Improving subnational government development finance in emerging and developing economies: Toward a strategic approach

Smoke, Paul J. Working Paper Improving subnational government development finance in emerging and developing economies: Toward a strategic approach ADBI Working Paper Series, No. 921 Provided in Cooperation with: Asian Development Bank Institute (ADBI), Tokyo Suggested Citation: Smoke, Paul J. (2019) : Improving subnational government development finance in emerging and developing economies: Toward a strategic approach, ADBI Working Paper Series, No. 921, Asian Development Bank Institute (ADBI), Tokyo This Version is available at: https://hdl.handle.net/10419/222688 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/igo/ ADBI Working Paper Series IMPROVING SUBNATIONAL GOVERNMENT DEVELOPMENT FINANCE IN EMERGING AND DEVELOPING ECONOMIES: TOWARD A STRATEGIC APPROACH Paul Smoke No. 921 February 2019 Asian Development Bank Institute The Working Paper series is a continuation of the formerly named Discussion Paper series; the numbering of the papers continued without interruption or change. ADBI’s working papers reflect initial ideas on a topic and are posted online for discussion. Some working papers may develop into other forms of publication. Suggested citation: Smoke, P. 2019. Improving Subnational Government Development Finance in Emerging and Developing Economies: Toward a Strategic Approach. ADBI Working Paper 921. Tokyo: Asian Development Bank Institute. Available: https://www.adb.org/publications/improvingsubnational-government-development-finance-emerging-developing-economies Please contact the authors for information about this paper. Email: paul.s[email protected]u Paul Smoke is professor of public finance and planning at the Robert F. Wagner Graduate School of Public Service of New York University. The views expressed in this paper are the views of the author and do not necessarily reflect the views or policies of ADBI, ADB, its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms. Working papers are subject to formal revision and correction before they are finalized and considered published. Asian Development Bank Institute Kasumigaseki Building, 8th Floor 3-2-5 Kasumigaseki, Chiyoda-ku Tokyo 100-6008, Japan Tel: +81-3-3593-5500 Fax: +81-3-3593-5571 URL: www.adbi.org E-mail: [email protected] © 2019 Asian Development Bank Institute ADBI Working Paper 921 P. Smoke Abstract Considerable attention has been given to enhancing subnational development finance in response to the 2008 global financial crisis and recent global development agendas, including the Sustainable Development Goals, Financing for Development, and Habitat III/New Urban Agenda. Much work on this topic is fragmented, focusing on specific elements of development finance: fiscal transfers, capital market access, public-sector lending agencies, or public-private partnerships. Most countries, however, have a range of subnational governments with varying needs and capacities that require different and evolving mixes of development finance mechanisms. Enabling greater subnational borrowing is often desirable but requires adoption of other reform policies to improve the fiscal capacity and creditworthiness of subnational governments over time. This paper reviews the rationale and potential for improving subnational development finance, outlines the overall landscape of institutional arrangements available for this purpose, and considers broad challenges involved. Based on a review of global practice and experience in selected Asian developing countries with a range of special entities and innovations to enhance subnational investment, it proposes a more integrated, strategic approach to building subnational development finance. Keywords: Subnational government finance, intergovernmental transfers, subnational government debt, subnational government financial intermediaries, Asia JEL Classification: H70, H71, H72, H74, H77 ADBI Working Paper 921 P. Smoke Contents 1. INTRODUCTION ......................................................................................................... 1 2. RENEWED INTEREST IN SUBNATIONAL DEVELOPMENT FINANCE ................... 2 3. CHALLENGES TO IMPROVING SUBNATIONAL DEVELOPMENT FINANCE ......... 4 4. THE LANDSCAPE AND FOUNDATIONS OF SUBNATIONAL DEVELOPMENT FINANCE ........................................................................................ 5 4.1 Subnational Development Transfers ............................................................... 5 4.2 Subnational Borrowing .................................................................................... 6 4.3 Public–Private Partnerships ............................................................................ 7 4.4 Recurrent Subnational Finance ....................................................................... 8 4.5 Other Elements Supporting the Intergovernmental Fiscal System ................ 11 5. IMPLICATIONS FOR A STRATEGIC APPROACH TO BUILDING A DEVELOPMENT FINANCE SYSTEM ................................................................... 12 5.1 Developing a Range of Subnational Lending Mechanisms ........................... 12 5.2 Determining an Appropriate Mix of Development Finance Instruments ........ 15 6. SELECTED EXPERIENCE WITH SUBNATIONAL DEVELOPMENT FINANCE INTERMEDIARIES ................................................................................... 17 6.1 India ............................................................................................................... 17 6.2 The Philippines .............................................................................................. 19 6.3 Indonesia ....................................................................................................... 21 6.4 Cambodia ...................................................................................................... 22 6.5 Observations on the Selected Cases ............................................................ 23 7. INNOVATIONS TO SUPPORT ENHANCED SNG DEVELOPMENT FINANCE ...... 24 7.1 Grant–Loan Linkages .................................................................................... 24 7.2 Performance-Based Grants ........................................................................... 26 7.3 Initiatives to Support Project Preparation and PPPs ..................................... 27 8. CONCLUDING OBSERVATIONS ............................................................................. 28 REFERENCES ..................................................................................................................... 30 ADBI Working Paper 921 P. Smoke 1 1. INTRODUCTION Renewed attention to enhancing subnational government investment and development finance has emerged in recent years.1 There have been previous efforts to improve subnational government access to sources of development finance, and some were productive. Many of them, however, foundered, and especially in low-income countries, subnational governments have played a limited role in public investment. Subnational government investment accounts for an average of 1.5% of GDP (in a sample of 95 countries covering the income spectrum), but the percentage for low-income countries is only 0.4.2 Subnational government investment as a share of total public investment (Figure 1) averages 39.1%, ranging from 49.1% in high-income countries to 7.3% in low-income countries.3 Figure 1: Subnational Government Investment as a Share of Total Public Investment by Country Income Group (OECD-UCLG Sample of 95 Countries 2013) (%) Is it feasible to improve the role and performance of subnational investment and development finance?4 The 2008 financial crisis highlighted consequential risks and underlying vulnerabilities in the international financial system. Political crises, natural disasters, outbreaks of disease, and the emergence of conflicts, among other shocks, can also substantially affect public finances, and in the case of weaker economies, may have an impact on the nature and levels of development assistance. At the same time, the availability and cost of capital have been relatively favorable in the current global environment. Although a range of risks would need to be considered and modalities would need to be sorted out, there should be favorable prospects for using 1 See, for example, Bahl, Linn, and Wetzel (2013), UCLG (2010, 2013, 2015, 2016), Frank and MartinezVazquez (2016), Bahl and Bird (2018), and UN ESCAP (2018). 