Chapter 14: Improving Capital Markets for Municipal Finance in Least Developed Countries

Dmitry Pozhidaev
Dmitry Pozhidaev is UNCDF Regional Technical Advisor responsible for UNCDF programming in Southern and East Africa. He has a master’s in finance from London School of Business and a Ph.D. in quantitative research and statistics from Moscow University.
Muhammad Farid
Muhammad Farid is an urban researcher at UN-Habitat and engages in policy oriented research. He has a master’s degree in economics from City University London.


Adopted in September 2015, the United Nations’ Sustainable Development Goals (SDGs) established an agenda for the next 15 years for developing and developed countries alike. These goals place a special emphasis on environmental issues in addition to reducing poverty and promoting quality education, good health, and gender equality.1

Over 80 per cent of the world’s population lives in less-developed regions—13 per cent of them in least developed countries (LDCs) that lag significantly in key social and economic indicators. It is especially import-ant to ensure effective SDG implementation in these LDCs.

A key challenge for LDCs is financing the implementation of the SDGs. Modern infrastructure is a key component in achieving the SDGs, and meeting only the basic infrastructure investment needs of developing countries amounts to an estimated US$1 trillion to $1.5 trillion annually.2 Moreover, economic growth in many LDCs is weak (for instance, annual GDP growth in the Middle East and North Africa region has averaged only 1.8 per cent over the last five years, whereas the growth in sub-Saharan Africa has slowed from an impressive 6.4 per cent during 2002–2008 to 4.6 per cent in 2014 and 3.5 per cent in 2015),3 domestic revenues are low,4 capital markets are weak or sometimes non-existent, political instability is high, and the taxation system is inefficient, with a narrow tax base. Lack of developed capital markets and inadequate financial institutions pose additional significant challenges to financing SDGs in LDCs. The private sector in the majority of LDCs is also under-developed, and despite an overall increase in foreign direct investments,5 large foreign companies are wary of high political and economic risks in these countries.6

Developing countries receive large amounts from official development assistance (ODA), international donors such as the World Bank and the UN, and other international development agencies (in 2014, LDCs received an estimated US$135 billion from OECD’s Development Assistance Commit-tee).7 Concessional official finance remains an extremely important source of financing, accounting for about 45 per cent of total international capital flows to the LDCs.8 Domestic resource mobilization is also an important factor in overcoming the financing deficit and propelling LDCs towards achieving the SDGs.

  • 1. World Bank, World Development Indicators, Featuring the Sustainable Development Goals (Washington, World Bank, 2016).
  • 2. United Nations, Addis Ababa Action Agenda (New York, United Nations, 2015).
  • 3. World Bank, World Development Indicators (Washington, World Bank, 2016); International Monetary Fund, Regional Economic Outlook: Sub-Saharan Africa: Time for a Policy Reset (Washington, IMF, 2016).
  • 4. LDCs on average (over 2009–2011) collect only 14.8 per cent of their revenue as a share of GDP. See World Bank, World Development Indicators (Washington, World Bank, 2016).
  • 5. FDI in low-income countries increased from 2.5 per cent of GDP to 4.4 per cent between 2006 and 2014. See World Bank, World Development Indicators (Washington, World Bank, 2016).
  • 6. Antonio Estache, “Infrastructure Finance in Developing Countries: An Overview,” EIB Papers, vol. 15, no. 2, pp. 60–88.
  • 7. United Nations, Third International Conference on Financing for Development: Taking Stock of Aid to Least Developed Countries (LDCs) (Addis Ababa, United Nations, 2015).
  • 8. UNCTAD, The Least Developed Countries Report 2014: Growth With Structural Transformation: A Post-2015 Development Agenda (Gevena, UNCTAD, 2014). Available from

Average annual GDP growth in the Middle East and North Africa region over the last 5 years: 1.8%

Municipalities are the engines of economic growth in LDCs and play an important role in generating higher domestic revenue, even in the poorest countries.9 Yet, despite significant domestic efforts and international support, municipalities in LDCs struggle to ensure adequate basic services and quality infrastructure for local development. Whereas the focus on own-source revenue generation should be maintained and intensified, domestic capital markets may offer additional opportunities for municipal development.

