Asian Development Bank Institute

20th Annual Conference

Managing Private and Local
Government Debt in Asia
November 30-December 1 2017

Towards a Pragmatic Framework for

Improving Subnational Government
Development Finance

Paul Smoke
NYU Wagner Graduate School of Public Service
The views expressed in this presentation are the views of the author and do not necessarily reflect the views or policies of the
Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or the governments they
represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any
consequences of their use. Terminology used may not necessarily be consistent with ADB official terms.
 OUTLINE
• I. Introduction: The Issue, Opportunities
and Challenges
• II. The Landscape of Subnational
Development Finance
• III. A Strategic Approach to Enhancing
Subnational Development Finance
• IV. Selected Experiences with SNG
Financial Intermediaries
• V. Concluding Observations
 I. Introduction: The Issue
• Considerable attention to SNG
investment and development finance of
emerging economies in recent years
• Reaction to massive infrastructure gaps
and global development agendas
• SNG share of total public investment
averages 39.1% (range: 49.1% in high-
income to 7.3% in low income countries)
• Is it feasible to improve the role of SNG
development finance in low/middle
income countries?
 Opportunities
• Availability of global capital & potential
returns on some infrastructure investments
• SNGs have or could be given legal
functions and may have advantages in
providing certain types of services
• SNGs in a better position to think more
holistically about integrated development
than fragmented national agencies
• Accountability linkages to citizens—
under appropriate conditions—are likely to
be more robust at the subnational level
 Challenges
• Weak domestic capital markets and SNG
creditworthiness limit SNG access
• intergovernmental frameworks do not
sufficiently empower, finance, incentivize and
support SNGs—the SNG share of public
spending is 29.7% in HIC and 7.3% in LICs
Particular constraints in SNG revenues—
weak OSR, flawed fiscal transfers
• Many intergovernmental fiscal (and other
decentralization) reforms are fragmented
and based on unrealistic expectations
 II. The Landscape of SNG
Development Finance
• Key instruments of SNG development
finance are intergovernmental transfers
and loans (bonds, commercial bank,
special financial intermediaries for SNGs)
• Transfers dominate in many emerging
economies and bonds are rare; special
financial intermediaries play varying roles
• Most SNG lending is often done through
special financial intermediaries, which
have long suffered from important flaws
• PPPs often seen as a solution for SNG
development finance but often problematic
 Recurrent Revenue and
Financial Management
• SNG development finance is obviously
dependent on sound recurrent finances
• Transfers also dominate on the recurrent
revenue side and many issues with their
stability and how they are allocated
• Have been successful revenue reforms in
traditional OSR and transfers, as well as
some innovations relevant for borrowing,
such as land value capture
• SNG financial and asset management
critical for borrowing
 Debt
• SNG debt averages 9% of total public debt
(OECD sample), effectively zero in many
developing countries
• In federal countries 32%, but falls to 17% in
non-OECD (biased upward by India
• Stock of SNG debt averages 57% loans
• Bonds average 31% in federal and 7% in
unitary) countries
• Loans from other sources (CG, special
intermediary) average over 60% and
dominate in developing countries
 Markets vs. Special Entities
• Limited prospects for direct access to
capital markets in many emerging
economies
• Role of special SNG intermediaries likely
to dominate (e.g. municipal and regional
development banks and funds)
• Such entities have long existed but many
experienced poor repayment and failed
to establish revolving funds
• What has accounted for often historical
weak performance?
 Common Challenges
• Heavy public sector control, weakening
management incentives and allowing
politicization of lending decisions
• Inadequate use of credit rating and
project appraisal, resulting in bad loans
• Interest rates often more heavily
subsidized than necessary
• Often heavily capitalized by loans from
international development and financial
institutions
 Common Challenges
• Some dominated multiple aspects of
subnational lending: project preparation,
technical assistance, ex-post evaluation: in
effect a monopoly
• Poor repayment enforcement, harming
SNG creditworthiness
• Insufficient capacity of these
intermediaries often a factor, reinforcing the
role of political dynamics and complex
intergovernmental relations
 A Few Basic Lessons
• More successful subnational government
credit institutions tend to have larger roles
for the private sector in management
and/or funding, and these roles may be
strategically planned to grow over time
• More successful subnational government
credit institutions generally make lending
their primary role, limiting (or isolating) the
common heavy level of involvement in
broader investment project functions
 III. A Strategic Approach to SNG
Development Finance
• Emerging economies require transfers and
special financial intermediaries; more
limited scope for bonds
• SNG financial intermediaries can take
multiple forms: dedicated accounts in
national ministries, separate legal entities
under full government control or with varying
mixes of public and private control
• Sources of finance for each of these
options will vary
Simplified Spectrum of Options
 Determining the Range
• Where there is sufficient potential for
SNG access to capital markets, this
option should be developed
• More typically, one or more types of
SNG financial intermediaries will
generally be needed with varying blends of
public and private roles
• The blend will depend on various
factors-- degree of subsidy required,
government attitudes private involvement,
and private sector interest
Evolution of Institutional Options
• In some countries the process could start
with the creation of a single dedicated
account in the Ministry of Finance to
on-lend donor/IFI funds to SNGs
• After a period, there may be scope to
create a separate legal entity, initially
perhaps fully under central government
control but diversifying sources of capital
• There may be a further transition to an
intermediary managed by the private
sector with more limited public support
 Other Support
• Beyond special credit institutions SNG
borrowing will often require risk
mitigation strategies, e.g.
– Full or partial credit guarantees
– Secondary market support
– Co-financing with private partners
