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Local governments in emerging, Latin American and Caribbean (LAC) cities, are facing a daunting task: expanding access to infrastructure services, with scarce financial resources, for fast-growing urban populations.
While local expenditures have increased over the past decade in LAC (from 5.5% to 6.6% of GDP between 2000 and 2007), capital investments–averaging 30% of total expenditures in ESCI cities–have proved insufficient to satisfy the rising demand for services. Closing the region’s infrastructure deficit requires US$250 billion annually over the next five years. In this context, cities have a crucial role in leveraging different sources of funding to reduce this gap.
In two previous posts, we analyzed two promising mechanisms for financing local infrastructure projects: betterment levies and public-private partnerships. Today, we examine municipal bonds by contrasting the experience between the US and LAC, leading to suggestions on how local governments in emerging economies can build creditworthiness for future borrowing.
Subway Line 4 in Budapest, Hungary. Photo: Marcell Katona
Municipal Bonds in the United States
Municipal bonds are quite popular in the U.S. About 44,000 subnational entities, including states and municipalities, participate in the municipal bond market. While municipal bond issuance has declined since the financial crisis of 2007-2008, bond issuance still averaged a high US$337 billion between 2011 and 2014.
Overall, the municipal bond market has been quite stable in the US; only 71 issuers defaulted between 1970 and 2011. In fact, shortly after the financial crisis, between 2010 and 2013, the municipal default rate was only 0.4%. With a well-established capital market, local governments in the US have been widely successful in issuing municipal securities to invest on key infrastructure projects including schools, hospitals, water and sewer facilities, roads, public power utilities, mass transport and airports. Can municipal bonds become as common and effective for infrastructure financing in LAC?
Terminal in Bogota, Colombia. Photo: Joao Carlos Medau
Municipal Bonds in Latin America and the Caribbean
Outside the United States, the market for subnational bonds is rather limited; however, some countries in LAC including Colombia, Brazil, Belize (yes, Belize) and Mexico have successfully experimented with municipal bonds.
- Rio de Janeiro (Brazil) issued its first international bond in 1996 for US$125 million over a three-year period with an interest rate of 10.3%. Fiscal reforms have restricted further bond issuances after the federal government restructured the states’ debt in 1999.
- Bogota (Colombia) issued its first–and only–international municipal bond in 2001 for US$100 million. The bond carried a 9.5% interest rate and a 5-year maturity date.
- In 2012, the City of Belize (Belize) established a domestic municipal bond program and issued three separate bonds. A first bond for US$2 million, carrying an interest rate of 3.5% and a maturity date of two years; a second bond for US$3 million with an interest rate of 5.5% and a maturity date of five years; and a third bond for US$5 million with an interest rate of 8% and a maturity date of 10 years. The city government used the proceeds from the bond to build over 100 streets in a country where only about 20% of streets are paved.
- Aguascalientes was the first Mexican city to issue a municipal bond in 2002. The debt instrument was issued for Mex$90 million with a 5-year maturity date. Over ten Mexican cities soon followed, including San Pedro, which also in 2002 issued a Mex$110 million municipal bond with a maturity date of seven years.
Unfortunately, these are exceptional cases and, truth be told, the municipal bond market in LAC is practically non-existent. Why? Think about what these examples have in common.
All bonds matured in the short/medium term (between 3 and 10 years), which does not approximate to the life cycle of typical infrastructure projects (20–30 years). In addition, the sizes of the bonds were rather small considering the cost of urban projects (i.e. capital costs for Bus Rapid Transit systems range between US$2.4–12.5 million/km).
This is mainly because, unlike municipalities in the U.S., local governments in LAC usually lack creditworthiness: municipalities do not meet the risk standards of the capital markets. For example, most ESCI cities have poor credit ratings, ranging between B+ and BBB-, which is insufficient to obtain a long-term loan (20–30 years).
Juscelino Kubitschek Bridge in Brasilia, Brazil. Photo: Marco Mugnatto
The way forward: strengthening creditworthiness of local governments in LAC
Municipal bonds are a powerful financing tool for increasing capital investments. However, mainstreaming municipal securities in LAC requires improving the creditworthiness of local governments. Here are a few steps governments can take on this matter:
- Central governments should establish transparent grant transfer formulas that guarantee stable and predictive revenue flows for local governments. Intergovernmental transfers should be designed, to the extent possible, in such a way that subnational governments have an incentive to increase their own-source revenues.
- Central governments should also provide greater fiscal independence to local governments, clearly establishing expenditure responsibilities and sources of revenue, following the ‘finance follows function’ principle.
- Municipal governments can work on modernizing and regularly updating land registration and cadaster systems to improve the collection of land and property taxes.
- In addition, subnational governments must achieve greater transparency and accountability. Integrated financial management systems and e-government applications can help.