Capital Financing Program Considerations for Cities & Municipalities

Introduction

In most developing country cities, basic infrastructure and services are already stretched beyond capacity. This means that economic growth is being stunted, quality of life is spiralling downward and urban poverty is on the rise. Now consider that population in cities in the developing world is projected to double and reach 4 billion by 2030. This explosion in urban growth compounds the need for expanded basic services to the urban poor and improved infrastructure that attracts businesses and strengthens a city’s competitiveness. The management and financing of these needs will increasingly become the responsibility of city governments as more and more countries decentralize fiscal and administrative functions. Thus, city governments have a substantive role in financing capital improvements and facilitating local investment through mechanisms available to them, including local revenue generation through tax and fee collection, public-private partnerships, equity sharing of capital projects, and incurring private sector debt.

Capital Financing

Also Read: Infrastructure Financing Through Land Based Financing

Program Considerations

Enabling Environment

An enabling environment at the national level is instrumental for a city government to finance basic services and infrastructure. The central government should decentralize predictable revenues to cities–through a broad tax base and stable transfers–and make it legal for cities to use their land or other assets as collateral. Legislation should allow for direct private sector investment in public services through leasing and concession arrangements that allow the investor to reap appropriate benefits from the investment. In countries where cities are still gaining experience with borrowing, national guidelines for limiting borrowing or for maximum debt service levels, for example in relation to their budget, may be appropriate. A legal framework and predictable enforcement of it — at the national and local levels – also contribute to an enabling environment where city authorities are empowered to manage their service and infrastructure needs and the financing of them.
Central and local governments should be aware that investors, lenders, and credit agencies consider the following factors indicators of high risk, and should take actions to minimize them.

  • Newly created and evolving legal frameworks;
  • Shifting intergovernmental relationships;
  • Incomplete or outdated demographic and socioeconomic data;
  • Financial data that is not independently audited or prepared according to international standards;
  • Risky debt profiles (short-term; bullet maturity; foreign currency exposure, etc.);
  • High levels of contingent liabilities (for example, numerous and weak municipally owned companies, large number of guarantees issued by municipalities, and un-funded pension liabilities);
  • High levels of uncollected taxes and fees.

Creditworthiness of the City

Creditworthiness is important to cities interested in financing capital improvements because it is a determining factor investors and banks use to assess risk. To encourage private sector investment, city governments should take steps to increase transparency and reduce corruption at the city level. City governments can use performance based budgeting, independent audits of city finances and double-entry accounting to demonstrate consistent governance despite fluctuations in political leadership. City governments should also develop and follow a capital investment plan that identifies and appropriately sequences priority investments and takes into account the reduced operating and maintenance costs/savings as a result of the investments. For cities interested in a general purpose loan collateralized by the city’s general revenues and a pledge to use a share of the revenues for loan repayment, the city government should efficiently administers its taxes, have stable revenues and build a solid record of loan repayment. Without these conditions investors are more likely to require collateral in the form of physical assets.

Related: City finance

Planning

Ensuring customer satisfaction with capital investments begins with a participatory and transparent planning process. (Link to Participatory Management) City leaders should invite citizens (future customers), and stakeholders from the business and NGO sectors to identify their priorities and expectations for municipal capital investments as well as their willingness to pay for new and improved services. The service and infrastructure priorities identified by the community and their willingness to pay should drive local government decision making. City leaders should also manage expected future growth by linking financing initiatives, such as the city’s capital investment plan, to broader urban planning and community visioning exercises. Given the projected rate of urban growth in most developing countries, it is essential that city leaders be forward thinking in planning their service and infrastructure improvements. Inviting participation from citizens, particularly the urban poor, can include engagement in city planning through referenda, public comments on zoning and land use decisions, and public hearings on the budget or the city’s strategic plan.

Identification of Bankable Projects

Identifying infrastructure priorities through participatory planning and growth management and establishing the city’s creditworthiness may not be enough to entice local private investment. City governments will also need to identify city investment projects that are bankable (i.e. projects in which the private sector would want to invest). Investors judge creditworthiness of individual projects based on financial analyses that include past, present and projected municipal revenue streams, sources and uses of project funds, debt service schedules and project revenue schedules. They will also assess the efficiency with which the relevant enterprise is currently managed, the capacity of its staff and the costs to operate and maintain the facility once completed. Investors — both equity shareholders and lenders – may perform additional project analyses to determine other risks associated with project (investment) viability, including probability of service delays and shutdowns and their likely effects on demand. City governments can identify bankable projects by having access to: demographic and socio-economic statistics about customers, history of predictable revenue generation, reliable mechanism for revenue collection, and projections for future growth prospects and profitability.

Finance Mechanisms

Mechanisms for financing local capital investment needs range from the city’s operating budget and expansion of local revenue through better tax and fee collection to public-private partnerships, such as leases, concessions, and in some cases actual privatization. (link to Service Delivery brief.) Cities may also draw on other debt financing mechanisms, such as project finance, pooled finance mechanisms, special purpose authorities, municipal bonds, private sector loans and partial guarantees. Project finance through a municipality is funded with local investment that is repaid from the project’s revenues, i.e. user fees, tariffs, which are managed in a separate fund. This financing arrangement usually includes a grace period that postpones repayment until the project is complete and project revenues can be collected.
For small to medium-sized municipalities tapping independently into the local capital market may be difficult because of high transaction costs relative to capital needs. For these cities — and those with infrastructure needs that extend beyond their municipal boundaries – pooled finance mechanisms, or bond banks, offer several advantages. Because capital is raised for a group of cities and various investments, the risk to investors–therefore the interest rate for the cities–is lower. Marketing costs are incurred for the fund as a whole instead of for individual investments. Such mechanisms also realize economies of scale in loan origination and supervision.
Another available finance mechanism is the creation of special purpose authorities, which manage a particular government function and are authorized to borrow for investment purposes, subject to constituent approval. Special purpose authorities have an advantage in that constituents can be confident that the funds raised will be used exclusively for investments related to the particular function. Cities may establish special purpose authorities within their boundaries or in cooperation with other neighboring cities. Some examples of areas where special purpose districts have been successful are common property resources, such as water supplies, wood stocks, and fisheries, and transportation infrastructure, such as waterways, ports and highways.

For larger developing country cities with identified bankable projects and in need of longer-term capital, municipal bonds or commercial loans may be appropriate finance vehicles. Municipal bonds pay for such things as bridges, roads, etc., and are secured by a pledge of gross revenues, making payment of debt service senior to payment of operating expenses. Revenues include any income derived from the operation of the project including toll revenues, insurance proceeds, condemnation awards, liquidated damages, and investment earnings as well as any other moneys deposited into the revenue fund. Commercial loans may also be an option cities can pursue for longer term capital needs.
When the local private sector is reluctant to invest despite an enabling environment, improved city governance and available bankable projects, international donors could facilitate investment through risk sharing in the form of partial local currency guarantees, such as USAID’s Development Credit Authority, or the Cities Alliance’s Community-Led Infrastructure Finance Facility, and Community Water and Sanitation Facility. In addition to facilitating private sector financing of public capital improvements, donors can help move local firms down market to service the growing number of urban poor by explicitly incorporating low-income neighborhoods into partial guarantee arrangements.