As more and more countries decentralize, the provision of infrastructure is increasingly becoming the responsibility of sub-national authorities (local governments and public utilities).  These authorities are finding it necessary to seek long term private financing for their infrastructure projects.  Using annual budget allocations to build infrastructure is difficult to manage because the funds required vary greatly from year to year.  Long term debt financing allows sub-national authorities to smooth out the annual funding requirement by borrowing a large amount of capital at one time and then
repaying the debt in predictable annual increments small enough to make the project affordable to the people served. The Public Private Infrastructure Advisory Facility (PPIAF) works with sub-national authorities to enable access to private financing on the best possible terms, and shares the lessons learned from its global experience.   

   

The Cost of Borrowing

    

Long term financing for infrastructure projects can be costly for sub-national authorities.  However, some authorities obtain better terms for their financing than others from financial institutions.  Since every authority would like to lower its cost of borrowing, it is important to understand why some pay less than others. 

 

The cost of long term financing for infrastructure development depends on the level of confidence that financial institutions have that a sub-national authority will repay its debts.  The term creditworthiness is actually a way of describing that level of confidence.  It is a relative term since some authorities are more creditworthy than others.

The more creditworthy authorities obtain financing for their projects at less cost than the less creditworthy.  So, what can a sub-national authority do to minimize its cost of financing?  Ultimately, it is the institutionalization of good financial management practices that enables a local authority to achieve
the highest feasible level of creditworthiness.  However, it is also essential that financial institutions recognize and understand the quality of an authority’s finances so that their level of confidence increases and they offer the best possible terms for the borrowing.

    

Demonstrating Creditworthiness to Lenders

    

In many countries, financial institutions have little experience lending to sub-national authorities.  As a result, most have not developed the capacity to assess an authority’s creditworthiness.  Since the creditworthiness of this class of potential borrowers is not well understood, financial institutions often choose not to provide long term financing for their infrastructure projects.  Even when lenders want to offer infrastructure financing, they may have difficulty differentiating between more creditworthy and less creditworthy borrowers and therefore have no basis for establishing lending terms that balance risk and return.  Under such conditions, lenders impose costly lending terms to protect themselves against unknown risks. 

    

Sub-National Public Finance Credit Ratings

    

Fortunately, in most countries, internationally respected credit rating agencies can provide financial institutions with a substitute or supplement to their own creditworthiness assessment capacity.  It comes in the form of a sub-national public finance credit rating.  The agencies’ credit ratings are based on an objective external analysis of a sub-national authority in terms of carefully selected risk factors affecting its ability and willingness to repay its debts.  Because the agencies’ principal business is assessing risk, they have a depth of analytic expertise that most financial institutions cannot match.  For this reason, obtaining a public financecredit rating is an excellent way for sub-national authorities to convincinglydemonstrate their level of creditworthiness to financial institutions. 

    

Each credit rating agency has its own methodology for assessing the risk that a sub-national authority will default on its debt.  However, the essential factors analyzed by these methodologies are virtually the same.  The agencies analyze and assess:

    

1. The institutional framework surrounding the sub-national authority including:
centralized/decentralized governance; degree of fiscal autonomy; formal
responsibilities of the authority; legally mandated annual expenditures; and
the characteristics of any funding provided from the national government.

    

2. The economic outlook for the sub-national authority including trends in: the
economic base; the local revenue based; employment conditions; local income and
wealth; demographics; and the per capita tax/fee burden compared to other
similar sub-national authorities and the national average.

 

3. The sub-national authority’s debts and other liabilities including: current
debt (long or short term, fixed or variable interest rate, to be paid in local
currency or foreign currency); the debt service burden; the needs for future
debt financing; other liabilities and contingent liabilities and how they are
funded.

 

4. The sub-national authority’s finances including trends in: total revenues
(their volatility, their diversity, their predictability); total expenditure;
the balance (surplus or deficit) between recurrent operating revenues and
recurrent operating expenditures; reserves; and liquidity. 

 

5. The management and administration of the sub-national authority including:
institutionalized financial policies and procedures; management of the budget;
accounting and financial reporting; independent external audits; the affects of
politics, labor issues, or citizen initiatives; and the degree of revenue and
expenditure flexibility. 

