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). 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. 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.