2 OECD-UCLG (2016), p. 34. 3 OECD-UCLG (2016), p. 38. 4 See, for example, Ingram, Liu, and Brandt (2013), Ahmad (2014), Alm (2015), UN-Habitat (2015), AFDUNDP (2016), and Frank and Martinez-Vazquez (2016). ADBI Working Paper 921 P. Smoke 2 public institutions and resources to leverage more private finance to support infrastructure investment.5 Recent transformations in development assistance actors and mechanisms have also generated opportunities to develop innovative approaches to subnational development finance. The form and extent of such efforts, however, depend on understanding the context of particular countries and determining appropriate means and paths to enhanced subnational investment. This paper considers if and how subnational governments might play a stronger role in infrastructure investment, with a particular focus on emerging and developing economies in Asia. The next section outlines the rationale and potential for improving subnational development finance, followed by a summary of the broad challenges involved in doing do. The fourth and fifth sections respectively outline the landscape of subnational development finance options and present the case for taking a more integrated, strategic approach to developing it. The sixth section discusses a number of recent Asian experiences with a range of special entities designed to enhance subnational investment, followed by an overview of a number of recent innovations that may have potential to support subnational development finance. The concluding section provides some summary comments and recommendations. 2. RENEWED INTEREST IN SUBNATIONAL DEVELOPMENT FINANCE The emerging focus on a potentially productive role for subnational governments in financing public investment has been reinforced by a broader rethinking of national fiscal policy in the wake of the 2008 global financial crisis and the evolution of recent global development agendas. The UN Secretary General's Synthesis Report on the Sustainable Development Goals (SDGs) states that “many of the investments to achieve the sustainable development goals will take place at the subnational level and be led by local authorities.”6 A High Level Panel on the Post-2015 agenda posits that the battle for sustainable development will be lost or won in cities. The Habitat III/New Urban Agenda calls for a new model of urban development that is intended to integrate all facets of sustainable development in order to promote equity, welfare and shared prosperity.7The Addis Ababa Action Agenda on Financing for Development emphasizes the subnational role in financing development and commits to increasing international cooperation to support subnational governments for this purpose. 8 Beyond responding to fiscal crises and development policy trends, a number of factors underlie the renewed focus on subnational governments in development finance.9 First, high-income countries—and increasingly other countries—expect subnational governments to perform a range of public functions, including infrastructure investment. Of course, fiscal decentralization is more recent and less advanced in many low-income and even middle-income countries, where subnational governments may account for 10% or less of public expenditures (Table 1).10 The share, however, is substantially higher in some Asian cases, such as India, Indonesia, and the Philippines, and the People’s Republic of China (PRC) is a special case where subnational governments 5 See, for example, De La Torre, Gozzi, and Schmukler (2017). 6 UN General Assembly (2014), p. 22, par. 94. 7 UN Habitat, Habitat III Secretariat (2017). 8 UN (2015). 9 See a more detailed discussion in UCLG (2015). 10 OECD-UCLG (2016), UNDESA-UNCDF (2017). ADBI Working Paper 921 P. Smoke 3 dominate public expenditures. There are also efforts and further potential to expand the role of subnational governments in many other cases. Table 1: Subnational Government Expenditure as a Share of GDP and Total Public Expenditure by Country Income Group (OECD-UCLG Sample of 95 Countries 2013) (%) SNG Expenditure Low Income Lower Middle Income Upper Middle Income High Income All 95 Countries % of GDP 1.7 6.3 8.3 13.2 9.0 % of public expenditure 7.5 20.3 25.1 29.7 23.9 Second, many countries suffer from large deficits in basic infrastructure and services that support development.11 Filling infrastructure deficits and meeting new needs will require considerable planning and investment, much of it for services that subnational governments do or could play a significant role in providing and financing. Although experience is varied, some evidence indicates that under the right conditions, subnational governments can play a role in advancing local and national development by generating resources, taking responsibility for public investments, and managing service delivery.12 Third, many SDGs and other global development goals embody components that must be dealt with in an integrated manner in specific locations, as embodied in SDG 11 (sustainable cities). Subnational governments are considered closer to their constituents and are expected to face greater incentives and opportunities than central government agencies to think holistically about integrated territorial development, which is seen as key for sustainable development.13 Moreover, 103 of the 169 SDG targets (61%) have been determined to include a component that will require attention at the local level.14 Fourth, population growth and the march of urbanization in middle-income and lowerincome countries will result in a substantial increase in demand for infrastructure.15 Cities play an important role in driving economic growth, often producing 25% or more of GDP in countries of all income levels. Almost half of the global population is already urban, and urbanization is projected to approach near 85% in industrialized and 64% in developing countries by 2050.16 The ability of urban areas to create jobs, deliver public services, and generate sustainable growth, however, is mixed, and the situation is particularly challenging in less-developed countries. There is a general consensus that urban areas will have to do better in making public investments and creating an environment for private investments.17 11 Ingram et al. (2013), UCLG (2015), Frank and Martinez-Vazquez (2016). 12 Evidence is reviewed in Local Development International (2013) and European Commission (2016). 13 CLGF (2007, 2013), Romeo (2013), and European Commission (2016). 14 Greene and Meixell (2017), p. 10. 15 See UCLG (2010, 2014), Ingram et al. (2013), UN General Assembly (2014), and Frank and MartinezVazquez (2016). 16 See, for example, UNDESA Division for Sustainable Development (2015). 