THE HUNGARIAN MUNICIPAL GUARANTEE SYSTEM. Dr. Péter Szegvári Background, the importance of municipal borrowing

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1 THE HUNGARIAN MUNICIPAL GUARANTEE SYSTEM Dr. Péter Szegvári 1 1. Background, the importance of municipal borrowing The coming years for Hungarian municipalities could be characterised by challenges due to the growing needs of infrastructure stemming from the under-investments of the past, when municipal investment rates sometimes did not reach even the required rate of replacement. The economic growth and also the decreasing inflation rates provide a positive environment for infrastructure development. In order to mobilise private funds for municipal investments, local governments must be able to generate local revenues and to co-ordinate public and private funds of the investments. The level of private fund integration into municipal financing depends on the budget characteristics of the municipality: whether it possesses own resources and is able to attract private money with its prudent behaviour or not. In Hungary, the municipal sector s ability to mobilise the private sector is very limited because of its very fragmented system and small budget, from which it is almost impossible to finance investments in infrastructure that usually require large sums. The enhancement of municipal infrastructure is also an important task of the central government, as its current level does not reach the level required by the European Union and the continuous under-investments would also result in costly investments in the future. As the municipal capital spending has great effect on the balance of the central budget, the interest of the government is to help developing a system, in which municipalities are able to raise money safely for infrastructural purposes without menacing the macroeconomic balance. Potential financial sources for local investments are the EU subsidies from the Structural Funds. These are additional funds, meaning that the municipalities have to add their own part to the investment showing their financial strength and commitment to the investments, otherwise, these funds are available for the development. These own parts could also consist of central development subsidies, bank loans or private sources. In other words, the condition for accessing EU subsidies is the setting up of a municipal financing system allowing municipalities to raise funds from the credit market. 1 Head of Secretariat at the State Secretariat for Public Administration and Regional Policy, Prime Minister s Office, H-1055, Budapest Kossuth tér 4. Hungary

2 Considering that most of the own sources would come from bank loans, further criteria for accessing EU funds is money raising ability on the local credit market. Setting up this institution is the interest of the municipalities, the banks with municipal clients and the state itself. 1.1 Municipalities: The main incentive for municipalities (i. e. join the Guarantee System) lies in the fact that with its help they would have access to bank loans and other private sources with lower costs and better general conditions, as the risks associated with municipal lending would be spread among several partners. 1.2 The State: Setting up a municipal guarantee institution is good for the state as it would broaden the possibilities for financing local investments, and would decrease the pressure on the central budget. 1.3 The Banks: Banks are competing for new clients. The local government sector s demand for loans will probably increase in the coming years due to the above-mentioned reasons, and that would mean a possible target for lending out money. This opening towards local governments will not result in the decrease of the banks profit as long as the use of market tools reducing risks is associated with municipal lending. The most important characteristic of the guarantee institution is mutuality. This kind of cooperation of municipalities means that together they represent a stronger actor on the market than they would do if they acted individually on the market with their demand. 2. The characteristics of the system Based on international experiences in Hungary, we are trying to set up a system that is able to assure the actors of the market, that lending to municipalities is safe and the risks are comparable to the benefits of taking part in a municipal investment.

3 2.1 Advantages One advantage of creating a municipal guarantee institution is that other municipal assets that were used as guarantee for securing municipal loans, but were not directly related to the purpose of the loans, could be used for other purposes or could be sold. With this kind of guarantee, the administration costs of the loans would decrease, as the risks would be spread out among several actors on the market. As the municipalities are responsible for each other s debt (mutuality), they would force each other for being more diligent, which would lead to a safer management of municipal debt and finance. The municipal investment plans would probably be more elaborated and, the quality of debt applications would meet the requirements of the debt suppliers. This would also lead to the development of the municipal credit market. 2.2 Services provided by the guarantee institutions Consulting services Municipalities have to hire costly experts of different areas in order to plan and realise a project. If the institution provided these services, it would be profitable for the local government itself, and, of course for the guarantee institution, because taking part in the preparation of the different project plans help the institution to have a deep understanding of the whole of the project and assessing the risk would be much easier. The guarantee fund could also take part in finding investors for the project, for it would have a broad knowledge of the market through its other partners. They would also participate in preparing applications for international loans offered, for example, by international organisations, such as The World Bank Credit rating Credit rating agencies are important institutions for developing municipal credit markets. The availability of municipal budget data, strategic plans and economic and social environment is essential for rating municipalities. The services of international rating agencies are very expensive. Besides, municipalities do not feel their importance yet. The guarantee institution would have to make a credit assessment for assessing the risks it is taking when providing the guarantee. This could be an initial step for the general rating of municipalities.

