally seen as not creditworthy and may be unable accompanies the letter grade also provides the data to access long term financing. In addition, national and analysis that financial institutions need in order to scale credit ratings differentiate among the creditwor- understand the finances of their potential borrower. thy authorities in a country by identifying where they stand on a scale that runs from more creditworthy to International Scale Ratings and less creditworthy. This provides financial institutions National Scale Ratings with a solid analytic basis to differentiate their lending terms among borrowers in a way that balances risk A sub-national public finance credit rating can be and return. Lower rated authorities pay more for long either an international scale rating or a national scale term financing because they are riskier than higher rating. The national scale rating includes a country rated authorities. designator in parentheses, e.g. (mx) for Mexico. The difference between them is their basis for comparison National Scale Ratings and Infrastruc- of the risk of default. An international scale rating ture Bonds compares the sub-national authority to the best credit risks in the world: AAA sovereign governments such Long term financing for infrastructure can take the as Germany, the United Kingdom, and the United form of bank loans or long term bonds sold to inves- States. The purpose is to provide international inves- tors. Loans are drawn up by a bank that holds the tors with a way to measure the risk of lending to the entire loan in its investment portfolio until it is fully authority compared to investing in risk free bonds repaid. On the other hand, bonds are securities that issued by the most financially secure governments are issued by a sub-national authority and sold to a in the world. On the other hand, a national scale variety of investors in a form that can be either held in 4 in a form that can be either held in portfolio or traded on advantages. The Rating Report that accompanies the a securities exchange. While not every country has expe- letter grade spells out the financial strengths and weak- rience with infrastructure bonds issued by sub-national nesses of the authority in some detail, and can be used authorities in the local capital market, they can be an to guide an authority’s financial management improve- efficient form of financing for long term investments. ment efforts. Since ratings are made public, they are a simple and transparently means of communicating Long term bonds are issued by a sub-national authority an authority’s financial condition to key stakeholders with a “face value� and repayment terms specified in and the community at large. They can also be used by the bond. Local investors need a quick and easy way national governments to monitor the financial health of to assess the risk of purchasing the bonds so that they sub-nationals with complete objectivity. can balance risk and return when making their purchase offer. National scale public finance ratings serve this Because of the multiple advantages of having sub- purpose. national authorities rated on a national scale, some governments have made ratings a regulatory require- In basic terms the importance of ratings for bonds can ment in certain circumstances. In Mexico, it is a be described as follows. When a sub-national authority requirement for sub-national authorities to be rated and their financial advisor design a bond, the authority’s by at least two rating agencies in order to undertake national scale rating (which quantifies risk) combined any kind of long term borrowing. In India, the national with capital market research (which quantifies the return government requires sub-nationals that participate in that local investors require at a given level of risk) deter- a particular incentive grant program to be rated as a mines the repayment terms that are specified in the means of measuring the impact of financial reform bond when it is issued. The objective is to specify the efforts linked to the grants. least costly repayment terms that will attract enough investors to sell all of the bonds at their “face value� so that the authority gets the amount of money it needs to The Sub-National Te c h n i c a l complete its infrastructure project. Assistance (SNTA) Program Later, when a bond holder wants to sell some of the As more and more countries decentralize, the bonds on the local securities exchange, the national scale provision of infrastructure is increasingly becoming rating (which is reassessed annually) is used by potential the responsibility of sub-national authorities (local buyers to determine whether the repayment terms speci- governments and public utilities). These authorities fied in the bond still constitute a rewarding investment. are finding it necessary to seek long term private If risk now outweighs desired return, the buyer will offer financing for their infrastructure projects. Using less than face value for the bonds. If current risk is low annual budget allocations to build infrastructure enough to warrant less return, the buyer will offer more is difficult to manage because the funds required than face value for the bonds.. vary greatly from year to year. Long term debt financing allows sub-national authorities to smooth Other Advantages of Obtain- out the annual funding requirement by borrowing SNTAbRIEFS PPIAF Approved Logo Usage ing a Rating a large amount of capital at one time and then SNTAbriefs share emerging knowledge on repaying the debt in predictable annual increments sub-sovereign financing and give an overview In addition to providingLogo - Black the means small enough to make the project affordable to the of a wide selection of projects from various for sub-national authorities to regions of the world. Related notes can be found people served. The Public Private Infrastructure at www. ppiaf.org. SNTAbriefs are a publication of demonstrate their creditworthi- Advisory Facility (PPIAF) works with sub-national PUBLIC-PRIVATE IN F R A S T R U C T U R E A D V IS O RY FA C IL IT Y PPIAF (Public-Private Infrastructure Advisory Facility), a ness to financial institutions, authorities to enable access to private financing multidonor technical assistance facility. credit ratings offer other on the best possible terms, and shares the lessons The views are those of the authors and do not necessarily learned from its global experience. reflect the views or the policy of PPIAF, the World Bank, or any other affiliated organization. Logo - 1-color usage (PMS 2955) c/o The World Bank, 1818 H St., N.W., Washington, DC 20433, USA For more information visit the PPIAF website at Phone (+1) 202 458 5588 FAX (+1) 202 522 7466 www.ppiaf.org. general EMAIL ppiaf@ppiaf.org web www.ppiaf.org PUBLIC-PRIVAT E INFRASTRUCTURE ADVISORY FACILITY