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Budgeting and Financial Management for Local Government April 2000
David C. Jones, C.P.F.A., F.C.C.A.(UK), Research Fellow & Visiting Instructor, Center for Urbanization Studies, Graduate School of Design, Harvard University, 48, Quincy Street. CAMBRIDGE. Massachusetts Tel: 617-495-4964 Fax: 617-495-9347 E-mail: firstname.lastname@example.org
and as: President, Farsight Inc. International Financial & Management Consultants 4936, Andrea Avenue, Annandale, Virginia. 22003. USA Tel: 703-978-8564 Fax: 703-978-8014 E-mail: email@example.com
CAPITAL INVESTMENT PROGRAMMING AND ITS FINANCIAL IMPLICATIONS BACKGROUND AND FINANCIAL FRAMEWORK General Capital Investment Programs are usually thought of as building things. This includes: development of land; erection of buildings; installation of roads, bridges, pipes and other infrastructure – above, on and under the ground; or, the supply of equipment for use on a semipermanent basis. Primary participants in these activities are mainly engineers. Thus, it is natural that they will be concerned to build and install, as rapidly as possible, the infrastructure and other fixed assets perceived to be urgently needed. They, after all, have the primary expertise for this task. A principal limit on the pace and magnitude of their work is, clearly, financial resources. A capital investment program, therefore, is an opportunity for prioritization of fixed asset implementation activity and the related access to urgent and important funding sources. It will also show how the vision and operational strategy of a community is reflected in the program for capital expenditures Because of the very large Capital Investment Programs (CIP) to be financed, failure to consider the availability of funding could give rise to an undue sense of urgency. That might engender a disregard for the need to carefully examine each project component with due diligence. It is important, of course, to ensure that the necessary funding will be available, in full and on time, as and when needed for each project component. However, it is also important to ensure that: (a) each project component, as well as its size and scope, is selected on the basis of a rational prioritization, with reference to its financial and economic costs, measured against its benefits or effectiveness – economic, financial, social and equity; and (b) each project component represents the least economic cost of providing a sound solution to the concern being addressed. These should be addressed on the basis of life-cycle costs. These allow for the capital costs and also the impact of these on recurrent finances, together with costs of operation, maintenance and administration. Also to be considered are the costs of replacement or rehabilitation of equipment that will not continuously serve with optimum efficiency, or even become unserviceable, during the life-cycle of the principal project assets. Analyses will need to allow for expenditure in later years to be discounted against earlier expenditures. It is also important to take account of the extent and timing of revenue flows from the use of various infrastructure items. Some components, such as water supply, will provide immediate individual benefits and may well be connected with optimum promptness.
Others, such as sewerage, provide benefits that are only partially directed to individual households. Some benefits accrue to the community as a whole. They are also more diverse and less immediately obvious. It may be that there will be a greater reluctance by individual households to connect to the system. Solid waste services also exhibit some of the same characteristics. Sometimes, financial revenues may still be collected, by levying charges whether there is a direct household service or not. However, this may well be contentious, especially for sewerage. For example, households that can ill-afford this may need modifications to internal plumbing. Moreover, lack of connection will likely have technical shortcomings. Low flows will potentially harm the sewer pipes, while a lack of connections will limit public health benefits to the wider community. Some infrastructure, such as roads and drainage, will likely provide benefits that are of a general public nature, rather than to individuals. Road improvements1, moreover, are likely to improve the efficiency of other public services that rely on transport, especially solid waste removal, police, fire and ambulances. The operation and maintenance of roads and storm drainage, together with necessary capital cost recovery, will need to be borne mainly from general taxes. Thus, it is important to ensure that the necessary increases in general tax revenues are engendered from: buoyant increases in the tax bases; politically acceptable and administratively sustainable increases in the tax levies; or, reductions in other tax-borne expenditures. The lastnamed would need to result either from efficiency improvements or curtailment of other services. All of these matters are the concern of both technical and financial expertise. Moreover, they have financial and economic effects beyond the scope of the individual projects. They impact upon the entire financial framework of the local government unit, and way beyond it, to other entities. Engineering specialists should, therefore, work closely with financial colleagues. This will provide greater assurance that appropriate costs are budgeted and accounted for, in ways that will be both credible for reporting and useful for effective action. Most importantly, these are policy issues. Cost Recognition The above view of Capital Investment Programs has focused on the raising and spending of cash, to provide the infrastructure and other assets. Some attention has also been given to the provision of funds to operate and maintain these. Certainly, cash-flow management is important, for a variety of reasons. However, other than by blind coincidence, "cash-flow," is unlikely to be synonymous with "cost." Cost definition cannot be meaningful unless based on economic principles. Therefore, it should relate as closely as possible to the concept of resource consumption, rather than to the mere receipt and payment of cash. It should also incorporate, where possible, recognition of the recovery of capital costs.
These need not be major or massive improvements. Sometimes, improved access to pedestrians and non-vehicular transport can bring notable economic and social benefits, relating to access and egress at awkwardly located spaces.
dividend and retained earnings). return on investment. Return on Investment Included as part of the "return on investment" is the provision for dividend and retained earnings.in terms of the production of goods and services. maintenance of all premises. however. This would allow for periodical fluctuations in financial fortunes. including those of lenders. and Return on Investment (interest. adjustment of value. either in terms of changes in real values (opportunity costs) of property or in recognition of the effects of changes in monetary values (inflation and deflation). more specifically: risk. costs – in terms of resource use – of any business or public activity 2 should include properly recognized and recorded expenditures on the following: (a) (b) (c) (d) operation of the activity . or (for property owned): (i) (ii) consumption of capital. the interests of owners (shareholders) are reported as the earnings (profits) after all claims have been met from outside of the entity. typically accruing to the owners (shareholders) of an entity. Administration & taxes. typically recognized as depreciation of premises. Rent (capital recovery) and Surplus. either (for property not owned) the market rent. and." over and above the expected and reasonable costs of capital. together with the payment of taxes. and. common agreement among economists that what are considered to be 2 This concept is referred to elsewhere (e. These are items which. His costs must cover: Operation. it would be prudent to expect that the budgeted activity costs would also allow for an additional (albeit small) "surplus. 4 ." The distinction arises because financial accounts reflect “property rights” rather than economic principles. the rental cost (capital cost recovery factors) of fixed and working capital. There is. in a set of training slides) as “OMAR’S CAR. uncertainty. and. Thus. Adjustment of Value (revaluation). necessary to ensure that operations are efficiently effected. either by dividends to owners or by retained earnings. new activity. including interest on debt and an expected and reasonable return on contributed (equity) capital. Maintenance. plant and equipment in a satisfactory condition to perform its operations in a safe and efficient manner for its entire working life.Therefore.g. administration and management of the activities. longer-term stability. which are resource costs. comprising. according to "generally accepted accounting principles" are not treated as costs but as allocations of "profit. plant and equipment. (iii) After covering all the above.” It reflects that the COSTS of any business or activity are synonymous with those of a taxi-owner (called Omar). The Rent concept (CAR) covers: Consumption of capital (depreciation).
