Enhancing the access of municipalities and municipal corporations to the domestic finance market

1. Enhancing the access of municipalities and municipal corporations to the domestic finance market Conference Regional Development and Municipal Finance Arabela Aprahamian, ECSPF, World Bank Michel Noel, ECSPF, World Bank

2. Agenda • The two sides of the market • Evolution of the municipal finance market since 2002 • Reforming the legal and regulatory framework for the municipal finance market • Enhancing access of municipalities and municipal corporations to domestic finance market • Mobilizing equity finance for municipal corporations

3. 1. The two sides of the market 1.1: Municipal finance: borrowing by municipalities on own account . possible explicit or implicit government guarantees . part of general government debt 1.2: Municipal corporation finance: . Borrowing by municipal corporations - possible explicit or implicit municipal guarantees - outside general government debt . Equity mobilization by municipal corporations . various forms of PPPs - PFI contract: equity in service corporation - concession: equity in operating company - divestiture: equity in underlying assets

4. 2.1 Overall financial market conditions: Convergence and entry into EU single market-> reduction in sovereign spreads

5. 2.2 Municipal finance market conditions: reduction in spreads, lengthening of maturities

6. 2.2 Municipal finance market conditions -> increased geographical dispersion of municipal loans Loans >1 year maturity 2005 2006 2007 (in % of total) Bucharest 41.4 22.2 Municipalities > 100K 41.8 53.0 69.5 Municipalities < 100K 11.3 15.5 21.2 Small cities and communes 5.5 9.3 9.3

7. 2.2 Municipal finance market conditions -> higher geographical concentration of municipal bonds Domestic currency bonds 2005 2007 (% of total) • Municipalities >100K 52% 94% • Municipalities <100K 37% • Cities and communes 11% 6%

8. 2.2 Municipal finance market conditions -> compression of municipal spreads due to: • Excess liquidity in domestic banking system (until recently) • Pricing behavior of BCR (prior to privatization end-2006) • Moral hazard due to deficiencies in legal and regulatory framework

9. 3. Reforming the legal and regulatory framework for municipal finance market Key policy reforms to reduce moral hazard: • Move from ex-ante control of municipal borrowing to market-based discipline; • Remove implicit central government guarantee of local government debt; • Phase-out short-term Treasury loans ; • Clarify certain procedures of the local government bankruptcy framework; • Define the modalities of application of the Risk Fund; • Increase risk weight for unrated municipalities in calculation of regulatory capital for banks

10. 3. 1 Move from ex-ante control of municipal borrowing to market-based discipline Two types of control under Law 273/2006: • case by case ex-ante authorization by MOF • prudential limit on local government debt service (30% of own revenues); +case by case derogations issued by MOF (ex Bucharest in June 2005) GD 9/2007: major source of moral hazard on municipal finance market • MOF assumes the role of assessing municipal creditworthiness of local government for each new borrowing • Political pressure on MOF to bail-out local government in case of default on debt obligation it has itself approved

11. 3. 1 Move from ex-ante control of municipal borrowing to market-based discipline 1. Phase one: • automatic authorization by MOF unless otherwise notified within 15 working days • simplified dossier of application (local government decision to borrow, loan agreement or bond prospectus, past and current budget execution) • decision to deny based solely on documentation submitted or breach of prudential limit • decision communicated on website • right to appeal decision -> separate regulation • prohibition of case-by-case derogation of debt service ceilings

12. 3. 1 Move from ex-ante control of municipal borrowing to market-based discipline Phase Two • automatic authorization • ex-post control of local government borrowing through quarterly budget execution review process • if breach of debt service limit, prohibition of new net borrowing until budget brought back into compliance with prudential ratio

13. 3. 1 Move from ex-ante control of municipal borrowing to market-based discipline Phase Three • ex-post control through regular yearly budget execution review process • prohibition of new net borrowing if breach of prudential limit

14. 3. 1 Move from ex-ante control of municipal borrowing to market-based discipline Following entry into Euro-zone: • local governments obtaining two global scale, local currency • credit rating by established credit rating agencies can have more relaxed debt service limit -> give room to market participants for making credit decisions based on credit quality • Ex post control exercised by MEF • Ex-ante approval maintained in case of borrowing in foreign currency ( outside Euro-zone following Euro entry)

15. 3.2 Remove implicit central government guarantee of local government debt • Article 63 of LPF allows local government debt to be guaranteed by own revenue (incl government transfers) • Gives precedence to such debt over all other claims against local government -> some financial institutions consider that own-revenue guarantee is exercisable with Treasury -> local government own-revenue guarantee considered as good as government guarantee -> mentioned in bond prospectus to investors