However, LDCs’ structural economic weaknesses restrict municipalities’ access to capital markets for infrastructure financing. In addition, the legal and regulatory frameworks for subnational borrowing often make access to capital markets difficult or even impossible.10 This is exacerbated by inadequate governance and fiscal management and by a lack of understanding about how capital markets operate at the local government level. As such, as shown in Table 1, municipalities rely primarily on transfers from the central government through grants and other mechanisms, as well as on own-source revenues from taxes, fees, and charges, with the latter often amounting to no more than 10 per cent of the entire municipal budget (with the exception of capital cities).

  • 9. The municipality of Kabul in 2011 collected 2.9 billion AFN (US$42 million) in revenue for its population of about 3.5 million people. An additional 30 per cent of revenue is estimated to be generated by registering all the properties in Kabul city and collecting property-based taxes. See GoIRA, The State of Afghan Cities (Kabul, GoIRA, 2015), p. 42.
  • 10. A number of LDCs issued regulations on municipal bonds and PPPs for sub-sovereigns, including Uganda (2013) and Tanzania (2014).
Local government capital revenue sources and average shares (LDCs)
Table 1

Reliance on central government transfers limits the size of investment capital and places the full economic burden of funding long-term infrastructure development on the present generation. It also contradicts the global trend of municipalities and other sub-sovereigns increasingly relying on infrastructure financing from the private sector.11

Figure A offers clear evidence of the growing global trend in public–private partner-ship (PPP) infrastructure projects,12 which increased more than three-fold between 2001 and 2012. The involvement of private capital in financing infrastructure in LDCs has increased by an impressive 3.5 times from US$1,495 million to $5,190 million; however, it started from a very low base and accounts for just 3 per cent of global private infrastructure financing.

Over 80 per cent of the world’s population lives in less-developed regions—13 per cent of them in least developed countries (LDCs) that lag significantly in key social and economic indicators. It is especially important to ensure effective SDG implementation in these LDCs.

Private sector involvement in infrastructure financing, 2001–2012
Figure A

Figure B indicates that in Africa, where 34 LDCs are located, private resources in terms of market capitalization (US$1.5 trillion) by far surpass government revenues or ODA as sources of infrastructure financing. As capital markets in LDCs mature in terms of sophistication, scope, and capitalization, and municipalities improve their financial position and expertise, it is fair to expect that private capital will play an increasingly important role in financing municipal infrastructure in LDCs.

Sources of financing for African development
Figure B

This chapter begins by examining the various methods of using capital markets for municipal finance in LDCs. It then describes financial and non-financial mechanisms most suitable for municipalities in LDCs. Next, the chapter touches upon the emerging financial innovations that, although not currently present in LDCs, may play a more significant role in the future. It concludes with a discussion of the decision-making process and specific steps municipalities can take to access market-based funds (conventional or otherwise).

Use of capital markets for municipal finance

While capital markets may not be thriving in the LDCs, there are still many opportunities for municipalities and other sub-sovereigns to attract private capital for infrastructure financing. Whenever possible and economically sound, public funding should be used as leverage for increasing private investments in infra-structure.

Typology of financial markets
Figure C
* The credit market is defined narrowly as a marketplace for trading, structuring, and investing in the credit/credit risk of public and private borrowers through short-term lending or through credit derivatives and structured credit products.

As shown in Figure C, private finance comes in two basic forms: equity and debt. Equity is financial interest in an infrastructure project that is sold to private investors by the project owner (a public or private entity). Unlike debt, equity does not have to be repaid, but it is much more difficult to acquire and more expensive than debt. In more developed countries, municipal companies are listed on the stock exchange and issue equity either for public or private placement with targeted institutional investors (such as pension funds). However, this avenue is only available for established and well-capitalized companies and requires well-developed and thriving venture capital and stock markets.