4 2.2.3 International loans International organisations would probably prefer to allocate their money into a municipality that had been rated by the guarantee institution and is secured by it. They would also have more confidence if the experts of the guarantee institution had given their opinion to the project previously, and kept monitoring the realisation of the development to the end. 2.3 Financial sources of the system The most exciting question concerns the financial background of the municipal guarantee system. This background must be stable enough to fulfil the requirements of the safe operation and should not exceed a level that is not bearable for the municipalities, as parts of this fund would originate from municipal payments. The fulfillment of these two requirements at the same time will be a difficult task for Hungary. The main sources for the guarantee institution could be! equity provided by the founders,! the equity of the municipalities joining later! the payments of the municipalities into the fund willing to use its services! fees for guarantee,! the profit, reserve fund! refund from the collection of collateral guarantees offered as securities coverage 2.4 The guarantee institutions One key element of the municipal guarantee funds is their reserve generating system. Municipalities wanting to enjoy the services of the fund pay into its reserve fund. It means, that as owners they have the right to the guarantee but they are responsible for its operation to the extent of loans and guarantees. The municipality must develop a loan raising system, which allows it to avoid every possibility of bankrupting. It has to cover every risk and minimise the vis maior cases in its contracts when it is not possible to determine who is responsible for the failure of the project. The guarantee institution can operate safely if it has enough sources for fulfilling its obligations in the case of a pre-estimated failure rate. Based on EU and other international experience, the maximum obligation undertaken by the institution cannot exceed 10 to 12 times the value of its assets.

5 Banks might ask why they would add sources for a guarantee system. One incentive for banks would be if the guarantee only applied for those that are owners of the institutions. As lending out money into a system with state counter guarantee is highly in the interest of the bank, this would enhance their willingness to own a part of it. The operation of the system is also in the interest of the Municipal Associations and this could be manifested in their ownership as well. The interest of the municipality is to raise loans with lower costs, the banks would have a stage to lobby for regulations that are more suitable for their own business policies and the interest of the state would be to minimise the costs related to municipal bankruptcies. 2.5 The state counter guarantee fund Sources of the state counter guarantee fund should be separated from the central budget. Founders of the municipal guarantee institutions should include the municipalities, banks with municipal clients and the state itself (with a participation of approx. 25%). The state counter guarantee fund would be owned by the state. Other owners could become part of the system only in an indirect way, e.g. the World Bank with a partial counter guarantee would support its operation. The guarantee taken by the fund should be up to 70%. This would meet such EU requirements as risks being spread among several partners, and would ensure the acceptance of the fund by other lending institutions. The guarantee institutions must have the revenue for covering their operation costs. We can set as a requirement that this must be covered from the profit of the organisations. 2.6 The legal form One base of the system is a loan guarantee institution with the legal form of a shared corporation due to the fact that Hungarian laws without amendments do not allow guarantee institutions to have the legal form of a partnership or a co-operation (i. e. these institutions cannot offer the guarantee service). The other possibility is a foundation that gives state guarantee in specified cases of defaults. The legal form of the state guarantee institution would be the fundation.

6 3. The operation of the guarantee system We suggest the guarantee taken by the guarantee institutions to be 80% and the counter guarantee by the state fund to be 70%. In this way the risk would be shared by the lending bank (20%), the Guarantee institutions and the Guarantee Fund (80%). Part of the risk must be held by the municipality itself, so the local government must provide its own share to the development, but the amount of this share is obviously lower than it would be without the intervening guarantee institutions. The previous practice mortgaging municipal assets could be changed by securing loans with income from fees and local taxes. **Table 1** 4. Financing need Sources required for setting up the guarantee system depend on the loan demand of Hungarian municipalities. If we assess that the municipality will need approx. 10 billion HUF loan, than the municipal guarantee institutions will need a capacity for 8 billion HUF guarantee. It means that the institutions must possess at least 300 million HUF sources (assets), and the Counter Guarantee Fund has to possess 700 million HUF sources. In this case, the guarantee institutions provide 80% guarantee for 10 billion HUF loans, and their assets covers 12,5% of the guarantee taken. With the required changes in Hungarian law the above-described Hungarian Guarantee System can be set up within a year. **Table 2**

7 Table 1: Risk sharing in the Municipal Guarantee system Total risks of loan 100% Risk of the Bank 20% Rsik taken by Guarantee Institution + Fund 80% Guarantee Institution 24% Guarantee Fund 56%

8 Table 2: The process of risk allocation in the Municipal Guarantee System M unicipalities 4. repaym ent of Guarantee In stitu tion G uarantee Fund 1. loan 2. guarantee 3. counter guarantee i t i Bank

Presentation. December 2011

Presentation. December 2011 Presentation December 2011 Overview Foundation in 1991 Banking license received in 1993 Status Specialised credit institution 100 % of shares owned by the State Statutory repayment guarantee provided by