Even if the deficit is covered by increased taxes. with interest."normal" profits are no more than a part of the "opportunity cost of capital. or it will eliminate some part of the overall "surplus. In many presentations (of this and other urban transit systems). Ricardo. and in what form. Sometimes. Equity includes "retained earnings. Either it will add to the overall "deficit. and. For example." This is somewhat analogous to what is described as "surplus" in the above set of distinctions3. 3 4 Economists sometimes refer to this as “economic rent. when these become pervasive. budgetary management. the funds used for this purpose still have an opportunity cost. subsidies are appropriate." These are somewhat analogous to situations where borrowers retain compound interest." which will have to be borrowed. An August 2004 press article.” a concept introduced by the classical economist. fiscal deficits. the financing of capital expenditure from general government revenues (local. the standard practices of financial analysis deal explicitly with costs of capital. or is affected by: cost accounting systems. Then. In some countries. Effective decisions on public service delivery." which will create a loss of interest on the related monetary investment. it had in the past typically been standard practice for state and local governments to finance up to and including 100% of many items of capital expenditure by the borrowing. prices. funds or governmental entities7. Indeed. of the type used for the various capital programs supported by state or local governments. for economic or social reasons. as in transfers from other accounts. 5 This includes grant financing. 7 An example is the Washington Metro-rail transit system. completely ignoring the impact of the costs of the use and deterioration of the fixed capital assets. as the weighted consolidation of the separate and specific returns to debt and equity financing4. even where all or part of these assets may have been financed from sources other than debt5. the costs of these are determined. cost recognition. allocation of overheads. indeed. This usually had amortization periods closely related to the working life of the fixed assets acquired.” 5 . or to what extent. it affects. Furthermore. unless they include reference to all of these various factors. Costs of service cannot be credibly stated. However. it is necessary to “shop around” for capital funding from constituent governments. the return on total net assets. unless costs are determined in an authentic fashion. However. 6 This is not an argument against the financing of fixed assets from taxes . state or central) will do one of two things." Only extra-ordinary earnings are typically regarded as true "profits. there is no way to know whether. maintenance of assets. inter-governmental transfers.only an explanation of its consequences. nor fully recovered. the subsidies already exist (such as in the initial capitalization) or are ultimately justified. “costs” are postulated only as operating costs. The issue of cost definition has been fully stressed and explained because it forms the basis against which all related aspects will need to be assessed. depend upon whether. They will also forego the use of the principal sum. This has a parallel in the public sector. in that they are expected to earn returns. to be consistent. refers to “Urgency Drives New Metro Pitch for Funds. should relate to the maintenance. use and consumption of resources and not to the manner in which these resources are originally financed. the taxpayers (effectively the "shareholders" of the government) will (collectively) lose the equivalent in interest on what would otherwise have been their own money6. notably in the USA and UK. Furthermore.
economic or financial policies (and discouragement of those which are not). that of the local government units. As required by law. (f) enhancement of limited local resources to provide reasonable flexibility in decision-making on the provision of services. (c) equalization. income tax. Among the many reasons for government grants are the following: (a) transfer to local government units of a proportion of revenues collected in or for their areas. the prime responsibility is. sales tax. incorporating full accounting for resource use costs. (e) encouragement of practices which are consistent with national social. as well as economic logic. These include stipulations for full accounting of all fixed assets.g. where appropriate at current (replacement) values. There needs to be a great deal of common sense and political wisdom. are attempting to encourage and support activity by the local government units. depreciation and interest costs. it follows the “Code of Practice on Local Authority Accounting in Great Britain” and the “Statements of Standard Accounting Practice” (SSAP) required by the Chartered Institute of Public Finance and Accountancy and other UK professional accounting bodies. England8. irrespective of the method of financing. group of nations or region (e. of many other countries. local roads and public health). but which can be collected more efficiently at national level (e. A most important means of financial support by the central government of local government units is the government grant. (b) support for services in which national government has an interest but which may be better performed locally. Government Grants Central governments. This includes activity that it favors or for which there is some clear justification on national grounds.g. However.g. It includes imputed rental. (d) provision for specific burdens upon individual areas not shared generally. of the needs and resources among different areas. primary and secondary education. (g) major shifts in political. with input from local people (e. is given in the annual financial statements of the City of Birmingham. VAT and customs duty). increasingly. economic or social characteristics of a nation. 8 These statements are available separately.An example of the presentation and use of financial statements. to some degree. the massive political changes resulting from the liberalization policies in Eastern Europe). 6 .
much local infrastructure is in a very poor state and in urgent need of replacement. existed. For example. there is no reasonable supply of market-driven medium-term or long-term capital. 9 For example. USA. instead of encouraging the continuance of a service using existing available equipment and infrastructure. poor distributive economics) to complain of local tax revenues “sent elsewhere in the state. for installation of. at market interest rates. the local government would be faced with a more evenhanded financial choice. Then.” 10 This is the situation in many formerly – and still currently – disadvantaged communities. too large or even not justified at all. with the meager and uncertain financial resources available to the central government. In principle. Even if there were. This is very serious in any country where capital resources. Faced with a choice of spending its own resources on maintenance or getting a grant for new capital investment. Until local recurrent financial resources grow sufficiently robust to operate and maintain the new infrastructure. with a great deal more economic potential than elsewhere. are scarce and thus costly. arguably comprise the Nation’s wealthiest area. capital charges) on the new one. It would either continue to pay operation and maintenance costs for the old (probably inefficient) asset or pay debt service (more strictly. it may also be one of the most important commercial centers. Capital Grants Grants may be given towards specific capital projects or to support recurrent operations. First. They will tend to support new capital schemes. 7 . Finally. emanating from socialist or other centrally-planned economies. application of these principles may often be difficult. 11 This may not be exactly correct. the Northern Virginia suburbs of Washington DC. However. whatever may be argued for the needs of a particular area. Second. there is no satisfactory mechanism to administer it. many local government units lack credit-worthiness. hitherto. infrastructure in areas where little or none had.in the administration of a grant structure. there may be a case for declining annual interim central government support towards this expenditure. Thus. Central governments sometimes use capital grants as “pump-priming” mechanisms. It makes good local politics (albeit. in practice. Indeed. Third. perhaps too soon. a local government unit may be strongly tempted to opt for a capital grant. capital grants at least represent one-time payments for which there is no continuing obligation beyond the duration of a particular program11. for the life of the new asset. even inappropriate. in favor of much poorer areas9. such as those in the former Soviet Empire. there are some areas or communities that have been so disadvantaged that there is little or no decent infrastructure to begin with10. there might be a strong economic or equitybased case for a net transfer of resources away from the area. A more appropriate financial support for capital expenditure would be a loan. capital grants have a distinct disadvantage. at least until revenues are greatly stabilized and enhanced. especially in foreign currency. or access to.
Some of the methods to be considered for the administration of a recurrent grant system are set out below.g. of the special needs of 8 . expansion. giving preference to areas of greatest need and with the poorest resources. projects will qualify if they meet pre-determined conditions that apply to all similar and relevant circumstances. They can also be highly selective. varying from service to service. at least. this may also need to be supplied by central or state government grants. (f) population – central government provides a lump sum per head of population. To some degree. This suggests that the central government ministry responsible for local government should try to develop an improved capability for project appraisal. Sometimes.g. Possible assessment and distribution methods for recurrent grants are: (a) budget review – central government reviews each local budget in turn. This could provide significant assistance to local government units in planning their development. which could vary among age-groups to take account. for example. assesses its credibility and provides a grant to cover all or some of any expected recurrent deficit. reconstruction and rehabilitation of infrastructure. Usually. after careful examination and appraisal of the project by central government officials. Where used. properly the primary responsibility of the central government. at present. as an alternative. Recurrent Grants However capital expenditure is financed or supported. methods must be found to provide this support. The ministry of “local government” or of “finance” should. (d) revenue compensation – central government covers losses resulting from curtailment of local revenues as a result of national policy (e. (c) reimbursement – central government effectively pays for the costs of delegated services. However. there will usually be some need for continuing support of recurrent operations. typically. staff of a "development fund" or "municipal bank"). there is a system which combines a local government’s own revenue sources with recurrent grants from state or central governments. Thus. even without grant support. (e) percentage – central government provides a percentage of the cost of local services. or those acting on their behalf (e. it must be realized that. therefore. with percentages. capital grants offer the opportunity to assist with the initial installation. attempt to build a data-base for this and many other purposes. they will almost always represent a proportion of an approved capital cost. abolition of a local tax based on incomes or the imposition of rent controls affecting property tax valuations).Thus. such as nation-wide salary increases. (b) policy support – central government undertakes to reimburse local government units for the costs of nationally mandated policies. many would need to rely upon statistical information that is simply not available or reliable.