17 See, for example, McGranahan and Sattherthwaite (2014) and UN-Habitat (2016). ADBI Working Paper 921 P. Smoke 4 Finally, there appears to be a growing sense that subnational governments can play a consequential role in helping to address contemporary global challenges—global warming, energy shortages, health crises, and food insecurity, among others. Such challenges obviously require concerted national and international action, but subnational governments in some countries have already taken steps to deal with such issues—through climate adaptation policies, green growth strategies, and other efforts that require capital investments.18 3. CHALLENGES TO IMPROVING SUBNATIONAL DEVELOPMENT FINANCE Given the potential value of a strong subnational government role in public investment, why has more progress not been made in emerging economies? On a general level, the challenges involved in financing public investments are well known, especially in poorer countries. Public finances, including flows of development assistance, face many limitations and are often subject to significant volatility. 19 Infrastructure investment requires long-term finance, but short-term finance is more readily available in some cases. More specific to the question at hand is the lack of robust intergovernmental frameworks and policies to empower, finance, incentivize, and support vibrant subnational governments.20 Current systems in many countries exhibit various deficiencies or need updating to reflect changing conditions and new challenges, and capacity deficits can be large, especially in low-income countries. Particularly salient are revenue limitations— own-source revenues, intergovernmental transfers, and development finance—and unfunded expenditure mandates are not uncommon.21 A great deal has been written and substantial reforms have been undertaken to expand and enhance fiscal decentralization in recent years. 22 These measures have demonstrated some productive progress, but many have been disappointing, especially in lowand middle-income countries. Weaker than expected performance of reform programs results from various factors, including insufficiently contextualized reform design, unrealistic time frames and expectations of progress, fragmented implementation, and political economy forces, such as a common central government disinclination to strengthen subnational governments and the potential effects of problematic local politics. Mainstream approaches to fiscal decentralization are valuable, but their application must recognize the challenges to be overcome and the widespread dissimilarities in structures, responsibilities, capabilities, and performance across and within countries.23 Beyond these general challenges to fiscal decentralization, much of the effort specifically on subnational development finance has been relatively disjointed. Rather than looking at development finance in the context of fiscal decentralization overall and the broader economic, institutional, and political context, various analysts and frameworks have tended to focus on (and try to promote) specific individual reform elements— 18 See, for example, UCLG (2013, 2016). 19 World Bank and IMF Development Committee (2015). 20 See discussion in Smoke (2017). 21 See, for example, UCLG (2010, 2015), Martinez-Vazquez and Vaillancourt (2011), Bahl, Linn, and Wetzel (2013), UN-Habitat (2015), OECD-UCLG (2016), and Bahl and Bird (2018). 22 The references cited in the previous footnote discuss these reforms in detail. 23 See summary in Smoke (2017). ADBI Working Paper 921 P. Smoke 11 In addition, there has been a growing tendency to allocate the transfer pool on the basis of objective criteria, reducing politicization and improving transparency. Transfer formulas allow the central government to advance certain goals—enhancing subnational resources (and redistributing to fiscally weaker subnational governments), increasing autonomy (through unconditional transfers), and targeting high-priority functions (through conditional transfers). A key decision about transfers is to determine the relative importance of goals and what this implies for how transfers should be structured and allocated. Another area of concern is the incentives generated by transfers. If the total volume of transfers is large and the formula creates disincentives for subnational tax effort, they may dampen local revenue generation (and local accountability) as well as discourage borrowing by creditworthy subnational governments, even for self-financing infrastructure (reducing funds for weaker subnational governments or less bankable investments). In addition, strong conditions placed on transfer use may create incentives to overprivilege certain sectors or to invest in infrastructure that subnational governments do not have sufficient recurrent resources to operate and maintain. Despite some identifiable trends, the practice of intergovernmental transfers is highly diverse. Many countries increasingly define rules to determine the annual pool, for example basing it on a share of certain national revenue sources (e.g., Cambodia, Ghana, Kenya, Indonesia, Mexico, the Philippines). In other cases, the pool is still determined annually in the budget process (e.g., South Africa, Uganda) or set for a specific period of time (e.g., five years in India and Pakistan based on National Finance Commission recommendations). A number of countries have developed relatively unified transfer systems, for example a single or dominant unconditional formula-based transfer, as in Indonesia, Kenya, the Philippines, and South Africa. Other countries use multiple transfer programs or place conditions on revenue-sharing use, as in Brazil, Ghana, and Uganda. The degree of restrictions can shift, as in Uganda, where the central government introduced numerous conditions on the use of transfers. Many countries share national revenue with each level of government, but in some cases, particularly federal systems such as India, Mexico, Nigeria, and Pakistan, most transfers go to the intermediate tier, such that decisions about sharing with lower tiers rest with states or provinces. Excessive conditions placed on transfers could constrain subnational governments from meeting debt service obligations. 4.5 Other Elements Supporting the Intergovernmental Fiscal System This paper focuses primarily on subnational finance, but such policies do not operation in isolation, and it would be negligent not to acknowledge briefly the broader considerations that affect subnational fiscal performance.36 These include the quality of the larger intergovernmental system, the capacity of subnational governments, and the incentives they face to make financial mechanisms and processes work on the ground. As noted above, subnational creditworthiness is contingent on reliable and adequate levels of recurrent revenues. More fundamentally, subnational fiscal responsibility depends on sufficiently empowered and motivated subnational governments that have at their disposal adequate systems for planning, budgeting, implementation, financial management, asset management, etc. 36 See, for example, the discussion in Connerley, Eaton, and Smoke (2010) and Smoke (2015). ADBI Working Paper 921 P. Smoke 12 In addition to these empowerment and system requirements, the operations of subnational governments need to be sufficiently transparent and subject to accountability provisions. 37 Upward accountability mechanisms can improve compliance with budgeting and financial management systems as well as promote national development priorities and basic service standards. Also relevant is downward accountability of subnational governments to their constituents through elections and non-electoral means (subnational borrowing may be subject to referenda). Together, transparency and accountability can help to ensure that subnational borrowing and other fiscal powers will be used responsibly. 