Subnational Government Borrowing Regulations: Insights from Emerging Economies

By Pavel Kochanov , Senior Municipal Finance Specialist, IFC

In our earlier blogs on IFC’s approach to providing commercial financing to subnational governments (SNGs), we covered credit risk and the limited use of commercial borrowing in emerging markets . In this third blog, we explore the regulatory landscape of SNG borrowing, highlighting the diverse regulatory approaches used across emerging economies. Borrowing is an important element of public finance systems, and plays a critical role in supporting high-priority investments by SNGs in local infrastructure. However, a complex set of challenges, including intricate approval processes and inadequately tailored prudential limits, hinder the borrowing capabilities of SNGs in emerging markets.?

Exploring the SNG Regulatory Framework?

The borrowing ability of SNGs is largely determined by existing national regulations, which also specify the nature of borrowing, the limits on borrowing, and the approval process. There is a compelling rationale for these regulations to facilitate prudent levels of commercial borrowing by creditworthy SNGs. This has been discussed in the recent working paper by Professor Paul Smoke (New York University). In almost all developed countries, the practices governing SNG borrowing are generally conducive to active use of debt instruments. In most emerging economies, SNGs are technically allowed to borrow without sovereign guarantees, particularly in local currency from domestic investors. However, in practice, the ability to borrow varies across jurisdictions because the overall borrowing regulations in these economies vary significantly, ranging from highly restrictive to relatively open frameworks, and from reasonably sophisticated to underdeveloped in terms of their implementation.?

As an example, the Constitution of Argentina grants extensive borrowing rights to SNGs, allowing them to issue bonds and raise bank loans, borrow in local and foreign currencies from domestic and foreign entities, and create debt security by pledging their revenues. Similar, relatively flexible SNG borrowing regimes are seen in certain middle-income countries, such as Colombia, Mexico, Morocco, Turkey, South Africa, Nigeria, the Philippines, and in various Eastern European countries.???

Borrowing Challenges in Emerging Economies?

In contrast to the countries discussed above, some emerging economies often prohibit or significantly limit the borrowing rights of SNGs. For example, county governments in Kenya are only allowed to borrow with a guarantee from the central government. Similarly, in certain countries such as Uzbekistan, Tajikistan, Cambodia, Myanmar, Cameroon, sovereign debt is the only borrowing option available to SNGs. In some cases, while SNG borrowing may not be explicitly prohibited, the regulatory frameworks that are in place either do not mention or do not sufficiently specify the borrowing process, making borrowing almost impossible. For example, there are no legal barriers to municipal borrowing in Azerbaijan, however formal mechanisms for applying for or receiving loans are not stipulated in the legislation (according to SNG-WOFI, the OECD/UCLG World Observatory on Subnational Government Finance and Investment).???

Bringing about regulatory change is not straightforward and requires sustained engagement, often with multilateral support. A recent positive case study is the city of Almaty, Kazakhstan (with an investment-grade credit rating from Fitch Ratings), which was recently authorized to raise commercial financing on a pilot basis.??

Typically, advances in SNG borrowing regulations align with the degree of fiscal decentralization within individual countries. An open SNG borrowing regime is unlikely (and presents legitimate credit concerns) in highly centralized countries with fiscally weak SNGs. However, regulatory restrictions can persist in both relatively developed and sufficiently decentralized countries.?

Insights from SNG Business Review?

We assessed SNG borrowing regulations across 50 emerging economies. Here is a brief overview of our observations:?

• In most countries that allow SNG commercial borrowing, central authorities specify prudential limits for debt. These limits typically take the form of financial covenants. Commonly used limits include debt-to-revenue ratios (in approximately 25 countries) and debt service-to-revenue ratios (in about 20 countries). The thresholds for these limits typically range from 40% to 150% for the former and 5% to 30% for the latter, highlighting the significantly different levels of borrowing flexibility which exist across countries.?
• Central government approval for SNG borrowing is required in over 30 countries. This approval process, normally managed by national ministries of finance, should ideally adhere to transparent rules and avoid political influence or motivation. However, in certain countries, central government approvals can be complex, involving multiple ministries, and are invariably highly time-consuming.??
• The purpose of long-term borrowing is often restricted to financing capital expenditures, commonly referred to as the so-called golden rule. This rule is widely endorsed globally and viewed as sound financial practice.?
• Many countries impose restrictions on foreign currency debt, a prudent requirement given that SNGs generally lack revenues in foreign currencies and should avoid currency risks. In cases where domestic financial markets are shallow and SNGs are strongly creditworthy, certain jurisdictions have allowed foreign currency borrowing to allow the SNGs to diversify their funding sources.?
• Some countries may have unique or less common requirements. For example, in Guatemala, there is a restriction on the maximum tenor of the debt, which is tied to the term of the administration, posing challenges for financing long-term infrastructure projects.??

Going Forward: Challenges and Considerations???

SNG borrowing regulations are intended to ensure that creditworthy SNGs can borrow to finance capital expenditures in a prudent way. However, in many emerging economies, these regulations have several drawbacks:?

• Large and creditworthy SNGs can be overly constrained if regulations fail to differentiate and provide them with more flexibility in commercial borrowing compared to smaller and weaker SNGs.?
• In some countries, SNG borrowing regulations may be either underdeveloped or overly complex, not aligning with the level of development in the subnational sector. Excessive requirements and cumbersome processes can create ambiguity and disincentivize SNGs from considering debt financing.?

• Creditworthiness and borrowing capacity might not be the main criteria for SNG borrowing regulations, leading to prudential limits set at inappropriate levels. SNGs in Romania, for example, face no prudential limit on the debt amount and are only required to adhere to a relatively relaxed debt service-to-revenue ratio of 30%. However, comparatively low annual debt limits exist for the entire municipal sector, revised annually. These limits are allocated on a first-come-first-serve basis and do not consider borrowing capacity or the specific needs of individual local governments.?

In summary, SNG borrowing regulations in emerging economies reveal a diverse regulatory landscape, ranging from highly restrictive to relatively open. While borrowing is crucial for financing local infrastructure investments, in many emerging markets immense challenges persist due to the intricate nature of approval processes and inadequately tailored prudential limits, hindering the financing capabilities of SNGs in emerging economies.

Read more on this topic:

• Credit Risk of Subnational Governments in Developing Countries
• Subnational Governments in Emerging Markets: The Case for Commercial Borrowing
• Fiscal Decentralization and Subnational Government Investment in Developing Countries: The Case for Increasing Subnational Borrowing and Commercial Debt

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