(h) revenue potential – central government compensates for potential loss of revenue. (g) unit – central government provides a lump sum per unit of service or potential service (eg. per refuse vehicle). 9 . per patient at clinics. for example. based on property tax values or assessed incomes for graduated tax. (i) revenue sharing – government designates all or part of nationally-collected revenues (eg. with respect to education.children and the elderly. health and welfare. relative to total population and national average tax potentials. and (j) formula – a variety of factors is taken into account to provide a grant structure which meets multiple objectives. vehicle licences) to be shared among local government units. per mile of road. although only some of them may be chosen for practical use. All of these procedures are appropriate for most sets of circumstances.
information and waste products. some very beautiful. somehow. theatres. surface drainage. In a local or regional community. Even in the physical sense. constraints and opportunities inherent in any community can lead to very serious shortcomings. there are many. If social concerns are added. the much-heralded “Big Dig. directly. USA. linkages.” A local government unit. All of these infrastructures. realignment and tunneling for this. This is especially the case with capital investment programs. operating with increasing inefficiency. goods. or a small group of people. impacted by the construction. tradition and heritage of the community. water supply. one way of perceiving a community is as a giant transportation system: for people. they will be overloaded. offices. some will be destroyed or significantly altered. heritage. many. If not. Firstly. required huge expenditures for construction. ecologist and environmentalist: “When we try to focus on one thing by itself. It might be argued that almost everything in a community is concerned with transportation. must have an idea about where the community is going. schools.” for a $15 billion massive road improvement in Boston. it might be well to remember some words used by John Muir. we find it hooked to everything else in the universe. in one form or another. will need to be either developed or expanded. habits and prejudices. Every community is coming from somewhere. it can surely do better than just to prepare a list of projects that then need to be. Many of these are reflected in the buildings and other structures. electricity supply. with the actual road improvements. if there is to be reasonable communication among residents. one must also recognize that buildings will almost always have occupants. failure to visualize linkages. New buildings need new investments in roads. Indeed. if already at capacity use. What will it become? 10 . however. Change is inevitable and continuous. However. For example. so to say. public or private transport systems will be needed. some of these structures will be preserved. That is the need for vision. services. By consensus among residents and with pressures and influences from outside of the community. At least two other concerns will influence the development of a capital investment program within a community. there will be a need for shops. parks and many other developments to house or supply the goods and services needed by these people or their families. financed. Thus. sewerage. in the middle of the night. there is the history. among the various concerns. can hardly be so profound. footpaths. establishing a capital investment program. because of the large expenditures. They were.STRATEGIC PLANNING FOR CAPITAL INVESTMENT Introduction When looking at a strategy for a Capital Investment Program. It has history. Someone. realignment and compensation for objects and activities that had nothing to do. some quite ugly. Change is the motivator for the other concern. No community on earth just sprang up. traditions. and telephone services. the significant consumption of space and time and the specialist and often single-purpose nature of the assets installed. Also.
even at local level. will need to deal daily with predicaments. However. supportive. However. it can be at peace. even on a single issue. as explained later in this document. There is nothing for it to do. or of almost anything else. Finally. if a capital project cannot be financed. it may not be one with which the local government unit is willing or able to become involved. are by their nature clumsy and inefficient.How will its residents behave? What might have to be done to influence. permissive. management and service delivery. is difficult. will the potential adverse impacts on the environment be overcome. if sewerage is to be installed. Indeed. legal requirements and effective government. as a concern. helpful. even for the private parts of the service. Consequently. it cannot be implemented. It comes under its mandate and is addressed by its 11 . it might require substantial and costly modifications to the internal plumbing of residences and other buildings. will there also be enough to deal with the inevitable increase in sewage disposal requirements? If so. from a strategic perspective. benevolent. All of these concerns form a background to strategic planning. Firstly. coercive. A major constraint will be that of finance. perhaps three main reactions that can take place. These arise from the local government’s formal or informal mandate (longterm) its policies (medium-term) or its (short-term) provocations. the sewerage service will not be able to operate properly. Unless this is affordable to the owners. The mechanisms for doing this. one must examine not only whether an individual project can be financed but also whether all of the financial implications of its implementation can be efficiently coped with. Individual concerns must be tempered by sensible and efficient governance. the predicament might be quite a serious one. Consequently. is necessary. which will need to be addressed in some way by the management. the managers may decide that the provocation is the responsibility of the local government unit to deal with. Reaching consensus on a whole range of community issues often seems nearly impossible. Full and free citizen participation must be matched with constitutional rights. as a precursor to the establishment and timing of a capital investment program. There are. some understanding of the ability and willingness to pay. Each will create predicaments. as an institution. Indeed. Strategic Planning for Activity The management of a local government unit. sustain or curtail this behavior? How intrusive. This may be because it is beyond their mandate or contrary to their policy to become involved. Each will overlap and impact on the others. planning. the managers may decide that they have no concern to deal with. Secondly. officious or charitable should be the collective governance system? How reliant upon the free-market or how tolerant or corrective of market failure should it be? Reaching consensus. For example. if there is enough funding for a water supply extension.
this is similar to the distinctions drawn between outputs and outcomes. it was sometimes said that one of the first managers of the project had: “Both feet firmly planted in mid-air!” This encapsulates what is often meant by – and needed – as vision. unwilling or both. Only a strategic vision of future possibilities could have served to create the resurrection and transformation of this. However. For example. or. that it is either unable. however. ideas and concepts. Therefore. Finally. costed or held accountable for. goal or perspective. at this particular time. 12 . what a chief financial officer knows about accounting. what a public works director feels about the road maintenance program. It is. It comes under its mandate. it can be dealt with under its policy and is accepted as a concern. together with its tactical purpose. shabby storage sheds and polluted sites. Activity begins with a purpose. they are accountable for their activity: signing a contract for a water supply system. In some respects. the local government’s management may decide that the provocation creates a predicament that the local government will address. Therefore. the purpose should indicate what it is that the activity. repairing potholes and other road damage. incorporating activitybased budgeting and costing. both in tactical and strategic terms. as it has done substantially to date. the outcomes that relate to the visions of those with the wider views on policies. In other words. however profound. publishing a set of financial statements.policy. It may decide. From a strategic perspective. it must follow that there will be activity. it is doubtful whether this could have been achieved just by any number of tactical activities. to address it as a concern. Usually. for a variety of reasons. From a tactical perspective. For example. If an activity has no purpose. Thoughts. what they will be held accountable for is what they do about these concerns. rusting ship-hulks. The Vision Outputs achieve tactical purposes. only activity can be budgeted. do not find directly find places in the financial interpretations of activity. money spent on it cannot be justified. Outcomes achieve strategic purposes. it might be very interesting to know: what the mayor of a city thinks about a new water supply system. The purpose should be carefully defined. Its managers were faced with a ramshackle and moribund collection of derelict buildings. the purpose should indicate clearly and directly how the particular activity is expected to achieve it. it is relatively meaningless. or. typically. at this time. the only phenomenon that operators and managers can be held accountable is activity. for the London Docklands Development to have succeeded. Under the concepts of activity-based management. Under the principles of activity-based management. It therefore remains a problem and the people involved or affected by it will continue to suffer. however well-coordinated. is expected to contribute to the wider vision.