5. IMPLICATIONS FOR A STRATEGIC APPROACH TO BUILDING A DEVELOPMENT FINANCE SYSTEM Given the complex, diverse, and unevenly developed landscape in which subnational governments operate, it is important to plan efforts to enhance subnational development finance in a particular country carefully. Suspicious of special subnational financial intermediaries because of the challenges in making them work sustainably (reinforced by donor reluctance to support them), some countries perhaps have tried to move too quickly into developing municipal bond markets or PPPs and/or have continued to rely heavily on development transfers for subnational governments that could not take advantage of these more advanced financial arrangements. The fact remains that the majority of subnational governments in many developing countries are not creditworthy and will need assistance to access development finance and craft financing strategies. At the same time, in many countries at least some subnational governments could responsibly assume loans, if not directly from capital markets then from appropriately structured special financial intermediaries or commercial banks. Disadvantaged local governments with weak fiscal capacity, however, may have little hope of borrowing substantially from any type of financial intermediary in the near future. 5.1 Developing a Range of Subnational Lending Mechanisms Under these conditions, there would seem to be value in developing a range of development finance mechanisms appropriate to a particular country. Transfers will remain important in many countries (some of the concerns outlined above about how to structure transfers are revisited below). With respect to lending mechanisms, a simplified version of the general range of options is presented in Table 3. At the one extreme would be a government account managed out of a central government agency, such as a ministry of finance or a ministry of local government, and financed out of contributions from the national budget. At the other end of the spectrum would be fully private entities, such as commercial banks and financial markets, which provide access to private funding from domestic and/or international sources. In either of these extremes, there could be various alternative arrangements or contextualized restrictions. For example, the central ministry in which a loan account is based may secure resources from international development agencies or international financial institutions and then on lend them to subnational governments rather than rely fully on budget contributions. In the case of private entities, lending to subnational 37 See reviews of accountability in Boex and Yilmaz (2010), Yilmaz, Beris, and Serrano (2010), Agrawal and Ribot (2012), and Faguet (2014). ADBI Working Paper 921 P. Smoke 13 governments from private international sources may face challenges if there are serious risks of foreign exchange fluctuations, so funds made available might be restricted to domestic sources. The specific nature of the arrangements would be determined by the conditions in a particular country and the national legal framework regulating subnational borrowing. Table 3: Simplified Spectrum of Subnational Government Lending Mechanisms Management and Finance Ownership Government Agency Government Owned Mixed Public–Private Private Entity Lead Entity/ Institution Ministry of finance, local government Development bank or fund Development bank or fund Commercial banks, financial markets Potential Source(s) of Finance National budget or external donors National budget, SNG contributions, external donors, financial institutions National budget, SNG contributions, private investors, depositors, external investors Private finance (domestic or external) In between the government agency and private entity options are various types of special financial intermediaries specifically intended to lend to subnational governments for development. The closest to a fully public option would be a subnational development bank or fund that is fully owned and managed by the government. Such entities could be capitalized in a variety of ways, for example from the national budget, mandatory or voluntary contributions from subnational governments, or funds in the form of grants or sovereign loans from external donors and international financial institutions. Moving further to the private-sector side, a subnational development bank or fund could be co-owned and operated by the national (or a regional) government and private investors. Such entities would likely blend funds from public sources (contributions from national and subnational government budgets as well as money secured from international development and financial institutions) and private sources (private investors, individual deposits, etc.). The boundaries between the publicand private-sector roles in these subnational development banks/funds could vary. Even a fully national government-owned entity could include private-sector (and other nongovernment) representatives on the board of directors. In addition, some elements of the lending process (e.g., loan application appraisals) could be contracted to private firms, or private investors might contribute resources in the expectation of suitable returns. What would work in a particular case will depend on a variety of factors, including the extent to which subnational governments are creditworthy and infrastructure projects are financially viable. Equally important is the extent and authenticity of the central government’s willingness to relinquish borrowing decisions to subnational governments and lending decisions to private-sector actors, as well as the level of development of financial markets and the potential sources of funding for a development bank/fund, among other factors. The relative importance of the various options can also change over time as subnational government capacity and creditworthiness improve, financial markets develop, government attitudes about subnational borrowing evolve, and investor confidence in the ability of subnational governments to repay loans improves, among other considerations. ADBI Working Paper 921 P. Smoke 14 As indicated above, there is some evidence that subnational development banks/funds perform better the more the private sector is involved. Accordingly, there could be a situation in which most lending to subnational governments is initially channeled through the ministry of finance (as has long been the case, for example, in Indonesia, as discussed below), but over time the central government may decide to create a dedicated municipal lending entity outside of a government ministry. Initially it could be largely owned, operated, and capitalized by the central government (perhaps with external contributions). As this fully public entity establishes a sound track record and subnational governments develop creditworthiness, the door might open to more extensive private involvement in managing and financing a reconfigured entity, increasing the volume of funds available and possibly lending at closer to market terms. This is not to say that only one avenue for subnational development financing needs to be created initially and then strategically modified over time. In some countries there will be needs and opportunities to operate multiple channels that target different types of subnational governments and development projects from the beginning. If some large cities can go directly to capital markets for self-financing projects, it makes sense to develop a legal framework to enable that. Subnational governments with less robust fiscal capacity or facing greater challenges to recovering costs will have to rely on other lending mechanisms that have flexibility to offer more favorable terms and varying degrees of interest rate subsidization. And in some cases, subnational governments will likely have no access to