Getting ready for the big time: subnational Public Financial Management

For meaningful climate action and progress in sustainable development, cities need more money – lots, and fast, especially in the Global South; this much has become abundantly clear thanks to their steady rise to the top of the climate and sustainable development agenda, along with associated infrastructure financing.

Cities in the Global South compound these overall challenges to access finance. The international development community has taken notice and is bolstering existing and new city-focused programmes, but cities still remain imperfectly catered to through the preferred approaches of the large development banks.

The siutation has recently led the C40 Cities Climate Leadership Group (an influential global city network) and the Overseas Development Institute (ODI, a leading international development think tank), to jointly produce a working paper to explore the creation of a new multilateral Green City Development Bank specifically mandated to finance cities and their sustainable urban development projects.

There is now a flurry of research and initiatives looking to break down what exactly it is going to take to unlock sustainable urban infrastructure investment at pace in the developing world. While their conclusions are valuable, the importance of an overlooked field can be read between the lines: the niche expertise that is Public Financial Management and, more specifically, Public Financial Management for subnational entities.

Call me by my name

Known as “PFM” by insiders, it has long been more of a niche cross-cutting skillset than a unified discipline, sitting between public policy and public finance administration, primarily found in national and international-level public policy circles, including international institutions such as the IMF (the Fiscal Affairs Department, specifically) or the OECD, as well as in multilateral development banks (MDBs) such as the World Bank and certain national development finance institutions (DFIs). At subnational level, dedicated international PFM specialists are rarer still.

In broad terms, PFM maps out the tools and processes that a government can use to manage its short- and long-term finances in order to achieve its fiscal policy goals (e.g. employment, stabilising the economy, promoting sustainable development) and formalises how supportive or not the legal, political and administrative backdrop is for the government to do so (good luck defining a tax policy if there is no practical way to collect or administer it).

One of the key outputs of PFM is the ability to produce a budget (at least an annual one, if not a medium-term one) that is reliable, comprehensive and actionable.

Experience from C40’s engagement with cities suggests that private and institutional investors struggle with core challenges related to sustainable urban infrastructure, including lack of understanding of cities and their financial conditions.

Financing the sustainable urban future: Scoping a green cities development bank (C40 Cities, April 2019)

It is PFM’s historically niche status which at least in part explains why many of the recent research pieces looking into the barriers to raising finance at city and subnational level rarely if ever mention PFM by name, even though references to its many dimensions are ever-present: the need for subnational governments to secure “fiscal space” (the remaining surplus from forecast revenues after forecast baseline expenditures); tax policy and administration for own-source revenue (fiscal decentralisation); fiscal sustainability; cash and debt management; public investment management; etc. Oftentimes, the commentary will remain at the fiscal policy level (i.e. setting the goals) while ignoring the PFM (designing the tools and processes).

This has not only contributed to a lack of consistency in describing recommendations for subnational financing of urban development, but it has also meant that it is a little-known field in the private sector generally.

A pivotal skill: policy and creditworthiness

Enabling greater subnational borrowing is often desirable but requires the adoption of other reform policies to improve fiscal capacity and creditworthiness of subnational governments over time.



ADB Institute working paper: Improving
Subnational Government Development Finance in Emerging and Developing Economies: Toward a Strategic Approach (February 2019)

Many of the recommendations being aired to boost subnational urban finance propose urban policies along with reforms to the enabling environment, with such reforms aiming to support subnational entities’ ability to self-finance at least part of these investments. This leads to another highly relevant aspect of PFM, which is creditworthiness.

If creditworthiness is the outcome, then fiscal responsibility – the ability for a government to function with due regard for long-term financial discipline, and one of PFMs main dimensions – is its main enabler for governments. PFM entrenches fiscal responsibility through, among many interconnected dimensions, reliable budgeting, effective fiscal rules (e.g. debt limits), concentrated cash and debt management, and effective management of fiscal risks (e.g. commodity price volatility, climate-related physical risks, risk of cost overruns on planned investment projects).

In general, the creditworthiness of cities is low: so low that only about 4% of the 500 largest cities in developing countries are deemed creditworthy in international capital markets and only 20% can access local capital markets (when there is one, which is not a given in developing countries), according to the World Bank.