In comparison, in LDCs, private equity may be attracted through non-market mechanisms, such as when a private entity (including an institution-al investor) commits equity to a new infrastructure project through a project-based partner-ship arrangement with a municipality. In its most general form, such an arrangement would involve two equity holders: the municipality that invests equity-like capital in the form of land and physical infrastructure (i.e., buildings, utilities, roads, etc.), and the private partner that contributes the cash required for the construction of the project. This is how a municipal transportation project in Busia, Uganda, was financed (see Case Study 1) and how four municipal housing projects were funded in Kinondoni, Tanzania. Even the least developed among the LDCs can benefit from such arrangements. For example, the local government in Herat, a city in the west of Afghanistan, was able to attract private firms to invest in city squares, parks, and traffic light systems. The number of equity holders may vary depending on the project. For instance, the Busia multi-purpose parking project has three: the Church of Uganda contributing 10 acres of land, the municipality contributing relevant infrastructure, and a private partner contributing equity. Consequently, the Church of Uganda receives 6 per cent of project revenues, the municipality 4 per cent, and the private partner 90 per cent.

Case study
Multi-purpose parking project in Busia, Uganda

The municipal project in Busia, Uganda, pictured below includes a multi-purpose parking project in the District of Busia on the border with Kenya. The project uses the strategic border location of the district and is designed to facilitate cross-border movement and trade between Uganda and Kenya. The United Nations Capital Development Fund (UNCDF) helped develop and design the project as a tripartite public–private partner-ship among the local government, Church of Uganda, and a private investor (Agility Uganda Limited).

De-risking the project through local economic analyses, feasibility studies, and structuring and financial modelling resulted in leveraging 70 per cent of the total cost of this US$2.5 million project in private equity and debt. The project (currently under implementation) will greatly improve traffic flow and improve the town’s environment; boost business in the region; create over 100 jobs directly or indirectly including lorry, petrol station, and shop attendants; and, in addition to the license fees collected from traders, allow the local government to receive 10 per cent of the project revenue quarterly.

Busia multi-purpose parking project model, Kenya-Uganda border

Financial and non-financial instruments for municipalities

The past 15 years have seen significant innovation and increasing sophistication in debt instruments. However, only a few of these are available in LDCs. Local governments should consider two models of municipal credit—the bank lending model used in Europe and the municipal bond model used in North America—and select from each model various elements appropriate for their particular country’s sociocultural-political milieu. The most common long-term debt instrument available for sub-sovereigns in LDCs is a term loan from a commercial bank (including national development financial institutions and municipal development funds). A term loan is a loan with a maturity of more than five years and often includes a provision for a relatively long grace period of up to one year, during which the borrower does not pay the interest or the principal (or both).

However, subnational borrowing is, as a rule, heavily regulated. In most LDCs, there is a statutory limit on the amount of debt a municipality can contract, which is restricted to 20–30 per cent of the annual amount of own-source revenues. Municipalities are not allowed to borrow from foreign banks, and domestic credit may be constrained due to financial repression policies or other reasons. Hence, borrowing against the municipal balance sheet for sizeable infrastructure investments requires a robust financial position—a continued challenge for many LDC municipalities. When an infrastructure project is designed to produce revenues through charges or fees or by generating profit, it is possible for municipalities to borrow against the assets of the future project (including its future cash flows). In this case, the bank considers the project’s future revenues as collateral rather than the general municipal revenues.

Generally speaking, municipal bonds are part of the future rather than of the present in LDCs. There are two types of municipal bonds: general obligation, and revenue (or project-based). General obligation bonds are backed by a full faith and credit pledge from the issuing government entity and are heavily dependent on the financial position of that entity. Efforts to issue municipal bonds in LDCs have so far concentrated on this type of bond. Normally, municipal own-source revenues support these bonds and this is why the financial sustainability of municipalities is of such a critical importance for accessing capital markets with these instruments. However, there have been examples in emerging economies when sub-sovereigns issue viable bonds based on future transfers from the central government (the so-called future-flow bonds issued by a number of Mexican municipalities between 2001 and 2003).13 Naturally, this type of a bond assumes predictable and guaranteed central government transfers with a reliable interception mechanism. On the other hand, revenues, or project bonds, are backed by the pledge of a specific and limited revenue source originating from a particular project (e.g., fees from a public parking garage). Given the structural challenges of capital markets, only a few larger and richer municipalities can afford a municipal bond, such as Dakar in Senegal, Kampala in Uganda, Dhaka in Bangladesh, or Dar es Salaam in Tanzania.