borrowing and will continue to rely on intergovernmental development transfers. Whatever form financing mechanisms take along the spectrum from more public to more private, basic norms need to be followed. As noted above, the challenges with subnational development banks/funds with more public involvement have been how they have been organized and managed. Some entities have been one-stop shops for all stages of the development project cycle, creating conflicts of interest when, for example, the same entity that designed an infrastructure project was also in charge of appraising it for a loan. Too frequently, appraisal has been superficial, enabling approval of loans for nonviable projects and rejection of loans for good projects. There also have been challenges with subjective determination of loan terms. Repayment has been another challenge; many loans have not been repaid because a loan was attached to a nonviable project or repayment was not enforced. Many problems have been a function of managerial structures and lack of accountability, while others have been due to understaffing and insufficient or inappropriate capacity. Not uncommonly, politicization has played a role. The end result, however, has been similar: many subnational lending agencies have failed as revolving funds and have had to be continuously recapitalized. In some cases with heavy reliance on external sources, funds have continued to flow even when the mechanism was not performing. Apparently international financial institutions that provided loans benefitting these intermediaries were in some cases more concerned about being repaid by the client government than whether subnational governments repaid on-lent funds. And perhaps some central governments have accepted the need to bail out intermediaries because of the political benefits they derived from doing so. Clearly, how a subnational development bank/fund is structured and managed matters. Such entities need to be properly managed by directors who want the mechanism to succeed and create a foundation for further development of subnational lending. This means that they must be operated professionally, must objectively evaluate loan applications on standard terms using robust assessment tools, and must seriously consider the creditworthiness of subnational governments. In addition, loan repayment ADBI Working Paper 921 P. Smoke 15 must be treated as a requirement and enforced, insulating the lending entity from political interference to the extent possible. 5.2 Determining an Appropriate Mix of Development Finance Instruments The discussion thus far has centered on the options and challenges for developing a set of suitable subnational lending mechanisms in a particular country, with the understanding that a range of entities would often be required. The specific mix of mechanisms will depend on country context. Beyond the source of finance and the financing entity, the finance instrument is also important. Under the circumstances outlined above, it would seem sensible to acknowledge that a robust intergovernmental fiscal system would benefit from offering an appropriate spectrum of development finance instruments to its subnational governments. These could range from grants and subsidized (according to well-criteria) loans for fiscally weaker subnational governments and non-self-financing projects, to various types of loans for fiscally stronger subnational governments and self-financing projects. Table 4 presents a simple schematic illustrating how the finance mechanism mix might broadly differ among subnational governments with varying fiscal capacities and development projects with differing potential for cost recovery. There is, of course, potential for nontrivial subjectivity in defining these various classifications and for challenges in determining where specific subnational governments and projects fit into this landscape (as well as who makes those decisions). If such an approach were to be used, considerable care would need to be taken to develop objective criteria to define the categories in a clear way and to create practical assessment tools to operationalize the criteria. Table 4: Illustrative Financing Arrangements by Type of Investment and SNG Creditworthiness Type of Investment SNG Income Level/Creditworthiness Low Medium High Self-Financing Mix of loans (possibly subsidized) and transfers Mix of loans (possibly subsidized) and bonds (if feasible) Mix of bonds and loans Partially RevenueGenerating Mix of loans (likely subsidized) and transfers Mix of loans (likely subsidized) and transfers Mix of loans (possibly subsidized) and transfers (if justified) Non-SelfFinancing/Social Purpose Transfers only Mix of loans (possibly subsidized) and transfers Mix of loans (possibly subsidized) and transfers (if justified) Note: The mix of financing instruments would have to be based on objective criteria and the source of financing (Table 3) and would vary based on availability and specific criteria. ADBI Working Paper 921 P. Smoke 16 The expectation is that over time more subnational governments will develop greater capacity and creditworthiness and additional projects could be classified as at least partially revenue generating. This means that subnational governments may move across categories and pursue different types of development projects as the conditions in which they operate and their own capabilities evolve. Perhaps the most formidable test in this process is how weaker subnational governments would “graduate” from full reliance on grants and subsidized loans to greater use of credit markets. To some extent, such an evolution could happen naturally under conditions of sufficient macroeconomic growth, the development of a more appropriate institutional environment, and the emergence of favorable political conditions in which subnational governments increasingly adopt a developmental orientation and seek to improve their status and performance. The central government, however, could also proactively develop policies that favor progressive transformation through development of new systems and procedures, creative use of incentives to influence subnational fiscal behavior, and supportive technical assistance and capacity-building initiatives where needed. One potentially productive approach would be to pursue more coordinated development of grant and loan financing options such that these mechanisms are appropriately used. The range of development finance options could be set up, for example, to ensure that fiscally strong urban governments would not be eligible to receive grants for self-financing infrastructure projects, a practice that diverts grant resources from fiscally weaker subnational governments currently unable to borrow. At the same time, it is neither productive nor sustainable to keep weaker subnational governments perpetually dependent on grants and subsidies. The structure and allocation of transfers could generate incentives for these weaker subnational governments to improve their capacity and modify their behavior so that they can begin to borrow. Initial borrowing could be realized through subsidized loans from special financial intermediaries (development banks/funds), moving later to borrowing on more market-based terms. If even weak subnational governments must borrow for a modest percentage of infrastructure project finance and they are supported to build the capacity and exercise the fiscal discipline required to manage the loan (including local revenue generation for repayment), they can begin a trajectory of building creditworthiness that can progressively improve over time. The idea of a grant–loan linkage is discussed in more detail below. Finally, adopting national policies regarding the structure