Making matters worse, there has historically been little incentive for subnational governments to shoulder accountability for financial discipline, unless under central government oversight and pressure, since only a minority of cities worldwide (including in advanced economies) are legally empowered to raise their own tax revenues and finance in the first place (fiscal decentralisation), and that the revenue sources upon which cities are mainly dependent on – fiscal transfers from the central government and aid – can be volatile, especially in developing countries; such volatility does not support borrowing capacity.

In such a context, it should come as no surprise that the big development banks are in general “skilled and staffed to direct financing into sovereign-guaranteed loans”, as observed by C40 Cities in their abovementioned working paper. Why place disproportionate resources to cater to a subnational segment which is ultimately credit-dependent on the central government in most cases?

It follows that in order to boost city-level finance, more needs to be done to give them the tools to incentivise financial discipline, establish creditworthiness and focus on their idiosyncrasies. This is where the broad perspective and methodical approach of PFM becomes essential, in order to prepare the roadmap and tools to creditworthiness.

How to run and build a house

The dichotomy of the approaches currently adopted by development banks to address both subnational financing and creditworthiness is a reflection of the dilemma they appear to face: the need to sequence efficiency and longer-term engagement.

On the one hand, there are agenda-free (or at least agenda-light) programs intended to build up city creditworthiness through PFM, such as the World Bank’s City Creditworthiness Initiative. But at a time when bold action is urgent, the issue of such a general approach is timeframe.

It is indeed hardly an exaggeration to compare a perfectly sequenced set of PFM reforms – one that gradually builds up a government’s fiscal sustainability and delivers fiscal decentralisation – with a quest for the Holy Grail: it takes a long time (sometimes over a decade, depending on the scope), demands commitment (including from the central government), can require “champions” for the magic to happen (I couldn’t find another way to fit Merlin into this metaphor), and is often fraught with partisan intrigue.

On the other hand, a wave of more agenda-specific project preparation facilities dedicated to urban infrastructure and green cities has been launched within the past decade: the Asian Development Bank’s CDIA, C40 Cities’ Cities Finance Facility, EBRD Green Cities, etc. This favoured approach by development banks can be described as primarily a top-down one: mobilising willing subnational entities to qualify their projects for finance by complying with ‘bankability’ requirements.

On the plus side, such facilities help bridge capacity gaps, promote quality consistency and provide a ‘true North’ for prospective subnational borrowers on the road to producing ‘bankable’ projects. However, the implementation will more often than not have PFM implications, some of which can be misaligned with a government’s other, more immediate sequence of PFM reform priorities: new taxes and their administration; reporting requirements; reliable controls and oversight mechanisms, etc.

Rather than looking at development finance in the context (…), various analysts and frameworks have tended to focus on (and try to promote) specific individual reform elements— development transfers, tapping capital markets, public-sector lending agencies (…), or public-private partnerships, among others.

Improving subnational government development finance in emerging and developing economies: toward a strategic approach (ADB Institute working paper – February 2019)

This situation is worsened by the sheer variety of competing infrastructure and sustainable urban development promoted by various parties and their project preparation facilities, each with their own PFM implementation needs: Public-Private Partnerships (PPPs) are a mainstay in infrastructure reform despite their mixed results in developing countries; Transit-Oriented Development (TOD) and land-based finance are now heavily promoted by the Global Environment Fund and by think tanks including the Environment Defense Fund (sic) and the Coalition for Urban Transitions; financial institutions would like to see the more advanced cities in the Global South follow the lead of Cape Town in South Africa and issue green bonds.

The third way: subnational PFM and the bottom-up approaches to structured urban financing

Fiscal decentralization, innovative municipal finance, and structured project finance can drive public and private funding that underpins local economic expansion, women’s economic empowerment, climate adaptation, and sustainable development.

UN Capital Development Fund:  Strategic Framework, 2018-2021 (January 2018)

Meanwhile, in a much less-heralded corner of development finance, an outreach effort is currently underway, fuelled by the experience and lessons of (a small group of) subnational PFM-led finance practitioners seeking to enhance the visibility and consistency of more bottom-up approaches to subnational finance, namely municipal finance as well as more structured, subnational PFM-driven approaches.