Bonds, particularly those placed with banks and institutional investors, are issued in minimum denominations of $5,000 or multiples of $5,000. However, it is also possible to issue retail bonds in much smaller denominations, provided there is adequate demand. The so-called Jozi bonds issued by the Municipality of Johannesburg in a denomination of 1,000 rands (approximately US$70) are very popular with the city’s residents and can be bought at any South African Post Office in the wider Johannesburg area. Importantly, these bonds are tradeable in the secondary markets, which makes them a liquid asset for households.

The financial system in most LDCs remains bank-based rather than market-based. Hence, the main sources of private capital for financing infrastructure in those countries are banks and private companies partnering with public entities. Going forward, institutional investors such as government and private pension and insurance funds should play a more prominent role in financing infrastructure.14 So far, the engagement of such institutions in infra-structure financing in LDCs has been limited to large projects supported by the central government and multilateral financial institutions, such as the US$4.8 billion Renaissance Dam in Ethiopia. Unlocking this capital for smaller infrastructure projects sponsored by local governments would mean a significant increase in the availability of capital for infrastructure investments.

  • 13. J. Leigland, Municipal Future-Flow Bonds in Mexico Lessons for Emerging Economies (The Journal of Structured Finance, Summer 2004, Vol. 10, No. 2: pp. 24-35)
  • 14. According to the African Development Bank, Africa’s pension funds currently hold US$380 billion in assets, thanks to a decade of economic growth. Even then, only very few countries, including South Africa, have pension systems that are broad-based, relatively transparent, and protect beneficiary rights. See United Nations, Africa Renewal, vol. 28, no. 3 (December 2014), p. 7.
Mechanisms of public sector support for infrastructure financing
Figure D

At the same time, municipalities and other local governments in LDCs can benefit from existing mechanisms of public sector support to attract private capital for infrastructure financing (these mechanisms are illustrated in Figure D). Public support extended by government and multilateral and bilateral development agencies includes financial instruments that can be used to mobilize private sector infrastructure investment, such as (1) grants and other subsidies (e.g., output-based aid to complement or reduce user fees and tax relief) as well as interest-free loans; (2) various types of guarantees; and (3) concessional loans. The public sector offers a wide range of specialized de-risking instruments designed to address the challenges of infrastructure financing in developing countries, such as political and currency risks, and include political insurance, synthetic local currency loans, currency swaps, and interest rate swaps. Municipalities and other local governments need to develop a good understanding of the available public support instruments and gain relevant expertise in their application.

Type of financing, capital providers, and instruments for municipal infrastructure financing
Table 2

Access to capital markets can significantly improve the financial opportunities for municipal infrastructure investments. Yet, capital markets (and external finance, generally speaking) are not a universal answer to the challenges of municipal development. Resorting to external finance involves a number of risks. For instance, ownership may be compromised because equity finance comes with the baggage of voting rights for external parties. In addition, because interest needs to be paid on debt finance, a municipality will have to return more than initially acquired, whereas the pledged collateral may be seized by the lender in case of default. Borrowing not only expands the financing capacity of local governments, but also entails the risk of insolvency.

Hence, the decision on infrastructure financing modality should be considered in the overall context of the municipal capital investment plan and municipal financing strategy and plan. (Table 2 briefly presents the defining features of these different modes.) The nature of the project and its revenue generation capacity, the cost of internal and external capital, the optimal funding structure, the financial position of the municipality, and other factors need to be taken into account when deciding how infrastructure development should be financed.

View of Addis Ababa, Ethiopia

Non-conventional and emerging financial instruments for municipalities

The previous sections focused on convention-al financial instruments that have been used by municipalities for a long time and are relatively well-known. This section explains two types of emerging instruments that municipalities in LDCs consider in addition to more traditional instruments: Islamic equity-, debt- and lease-based contracts and diaspora bonds.