and management of subnational lending entities and creating various types of financial mechanisms are not enough. It will often also be necessary to develop other means to facilitate subnational access to credit, such as risk mitigation strategies. These include comprehensive or partial credit guarantees from the central government or development partners, cofinancing initiatives, secondary market support, use of bond banks and credit pooling, and risk instruments offered by the insurance industry.38 Although risk mitigation can create moral hazard by shielding subnational governments from the consequences of their behavior, strategic use of such instruments seems inevitable where subnational governments are not independently creditworthy and private lenders would be unlikely to extend credit in the absence of government policies to alleviate risk. 38 See, for example, Kehew et al. (2005), Matsukawa and Habeck (2007), Annez and Peterson (2007), Eichler (2012), FMDV (2015), OECD (2015), and De La Torre et al. (2017). ADBI Working Paper 921 P. Smoke 17 6. SELECTED EXPERIENCE WITH SUBNATIONAL DEVELOPMENT FINANCE INTERMEDIARIES The illustrative strategy outlined above relies heavily on the notion that in developing and emerging economies, where a limited number of subnational governments can directly access markets to secure development finance, dedicated financial intermediaries—perhaps multiple versions—will play a substantial role. In some countries, such entities have been important. As noted above, many have faced challenges, but some have yielded positive results, and countries seem to be learning from past mistakes. It is impossible to cover the range of diverse intermediaries that have been used or proposed in Asia and globally due to space and information limitations, so this section provides more information on only a few cases that have had some success or seem to hold promise. There is first a discussion of the experiences to date in India and the Philippines, both of which use a variety of subnational development finance entities that have expanded subnational access to development finance. This is followed by an overview of different mechanisms recently launched in Indonesia and Cambodia, with the latter developing a financing entity that focuses on development transfers rather than loans. 6.1 India Since the Ahmedabad Municipal Corporation first borrowed directly from the capital market in 1998, Indian municipal corporations have raised sizable resources through both taxable and tax-free municipal bonds, with and without state guarantees. 39 Some of the more innovative and influential mechanisms for subnational lending, however, have been at the state level. Two that have been considered productive and successful—mixing public oversight with private finance—are the Tamil Nadu Urban Development Fund and the Greater Bangalore Water and Sanitation Project. 6.1.1 Tamil Nadu Urban Development Fund The Tamil Nadu Urban Development Fund (TNUDF) is a financial intermediary facilitating access to capital markets for the financing of infrastructure by urban local bodies (ULBs, which include municipal corporations, municipalities, and town panchayats) in the Indian state of Tamil Nadu.40 It was established in 1996 as a trust fund, motivated by the government of Tamil Nadu’s successful experience with the Municipal Urban Development Fund financed by the World Bank. The fund is managed by Tamil Nadu Urban Infrastructure Financial Services Limited (TNUIFSL), a public limited company with equity participation from the state of Tamil Nadu and various private financial institutions (ICICI Bank, Housing Development Finance Corporation Limited, and IL & FS Financial Services Limited), making it a PPP with the private sector holding the majority. This arrangement allows for public-sector involvement but keeps management of the fund at a distance from the government.41 39 Government of India (2010, 2015), World Bank (2015). 40 For more details see http://www.tnudf.com. 41 TNUIFSL is also responsible for the management of a number of other infrastructure funds such as the project development grant fund, Project Sustainability Grant Fund, Chennai Mega City Development Fund, Tamil Nadu Urban Road Infrastructure Fund, and the Water & Sanitation Pooled Fund. ADBI Working Paper 921 P. Smoke 18 The TNUDF’s financial resources consist of capital provided by the partners as well as funding from a World Bank line of credit, market borrowing, and other institutional borrowing—from the Japan Bank for International Cooperation and KfW (German Development Bank), among others. The fund makes a profit and performs well, with a loan recovery rate of 100% in the financial year 2015/16. Its institutional creditors are repaid through the government of Tamil Nadu and the Indian government. TNUDF enables debt financing of local infrastructure development projects by providing access to capital markets either directly or through pooling arrangements. It also offers grants for public infrastructure targeting the poor. ULBs may request a broad range of technical assistance and capacity-building support, not only for financial appraisal, structuring of projects, and related fund sanctions and disbursement, but also for project development, monitoring, and management more generally. Eligible ULBs apply for financing for a variety of urban infrastructure projects. Currently, the TNUDF project portfolio is composed of 39% bridges and roads, 38% sewerage and sanitation, 17% water supply, and 6% other projects. Loans to the ULBs usually have repayment terms of 20 years with a 5-year grace period at a fixed rate. They can cover up to 60% of the project cost. One way the TNUDF facilitates subnational access to the credit market is by pooling capital requirements of several ULBs for specific projects and issuing bonds on the capital market on their behalf. In general, projects are required to generate enough revenue to service the debt and cover operations and maintenance, either through user charges or tolls or through upfront user contributions. If this is not feasible, other local revenue sources must be earmarked. An escrow arrangement is set up to ensure that the identified revenues are generated and spent toward debt service. A safeguard mechanism further ensures debt service compliance by intercepting and repurposing intergovernmental transfers to the ULBs in case of default. Further guarantees to the pooled fund are provided by the governments of India and of Tamil Nadu and by donors (e.g., USAID). These safeguards bolster the fund’s credit rating and reduce the interest rate. The technical assistance and capacity building provided by TNUDF increase the fiscal, technical, and managerial capacities of the ULBs, for example with regard to accrual-based accounting, collection efficiency, effective service delivery, and tariff rationalization, which is particularly beneficial for smaller ULBs. This increases transparency and makes ULBs more attractive for private investors. It also stimulates further reforms in accounting, tax mobilization, e-governance, decentralization, etc. This public–private debt facility helps to build the creditworthiness of ULBs and advances the development of a municipal debt market, but the lending policies are somewhat rigid. They do not allow for the resetting of interest rates and are not conducive to early repayment of the principal, which reduces their competitiveness with pure market models in the long run. 6.1.2 Greater Bangalore Water and Sanitation Project The Greater Bangalore Water and Sanitation Project (GBWASP) was set up as a pooled financing mechanism to facilitate provision of piped water and sanitation to the greater Bangalore region (Bangalore, the capital