New solutions to close the gap on municipal finance
As city authorities increasingly consider bonds and global markets, they are overlooking a key resource: their domestic wealth. Habitat III is an opportunity to strengthen focus on land assets, productive capacities and local expertise.
Urbanization is driving population growth. U. N. projections estimate that by 2030 — the target year for the new Sustainable Development Goals (SDGs) — the urban population will increase from today’s 3.5 billion to five billion, more than half of the global population. Most of that growth will take place in developing countries in Africa, Asia and Latin America.
Urbanization is expensive. It requires centrally planned infrastructure including electrical grids, power stations, roads and highways, water-supply networks and sewage, telecommunications networks, railways and airports, in addition to public and private services — schools, hospitals, markets and more.
Funding basic urban infrastructure today accounts for 80 percent of global investments. According to the World Economic Forum, such investment needs stand at USD 3.7 trillion per year until 2050. With current yearly investments of just USD 2.7 trillion, we are left with an infrastructure investment gap of USD 1 trillion each year.
In high-income countries, central governments finance the majority of urban infrastructure. Cities in developing countries also finance a significant portion of infrastructure projects with financial resources provided by central governments. However, the responsibility of linking roads to regional networks and maintaining regional infrastructure interlinked with that at the local level is unclear in many countries. Often, it lacks requisite financing.
Achieving healthy municipal finance
In high-income countries, urban revenue is generated primarily through taxes, public assets (for instance, public land and other publicly owned property) and central government transfers to municipal authorities.
“With current yearly investments of just USD 2.7 trillion, we are left with an infrastructure investment gap of USD 1 trillion each year.”
The more economically developed the city, the less it tends to depend on transfers. In cities such as New York, Stockholm, Seattle and Tokyo, locally based revenues are over USD 3,000 per capita each year. Such cities are more able to attract multinational corporations that benefit from strong property rights and contribute to municipal and national revenue streams.
In many cities in the developing world, locally generated urban yearly revenue ranges from USD 100 to USD 500 per habitant. And in smaller cities in Africa and South Asia, it is not unusual for some municipalities to receive less than USD 50 per resident.
The size of a city is not the only variable that matters in determining the volume of local revenue streams. For example, there is room to improve tax-collection efficiency in developing countries, where such revenue remains well below that in developed countries. However, in cities where municipal authorities lack the capacity to boost revenue, increasingly such efficiency may not be enough to significantly improve their ability to invest in and maintain local infrastructure while also providing public services.
Facing deficits, local authorities usually turn to revenue sources that are beyond their capabilities. When experts from my office visit cities in developing countries, frequently we are requested to support bond issuing or attempts to obtain funding from international financial markets.
There is nothing wrong with such goals. But it is important to bear in mind that bonds require creditworthiness, a reputational history that signals the likelihood of repayment by the local government. In turn, that may be expensive and complex — and even if obtained, it is still a debt that must be repaid in the future.
Meanwhile, many countries asking these questions are missing an important first step: taking advantage of their own domestic wealth — what we call “endogenous” sources of finance. This year’s Habitat III conference and its outcome strategy, the New Urban Agenda, offer an opportunity to refocus the global discussion on these sources.
Yet while the Habitat III preparatory documents that will support the draft for the New Urban Agenda do mention this issue, they do not do so strongly enough. Habitat III needs to adopt as a priority the need for local governments to understand and leverage their own assets and wealth. After all, these are the resources that are within cities’ immediate reach.
Three priority revenue sources
Endogenous sources of revenue are the basis for a healthy municipality. Here are three such sources that deserve special mention.
“While the Habitat III preparatory documents that will support the draft for the New Urban Agenda do mention ‘endogenous’ sources of wealth, they do not do so strongly enough.”
The first are land assets. Municipalities need to improve property rights via land registration. In addition, local governments must have a system that enables them to periodically update information on asset and property ownership. Such a system requires a basic level of technical expertise, an electronic network and an accounting system.
By reinforcing property rights through a central system that monitors and updates public and private land assets, municipal governments can establish a foundation for land-value sharing. In turn, this enables all interested parties (for instance, residents and local governments) to apply urban planning tools to renew and expand cities, improve neighbourhoods and increase property values.
Cities that apply these tools are able to generate more revenue from property taxes and “betterment levies”, and to direct those resources toward improving housing for residents and compensating proprietors with income. This creates a virtuous circle for city renewal and expansion. Indeed, land-value sharing has been very successful in cities in Japan, the Netherlands and other countries, where such systems have been in place for more than a century.
Next up are productive capacities. Improving and expanding the layout of cities enhances productive capacity and the mobility of people and goods, so urban areas can generate more income from the private sector. This dimension is usually considered part of strategies around local economic development, and such policies will need to be updated in order to support a productive economy that prioritizes liveability and equity as well as higher urban revenues.
How the city is configured — its transportation system, public space and more — is directly connected to its capacity to improve productivity and expand wealth. Look at the example of mobility: Cities with improper transport systems cannot connect people to jobs, and firms are unable to compete and generate sufficient income. Thus, municipalities lose revenue, hampering their ability to provide public goods. Cities that offer a good environment in which to live and efficient urban layout in which to produce, on the other hand, attract people and firms, creating sustainable sources of income.
The third vitally important endogenous source of revenue is financial management expertise. This varies broadly among municipalities depending on the level of revenue, region and country. In non-metropolitan municipalities, it may be important to improve basic financial capacity, ranging from accounting rules, capital investment plans, sustainability financial ratios, and rules for expenditures and revenue.
