5.1 Relevance of borrowing and capital finance

The fourth and final pillar of fiscal decentralization is comprised of subnational government borrowing, debt, and capital finance. The volume of this pillar of fiscal decentralization is often the smaller compared to the others; on average, borrowing and other sources of finance account for approximately 5 percent of total subnational revenues (OECD/UCLG 2019: 71).

Despite its relatively small overall volume, the topic of subnational borrowing and capital finance attracts considerable interest due to its potential to “punch above its weight,” to the extent that it enables subnational governments to mobilize relatively sizable resources for the purpose of financing specific capital investment projects. Unlike the earlier pillars of fiscal decentralization (revenues and transfers), however, borrowing or other forms of capital finance, does not actually increase the amount of money that is available to subnational governments over time (Figure 2.3). Instead, financing mechanisms such as loans or bonds merely shift access to funds over time, as loans contracted today have to be repaid over time and thus reduce the resources available for public expenditures in the future.[32]

5.2 An overview of subnational government borrowing, debt and capital finance

Local and regional governments in many countries face a balanced-budget requirement. This means that, in principle, subnational governments should balance their budgets each year and ensure that they are able to cover their planned expenditures with available own and shared revenues and transfers. Problems arise when local income (revenues and transfers) and expenditures are not balanced at the end of the year.[33] If allowed at all, subnational governments often face limitations on their power to borrow. In many countries, borrowing is only permitted for the purpose of financing capital investments, rather than borrowing for financing unsustainable recurrent spending or deficits.

There are a number of advantages to allowing subnational governments to prudently engage in borrowing and accessing capital finance. Access to borrowing and other capital financing – whether through loans, bonds, or other financing arrangements, such as public-private partnerships – allows subnational governments to finance “lumpy” long-term capital investments without the need to fund the entire investment upfront from recurrent revenue sources. Because the benefits of long-term investments are spread out over time, financing thus allows for inter-temporal matching of the benefits and repayment costs of the capital investment. Subnational borrowing could thus speed up subnational capital investments and thereby improve public services and catalyze economic growth. But there are also fiduciary risks associated with subnational borrowing. For example, when subnational governments borrow excessively, select capital investments poorly, or when they fail to repay their loans. If allowed to borrow at scale, subnational governments may also crowd out central government borrowing and private sector investment, posing potential macro-fiscal risks.

Due to potential risks, central governments impose restrictions on subnational borrowing. Such limitations may range from requirements for subnational governments to meet certain borrowing standards. These may include debt-to-revenue ratios; preapproval from the Ministry of Finance for loans; only permitting subnational governments to borrow from domestic banks, from the central government itself, or centrally-approved financial intermediaries—such as national investment banks, municipal development funds or local government loan boards (Box 5.1). Although such financial intermediaries have been used successfully in many countries with robust decentralized systems, the governance of such institutions in weaker governance contexts has yielded mixed results.

At the cutting edge of subnational borrowing capital finance are more sophisticated financing instruments—such as public bond issuances or advanced public-private partnerships. These are typically only suitable for larger subnational jurisdictions that have a robust economic base, are politically stable, are administratively well-capacitated, and manage their finances in a prudent and transparent manner (in order to ensure creditworthiness).

Box 5.1 Municipal Development Funds

Municipal Development Funds (MDFs) are parastatal institutions that lend to local governments for infrastructure investments. These are essentially financial intermediaries that provide credit to local governments, and are usually seen as an intermediate step in the way towards self-sustaining municipal credit systems that can access domestic and international capital markets for financing.

There are two main types of MDFs. The first type, currently more widely used in the developing world, functions as a substitute for government capital grants to local authorities. These MDFs provide capital at below-market rates, combining subsidized loans with grants. Usually, these MDFs exploit the favorable terms of their loans to impose strict standards of project preparation and implementation.

A second type of MDFs categirizes those that are used to serve as a bridge between local governments and the private credit market. These MDFs lend at market rates, allocate capital according to decisions of private lenders, transfer all credit risk of municipal loans to private lenders, and keep a record of municipal creditworthiness.

Source: World Bank (2011).

5.3 An overview of non-devolved borrowing and capital finance

As presented earlier in Figure 1.2, it is not only local governments that can engage in borrowing for the purposes of financing capital investments. Central governments, centrally state-owned enterprises or parastatals and, in some cases, local service delivery entities, can engage in borrowing in order to finance capital investments. In other cases, parastatals or off-budget entities serve as lenders to local government or local service delivery entities. Similar to non-devolved fiscal transfers, these non-devolved financing flows are often overlooked in analyses of fiscal decentralization and intergovernmental finance. This is especially the case when both the provider as well as the recipient are off-budget entities—for example, a loan from a parastatal or national fund to municipal utility company.