of the state of Karnataka, is now officially known as Bengaluru), which includes eight surrounding ULBs that were merged into the Greater Bangalore City Corporation in 2007.42 It started as a 42 See the Bangalore Water Supply and Sanitation Board website at https://bwssb.gov.in/. ADBI Working Paper 921 P. Smoke 19 development assistance project in 2003 to establish a market-based financing framework following pooled financing models for infrastructure provision initially promoted by the Financial Institutions Reform and Expansions Program of USAID. The GBWASP steering committee was composed of representatives of the state government of Karnataka: the Urban Development Department of the Karnataka Urban Infrastructure Development and Finance Corporation (KUIDFC), a public-sector company responsible for developing and implementing urban infrastructure projects, and the Bangalore Water Supply and Sewerage Board (BWSSB), responsible for managing water supply and sanitation in the Bangalore Metropolitan Area. KUIDFC was in charge of managing the Karnataka Water and Sanitation Pooled Fund (KWSPF), allowing access to the capital market. The BWSSB was responsible for the technical oversight of the project and, ultimately, for the operation of the expanded water and sanitation network. The project was financed through a combination of public and private sources. Public funds came from the state government and from various national schemes, particularly the Megacity Loan program and the Jawaharlal Nehru National Urban Renewal Mission. Some funds came from municipal bonds floated by the KWSPF, which functioned as a financial intermediary between the ULBs and the capital market, pooling ULB revenues to spread risk and lower interest rates. The fund was secured by a USAID 50% guarantee on the principal. ULB property tax revenues placed in an escrow account served as a further safeguard. In 2005 the fund issued 1,000 tax-fee municipal bonds at an interest rate of 5.95% and a term of 15 years. The largest share of project funds (about 35%) came from beneficiary capital contributions, which were requested before the beginning of project construction from all residents in the metropolitan area who planned to benefit from the expansion. The amounts varied based on type of property (residential or commercial) and plot size. Contribution was compulsory, and a penalty was charged if the payment was delayed. The project has been criticized for a top-down approach and a lack of effective communication vis-à-vis its beneficiaries and the ULBs involved, although some amendments were made to the project design in response to citizen complaints. Furthermore, shortcomings in the project planning and budgeting resulted in time delays and greater costs. Overall, however, it has significantly contributed to improving access to piped water and sanitation in the Bangalore metropolitan area. 6.2 The Philippines The Philippine Ministry of Finance developed a Local Government Unit (LGU) Financing Framework in 1996. The framework provided for a segmented and targeted approach to LGU capital financing. Lower-income LGUs were expected to access subsidized loans from the government, while the wealthiest LGUs were expected to access private commercial finance. Those in between the two extremes were to be served by various governmental financial institutions. Provisions were also made to encourage PPPs, and a number of limited transfers for infrastructure finance were developed. The performance of the framework has lagged expectations, but two mechanisms—the Municipal Development Fund and the Local Government Unit Guarantee Corporation—have proven to be successful in improving infrastructure finance access to some segments of the LGUs. ADBI Working Paper 921 P. Smoke 20 6.1.1 Municipal Development Fund Office43 The Municipal Development Fund (MDF) in the Philippines was created in 1984 as a way to offer LGUs access to capital finance for social and economic development projects. Since 1998 the fund has been managed by the Municipal Development Fund Office (MDFO) in the Department of Finance, which also manages a wide range of other financing windows (e.g., Disaster Management Assistance Fund, Municipio Fund, Public–Private Partnership Fund). Each varies slightly in purpose and/or target group, but all are geared toward facilitating financial access for LGUs. The MDFO is directed by a Policy Governing Board. This is composed of representatives from a range of central government agencies: the Department of Finance, the National Economic Development Authority, the Department of Budget and Management, the Department of Interior and Local Government, and the Department of Public Works and Highways. The MDF is a revolving fund capitalized by grants and loans received from international donors and financial institutions. This arrangement not only harmonizes and aligns disbursement mechanisms for LGU funding but also allows the central government to monitor the disbursement and utilization of international financing. Eligible LGUs can apply for financing generally consisting of a combination of loans and grants. For many LGUs, especially smaller ones without access to private capital, the MDF constitutes the main source of infrastructure financing. The MDFO evaluates project proposals and administers resources. It can also provide technical assistance to support LGUs in selecting and formulating investment projects that are high-quality, financially sustainable, and provide at least some degree of cost recovery. MDFO also encourages efforts to raise private funding and other forms of cooperation with the private sector, for example through the Public-Private Partnership Fund. The financing mechanisms offered by the MDFO promote the development of financial discipline, capacity, and transparency among LGUs, thus increasing their creditworthiness. Through a system of credit monitoring, the MDFO evaluates the bankability of LGUs and graduates creditworthy LGUs to the private capital market. 6.1.2 Local Government Unit Guarantee Corporation44 The Local Government Unit Guarantee Corporation (LGUGC) provides another type of mechanism for subnational lending. It is a private financial guarantee institution that was incorporated in 1998 by its stockholders, the Bankers Association of the Philippines and the Development Bank of the Philippines. It does not lend directly but provides financial guarantees for LGUs and other public and private entities, such as water districts, electric cooperatives, renewable energy technology projects, and medium and large enterprises, in order to enable them to access capital for infrastructure from private-sector financial institutions. It thus considers itself “the private sector link in public–private partnerships for local development financing.” The basic LGUGC approach is to provide guarantees to partner financial institutions in case of borrower default. For water projects, USAID provides a co-guarantee of up to 50%. In return, the partner financial institution, usually a LGUGC bank or subsidiary, provides loans to or underwrites bond issues for borrowing entities. For these guarantee services, borrowers pay a guarantee fee, which may range from 0.25% to 2.00% per year of the amount borrowed, depending on the risk assessment. 43 Detailed information can be found at http://www.mdfo.gov.ph/#. 44 Detailed information can be found at http://lgugc.com/. ADBI Working Paper 921 P. Smoke 27 7.3 Initiatives to Support Project Preparation and PPPs In an effort to help subnational governments develop better infrastructure projects and secure financing, a number of development partners have supported or proposed the creation of Project Preparation Facilities (PPFs).50 These take multiple diverse forms. One such effort is the Cities Development Initiative for Asia (CDIA), a joint initiative of the Asian Development Bank (ADB), several European bilaterals, and the Shanghai Municipal Government. 