Subnational Government Capital Market Activity in Emerging Markets

By Jean-Baptiste Legrand , Industry Specialist in Cities and Environment Infrastructure Group

This is the fourth blog in a series on IFC’s approach to providing commercial financing to subnational governments (SNGs). In this blog we cover the significance of SNG bonds in emerging markets?and the constraints faced by SNGs in accessing capital markets.

General obligation bonds characterize SNG capital market financing in emerging markets.

The SNG space is dominated by two types of bonds: general obligation bonds, supported by the entire budget, and revenue bonds whose purpose is to finance a specific project, such as toll roads or a water treatment plant. Unlike general obligation bonds, revenue bonds are repaid by revenue generated from the project they finance. In developed markets we see large issuances of both revenue and general obligation bonds. For example, the $4 trillion U.S. bond market is characterized by thousands of outstanding revenue bonds for all types of tickets. We normally only see general obligation bonds issued by SNGs. General obligation bonds present a lower risk for investors as repayment depends on the entire counterparty revenue base (e.g., central government transfers, tax, and non-tax revenue), rather than on the performance of specific projects. The economics of infrastructure projects is more challenging in Emerging Markets (EMs); this could change in the future, leaving space for revenue bonds. The planned ramp-up by 世界银行 Group of guarantees and other instruments that mitigate risk could play an important role in facilitating the growth of this market.

Bank loans continue to dominate the SNG debt market in emerging markets.

Bank loans typically offer longer maturities and flexibility over the funding availability period, while bonds need to be fully disbursed after placement. Bonds also require more debt management capacity (especially non-amortizing bonds) and could therefore present constraints for SNGs in EMs. Regular SNG bond issuances are seen in less than 10 EMs and generally stem from ‘Tier 1’ issuers that already have experience with commercial borrowing - for example, Johannesburg, Cape Town, Ekurhuleni (South Africa), Lagos (Nigeria), Istanbul (Türkiye), Mexico City (Mexico), Bogota, Medellin (Colombia), and Zagreb (Croatia). Some countries have recently put in place the borrowing framework to authorize SNG bond issuances, as in Almaty (Kazakhstan).

Within EMs, China and India stand out as exceptions. In China, bonds are the only instrument allowed by law for commercial financing by SNGs. In India, bonds are favored by national authorities (central government and the Reserve Bank of India) who incentivize issuances (for example, through targeted subsidies) to support the development of domestic capital markets, including those for the Urban Local Bodies.

Factors constraining SNG capital market activity in emerging markets.

In addition to ?client capacity, there are other factors explaining the limited development of the SNG bonds market in EMs:

• Lack of transparency and (occasionally) weak reporting standards hinder the ability of potential investors to adequately assess the risks. Underdeveloped legal systems are a source of concern, particularly for foreign investors.
• Restrictive borrowing frameworks, where SNGs are not authorized to issue bonds, as in Brazil.
• Limited investor base/domestic demand, compared to developed markets such as the United States, Germany, or Japan. This could be due to lower credit quality and lack of financial and tax incentives (such as those given to investors in the United States). In other instances, weakening sector creditworthiness and exposure to currency depreciation, vis-à-vis the US dollar, are concerns for international investors. For example, debt from private lenders to South African metropolitan municipalities has declined following multiple sovereign credit downgrades, the impact of the COVID-19 pandemic, and the energy crisis.

Enablers for future SNG bond activity

Key EMs (Colombia, Mexico, Morocco, India , and South Africa) should see increasing capital market activity in the long run, with increasing sophistication of borrowers, predictability of revenue, transparency, a growing investor base, and improving reporting standards.

Debt security mechanisms can play an important role in addressing the creditworthiness concerns of investors. For example, Mexico allows states and municipalities to sell debt secured by a trust, which holds the future federal tax participation payments; payments from the federal government are made directly to the trust, which in turn repays interest and principal to bondholders. Similar structures are available in Nigeria and Argentina, which in turn helps promote capital market activity.

Sustainability-linked bonds (SLBs) bring visibility to the market. In July 2023, the municipal holding company of the city of Zagreb placed a EUR 305 million SLB to incentivize waste management and increase the share of renewable energy investments by the city. This was the first municipal utility SLB in central and southern Europe.?

IFC record of SNG capital market financing.

IFC - International Finance Corporation can provide technical assistance to build debt management capacity and obtain a credit rating for first-time public issuers. These two elements are critical to attracting wide groups of international and domestic investors and facilitating the dynamic development of SNG debt markets.

Previously, IFC has supported subnational bonds as an anchor investor (in Ekurhuleni, 2017 and 2020; and Zagreb, 2023) and as a bond guarantee provider (in Johannesburg, 2004). IFC’s investments and guarantees have enabled the lengthening of bond tenors, aligning debt maturities with long-life infrastructure assets and improving creditworthiness and development impact. ?

Going forward, the World Bank Group’s Unified Guarantees Platform and the rollout of risk mitigation/participation products can play a key role in the growth of capital market issuances in emerging markets.

References

Subnational Debt 2024: Chinese Governments Reach Their Limits; Other Emerging Markets Taper

Borrowing, February 29, 2024

Local Government Debt 2022: Emerging Market Borrowing Loses Momentum

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
• Subnational Government Borrowing Regulations: Insights from Emerging Economies

Follow IFC Infrastructure to read other blogs in this series as they are published.

Learn more at: www.ifc.org/cities .