then thoughts and ideas. Predicaments engender responses. to deal with a specific predicament or concern. Concurrently. Finally.Purposes. Then there may be intellectual and physical work on project implementation. There are many stakeholders and all will expect to be considered. It is. the unit of activity which can be implemented. This will need to link up to predictions about the movements and demography of people. Much of this will be directed towards economic efficiency. Different modes of operation will apply in different circumstances. Eventually. It is very hard to keep up with this phenomenon. As already indicated. however. there is a need to keep abreast of evolving technologies. Strategically. For example. The latter is often confined to a single site or project area. Unfortunately. the strategic implications. project implementation will hardly ever run smoothly. a project to deliver additional electricity will confine its construction activity to the project site and to any new transmission facilities. With capital development projects. This. are virtually certain to encounter obstacles. Design and implementation of a capital project will need to take account of its ultimate operations. Tactical Planning for Activity In the language of Capital Investment Programs. programs and budgets. as well as the operational impacts. Instead. however. whether inside or outside of the primary activity. a response to a predicament must be in the form of activity. environmental concerns. maintenance facilities. new fuels. They could be perceived of in shorter-term time packages. it will be integrated within the entire system of electricity delivery. again. be implemented over a five to ten year time frame. Assessments need to be made about the time-span of the activities and also their spatial coverage. it is typically bounded by time. and. planning will need to be looking far ahead of the present. rather than programs of operational activities. However. These will often begin with feelings. The first activities will likely be plans. With respect to efficiency of operations. one is often talking about long time spans. needs to be both tactical and strategic in outlook. could cover much wider spatial dimensions. transport facilities. These may be 13 . These must be organized to work efficiently. however well-planned or well-executed. raw materials. however. budgeted and costed. perhaps linked to much longer strategic time-frames. resources must be assembled. The activities. an activity is often referred to as a project. it will be necessary to examine the motivations and incentives of those involved. space and tactical purpose. the supply of electricity will be perceived of in yearly or other relatively short-term time packages. with fairly narrow spatial coverage. When completed. In modern times. It may well. to identify new sites. especially with respect to the prices and availability of (say): trained workers. the operation and maintenance of the project will not be so isolated. however. some technological changes are unfolding with breathtaking speed. growth of new areas and many other considerations. Outputs and Outcomes When purposes have been established. as well as about the operations of a variety of related activities.
Each new situation. All must be resolved and the funds to do this should have been allowed for. so that the activity can continue and the purpose achieved. a great deal of time. Hidden blockages may appear under the ground or in the office! Explosions may occur when blasting out rocks or blasting out people. moreover. until the project is again brought into equilibrium or is finally completed. money ad frustration. Each of these will have financial and operational implications. 14 . therefore. This can absorb. Sometimes. have many implications involving decisions. Each will have its own new set of tactical.political. will become a new predicament. This will usually have even larger financial and operational implications. Activities. technical. major tactics and even entire strategies will need to be revised. sometimes. financial or of many other kinds. strategic and other concerns. They may be as often administrative as physical. energy. They will all need to be mitigated or resolved.
as is common.FINANCING OF PUBLIC SECTOR INFRASTRUCTURE Overall Financial Requirements 00000000From the overall perspective of various entities dealing with public utilities and infrastructure. 12 It is often just as financially imprudent to finance long-life assets from short-term loans as to borrow for too long a period. This will apply to the funding of ongoing public services as well as to capital investment. These. This may preempt more important and urgent recurrent expenditures. if more creative options are not available. to the working lives of the assets to be financed and to their ability to efficiently deliver the future benefit flows12. sale or grant of concessions for publicly owned land. It creates additional burdens on current finances. it is likely that some attractive packages can be arranged. Where cities are. sites formerly used for other purposes. electricity and water supply services often operate under policies dominated by public welfare considerations. permanent works and equipment. Because short-term financing is often more readily available than that for longer terms. current budgets of municipal governments must often provide for heavy annual subsidies of these. subsequent operation and maintenance will likely require significant annual subsidies. Where underground rapid-rail systems are planned or under construction. with both local and foreign investors. In particular. will need to be cleared and then made environmentally safe. but inevitable unless the loans can be rolled over or refinanced. future demands on public financial resources will be formidable. it creates a great temptation for municipal governments to rely upon it too heavily. in exchange for private sector financing of public infrastructure. located astride rivers. gas. as closely as possible. long-term borrowing should be confined to the financing of investment in land. capital-financing requirements will be huge. maintenance and capital-cost recovery. These basic principles may be summarized as follows: a. As a result. buildings. Moreover. Indeed. there may be considerable potential to use leasing. too. not justified by the longer utilization of the assets. Often. prices are inadequate to cover operation. it is clear that in many situations. Underground piping is also old and worn. The development of new residential and commercial areas typically demands large inputs of primary infrastructure. 15 . in many situations. however. especially industrial ones. It should. be cautioned that the search for innovative financing options should not overshadow the need to apply some well-known and commonly used principles. intended to provide a future flow of benefit to the community. borrowing periods should be related. valid in most situations in the world. For example. there is also need for substantial upgrading of river crossing facilities. Thus. b. drainage and sewerage systems are totally inadequate to deal with even the current needs of residents. must be the inevitable fallback positions. streetcar. world wide. road-space. Bus. Basic Capital Financing Principles The search for alternative financing of public services and infrastructure should clearly explore possible new approaches.
on an annual basis. Public Sector Institutions Based on institutional performance in many places. such as capital grants and donations. Furthermore. and. as in the case of publicly owned utility corporations. the various revenues used to bring the recurrent budgets into balance must exclude revenues from sales of land and other public assets. the United Kingdom central government credited the proceeds of its privatization activities to its recurrent budget. This practice was severely criticized by many public sector financial specialists. 16 . It is important to note. They concern: financial markets. institutional structure. First." This is frequently referred to in discussions about the restructuring of state owned enterprises. that the establishment of a corporate structure for wholly or partially autonomous operations is not necessarily consistent with the concept of the private "joint stock company. in the "Western" system. by the national or municipal government. These funds flows are of a "windfall" nature. as in the case of so-called "preference shares. of a specific set of concerns to be addressed by each individual entity. together with all interest. They should. holdings by minority stockholders may endow them with only nominal (legal) ownership. ownership. if there is really no intention to give effective ownership to investors. from either taxes or user charges. capitalization from financial markets does not necessarily provide for effective ownership. a circular set of discontinuities can be perceived. the issue of different classes of stock may result in the trade-off of decision-making power for security. d. with no effective control or management. Instead.c. The options often postulate some form of corporate structure. all expenditures relating to the current delivery of public services. within the working lives of the assets financed. 13 By contrast. and. This has one important advantage. Thus. maintenance and debt service on fixed assets should be met. including operation. thus. control and management. it is possible to postulate a number of options for service delivery entities. They must also exclude other one-time financial inflows. rather than stocks (ownership). however. Such capitalization may come from bonds (lending). within the jurisdiction of a municipal government. public utility consumer contributions and receipts from the disposal of public enterprises to commercial interests. be reserved for capital expenditures13. It allows the setting." Finally. long-term loans should be fully repaid. it can be held accountable for both financial stewardship and operational performance. The distinctions among them largely relate to the extent to which the services provided will be (wholly or partly) directly revenue seeking or tax-borne. virtually all capitalization is from bond issues. 0It follows that municipal governments and public utilities must continuously operate within the framework of a balanced recurrent budget. to some degree separate from the overall administration of the municipal government. Against these. The formulation of a corporate structure for each set of objectives offers the opportunity that the activity of each autonomous entity will be substantially immune from the likely changing political agendas of the core governance function. Furthermore. from stable and growing sources of local revenue.