51 CDIA supports medium-sized cities in the Asia and the Pacific region to take projects identified in their development plans and transform them into specific infrastructure investments with a focus on urban environment, poverty reduction, and climate change adaptation. CDIA works with cities to support infrastructure planning, prepare feasibility studies, build capacity, and locate potential sources of finance. It has involved 55 cities in 14 countries, including Bangladesh, India, the Lao People’s Democratic Republic, and the Philippines. Other examples include the International Finance Corporation Global Infrastructure Project Development Fund52 (although this focuses on private-sector-led projects), the African Development Bank Infrastructure PPF,53 and the ASEAN Infrastructure Fund54 Although these other PPFs are not specifically targeted to subnational governments, there may be lessons that can be drawn that could be directly applied to subnational public infrastructure projects. A number of international agencies and initiatives have been attempting to enhance the use of PPPs and assist with setting them up. For example, the Public–Private Infrastructure Advisory Facility (PPIAF), a multi-donor technical assistance facility based at the World Bank, has been supporting some subnational PPPs.55 The European Bank for Reconstruction and Development (EBRD) supports the creation of infrastructure PPPs.56 This is done through sub-sovereign direct lending, along with efforts to improve the creditworthiness of subnational governments, and the piloting and development of contractual agreements that involve the EBRD, subnational governments, and a designated public service provider. Such efforts have mostly not targeted developing countries, but over time there may be ways to adapt them for such use. A number of country-specific initiatives have also been established. The Philippines, for example, has made strong progress in developing subnational PPPs, especially in water and electricity, after a long period of experimentation and learning. The Project Development and Monitoring Facility (PDMF) is supported by the ADB, Australia, and Canada to assist with the preparation of infrastructure projects for a PPP Center attached to the National Economic Development Authority.57 Other mechanisms tailored to the local context have also been created in India, Indonesia, and Viet Nam. These initiatives are relatively new but growing rapidly and starting to show at least some impact. 50 GIZ (2014), World Economic Forum (2014), Schmidt-Traub and Sachs (2015). 51 http://cdia.asia. 52 https://www.ifcamc.org/funds/ifc-global-infrastructure-fund. 53 https://www.afdb.org/en/topics-and-sectors/initiatives-partnerships/africa50/. 54 https://www.adb.org/site/funds/funds/asean-infrastructure-fund. 55 https://ppiaf.org/sub-national-ta. 56 http://www.ebrd.com/infrastructure/infrastructure-IPPF.com. 57 See ADB (2016) and https://ppp.gov.ph. ADBI Working Paper 921 P. Smoke 28 8. CONCLUDING OBSERVATIONS Given the multifaceted, varied, and asymmetrically developed landscape in which subnational governments operate across developing and emerging countries—both in Asia and globally—enhancing subnational development finance must be tailored to the country context. In recent years, some countries have tried to engage too quickly in developing municipal bonds and/or overly ambitious use of PPPs, and many have maintained heavy use of development transfers for subnational government infrastructure. Insufficient attention to developing the types of special financial intermediaries discussed above seems to result from concern—on the part of developing and emerging countries and international development partners—about the documented difficulties involved in making such entities work sustainably and, in some cases, unrealistic expectations regarding the role that municipal bonds can play in the near term. Although there is good reason not to repeat past missteps with subnational financial intermediaries, their performance issues often stemmed from correctable defects in their design and implementation rather than inherent shortcomings in the underlying concept. Even more significant, there can be little doubt that a large proportion of subnational governments in many developing and emerging countries are not creditworthy and will require support to build fiscal responsibility and access development finance. The weakest subnational governments, whatever their needs, may not be able to borrow in the near term. At the same time, there are likely to be subnational governments in many countries capable of assuming debt, if not directly from capital markets, then from properly structured financial intermediaries and commercial banks. Given the diversity of conditions, there is no universal solution to expanding subnational government borrowing. Instead, there is a strong case for promoting a spectrum of development finance mechanisms appropriate to each country. Stronger subnational governments should have direct access to capital markets, subject to an adequate regulatory framework. Those without direct market access could be served by financial intermediaries structured according to accepted principles with an initially appropriate level of private-sector involvement that can grow over time. Means to mitigate risk may be needed, such as credit guarantees, co-financing initiatives, secondary market support, bond banks, and credit pooling. Improving subnational development finance will also require restructuring broader intergovernmental fiscal frameworks as well as initiatives to build fiscal responsibility and creditworthiness. There is often scope to strengthen subnational government mechanisms and capacities to raise own-source revenues. These will include traditional sources, such as local taxes and user fees, and more innovative approaches, such as sources that capture part of the local added value (economic, land, property) produced within the territory of subnational governments. Intergovernmental transfers may require reform to improve predictability and buoyancy, to institutionalize transparency in how they are allocated, and to promote their use in a way that promotes accountability. There is some potential value to expanding the use and quality of performance-based transfers. ADBI Working Paper 921 P. Smoke 29 Equally important are efforts to strengthen subnational government financial and asset management systems and capacity, including for budgeting and expenditure control, administration of subnational government taxes and fees, life-cycle and portfolio management of local assets, design and implementation of local investment projects, and effective use of accountability mechanisms. All of these measures can contribute to subnational government fiscal responsibility and creditworthiness. Finally, there is potential value in developing appropriate and well-enforced PPP regulatory frameworks to support blended financing and assist subnational governments in building accountable and fair partnerships with private enterprises. A key concern is that such frameworks should create conditions conducive for private engagement but preserve public interests and help to ensure access for the more vulnerable to public infrastructure. In short, the reform agenda for subnational development finance and intergovernmental relations more generally is often very demanding. Not everything can be done at once, even in countries with more developed systems. 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