16. 3.2 Remove implicit central government guarantee of local government debt • Law 288/2002 stipulates that State Treasury can only execute payments when ordered by budget manager of public institutions • This appears to give local government discretion in honoring their guarantee or not • Law 110/2007 addresses this ambiguity: if a public institution fails to fulfill its payment obligation within 6 months from enforcement order, creditor may request enforcement based on Civil Procedure Code and/or other applicable legal provision • Credit release authorities (ie mayors and president of city councils) must order all steps to ensure payment of amounts due • In case of failure to comply, State Treasury, acting on instruction of court, may transfer the funds directly from municipality account to creditor -> Unclear if market participants make distinction between these procedures and central government guarantee, resulting in moral hazard on municipal finance market -> Policy reform • Ensure that future legislation and regulations in the field of public debt makes it clear that local government debt carries no implicit Government guarantee

17. 3.3 Phase-out short-term Treasury loans Three problems with the ST Treasury loans to local governments • MOF assumes role of credit allocation and pricing for local governments • International experience shows that Treasury loans or other government-run credit facilities are open to political pressure • Treasury loans are ready-made instrument to bail out local government in case of default ->Treasury loans soften budget constraint for local governments and generate moral hazard on municipal finance market -> Policy reform • Progressively phase-out Treasury loans, starting with largest cities • Use provisions of LLPF allowing local governments to open bank account linked with a loan from commercial bank and open overdraft facility with private banks

18. 3.4 Clarify certain procedures of the local government bankruptcy • Articles 74 and 75 of LLPF provide sound legal framework for local government bankruptcy • 2007 version of Draft Law implementing Art. 74 and 75 of LLPF specify criteria for declaring state of financial crisis and termination, content of financial recovery plans, participants in process, and sanctions -> Policy reform • Clarify definition of essential municipal services • Define highly restrictive conditions for Treasury loans and for support from Government reserve fund to local governments undergoing plan of insolvency recovery

19. 3.5 Define the modalities of application of the Risk Fund • LLPF provides establishment of Risk Fund to cover financial risks deriving from guarantees by local government units for loans contracted by municipal corporations • Risk Fund accumulates commissions and other fees paid by beneficiaries of loan guarantees and is used in case of guarantee calls -> Policy reform • Define methodology for valuation of guarantee fees in parallel with methodology used for National Risk Fund

20. 3.6. Increase risk weight for unrated municipalities in calculation of regulatory capital for banks NBR regulations require: • 50% risk weight for loans to jurisdictions with no credit rating • variable risk-weight for rated jurisdictions -> Policy reform • Raise risk-weight to 100% for jurisdictions with no credit rating

21. 4. Enhancing access of to domestic finance market -> Design and implement coherent strategy to enhance access of municipalities and municipal corporations to domestic finance market in the context of EU single market -> Consists of range of technical assistance and financial support instruments modulated in function of the risk profile of particular sub-national entities

22. 4. Enhancing access of to domestic finance market

23. Tier 1: Low-risk sub-national entities -> small group of 10-15 municipalities at one to two notches below sovereign rating (based on international credit rating or internal risk assessment by banks) -> can access domestic market at maturities exceeding 15 years and at spreads below 50 basis points without sovereign guarantee -> have graduated from support from IFIs because the cost of credit enhancement that could be provided by IFIs to them would be higher than benefit of enhancement in terms of spread reduction and maturity extension -> in practice some of these municipalities still draw IFI resources but this is expected to change over time

24. Tier 2: Medium-risk sub-national entities -> Market access at higher spreads and shorter maturities -> Dual package of technical assistance and financial support -> Technical assistance • Develop capacity to prepare investment programs and projects • Develop conditions for private participation in local infrastructure (tariffication of utilities) • Structure PPPs • Administer social protection programs for low-income households • Obtain credit rating

25. Tier 2: Medium-risk sub-national entities -> Financial support • Provide credit enhancement for local government debt • Partial credit guarantee facility (PCGF) for sub-national debt obligations

26. 4.3 High risk municipalities/municipal corporations -> no access to domestic financial market, even with credit enhancement -> uncreditworthy entities should not borrow from any source (including on-lending from central Government) -> Support to focus essentially on technical assistance to strengthen fiscal and financial management and corporate governance up to point where entities can produce audited financial statements -> For small cities, promote inter-municipal undertakings with medium cities to achieve economies of scale -> Establish competitive capital grant program • Subject grants to transparent requirements (score) • Subject repeat grants to specific improvement in score • Graduate to Tier 2

27. 5. Mobilizing equity finance for municipal corporations Local Infrastructure Equity Fund (LIEF): 5.1 LIEF characteristics 5.2 Selection of Fund Manager 5.3 Establishment of Fund 5.4 Establishment of JVs 5.5 Procurement of investment programme