with no private stockholdings and no intention to create them. some of these have been collectively designated as: “quasiautonomous national government organizations” (QUANGOs). Policies of institutional restructuring should be evaluated not only with regard to a set of given objectives but also in terms of how those objectives might be achieved in alternative ways. it is virtually impossible for the stockholders. as a group. In the UK. to be wholly financed from direct government loans or grants. For example. there are many other forms of delegation to individual entities. in turn. not to regard "privatization" as a panacea. for the delivery of public services. for example. artifact. In the public sector. the "equity interest" of the government is often merely a formal. “quasi-autonomous local government organizations” (QUALGOs). This function must be delegated to a board. whereas the personal goals of the chief executive – especially if not a substantial stockholder – may concern benefits. gas and solid waste management). This is particularly true when dealing with activities that are considered as "natural monopolies. offers a range of options which might be substantially different from what is commonly now known as "privatization. The related demise of the accounting firm." Some might involve corporate structures. it should be regarded as one of the tools. a financially autonomous corporate structure may not necessarily imply the use of capitalmarket financing. hospitals or colleges) to wholly owned government corporations. Among the most notorious have been Enron. to manage the day-to-day affairs of the corporation. This has been dramatically illustrated by the disgraceful (and illegal) behavior of some US companies delivering “public utility” services (electricity. where the public interest is present. legal ownership. power. imply effective control or management14. because it most certainly is not. within publicly-owned autonomous corporations. Neither the board nor the managers necessarily have identical agendas to those of the (stockholder) owners15. therefore. Instead. be dominated by the chief executive and managers.Second. albeit it an important and powerful one. control and "perks. telephones. of either operations or prices. as with London Docklands Development. autonomous control or management need not necessarily imply the use of a corporate structure – and certainly not in the "joint-stock" form. through stockholding. state or national government. the establishment of financially autonomous entities. WorldCom and Waste Management Inc. These may range from the establishment of quasiindependent government departments or operational units (such as schools. Thus. therefore. which may. It is appropriate. Apart from the potential ineffectiveness of minority stockholders. In summary. Finally. for fulfilling the political and operational objectives of a local. some not. Arthur Andersen is well-known to all! 17 ." Furthermore. legal. It is quite common for public assets. the principal goal of the stockholders may be that of profit. 14 15 There is a great deal of literature on the economics of the “principal-agent” situation. and “arms-length management organizations” (ALMOs)." Third. does not necessarily. the pure profitseeking motive of the stockholders may be significantly over-ridden by regulation.
Whether or not this is always shared by workers. Furthermore. This could apply to both core governance activities. it may well create unacceptable quality for the lower prices. which it then chose to abuse. There may also be increased “economic externalities. This. For example. to less-skilled staff. on equal terms. necessary for the commercial enterprise to earn profits – otherwise. to ensure fair competition. where a quasi-monopolist bids for individual small packages of work. because under certain conditions. This is loss-leading: under-pricing the initial bid – to gain a foothold – by using financial support from the bidder’s other operations There are other factors. the savings and profits come about as a result of improvements in labor productivity. these would. It would also inhibit the return of the service to a restructured and more efficient local government unit. Much is currently written about the merits of competition. is often one of the more contentious issues. own all the essential vehicles. For such a system to work consistently. opportunities must be present for the public sector to save on costs – otherwise there would be no incentive to "contract out. after being formed into quasi-independent "direct service organizations. This would inhibit competition." An essential feature of such re-structured units is the establishment of costaccounting systems that are consistent with those of outside contracting entities. if the garbage-collection service were to be fully "contracted-out" by (say) a municipal government to a single – or very few – commercial enterprises. The importance to a commercial enterprise of consistently winning the 16 17 Conditions normally acceptable for efficient contracting-out of services are listed in Annex 2. in competition with one another. in collusion with its auditors (Arthur Andersen). plant and disposal sites. it must result in improved productivity in service delivery – in the sense of more service for lower unit cost. after a short time.” 18 Indeed. delivering a lower standard of service to the public. for such services to be provided by enterprises outside of the direct control of a public entity. 18 . Many activities offer opportunities for contracting. by presenting falsified financial statements. This is not a panacea either. as well as those provided by autonomous enterprises. there would be no incentive to tender. especially by preempting the public sector's ownership of essential equipment. This arrangement often leads to the "internal" entities actually winning and performing the contracts but with the added advantage of doing this under competitive conditions 17. There is no shortage of examples of "contracting-out" where major "savings" to the contractor have been as a result of paying lower wages. For example. Thus. it is often most useful to divide work in such a way that it can be delivered by several commercial enterprises. Often. Waste Management Inc. A very well-known technique is possible. It is usually appropriate for "contracting out" to be approached gradually.Contracting-Out of Public Services16 There is an alternative to the delivery of all services by the employment of direct labor by public sector institutions. by open competition. leaving the enterprises with a significant tendering advantage18. there is a greater potential for a single commercial contractor to develop monopoly power of its own. this has already occurred. The normal "Western" practice would be to allow the public sector "direct service" units to participate in the tendering. in terms of improved benefits." It is. it can do by gradually developing an incumbency position. has gained a significant foothold in the industry. with very few “fringe” benefits. by other competent contractors. also. If this is not done.
Indeed. The result could be the shifting of most of the cost-saving advantages away from the public sector. they may be illegal." This postulates that the advantages of obtaining a complete or partial monopoly on the delivery of public services makes it seem advantageous for potential contractors to employ lobbying and other methods of influence. there will be an ever more urgent need for them to be accurately and appropriately accounted for. is that referred to as "directly unproductive profit-seeking. to those who win – as well as to those who fail to win – a particular contract. These are not all. gradually and by experience. Instead. the enforcement of either financial penalties or performance obligations against recalcitrant contractors often proves costly. at further public cost. after deducting losses which might be suffered by (say) direct public employees. as private finance gets repaid while the public sector carries the extra cost of keeping services going and communities suffer. The employment of many individual contractors will pose different management concerns to the service delivery entity than those for its direct labor.” 19 . As the learning process results in improved managerial productivity. if an increasing number of contracts are entered into." often overlooked. there might be a shift of money to the lawyers. or always. contentious and ineffective20. the overall administrative costs will. An additional cost. 2004). or else allow the public to suffer the inevitable shortcomings. lobbyists. with "contracting out" the public entity often cannot divest itself of the ultimate responsibility for efficient public service delivery. administrative costs of "contracting out" will gradually fall. see: Allyson Pollock and David Price “The public pays the price when contractors pull out of projects” (© The Guardian. it will retain the risk that it will receive less than adequate service from its paid contractor. in assessing the net benefits from the use of contracting. Furthermore. It includes the words: “The idea that PFI is a partnership between government and business looks a hollow joke. etc. One important cost of "contracting out. The means to address these concerns need to be learned. is that of contract administration. This contrasts to original expectations of the "contracting-out" arrangements. the net benefits will arise only after all contract administration costs are fully allowed for. it will either have to remedy. rise. In "Western" systems. 19 This shift arises because there could be less real direct economic gain to the municipality and its public. would result in greater net benefits to the local public. Thus.contract could make it vulnerable to "trade union" type pressures from its own work-force. who would then reap the related economic benefits. However. clearly. their expenses may represent a dilution19 of the intended tangible gain to the public by shifting some of the net benefit elsewhere in the economy. whereby direct economic gains to contractors. into the pockets of either workers or commercial enterprise shareholders. As these costs. ethical. overall. This. Furthermore. sometimes claimed in economic writings. Mafia organizations. become material. These have social costs in themselves. Thus. the extra administration costs must clearly be offset against the direct productivity savings in service delivery. Tuesday July 27. nothing can compel the private sector to ensure continuity of provision while government-backed compensation arrangements ensure that profits can be earned at little or no risk to investors. time-consuming. Finally. For all the political brouhaha about partnership. 20 For more on this.