Sixteen out of 48 LDCs are members of the Islamic Development Bank, and Islamic finance is becoming more widespread in those countries15 as well as globally, growing at 10–12 per cent annually during the past decade16 (although it still constitutes only a fraction of conventional finance). Islamic finance uses a number of contracts that take into account three major prohibitions: against interest ( riba), against major uncertainty ( gharar), and against gambling (maysir). The major Islamic finance contracts used for long-term financing are summarized in Table 3.

Major Islamic financial instruments for capital finance
Table 3

Importantly, all Islamic finance contracts must be based on underlying real assets, thus easily lending themselves to the securitization process. The Islamic bond known as sukuk may be based on any of the contracts/instruments discussed in Table 3. A sukuk investor has a common share in the ownership of the assets linked to the investment, although this does not represent a debt owed to the issuer of the bond.

In the case of conventional bonds the issuer has a contractual obligation to pay to bond holders, on certain specified dates, interest and principal. In contrast, under a sukuk structure the sukuk holders each hold an undivided beneficial owner-ship in the underlying assets. Consequently, sukuk holders are entitled to a share in the revenues generated by the sukuk assets. The sale of sukuk relates to the sale of a proportionate share in the assets. Sukuk have been used for a long time to finance infrastructure projects in countries like Malaysia and Indonesia, and in the Middle East. The municipality of Tehran issued the country’s first sukuk based on the musharaka format in 1994; in 2013 Nigeria and Senegal both issued  sukuk to finance large infrastructure investments. Part of the growing trend is due to the lower cost because of strong demand, which makes sukuk cheaper than conventional debt.

An emerging financial instrument is diaspora bonds. A diaspora bond is a debt instrument issued by a country—or potentially, a sub-sovereign entity or a private corporation—to raise financing from its overseas diaspora. For many LDCs diaspora remittances are one of the most significant sources of external finance. Remittance receipts to the LDCs climbed from US$6.3 billion in 2000 to nearly $27 billion in 2011. In the median LDC, remittances account for as much as 2.1 per cent of GDP and 8.5 per cent of export earnings, and much more for small economies like Lesotho, Samoa, or Somaliland, where remittances represent between 20 and 50 per cent of GDP.17

A typical migrant saves a larger amount than the amount of remittances. Most of these savings are kept in bank deposits earning nearly zero interest these days. Diaspora savings for sub-Saharan Africa were estimated at US$30.4 billion in 2009.18

A number of countries have attempt-ed, with differing degrees of success, to leverage these significant financial resources through diaspora bonds. Israel and India have raised $35–40 billion using these bonds.19 Other countries, such as Zimbabwe, Ethiopia, and Kenya, have also tried this method. Diaspora bonds are often sold at a premium to the diaspora members, thus fetching a “patriotic” discount in borrowing costs. Besides patriotism or the desire to do good in the investor’s country of origin, such a discount can also be explained by the fact that diaspora investors may be more willing and able to take on sovereign risks of default in hard currency as well as devaluation, as they may have local currency liabilities and they may be able to influence the borrower’s decision to service such debt. According to the World Bank, there is a potential for raising $100 billion per year in development financing via diaspora bonds.20

  • 17. UNCTAD, The Least Developed Countries Report 2012: Harnessing Remittances and Diaspora Knowledge for Productive Capacities (Gevena, UNCTAD, 2014).
  • 18. S. Ketkar and D. Ratha, Diaspora Bonds for Edu-cation (Washington, World Bank, n.d.). Available from…
  • 19. S. Ketkar and D. Ratha, Development Finance Via Diaspora Bonds Track Record and Potential (Washington, World Bank, 2007).
  • 20. S. Ketkar and D. Ratha, Development Finance Via Diaspora Bonds Track Record and Potential (Washington, World Bank, 2007).

Accessing market-based capital finance

The first decision to be made by the municipality is whether an infrastructure project should be financed from internal or external funds. External funds (unless they come as grants) have a cost, and the municipality needs to decide if this cost is affordable given the nature of the infrastructure to be financed. The projects likely to be financed with market-based funds include revenue-generating projects and larger infrastructure projects that cannot be financed from regular municipal resources. Even when the decision is taken to tap into market-based funds (conventional or other-wise), the municipality should explore options for hybrid finance that combine own-source revenues and grants with external equity and debt.

