Local government borrowing is in for a boost

With Asia's local and regional governments increasingly mandated to develop infrastructure, subnational debt issuance looks set to increase. Standard & Poor's calls for sound financial management.

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.

Table 1. Restrictions on Asia's local and regional government (LRG) borrowing


LRGs are not allowed to borrow commercially. However, they are selectively the beneficiaries of debt assumed on their behalf and guaranteed by the central government, and have been permitted to establish investment companies to support policy implementation. State-owned enterprises (SOEs) have also borrowed to support quasi-fiscal and policy initiatives.


The constitution puts limits on the borrowing powers of the states. The states are, in principle, entitled to borrow, but they have to get permission from the central government if they have any outstanding debt to the central government. State governments cannot borrow abroad, but can receive external funding indirectly from international organisations and international development banks via on-lending from the central government.


The central government moved to allow LRG bond issuance in 2007, but to date there have been no local government issues; most LRGs fail to meet the minimum conditions set out by the central government with regard to such bond issuance.


Currently 46 LRGs (29 prefectures and 17 cities) out of  a total of about 1,800 are allowed to access capital markets, including foreign exchange borrowings. The rest either borrow from the central government or from banks.


Peninsular (West) Malaysian states are not allowed to borrow commercially. East Malaysian states have access to capital markets (including foreign exchange borrowings), but require federal government approval. Sarawak had tacit government approval to issue its US dollar bond, but still chose to issue via a special-purpose vehicle to avoid lengthy bureaucratic procedures and because of tax considerations.


LRGs do not borrow from capital markets, but there is no regulation prohibiting it. Regulation is under consideration.


LRGs borrow from the federal government, and do not have access to commercial borrowing.


LRGs can borrow in local currency only and are subject to a debt-servicing limit as a proportion of their regular income. In local currency, they tend to borrow from government-owned banks, but they generally have low credit standings with banks. As a result, their borrowings are backed by either pledges of cash or transfer payments from the central government. Only a small number/amount of local bonds has been issued so far, and all of them are guaranteed by the Local Government Unit Guarantee Corporation.

South Korea

Local governments are allowed to access capital markets in local currency, but need additional approval from the Ministry of Finance and Economy (MOFE) to borrow in foreign currency.

Sri Lanka

LRGs can borrow from banks, but are not allowed access to capital markets.


LRGs can access capital markets for both local currency and foreign exchange. Thus far, however, such borrowing has only been in local currency and has amounted to a relatively small share of the government bond market.


LRGs can borrow commercially in local currency, but require central government approval for any foreign exchange borrowings.


LRGs can borrow commercially in local currency, but require central government approval for any foreign exchange borrowings. A few large cities have issued domestic bonds.

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

China: Urban development investment companies (UDIC)


Key findings

Strategic management, organisational structure, and corporate culture

  • Short-term planning horizon and lack of a focused strategy
  • An emphasis on key individuals rather than decision-making processes

Financial policies and planning

  • Financial performance targets not linked with investment decision making
  • Lack of medium- to long-term funding channels and planning forces reliance on short-term credit
  • Policies constrained by the environment for corporate financial services

Transparency and reporting

  • Adequate level of reporting to government shareholders, but poor public disclosure.
  • Opaque decision-making structures that are not subject to outside scrutiny

Operational management

  • Generally strong technical knowledge and industry expertise
  • Good systems to manage suppliers
  • Weak internal controls and problems with the quality of internally-reported data.
  • Difficulties in aligning subsidiary performance with parent company interests and strategies

Ownership structure and government influences

  • Conflict between policy orientation and commercial goals
  • Public policy role often results in ad-hoc and unfunded mandates

Key governance structures, independence, and effectiveness

  • Governance closely linked with local government interests
  • Gap between board oversight and operations
  • Lack of enforced codes of employee conduct


Philippines: Local government units (LGU)


Key findings

Annual budgeting

  • Lack of program-based budgeting
  • Underdeveloped information systems and planning tools
  • Largely cash based

Financial policy and medium-term fiscal framework (MTFF)

  • Absence of medium-term fiscal framework or disconnect between MTFF and annual budgeting, investment planning
  • No fiscal/financial targets
  • Weak link between strategic goals and expenditure allocations

Financial reporting and disclosure

  • Existence of independent audited reports published on Commission of Audit website
  • Reliance on manual reporting and absence of management information system tools
  • Varying degrees of performance focus and benchmarking

Debt management

  • Borrowing depends on pledges of central government transfers and other collateral
  • Poor credit culture in general
  • Varying degree of emphasis on reducing borrowing costs

Liquidity and cash management

  • Lack of centralised cash management with multiple accounts
  • Limited short-term investment options
  • Conservative approach to cash management is a plus

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.

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