it could manage such a fund. the "Director of Finance" will need to take a leading role in advising on the allocation of loan resources and on providing guarantees of loans raised by or for the various entities. however. Public Borrowing .Control and Allocation Whatever other financing methods are used. they have followed the traditional British practice of being appointed from among what are sometimes termed “the great and the good’ of British society. in the UK for example. For a particular entity. for new rapid-rail transportation systems. especially new capital expenditures. through which to channel all or most of its public borrowing. among managements and boards of directors. whose boards have NOT been elected. They should do so. in addition to other activities and obligations. This would be in exchange for obligations to service the principal and interest obligations. this obligation would need to be undertaken in close consultation with the Director of Finance. for example. Such a fund would raise all public debt for the governmental. it may well be necessary for central governments to establish or adapt a centralized financing entity. It applies whether these revenues are used to finance the direct governmental functions of the municipality or – absent any ability or willingness to cover costs from charges – as increases in public utility subsidies. knighthoods and peerages abound! 20 . not as seeking a panacea but with a prudent balancing of productivity improvements against risks. much public expenditure is now controlled by organizations such as the QUALGOs and QUANGOs. This will demand that attention be given. therefore. by resolution. so as to lend to the various municipalities or operational entities. safeguards and administrative costs. Often. This could be especially burdensome. This is of crucial importance when the borrowing is for services that will be wholly or mainly financed from general revenues. public entities should exploit opportunities for alternative methods in the delivery of services and the performance of public activities. it is a fundamental principle of democracy that only an elected council or board21 may approve. Prudent financial management predicates that all public sector borrowing. It would then re-package this debt. Pending the establishment of efficient and effective financial markets. for whatever purpose and by whatever subsidiary public entity. Thus. on whatever terms and conditions were available in the market place. For example. to suitable systems of control and regulation of borrowing. Moreover. 21 Sadly. from either operational revenues or budgetary allocations. the financial resource requirements for public utilities and infrastructure will require significant borrowing." or "Capital Fund. Thus. there might be the establishment of (say) a "Public Works Investment Corporation. utility and infrastructure functions of the local governments. at the highest level of any municipal or other public sector entity.In summary. including taxes. throughout the entire financial management domain under its control." This could well be designed to function as a "Consolidated Loans Fund. be brought firmly under the control of the central financial management function of the entity. to ensure that long-term charges on general revenues be given priority over new expenditures." Alternatively. the raising of loans by a local government entity.
There are now many situations where nations and communities are emerging from "planned" to "market" economies. For them, an important feature in re-structuring the debt-management function of the municipalities or public utilities will be a shift of emphasis from an "allocative" approach to a "contractual" one. Lenders, in the public market place, must be assured that their debt service entitlements will be met in full and on time. Public service entities, in turn, must be aware that they will be held ruthlessly accountable, from their annual budgets, for the full allocation of debt service obligations, either directly or through a "Consolidated Loans Fund." Indeed, such a debt-management approach will require that all parties view their debt obligations as virtually "not negotiable." To facilitate the allocation of borrowing and other capital-financing resources against priority projects, it would be necessary to establish a centralized project appraisal capability. This could well be formed as part of (or as an adjunct to) the "Public Works Investment Corporation." It will need to use criteria which will be established in consultation with (or prescribed by) the national Ministry of Finance. Indeed, even though the borrowing and appraisal activities may be carried out within the Investment Corporation, it will be important for the Ministry of Finance to exercise a meaningful oversight and audit function. This accords with its overall responsibility for the allocation of public funds, through the budgetary process. It also allows the Ministry of Finance to fulfill its role as a macro-economic manager of the nation’s resources. Although the appraisal of capital projects will require guidance, direction and monitoring from the center, the primary responsibility should gradually be delegated to the entities most directly responsible. The process will then form part of the overall planning, programming and budgeting capability, which each service-delivery unit should develop for itself. Public Borrowing – Foreign Exchange Requirements In many countries, some of the capital financing requirements will need to be raised in foreign currency. These will likely be for the importation of foreign goods and services. However, if a community's domestic resources are inadequate to meet its infrastructure needs, it may be that part of its future borrowing – or its equity financing – even for locally procured goods and services, will come from foreign sources. In either case, a community's contractual obligations, with respect to its debt service, will extend to the foreign exchange requirements. In particular, if the value of the local currency deteriorates against the foreign currency of any loan, more local currency will be required to finance the debt service. Public sector activities will likely make significant indirect contributions to the earning of foreign exchange. For example, infrastructure improvements will facilitate both foreign trade and tourism. However, in practice, these activities will not generate foreign exchange directly. Thus, it will be necessary for the debt servicing entities to have access to foreign exchange earnings of the commercial sector. This will either be by contracts with commercial enterprises or – more likely – through the national banking system.
Public Borrowing – Financial Markets To ensure the most economical raising and use of public funds for infrastructure development, it will be necessary for financial markets to develop and sustain a significant capacity for the raising of funds. A large proportion of this funding will likely be in the form of bonds, rather than equity, consistent with the likely wish of many public sector entities to retain effective ownership in the hands of government. A most important feature to develop in the financial market, for both public sector and commercial financing, is that of trust. Investors must develop confidence that borrowing entities have the competence, sincerity and reliability to service their debts. This means that the financial market place must be provided with reliable information, which can be so assessed by independent bodies. These will comprise the regulators of the financial markets, as well as those with a fiduciary duty to the investing public, such as auditors, underwriters, issuing houses and rating agencies. Such bodies, where not already existing in adequate form, will need to be established, upgraded or improved. As already indicated, the sums needed to finance the services and infrastructure of many communities are formidable. Thus, the development of the quality of the administrative management of the financial market place will need to be matched by an adequate expansion and sustainability of its capacity to raise the required sums of capital. Investment Financing – The Competitive Environment Competition for investment capital will largely be based on perceived risk and return. For public sector bond issues, this will depend upon the interest rate, combined with the reliability and quality of the expected revenue earnings. These, in turn, will be based on either the expected operational and financial performance of the borrowing entity or the underlying strength of the local (municipal) taxing structure. Thus, sound pricing and taxing systems will be essential, in the promotion of bonds and other capital financing instruments. Also, there will be competition for funds from commercial activities. This may be significantly oriented towards equities. Moreover, for potential private investors in emerging economies, it might well be that their interests will lie more towards the opportunity for making fast profits than for longer-term goals. This situation may be reinforced by the fact that, under currently sustained social safety nets, investors will perceive that their basic long-term needs are provided for22. Discretionary funds may therefore be more willingly channeled into "glamour" security issues, albeit for more fickle purposes than for development of infrastructure. The latter, by contrast, may be considered, in the short term, dull and uninteresting as backing for security issues. Also, the commercial market place will not always provide more economically efficient alternatives to public sector activity 23. It is, unfortunately, highly speculative. The combination of empty offices and deteriorating public infrastructure in (say) the U.K. and U.S.A. is a current testimony to this, especially when there is so much consumer
This has a parallel in the U.S.A. There, it is claimed, federal insurance of the funds of depositors of "savings and loan associations" permitted a degree of public indifference towards reckless use of such funds by their unscrupulous or incompetent managements. 23 A significant market failure in this respect is that quicker private profits may often bring much higher investment returns than the more slow and ponderous – but eventually more enduring – public infrastructure improvements.