Improving financial management top to bottom can have significant benefits. Understanding accounting principles, training on capital investment plans and helping to set up basic electronic government systems have immediate results, as UN-Habitat projects in Asia and Africa demonstrate. Later, support must be given to improve technical knowledge of more complex financial instruments such as bonds, credit ratings, loans, green financing and others.
Too small to serve
The conditions necessary for healthy municipal finance seem fairly straightforward. So why is there so little progress in the understanding of and policies around these three areas? The reason seems to be that municipalities, in particular those of medium and small size, are at an intersection where they are large enough to count but still too small to serve.
Municipalities in developing countries are not ideal clients of credit for international development banks. Such institutions have good financial instruments and scale for countries, but they find lending to municipalities far more difficult. Besides the smaller scale of potential loans, fixed costs for a bank are too high to serve local governments.
Municipalities also require loans in local currency. While this increases exposure to financial crises and other risks, it also requires a guarantee by the sovereign governing body. Yet sovereign guarantees may create potential situations of moral hazard, where a municipality can obtain a loan even while knowing that it will be rescued if it does not perform.
An alternative source of funding is local and international commercial banks, but these are often too risk-averse to provide local financing. Moreover, commercial banks usually have more-profitable and less-risky investment options. Private investors are another source of finance, but typically they are able to finance only small local projects.
Thus, there are no easy solutions — and the urban community needs more ideas. Here are some potential solutions to filling the local finance gap.
Financing the gap
One potential solution is a national municipal corporation. This can be an umbrella department housed in a national ministry that supports municipalities with technical cooperation and consulting expertise. In some cases, it could also offer loans or guarantees that encourage pooled investments schemes.
“Habitat III needs to adopt as a priority the need for local governments to understand and leverage their own assets and wealth. After all, these is are the resources that are within cities’ immediate reach.”
For example, development banks can offer credit directly to the municipal corporation, which could act as a guarantor for all municipalities. As cities get bigger and become more metropolitan, they can create their own municipal corporation that serves smaller municipalities. Good examples of this approach already exist, such as Findeter in Colombia and Banobras in Mexico.
Another mechanism could be local infrastructure funds, where municipalities create an external investment body to manage local infrastructure. Such funds can be adapted to local conditions and provide funding to develop a project pipeline or eventually to co-finance local infrastructure projects.
Such a fund would require proper oversight, of course, to guarantee transparency and expertise. But by encouraging private-sector consulting and investment, local governments can generate capacity around incremental financing. There are several such examples in cities in the United States, Canada (Ontario is a particular case study) and Western Europe, but also in Africa and Asia. Those funds can also have a climate-change component and attract bilateral donors.
Financial markets can also be strengthened through the use of bonds, though significant complexities remain in this area. In Latin America, Rio de Janeiro, Bogotá, Belize and others have issued bonds; but at less than 10 years, the bond maturity tends to be too short for the lifecycle of an infrastructure project, which typically runs more than two or three decades.
In Africa, the situation is even more complicated. For the most part, African governments allow bonds to be issued only at the national level, with just a few cases of such actions at the subnational level — including in Dakar, where the process remains in limbo. The financing of bonds requires technical expertise, credit ratings and a proper legal framework. And still bonds are not a panacea: Like any loan, they constitute a debt and must be repaid.
One form of classical bonds is what is known as a pay-for-success contract, also called a social-impact bond. These don’t require a credit rating and can be implemented by a municipality through an external institution that manages the issuing of the bond and pays all parties if and when the social policy is achieved.
One example comes from the U. S. state of Massachusetts. In 2014, the state worked with the non-profit Roca and financial intermediary Third Sector Capital Partners to design a contract with a group of investors under which Roca was paid by the investors to operate a programme aimed at reducing criminal recidivism. Using a similar scheme to pay for local infrastructure is also possible — examples can be seen in firms such as Instiglio and the Global Impact Investing Network.
Cities and countries together
Municipal finance is like a Liebig’s barrel — a concept illustrating how the amount of water that a barrel can hold is limited by its shortest stave. Similarly, growth is constrained not by all resources but by the scarcest resource available.
For a city to achieve prosperity, a minimum of finance is necessary. Still, finance is a necessary but insufficient condition. Under what UN-Habitat calls the three-pronged approach, finance is joined by planning and legal frameworks as the three elements required for prosperity. While urban planning requires rules and regulations for urban expansion and finance to pay for city extensions, municipal finance requires planning and good city layout, as well as a policy framework that supports land-value sharing and private investment in public projects.
Thus, the New Urban Agenda resulting from Habitat III will need to integrate municipal finance with urban planning for sustainable urbanization. It will also need a legal framework that requires each country to formulate national urban policies that support the sustainable and equitable growth of cities.
Today, many forces are colliding: Population is growing in urban areas, cities aren’t generating sufficient employment opportunities (partly due to inadequate infrastructure), an urban infrastructure gap is rapidly growing in developing countries, and cities are feeling the pressures of growing urban populations with inadequate resources to provide housing services and basic infrastructure.
Progress on the SDGs, the eventual New Urban Agenda and the broader goal of prosperity will require all parties to work together — cities and national governments, the private and public sectors, policymakers and academia — on the complex challenges of urban development and their potential solutions.
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