    

Credit rating agencies assign a rating to a sub-national authority based on detailed information about that authority, and analysis of the factors above to predict the likelihood the authority will fail to repay its debts.  Although each credit rating agency has its own system of letter grades, generally the ratings range from AAA (highest credit quality) through BBB (credit quality good enough to be considered “investment grade”) to C (exceptionally high levels of credit risk) on a scale that progresses: AAA, AA, A, BBB, BB, B, CCC, CC, C with “+” and “-” to signal degrees of risk between the letter ratings.  The Rating Report that accompanies the letter grade also provides the data and analysis that financial institutions need in order to understand the finances of their potential borrower.

    

International Scale Ratings and National Scale Ratings

   

A sub-national public finance credit rating can be either an international scale rating or a national scale rating.  The national scale rating includes a country designator in parentheses, e.g. (mx) for Mexico. The difference between them is their basis for comparison of the risk of default.  An international scale rating compares the sub-national authority to the best credit risks in the world: AAA sovereign governments such as Germany,
the United Kingdom, and the United States.  The purpose is to provide international investors with a way to measure the risk of lending to the authority compared to investing in risk free bonds issued by the most financially secure governments in the world.  On the other hand, a national scale rating compares the sub-national authority to the best credit risk in their own country: the national government.  The purpose is to provide local
investors
with a way to measure the risk of lending to the authority
compared to investing in risk free national government bonds.  On any national scale, bonds issued to local investors by the national government are always rated AAA(ns). 

    

To avoid foreign exchange risk, sub-national authorities borrow in local currency from investors that are local financial institutions.  Therefore, the authority’s national scale rating is the one that is most useful for demonstrating their creditworthiness to lenders.  The difference between a sub-national authority’s rating on international and national scale is typically very substantial. For example, one metropolitan government in an emerging market country has been rated BB+ on the international scale (i.e. not investment grade for international investors), but the same rating agency rates the authority AA+(ns) on the national scale (i.e. a very good credit risk for local investors). 

    

Sub-national authorities which achieve an “investment grade” rating of BBB– (ns) or better on their national scale are considered by most financial institutions to be creditworthy.  Those with lower ratings are generally seen as not creditworthy and may be unable to access long term financing. In addition, national scale credit ratings differentiate among the creditworthy authorities in a country by identifying where they stand on a scale that runs from more creditworthy to less creditworthy.  This provides financial institutions with a solid analytic basis to differentiate their lending terms among borrowers in a way that balances risk and return.  Lower rated authorities pay more for long term financing because they are riskier than higher rated authorities.

   

National Scale Ratings and Infrastructure Bonds

    

Long term financing for infrastructure can take the form of bank loans or long term bonds sold to investors.  Loans are drawn up by a bank that holds the entire loan in its investment portfolio until it is fully repaid.  On the other hand, bonds are securities that are issued by a sub-national authority and sold to a variety of investors in a form that can be either held in portfolio or traded on a securities exchange.  While not every country has experience with infrastructure bonds issued by sub-national authorities in the local capital market, they can be an efficient form of financing for long term investments. 

   

Long term bonds are issued by a sub-national authority with a “face value” and repayment terms specified in the bond.  Local investors need a quick and easy way to assess the risk of purchasing the bonds so that they can balance risk and return when making their purchase offer.  National
scale public finance ratings serve this purpose. 

    

In basic terms the importance of ratings for bonds can be described as follows.  When a sub-national authority and their financial advisor design a bond, the authority’s national scale rating (which quantifies risk) combined with capital market research (which quantifies the return that local investors require at a given level of risk) determines the repayment terms that are specified in the bond when it is issued.  The objective is to specify the least costly repayment terms that will attract enough investors to sell all of the bonds at their “face value” so that the authority gets the amount of money it needs to complete its infrastructure project. 

   

Later, when a bond holder wants to sell some of the bonds on the local securities exchange, the national scale rating (which is reassessed annually) is used by potential buyers to determine whether the repayment terms specified in the bond still constitute a rewarding investment.  If risk now outweighs desired return, the buyer will offer less than face value for the bonds.  If current risk is low enough to warrant less return, the buyer will offer more than face value for the bonds.