spending on trivial distraction, entertainment and amusement It may well be important, therefore, for national and local governments to embark upon programs of public education, to encourage potential investors to channel funds towards public utilities and infrastructure. The costs of such a campaign might well be offset by the refinement of interest rates for public borrowing and the greater availability of funding. Both will bring net economic benefits. It is equally important to note that, in a market-friendly environment, the allocation of investment resources will be through investor perceptions of risk and return. Failure to recognize this, resulting in a return to a process of political allocation, will result in long-term economic inefficiency and a significant reversal of any economic reform principles. Resource Mobilization Competition for funds will not be only among opportunities for investment. As nations and communities move further towards a commercial environment, investment demands will compete against consumption opportunities, for both commercial and publicly provided goods and services. This may be all the more pervasive as an emancipated public seeks for immediate satisfactions, in the form of increased enjoyment and reduced suffering – of both inconvenience and privation. These attitudes, combined with the availability of savings, will determine how much funding is available for the different claims of public, commercial and private sectors. An important aspect of resource mobilization, as well as mitigating demands on general public revenues, will be through the use, where possible and appropriate, of economic efficiency prices, such as for public utility services. An essential part of any public information system will be to encourage the economic signals to be given by prices. In other words, a most effective way to get the attention of the public will be to charge full prices for services. The only significant opportunity for coercion, in these circumstances, is that common in all market or controlled economies – adjustment in the level of taxes. Local taxes will need to be set high enough to cover all recurrent public expenditures, including the service of debt. Chosen levels, of taxes and charges, will have political and economic limits on the public capacity to bear them. This will also affect the level of capital investment. Public Sector Financial Management The economic reforms undertaken in many countries, especially those of Eastern Europe, will likely lead to: a. b. c. d. a tightening of the allocative process; a need for fuller public information to support investment financing; increased importance of financial reporting, accountability and control; and, greater participation by citizens in the conduct of public affairs.
to facilitate both accounting for their managements and overall fulfillment of reporting requirements. 24 . more is required. accounting. In organizations of the size and diversity of large municipal governments. as used elsewhere. for all public sector activities.0These will require much greater attention to financial management. A key factor is to introduce a budgetary system that separates capital expenditure (and its financing) from recurrent revenues and expenditures. The introduction and development of appropriate technology should be encouraged everywhere. this has proven to be far too long for economic operation.S. many assets. Providing for improvements in overall accounting and financial management systems will be necessary ingredients in a more transparent and open system of accountability for stewardship of funds and performance of activities. budgeting and financial control practices will all require enhancement. throughout the governmental and operational entities of all communities. It will be important that a director of finance provide guidance. however. this is clearly inappropriate and inadvisable. Japan and Western Europe. For example. Directors of finance must also concentrate on development of management accounting information. training programs of finance department officials should include secondment to operational units. requires the development of appropriately standardized procedures that are still flexible enough to allow for the individual operating characteristics of the different entities. To achieve this. through the use of high technology equipment. instruction. This does not necessarily imply a centralized accounting or financial information system. Often. The use of management accounting will also provide information about the use of appropriate technology. Introduction of life cycle costing would draw attention to a need to scrap or dispose of assets when their continued use is no longer economic. However. so that their managements may make better-informed decisions24.A. What it does imply. Also. support." Currently. there is no assurance that the same blend of capital and labor. in a decentralized system. One feature of management accounting for decision-making is the use of "life-cycle-costing. Jones (© Chartered Institute of Public Finance and Accountancy (UK) and World Bank – 1982).. whether providing revenue-seeking or tax-borne services. such as buses and other operational vehicles. will automatically be the best for a particular country or – more specifically – for an individual local community. typically because of high repair costs in later years. Thus. to the municipality and its public. 24 A comprehensive textbook on these various aspects of accountability is "Municipal Accounting for Developing Countries" by David C. is that finance departments retain and enhance their capability to hold the operational units fully accountable to the community as a whole. are required to be used for life spans determined by governmental edict. auditing. training and some degree of control to operational units. one can often be impressed by laborsaving achievements observed in (say) U. It should be a responsibility of the finance department to organize and arrange flows of financial and other information to the operational units. However.
To the extent that either publicly owned or commercial enterprises are in a position to charge 25 . spatial. for example. The situation is different where the direct recipient of the service is not assessed as the sole. commercial. In general. welfare or financial hardship. If care is not taken. on grounds of economics. Where used.will be "locked into" over significant time-periods. however. or principal. Where claims are made for subsidy. the perfect is the enemy of the good. even in this case. with respect to the diversion of road congestion. it is often because the individual consumers cannot readily be identified. maintenance. however. in the administration of "means tests. This would include debt-service and unavoidable subsidy obligations. public utility companies should set charges which are intended to cover operation. These should be consistent with full-cost recovery of economic resources and coverage of all financial requirements. for these procedures to reflect the predicted economic. uncertainties or resentments in directing them to individuals. should be encouraged to charge economic efficiency prices. They should. wherever possible. all such entities. population and social changes. Attention must also be paid to financial commitments that a municipal government . still very contentious. physical. Thus. to rapid rail systems. the overall subsidy of service delivery systems is vastly more inefficient than the individual subsidy of deserving consumers.Planning. there can often be serious disagreement about the extent and amounts of subsidies. programming and budgeting of their activities. This may apply. It is important. especially significant growth or decline. a poorly directed subsidy may merely mean that the more profligate (and likely better off) consumers will (at standard unit prices) receive the highest cash subsidies. It is. depreciation (at current values) and a real return on assets. including the overall management of debt. be allowed only where fully justified and can be implemented in an efficient manner. even when there is broad agreement on the economic principles. valued in current prices. Sometimes. accident risk and air pollution. within the framework of an overall performance budgeting approach. The principal justification for subsidies to entities lies in cases where there are high transaction costs. Moreover. at least in the short term. Public Utility Pricing and Subsidy Some public utilities operate as natural monopolies. for example. evaluated and compensated. and limiting demands upon scarce general revenues. fiscal. This is an argument sometimes applied. The entities should also be required to generate funds from operations to cover debt service and to contribute towards expansion of facilities and plant. Programming and Budgeting Governmental and operational entities should be encouraged in the use of appropriate procedures for planning. To optimize the economic efficiency of their operations. these should be carefully evaluated. in principle. Moreover. because of administrative costs." This concern applies to both economic efficiency and equity considerations. beneficiary.or any of its entities . Arrangements are also required for both tactical and strategic cash management. the service characteristics should be conducive to a reasonable assurance that targeted consumers are most likely to benefit.
the more savings accrue to the public sector. contracts can be made with developers to provide a part of the sales price in the form of infrastructure. control or management of substantial public land." Property taxes may then not be collected for several years into the future. it may well be found that the role of an independent regulator must be to ensure that prices are set at levels which are high enough to fully cover costs. It will kill the goose that lays the golden eggs! Thus. For direct funding purposes. 26 . to encourage developers to risk new activities on the land. for the developer's own benefit. its initial value is very low. as well as having no public facilities and infrastructure suitable for new development. 26 Even these may be curtailed or postponed if the land is part of an "enterprise zone. such land will be subject to activity based on commercial valuations.monopoly prices. can be used for related infrastructure costs. This can be exploited in a variety of ways. after holding public hearings on all applications for price adjustments. In addition. in terms of the opportunity costs (or benefits) of its acquisition or disposal. such as a river bridge or a metro station. Cash proceeds not immediately used for development should be reserved for future capital expenditures. As indicated. there are notable savings in the transaction costs of land acquisitions. or financing opportunities. with the majority of required land in private ownership. not required for municipal purposes. A feature of the final disposal of land – whether in exchange for infrastructure or not – is that it represents the disposal of claims to future revenues from this land. As alternatives to receiving all sales revenues in cash. Land Management A major asset. The more that public land increases in value25. as well as to ensure that legitimate equity considerations are dealt with fairly. These should have the power to over-ride both the political agendas of government and also the pure profit-seeking agendas of the enterprises. it will be important for them to be properly evaluated and accounted for. Sometimes. In such a case. it becomes possible for a developer to accept a parcel of land. Thus. available to many developing cities. over situations found elsewhere. many witnesses seeking to be heard at such public hearings are less likely to be in favor of socio-economic-efficiency pricing than in imposing their private agendas. especially where this might otherwise involve compulsory purchase. The rest of the land can then be used for commercial facilities. receipts from the sales of public land. at no cash cost. such one-time sales or exchanges should not be regarded as recurrent revenues. Often. in exchange for the construction of the entire public infrastructure. much of the land required for infrastructure development may already be in public hands. However. is the ownership. Increasingly. This results in significant potential savings. This is another reason for careful matching of budgetary requirements to overall 25 This is particularly important where such public land is derived from abandoned or curtailed activities. it has become derelict and unattractive. Prime development land is sometimes located in the vicinity of significant public infrastructure. the prudence of land disposal – and of its extent and timing – will be influenced by the financial needs of the local government and its entities. Thus. or those of their interest groups. for the purpose of financing infrastructure. there should be provision for the regulation of such prices by independent national or local government agencies. Where such exchanges take place. with the exception of property taxes26. Examples occur where land occupied by railway yards. shipping or military interests is no longer needed for its earlier purpose.