Given the challenges that local governments or local service providers often encounter in securing private sector finance for capital infrastructure, higher-level governments use parastatal organizations, national authorities or funds, state-owned enterprises, or some other special-purpose vehicle to function as an intermediary to provide local governments with access to financing. Development institutions also sometimes set up mechanisms to facilitate on-lending to the local government level. As already noted, municipal investment banks or municipal development funds (MDFs) are one kind of such funding mechanism, often lending at concessionary rates or providing a mix of loans and grants. Other more targeted funds may also provide local governments with access to financing. For instance, the Green Climate Fund (GCF) can structure its financial support through a flexible combination of grants, concessional debt, guarantees, or equity instruments to leverage blended finance and crowd-in private investment for climate action in developing countries (GCF 2021).

5.4 Common obstacles in borrowing and capital finance: technical challenges

Perhaps the most prevalent obstacle to borrowing from private sector sources in developing and transition countries is that limited own revenue sources and weak financial management practices result in the lack of creditworthiness of local governments. Therefore, relatively few local governments are actually in a position to borrow or issue debt. A second problem in many developing and transition countries is the weakness of the suppliers of credit—financial institutions and capital markets. When one or only a few cities in a country are creditworthy, domestic lending institutions may not have experience in issuing loans to local governments. Likewise, formal markets for municipal bonds and other debt instruments may be weak or absent.

If local government borrowing the domestic and international (private) sources is prohibited, the only alternative local governments have is to borrow from a financial intermediary, such as a municipal bank or urban development fund, especially set up for this purpose. Setting up such funds is not free from technical or political economy challenges.

5.5 Political economy considerations: common obstacles in borrowing and capital finance

As was the case for the previously discussed three pillars of intergovernmental finance, there are strong political economy dimensions to the often weak reliance on local government borrowing and other financing instruments.

Efficient, inclusive, and responsive local governance: borrowing and capital finance. The most significant obstacle to allowing local governments to rely on debt and capital finance is not a technical problem, but rather, the “moral hazard” problem associated with borrowing. This is the risk that local officials will engage in excessive borrowing when they do not bear the full consequences of their choices. The moral hazard concerns are typically exacerbated in weak governance environments.

The most obvious moral hazard aspect of local government borrowing is that local political leaders who engage in borrowing receive most of the political benefits of borrowing, while doing so incurs financial liabilities that will have to be borne by taxpayers and other local officials in future years. Trouble ensues when an incoming local mayor or local council defaults on local debt contracted by the previous local administration, on the argument that the new administration and local taxpayers should not be held responsible for the repayment of funds that were spent unwisely by previous local administrations. In order to prevent such scenarios, higher-level governments tend to restrict the level and scope of—or simply to prohibit altogether—local government borrowing. In the United States, some states require local governments to obtain the permission from the voter directly—through a referendum—before contracting debt.

Moral hazard concerns related to local fiscal balance and borrowing grow exponentially when local governments and their creditors believe that local government debt is guaranteed by higher-level governments. As such an implicit or explicit guarantee would reduce the risk for banks and other lenders for extending credit to local governments that would otherwise be a credit risk.

Empowering intergovernmental (fiscal) systems: borrowing and capital finance. While moral hazard or political economy challenges associated with local government debt largely play out at the local government level itself, higher-level governments are not always insulated from similar challenges. This is especially true when the higher-level government is seen to implicitly or explicitly guarantee the debts incurred by local governments. For example, central government officials may choose to extend “deficit grants” to cover the budget deficit of local government jurisdictions that are politically or institutionally favored, while declining the same funding to other local jurisdictions.

A similar situation arises when the higher-level government controls the financial intermediary that lends funds to local governments. This may be the case of a municipal development fund controlled by the Ministry of Finance, or a Local Government Loans Board operated by the Ministry of Local Government. Depending on political circumstances, central government entities may relax the repayment requirements for such funds—for instance, in the run-up to an election—which can spell the financial downfall of the institution, if future borrowing depends on the repayment of existing loans.

Box 5.2 Background and resources on local government borrowing, debt and external finance

City Creditworthiness Initiative (World Bank): citycred.org.
Municipal Finances: A Handbook for Local Governments. Catherine Farvacque-Vitkovic and Mihaly Kopanyi: World Bank, 2014.
Guidebook on Capital Investment Planning for Local Governments. Olga Kaganova: World Bank, 2011.

[32] Sometimes this is referred to as the difference between “funding” and “financing”: funding is the money available to a subnational government (often derived from a variety of sources, including taxes, fees and transfers), whereas financing is the process of raising loans or capital (in the form of loans or bonds), typically for capital investment purpose.

[32] In fact, even with balanced budget requirements in place, subnational governments may actually incur a recurrent deficit when actual spending exceeds planned spending, or when actual revenues and transfers fall short of projected revenues and transfers. In some cases, local governments are able to borrow for short-term (cashflow) purposes. However, it is not unusual for subnational governments to deal with such budget imbalances by accumulating budget arrears with vendors and contractors.