Once the decision on funding with market-based capital has been made, the municipality has to consider the following options:

  • Borrowing from financial institutions or specialized development banks
  • Accessing capital markets or issuing bonds
  • Engaging private sector participation through contracts, leases, and concessions

Borrowing from financial institutions, particularly for smaller projects, may be the most straightforward and easiest option for most municipalities. It is particularly attractive when concessional funding is available from development banks or municipal development funds (MDFs). However, the municipality needs to decide (1) whether this borrowing should be made against the municipal balance sheet or against a particular project (if it is a revenue-generating project) and (2) whether borrowing is required at all, or if instead the requisite funding can be provided by a private partner in the context of a joint venture or a concession. If it is decided that the infrastructure investment will be funded with a loan (possibly in combination with other types of finance as discussed), a scan of the credit market will help identify the best credit providers in terms of the loan interest rate, tenor, and other conditions (such as a grace period). Whereas the municipality’s bank may seem like the natural choice, it may be possible to secure better credit conditions from a different financial institution based on the characteristics of the investment.

If the nature of the project allows a partnership with a private entity, the municipality has to choose the optimal contractual arrangements and the type of business structure (e.g., an SPV) best suited to the characteristics of the projects. Further analysis will help decide on the financial structure of this partnership and identify the types of contribution provided by partners. This will be followed by procurement of the project sponsor, project development approval, financial closure, and initiation of the project. Figure E outlines how the municipal transportation project in Busia, Uganda, discussed in Case Study 1 was developed and financed.

Steps in the development of the Busia, Uganda, transportation project (joint venture)
Figure E

If the type and nature of the project justify the issuance of a bond, the municipality needs to make sure that it qualifies for this financial instrument.

If the type and nature of the project justify the issuance of a bond, the municipality needs to make sure that it qualifies for this financial instrument. Before attempting to issue municipal bonds, a local government or local public service enterprise must be in good financial condition so that it can repay its debts. This means that there must be a reliable surplus of revenues over expenditures that can be used to make the interest and principal payments to bondholders on time and in full. Efforts may need to be made to increase revenue collection from existing taxes, fees, and user charges. It may also be necessary to reduce unnecessary expenditures or institute cost-saving measures in areas where it is essential to continue expenditures. Figure F provides an overview of which types of debt instruments are best suited to particular conditions.

Log frame for debt instruments
Figure F


There are a few key provisions relating to the use of capital market-based funds by municipalities.

First, tapping into capital markets is associated with financial and some non-financial (e.g., reputational) risks. A municipality may lose its valuable assets in case of a failure. Prior to plunging into the turbulent sea of capital markets, municipalities need to develop the capacity to understand and assess those risks.

Second, there is no one single mechanism or instrument that would best address municipal long-term finance needs. Application of the instrument is deter-mined by the nature of the investment to be funded, by the specific circumstances of a municipality, and by national regulations. There are always statutory limitations restricting the capacity of sub-sovereigns to use market-based capital. There may be more advanced financial instruments that smaller municipalities will never be able to apply. The use of hybrid instruments is encouraged. Overall, a progressive approach is recommended when municipalities move from simpler financial instruments (e.g., term loans) to more complex tools, such as SPV-based structured finance and bond issues.

Third, access to capital markets requires much more robust public financial management systems than most municipalities currently have. This includes proper revenue planning and administration, capital investment planning, and financial strategy development, to name just a few key conditions. Developing business acumen and the capacity to run municipalities as businesses is part of the process of local government re-engineering presently underway in a number of LDCs.

Fourth, obtaining a term loan, let alone issuing a bond, concludes a long process involving significant specialized expertise, which municipalities are in many cases unlikely to have. Hence, developing such expertise internally or ensuring ready access to external expertise becomes a critical issue.

Finally, getting access to long-term finance is not the end of the journey but rather a beginning. Debts, in whatever form they are incurred, must be repaid. Monitoring debt servicing and taking timely corrective actions to avoid default are critical for continued access to capital markets on favourable conditions in the future.