Within the haystack that is the universe of UN agencies, the UN Capital Development Fund (UNCDF) has been threading a unique needle, focused on creating thriving local economies. At the heart of UNCDF’s value proposition is the alignment of structured financing proposals with a local government’s present and planned PFM sophistication while incentivising greater financial discipline through structuring – an indirect form of fiscal decentralisation.

The tools and mechanisms that it applies are varied but comprise an element of performance- and compliance-based incentive, such as policy loans and grants whose outlay is dependent on the realisation of reform phases.

UNCDF’s strategic focus on the underserved “last mile” communities in the world’s Least-Developed Countries (LDCs) has meant that it has been able to operate independently from the large, national government-focused development agencies and financial institutions, and scale up innovative approaches to subnational finance and public-private partnerships in real-life conditions – a living lab, of sorts.

A testament to the value of its insights and experience, UNCDF announced last year the formation of a consortium with influential subnational government advocacy network United Cities Local Governments (UCLG) and the Global Fund for Cities Development (FMDV in French, a UCLG initiative): the newly-formed International Municipal Investment Fund aims to support ten pilot cities in the Global South and arrange any necessary finance based on UNCDF’s subnational PFM-enhancing experience.

Another unheralded organisation with a distinctive focus on subnational PFM is the Subnational Technical Assistance programme (SNTA), a sub-set of the Public-Private Infrastructure Advisory Facility (PPIAF), a multi-donor technical assistance facility that is financed by eleven multilateral and bilateral donors, including the World Bank. More agenda-driven than the UNCDF, the SNTA program provides grants for technical assistance focused on improving a subnational government’s overall PFM framework (systems and procedures, but also legal framework and institutional aspects), in view of readying them for potential public-private investments and delivering improved creditworthiness.

In PPIAF’s Strategy and Business Plan 2017-2022, SNTA recognises that it has accumulated a wealth of untapped insights and that it had so far taken a back seat to engagement with the wider community of infrastructure finance market participants. The program is therefore in an active phase of outreach to increase its visibility, exchange information and potentially form new partnerships.

One of SNTA’s most notable recent developments in that regard has been the formation of a municipal finance program, in collaboration with the World Bank and France’s international development agency, AFD – no more being a background player. In seven pilot countries, the program will leverage SNTA’s expertise to ready city governments for tailored, non-concessional financing solutions.

Getting ready for the big time

The scaling-up of structured financing approaches that are more tailored to a subnational entity’s circumstances and its degree of PFM sophistication would bring greater clarity to the bespoke needs and sequencing of concurrently planned reforms. It would also complement the current top-down approaches more commonly applied by DFIs and MDBs that seek to drive subnational entities to comply with ‘bankability’ conditions set by finance providers and intermediary funds.

In order for this to happen, the gap in PFM expertise between cities, urban policy specialists, development finance at large and private investors needs to be bridged. Thanks to the increased maturity of PFM practice, there is now an increasing number of forums to farm in such knowledge.

Now in its eighteenth year, the Public Expenditure and Financial Accountability (PEFA) program, supported by some of the main practitioners of PFM including the IMF, the World Bank and the European Union, publishes a publicly available and regularly updated ‘best practice’ methodology.

With more specific attention to subnational governments, UCLG launched in 2018 the World Observatory on Subnational Government Finance and Investment (shortened to the decidedly un-snazzy acronym “SNG-WOFI”) and held its first-ever international conference in June of this year.

While such shared understanding will not shift the reality of generally weak creditworthiness at subnational level, it should cement a common language between market participants and researchers, as well as, crucially, reveal a more detailed understanding of city and local government finance, which may encourage both public and private finance participants to take a more bespoke look at subnational borrowers, particularly in the Global South where needs are the greatest, and risk perceptions most flawed.

***

In another section of PPIAF’s Strategy & Business Plan 2017-2022, SNTA highlights that it is actively considering changing its name to enhance brand recognition.

First, if I could make a suggestion, it would be for SNTA to take charisma-challenged acronym SNG-WOFI along with it for a makeover. More to the point: these developments highlight a new confidence in the unique insights of these subnational PFM-led organisations, perhaps bolstered by the persistent barriers encountered through the more mainstream approaches to mobilising subnational finance. After many years of working in more anonymous circles, it may just be their time to shine.

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