– Use of bond banks and credit pooling
– Use of risk instruments offered by the
insurance industry
Tailoring Financing Arrangements
• In addition to institutional options, need an
array of financing arrangements
• Private sector mechanisms and
borrowing framework for creditworthy
SNGs/self-financing public investments
• Semi-public mechanism for less
creditworthy SNGs/less bankable projects
• Intergovernmental transfers and
special funds for the poorest SNGs and
basic poverty alleviation services
Illustrative Financing Arrangements
 Structure of Options
• Ensure that fiscally strong SNGs would
not be eligible to receive grants for self-
financing infrastructure projects, which
diverts grant resources from fiscally
weaker SNGs currently unable to borrow
• Generate incentives for weaker SNGs
to improve their capacity and modify
their behavior so that they can begin to
borrow for infrastructure investments and
build on that foundation over time
 Evolution of SNGs
• The expectation is that over time more
SNGs will develop creditworthiness
• There will also be potential over time for
more projects to be classified as at
least partially revenue generating
• SNGs may move across categories and
pursue different types of development
projects and finance as the conditions in
which they are operating and their own
capabilities evolve.
 Stimulating Change
• Key challenge: how weaker SNGs would
"graduate" from full reliance on grants and
highly subsidized loans
• Movement can occur from changes in
conditions: economic growth, institutional
reforms and shifts in political dynamics
• Central government policy can also help
to promote changes in the status of SNGs
development finance—regulations, systems
and procedures, incentives, technical
assistance and capacity building, etc.
 Grant-Loan Linkages?
• If a SNG wants public resources for a
development project, a standard
application package would be required
• Based on evaluation of the project, rules
are used to determine if the project should
be financed fully by grants, fully by loans, or
through a combination of the two
• Key rules to ensure efficient and fair use of
funds include, among others: cost efficiency,
tariff, interest rate, and affordability
standards
 Potential Benefits
• Uniform process and objective appraisal
improve fairness and project selection
• Loan element improves financial discipline
for fiscally weaker SNGs
• Closer to market rates on loans forces SNGs
to consider capital costs more fully
• Various standards—cost effectiveness, tariff
guidelines, affordability, etc.--help to ensure
operational efficiency, cost recovery and
targeting of need, lowering possibility of
subsidizing wealthy SNGs
 IV. Selected SNG Financial
Intermediaries India
• Municipal corporations have issued
taxable and tax-free municipal bonds,
with and without state guarantees
• Some states have innovative entities for
SNG lending, with a leader being the
Tamil Nadu Urban Development Fund
• Managed by a public LLC with equity
participation from the State of Tamil Nadu
and a range of private financial institutions
• Features: uses pooling mechanisms, can
offer grants, and can intercept transfers
 The Philippines
• Most SNG borrowing is done through a
range of financial intermediaries. Two
prominent actors are:
• Municipal Development Fund, a revolving
fund under the Ministry of Finance--mixes
loans (on-lent from IFIs) and grant finance
• Local Government Unit Guarantee
Corporation, a private entity (a major
shareholder is the Development Bank of
the Philippines)-- provides loan guarantees
to SNGs meeting eligibility requirements
 Indonesia
• History of SNG loans through Ministry
of Finance; generally poor performance
• Creation of the Regional Infrastructure
Development Fund, which is to be
operated by a state owned enterprise
• Initial capital will be a mixture of IFI loans
and a government equity contribution;
MoF assumes exchange risk
• Well defined lending and assessment
criteria and a linked but separately
managed Project Development Facility
 Cambodia
• Highly underdeveloped and evolving
SNG system with limited powers,
resources, capacity
• Borrowing currently infeasible--focus on
transfers via the Subnational Investment
Fund based in Ministry of Economy &
Finance (broader board of directors)
• Eligible SNGs apply for SNIF funding for
eligible types of projects
• Objective criteria for grant decisions and
past performance affects future eligibility
 Comparison of Cases
• Mechanisms differ, but successful entities
and new designs broadly consistent with
lessons from international experience
• Generally moving beyond past systems
in a positive way—broader management,
private involvement, robust criteria for
proposals, assessments, allocations, etc.
• TA for project development often offered
but through separate mechanisms
• A few link grants and loans, although not
in the systematic way previously discussed
 V. Concluding Observations
• The need for improving SNG development
finance in emerging economies in Asia
seems clear, but a pervasive lack of
creditworthiness creates challenges
• The diversity of SNGs across and within
countries also necessitates individually
tailored approaches, although they need
to be based on sound principles
• Weak creditworthiness reflects many
factors that emerge from both national
and local conditions and behaviors
 Concluding Observations II
• Simply developing improved SNG credit
mechanisms and more options is not
sufficient—reforms will often be needed
in overarching intergovernmental
frameworks
• The requirements range from system
basics, e.g. SNG empowerment to raise
and spend public funds and transfer
design and management, to development
finance needs, e.g. fiscal responsibility
and borrowing regulatory frameworks
 Concluding Observations III
• Creditworthy SNGs should have access to
capital markets with appropriate regulation;
they should not receive grants or subsidized
loans for self-financing projects
• Less creditworthy SNGs will need other
options, so developing one or more SNG
financial intermediaries along the lines
discussed earlier is generally indicated
• The fiscally weakest SNGs will continue to
depend on grants, but mechanisms and
incentives can be instituted to help them
develop the capacity for initially borrowing
 Concluding Observations IV
• How SNG financial intermediaries are
structured and operated matters—
ownership, management, sources of
finance, lending policies, etc. detemine
whether an entity will succeed.
• A variety of other mechanisms can be
used to help support SNGs to adopt
reforms that improve their fiscal viability
and develop investment capacity—
performance based financing, project
preparation facilities, etc.