Problems of Debt Financing for Bulgarian Municipalities

by Zdravko Setchkov

Financial Expert

FLGR

A seminar on Municipal Bond Financing took place on January 30, 1998, at the Lipnik business center, close to Rousse. Representatives of Bulgarian and US institutions (the Academy of Economics, Svishtov; RTI, North Carolina), finance experts (Nikko Europe Plc., London; Tod Torvinen, Director of Finance, City of Duluth, USA, etc.) and mayors of Bulgarian municipalities talked on this so important to the Bulgarian municipalities issue. Participants presentations and the follow-up discussions not only outlined a wide spectrum of problems hindering the investment process in Bulgaria, but also presented the experience of countries with developed municipal debt instrument markets. I will try to elaborate on some of these problems and practices further on.

One of the serious problems faced by Bulgarian municipalities during the last several years is the lack of capital funding sources for municipal infrastructure projects. The capabilities of traditional funding sources for capital financing, such as the national budget, were reduced considerably and their share is unable to cover the funding needs of the constantly deteriorating infrastructure in the municipalities. Unfinished construction, although funded by the budget, continues to be a serious problem for the investment process in our country.

The funding needs for capital projects can be temporarily satisfied by revenues from the sale of municipal assets, such as land, buildings, municipal companies and shares, if these are attractive and if there is a demand on behalf of local or foreign investors. Unfortunately, these conditions exist partially only in some of the bigger municipalities in our country. The one-time sale revenues do not provide a constant flow of revenues to the outdated city infrastructure. They are a temporary source which is important only during the period of transition and ownership restructuring in the country.

Are there other sources for capital investments in the country, and if so, what are they?

The legislative regulation of the alternative financing of the investment process is very concise and insufficient. Art. 52, Para 3 and 4, of the Local Self-Government and Local Administration Act (promulgated Official Gazette, No. 77 of September 17, 1991) only mentions municipalities right to use bank credits under procedures established by an Act, as well as the right to issue bonds. In the future Municipal Budgets Act, this opportunity will probably be regulated only in principle. The legislative regulation of the process (especially of bond financing) is still to be established, either by a separate Act or by making changes in the Securities, Stock Exchanges and Investment Companies Act.

Debt financing as a funding source for municipal investment activities is not unknown in Bulgaria s economic history. In 1906, the Municipality of Plovdiv issues a 50-year bond. Our latest experience in this field is also related to the Municipality of Plovdiv. Unfortunately, it could not be used as an useful example.

The opportunity to get credit is necessary and important to local government. Each municipality needs to aspire towards a stable loan policy, taking into consideration its future needs and capabilities, in order to get a high credit reputation.

Debt financing allows to speed up the investment process in the municipalities. With secured financial plans, it is possible to start the implementation of projects which would provide for continuity of the process. The share of finished projects rises considerably, and part of the burden is transferred to future users. At the same time, servicing the long-term debt requires spending part of municipal revenues for many years ahead, which limits to a considerable degree the opportunities for flexible policy to the changes in the economic environment and the revenues from taxes and fees.

Municipal debt instruments include:

• municipal bonds
• loans from financial institutions
• loans from the national government
• contracts for purchases on leasing.

The countries with a history of bond financing use several types of bond financing:

Generally secured bonds. These are used to finance public infrastructure projects, such as parks, schools, streets, public buildings, etc. The bonds are secured by the issuer s promise to pay the debt by using all existing revenues sources.

Bonds secured by revenues from fees. These are aimed at very specific users (airports, toll roads and bridges, parking spaces, etc.) They carry a higher risk to investors, so the interest on them is higher, too.

Bonds secured by increased tax revenues. Targeted at financing improvements in trade and in real estate value. Could be used to revive individual attractive areas.

Bonds for special areas or for areas with special tax policy. These are used to provide specific services, such as drinking water systems, highways, or combinations of services. The debt is paid with revenues from these sources.

