Local government borrowing is in for a boost

Until now, debt issuance by local and regional governments (LRGs) in Asia -- particularly in emerging Asia -- has been small compared with the US and Europe. But recent government policies in Asia calling for large increases in infrastructure development spending look set to change this. To improve the efficiency of fiscal stimulus measures, all government levels will be required to participate in the effort, from national to state/provincial and local governments, including via public sector companies.

In some cases, the money will come directly from national budgets. In other cases, it will be up to LRGs to raise capital. This, we believe, will lead to a short- to medium-term rise in LRG borrowing (including bond issuance) in Asia, and the emergence of LRG financing as a new asset class that's attractive to investors.

So far, LRGs in emerging Asia have had relatively little involvement in international or even domestic capital markets. Currently, Standard & Poor's Ratings Services rates just 12 LRGs in the region, compared with more than 150 ratings in Europe and over 15,000 in the US. As central governments ease restrictions (in some cases prohibitions) on LRG borrowing and debt issuance, a sound borrowing and monitoring framework should underpin the sustainability of local finances. For national governments and investors alike, improvements to local financial management practices, transparency, and governance will be key components of support for greater LRG debt issuance.

Recently, we began working with subnational governments in the Philippines, Indonesia, and China. As part of a joint project with the World Bank, we conducted financial management assessments (FMAs) and performed general credit analyses for eight local government units (LGUs) in the Philippines, six urban development and investment corporations (UDICs) in China, and one local government in Indonesia.

For the FMAs, we looked at their financial management systems and tools, both in light of international best practices and the local environment. We discovered a strong appetite for investments and borrowing, but an appetite that's matched by room for improvement in areas of public-sector management such as medium-term planning, debt management and debt culture, clarity of policy mandates, and strength of inter-governmental systems.

We found that the Philippine LGUs display basic to poor levels of financial management in most areas when compared with global best practices, although some evidence of intermediate practice has started to surface. Some cities demonstrate intermediate levels of revenue and cash management, and even the first steps in adopting a medium-term fiscal framework -- rarely linked, however, to annual budgeting. Transparency is quite poor, but is helped somewhat by publicly available audited reports, though often with significant qualifications. Debt management practices are rudimentary.

In terms of creditworthiness, the LGUs share common problems such as a weak inter-governmental system (with low system support to local governments) and an absence of institutionalised policies. On the positive side, the LGUs have moderate financial flexibility (ability to charge local taxes and fees, modify tax bases and rates), which is above that of their international peers and can be gradually tapped into as the economy develops and tax bases grow.

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In China, the urban development and investment corporations (UDICs) assessed so far display weak creditworthiness -- they are highly leveraged, face liquidity shortages, and operate in challenging industry environments. Some UDICs have broad policy mandates, and projects are delegated to them on an ad-hoc basis. This lack of a core industry focus complicates medium- and long-term planning. The disclosure of financial and operational information to government shareholders is adequate, but there is an observable lack of public disclosure of activities and accountability to the broader public.

On the positive side, we believe UDICs will benefit from government fiscal stimulus plans and medium-term infrastructure investment. Some UDICs have already tapped into domestic capital markets. The enhancements to financial management practices that the FMA can help bring about should help boost the entity's creditworthiness and improve stakeholders understanding of the entity.

Table 2: Key Observations From Standard & Poor's financial management assessments (FMAs) in China and the Philippines

Despite the immediate challenges they face, the examples of China and the Philippines remind us that subnational governments have great potential to contribute to infrastructure development through their own debt issuance, provided the right national and local frameworks are in place.

Generally, as systems of government mature, there is a trend toward decentralisation of governance accompanied by a greater independence of LRGs. After all, local authorities can often be more effective than central governments in the delivery of services and capital spending -- provided they have attained an adequate level of sophistication in management capacity. On average, decentralisation has been associated with a 15% improvement in the use of public funds at the local level.

Greater independence puts pressure on LRGs to improve their financial transparency and financial reporting. Credit ratings have already played a key role in furthering this end. In addition to the most common use of credit ratings, which is to assist an LRG in gaining access to cross-border government bond markets, other LRGs have obtained an S&P rating to enhance the potential for foreign direct investment, improve their funding conditions domestically, facilitate the dialog with various stakeholders, and to promote improved financial transparency. Further, as LRGs gain increasing autonomy in revenues and expenditures, they are likely to be held more accountable for their financial performance.

Raising the capacity of subnational governments and investment companies should include reforms to inter-governmental fiscal relationships, as well as local financial management capacity building. Addressing these issues is not just about borrowing capacity, it is also closely tied with improving financial management practices and accountability as a means of reducing contingent liabilities that the region's sovereign governments may have to assume.

There is clear potential for LRG financing as a major asset class in Asia, in our view. The increasing prominence of the LRG sector in the region and growing demand from large populations to improve the quality of public sector services will likely see a greater need for local and regional governments to borrow to maintain and upgrade infrastructure. This will occur at the same time as localities in the region and within each sovereign compete for new foreign direct investment. It will also go hand-in-hand with the important goal of developing local bond markets. While the increased share of private funding of public sector infrastructure is a long-term goal, the public sector has a key role to play in the medium term. Much of this financing will have to come from borrowed funds. Coupled with the increasing focus on better governance and transparency, this will in turn see the number of LRG credit ratings and FMAs increase.

The author of this article, Elena Okorotchenko, is a senior director of sovereign & public finance ratings for Asia at Standard & Poor's Ratings Services.