 

A Simplified Example

  

Let’s imagine that a sub-national authority wants to issue bonds in local currency (LC) to finance an LC 100 million infrastructure project.  In this example, the credit rating agency gives the authority a national scale rating of A+(ns) which is investment grade, but below the national government’s bond rating of AAA(ns).  Further imagine that research by the authority’s financial advisor shows that national government bonds with a 15 year term carry an interest rate of 5%, but meetings with potential investors reveal that a 15 year bond rated A+(ns) will have to pay 10% interest to attract enough investors to sell LC 100 million of bonds.  So, the authority issues 100,000 bonds that specify a 10% per annum interest rate payable annually for a term of 15 years and each bond has a “face value” of LC 1,000.  Let’s say that 5 investors buy 20,000 bonds each and a sixth investor
wants to buy some but there are no more available.  The authority receives LC 100 million and must repay bond holders a total of LC $13.1
million (principal and interest) each year.

    

Now imagine the following scenario…

    

  • The sixth investor still wants to buy 10,000 of the authority’s bonds.  This investor decides to be more adventurous than the other five, and is willing to accept 9.9% interest given the authority’s A+(ns) rating.  Immediately after the bonds are issued, the sixth investor offers to pay bond holders a premium price of LC 1,004 for each bond.  One of the other five investors sells 10,000 bonds and makes a profit of LC 40,000.  The sub-national authority is unaffected. 

 

  • One year later, the authority has improved its financial management and the rating agency upgrades their rating to AA(ns).  The bonds are now less risky.  New bonds with a AA(ns) rating would only have to carry an interest rate of 8.5% to sell out at face value.   If they want to, investors can now sell the bonds they hold for LC 1,017 each.  The sub-national authority is unaffected. 

 

  • One more year later, the authority has once again improved its financial management leading to a rating upgrade to AA+(ns).  The bonds are now much less risky than they were when originally issued.  Assuming bonds rated AA+(ns) can be issued at an interest rate of 7%, the authority’s bonds would be trading in the market at a price of LC1,102.  In this scenario, the authority decides to refinance their debt by selling a new bond issue with a total face value of LC 110,200,000; an interest rate of 7% and a 15 year term.  The proceeds of the new bond issue is used to buy back all of the old bonds which effectively reduces the authority’s annual debt service from LC 13.1 million to LC 12.1 million, while the funds available for their infrastructure project remain unaffected.

     

Other Advantages of Obtaining a Rating

    

In addition to providing the means for sub-national authorities to demonstrate their creditworthiness to financial institutions, credit ratings offer other advantages.  The Rating Report that accompanies the letter grade spells out the financial strengths and weaknesses of the authority in some detail, and can be used to guide an authority’s financial management improvement efforts.   Since ratings are made public, they are a simple and transparently means of communicating an authority’s financial condition to key stakeholders and the community at large.  They can also be used by national governments to monitor the financial health of sub-nationals with complete objectivity. 

   

Because of the multiple advantages of having sub-national authorities rated on a national scale, some governments have made ratings a regulatory requirement in certain circumstances.  In Mexico, it is a requirement for sub-national authorities to be rated by at least two rating agencies in order
to undertake any kind of long term borrowing.  In India, the national government requires sub-nationals that participate in a particular incentive grant program to be rated as a means of measuring the impact of financial reform efforts linked to the grants.

  

PPIAF Sub-National Technical Assistance Program

    

This briefing note is intended to be only an introduction to the issue of national scale credit ratings for sub-national authorities.  Concerned readers are encouraged delve into this topic more deeply and explore it from the perspective of their own country or institution.  PPIAF’s Sub-National Technical Assistance program (PPIAF/SNTA) can provide grants to authorities that want to obtain their first credit rating.  Assistance is also available to improve the creditworthiness of sub-national authorities and help them achieve an investment grade rating.  In addition, In addition, PPIAF/SNTA can assist sub-national authorities to better understand their local capital markets and obtain transaction advisory services to facilitate access to the market.