Bond pools and middlemen. Very often small issuers do not have the resources and expert skills to issue their own bonds. The amount of necessary capital is usually too small compared to the relatively high constant expenses for the issue. In such cases, the needs are grouped in pools which leads to economies of scale. The municipalities can establish middlemen which can take a loan and lend part of it at interest (Finland s experience in using this form of bond financing is applicable to Bulgarian conditions and scale).

When using loan capital, Bulgarian municipalities need to be aware of the multiple limitations which hinder the investment process in our country:

The legislative regulations and the national policy on financing capital investments in the municipalities is still being formed and established. The competencies of individual management levels in the decision-making process related to local capital construction projects and their financing, need to be clearly defined.

The responsibilities for the construction, use and maintenance of the property need to be clearly divided between the separate government levels (national, regional, municipal).

There are no objective criteria for defining target subsidies size in funding capital projects in the municipalities. This doesn t motivate municipal authorities to look for alternative financing methods.

It needs to be defined under what limitations are the municipalities allowed to get loans. The bodies assigned with the evaluation need to provide transparent evaluation criteria. Municipalities right to use future revenues as collateral for bond issues needs to be legislatively provided for.

The tax treatment of municipal bonds as equal to commercial issues makes them considerably less attractive for many of the potential players on the stock market. Many countries with developed markets for debt instruments use this form of budget subsidizing (income tax exemption) to finance public activities.

The need of government guarantees for municipal debts has to be regulated.

The major sources of revenues for debt servicing are the traditional budget revenues of the municipalities: taxes, fees, subsidies.

The well-motivated decision-making to issue bonds, as well as the successful debt administration, depend on the realistic forecast of all future revenues, national subsidies, national funds, contracts for services, etc.

The revenues have indicators; understanding them provides for making well-found decisions in issuing debt.

Sufficient volume. The chronic insufficiency of municipal budget revenues has grown in importance over the last few years. Assigning to the municipalities the obligation to finance activities which are not typically municipal, has become a permanent practice. Making decisions at central level that have to be financed by the municipal budgets leads to serious budget disproportion.

Revenue forecast. In many municipalities, the major part of own revenues is formed by the income tax allocations. The lack of specific regulations about the size of the allocation and the current method of defining it, makes it impossible to meet this indicator. The lack of municipal competencies with regard to defining the rates of local taxes and fees, makes them in most cases only registrators of the changes.

Stability of revenues. The period of transition towards a different economic basis, the regulations related to stimulating the activity of various economic subjects, and the quickly changing economic environment do nor provide stability of local revenues.

Control on revenues. Local governments are legislatively disabled to exercise control on local revenues. Their relations with local tax authorities are not clearly regulated. There are no mechanisms for impact on the revenue collection process.

Before making a decision to issue bonds, the municipalities must have a realistic capital construction plan.

The plan has to be adopted by the local government bodies and to reflect to a highest extent citizens priorities. Besides being used as a management tool, a well-prepared capital construction plan is also viewed as a positive effect by credit rating agencies.

Apart from the capital construction plan, every municipality which has decided to issue bonds must also develop and adopt its own debt policy. In developing their debt policy, municipal managements have to answer many questions and many municipalities are not prepared or lack the experience to do this.

What is the acceptable leverage level for the respective municipality?

What share of municipal revenues needs to be used for capital investments?

For what projects, and to what extent, is the municipality willing to sacrifice its flexibility?

Can the municipalities evaluate the economic viability of their infrastructure projects, given that there could be no accurate forecast of expected revenues and expenditures?

Significant difficulties will also arise from the necessity of gathering detailed financial information and presenting it to the public, to credit rating agencies and to potential investors.

Together with the necessity for legislative changes and for establishing a national policy for local government, there are also certain structural barriers that hinder the inflow of capital investments to the municipalities at the moment. The lack of developed secondary market for debt instruments in the country, the lack of reliable underwriters, as well as of many other elements of the real market, are a serious stumbling block before the creation of a favorable investment climate in the country.

The discussions on this topic are still to be held. Its importance is growing constantly. The in-depth review of the topic requires many discussions, seminars and other events. The Foundation for Local Government Reform has already expressed its willingness to follow-up on what has been already done with the support of the local governments.