27 . In addition. This is not. authorities have had. it will. the local government or development authority may sell land. is to militate against distortions within the allocative process of the public sector. of course. it can be subject to property tax. for example. This would represent a partial gift to the purchaser. effectively.A. usually. What the taxing of public facilities does achieve. For example. by retaining them within the public domain. until recently. this might be accompanied by a requirement that the owner (user) provide some degree of public facilities. to bring in additional revenue. are fixed on a "once for all" basis. In such case. however. Where the local government (or a development authority) has the power to grant planning (zoning) permission over privately-owned or rented land. however. as a condition of being granted planning permission. will be available to the general (recurrent) revenue pool to finance debt service. very limited scope to secure developer contributions for infrastructure. Environmental Accounting Increasingly. it will prevent hidden subsidies to (say) public utility enterprises that own substantial real property. taxation of public facilities will indicate the extent to which revenue is being foregone. with planning permission already included in the price. it is important for the seller and the purchaser to be certain whether or not this is the case.. To avoid disputes. will do just that. This cannot. who is. The "Planning and Compensation Act 1991" changed that position dramatically. The extent of this will be facilitated or curtailed. an excessive demand. by regulations regarding building height. developers typically make offers to provide public facilities. causing a potential loss to the developer. This may arise from technologically inefficient operation of current service delivery. First. then known as a "proffer." In Britain. Finally.development activity. An important point is that as future real land values increase. if a sewage treatment works is operating without 27 This is known. to cover such taxes. Developers can now be made to bear the costs of infrastructure and community facilities. In particular. in exchange for the valuable (monopoly) development right27. In the absence of a fully developed land-price information system. of course. although the setting of public utility prices. Sale prices. be pressed too far. An example would be the air rights over a "metro" or mainline station entrance. by contrast. Second. These rights can. rents – in real terms – can be adjusted to allow for this. in the U. when land is in the hands of commercial enterprises or is privately owned. continue to yield rents to its public sector landlord. as an "exaction. either on the land alone or also on improvements. be leased to developers to help cover the costs (or related debt service) on the principal facilities. along with other revenues. Where land is not disposed of by final sale. purchasing the present value of all future real land rents. it will become necessary to provide in the accounts of public entities for potential costs to remedy current environmental degradation. it might well be found that early disposal of land is – in real terms – under-priced. a municipality (or one of its entities) will own land rights in connection with the operation of public facilities. These. Even land owned by public sector entities should be subject to tax. state or local law forbids this." Sometimes. In some cases. will cause a backing away from the whole enterprise.S.
producing adequate effluent quality or disposal of sludge. this may create costs to be incurred in the future. 28 .
efficiency and effectiveness in the delivery of public services. mobilization of resources for both recurrent and capital expenditures. including privatization. as contrasted with specific activities or reorganizations. administrative. However. should be evaluated not only with regard to a set of given objectives but also in terms of how those objectives might be achieved in alternative ways. recoveries of full costs of service from direct users. use of "market-friendly" approaches in the procurement of the factors of production. policies of institutional reform and restructuring. financial and operational reform must often be undertaken. improvement and consolidation of debt management. f. or principally. Necessary Improvements The means to achieve economic development and reform do not necessarily.To the extent that these are only delayed – but eventually inevitable – they resemble future "debt service" on current "borrowing. identification. the conversion of (say) a municipal water company from a publicly owned corporation to a commercially owned one may be less important than a rationalization of its pricing structure. institutional change might not be necessary. introduction and use of appropriate technology. In this particular case. g. d. Tightening of environmental standards will – as a direct outcome – increase the costs of such ecological borrowing. However. agencies. will be virtually identical. b. the future resource demands. where appropriate and feasible. by economic efficiency pricing. many of the activities to be undertaken by the municipal governments or development authorities will have to be coordinated with many departments. c. in the form of goods and services. If the latter can be achieved under public ownership. economy. In addressing overall goals of reform. i. appropriate or desirable." Another example would be future closing costs of currently operating garbage disposal sites. exploitation and implementation of alternative methods of infrastructure financing. Furthermore. bureaus and commissions of a central or state government. For example. limitation of otherwise unconstrained demands upon the general revenues of the 29 . e. rather than financial. it is ecological. the public authorities should not use this further opportunity for reflection as merely a means to validate current practices or excuse itself from the need to take effective actions. from either charges or taxes. A great deal of institutional. h. borrowing. Indeed. overall management and administrative efficiency. lie in the restructuring of institutions. the following should rank as among the most important: a.
as much of the activity under the control of public entities is clearly concerned with government and public service delivery. consistent with optimal accountability for both stewardship of resources and performance of activities.public budgets. 0 Finally. 30 . j. and. maximization of the operational autonomy of entities. it is essential that their activities be (and be seen to be) consistent with the prevailing political agenda.
ECONOMIC AND SOCIAL IMPACTS ON LOCAL COMMUNITIES Community Balance Of Payments (1) Within the overall national and international economy. together with a discouraged and increasingly disadvantaged populace28. (a) tourism within the community by non-residents. indeed virtually impossible. refined or discarded. If neither of these occur to a sufficient extent. (c) investment earnings by community residents (including rents) from financial markets and assets elsewhere. The balance of payments is an assessment of the net flow of funds . This can be done only if all the principal flows are examined. it should be possible to assess (or at least to intelligently speculate) some of the local "balance of payments" effects. Commercial activity will bring inflows of funds to a community (from community non-residents) as a result of: (a)external work locations. The oft-perceived. It is made more difficult. They are not. such as the local government unit or a particular bank. the community's economic and social structure will deteriorate. They can then be used. depending on their reliability and the concerns to be addressed. for each development decision or strategy. remedy is the creation of more job opportunities for the local populace. (b) remitted earnings from outside the community. and. (b) local taxes. however. However. a local community must either sustain itself from its own production and exchange of satisfactions or else be supported by transfers from elsewhere. because economic data gathering does not normally encompass a detailed analysis of this type. usually governmental. and governmental activity.if it could be measured – for all community transactions with the outside economy. by the concern of making distinctions as to what constitutes a community 29. This can be sustained.FINANCIAL. Even transfers between different branches of the same government entity or commercial enterprise are included. commercial. arising separately and independently in the normal course of personal. by individual communities. 28 For a detailed explanation of these effects – and the need for commercially viable remedies – see "The Competitive Advantage of the Inner City” (11/1/94) by Professor Michael E. 31 . Even an educated guess as to the likely direction of net incremental funds flows will be of decision-making value. This concept is more intuitive than statistical. These will include (but not wholly comprise) payments to and by banks and governments. This will often leave in its wake a declining physical infrastructure and derelict buildings. though commonly simplistic. 29 It is important not to be misled into a perception that the funds are flowing though a particular official entity. Porter of the Harvard Business School. only by the maintenance of a substantial balance between financial flows of funds into and out of the local community.
The same kind of commercial activity will also bring about outflows of funds (to community nonresidents) as a result of: (a) purchases of goods; (b) services by non-residents (including outside residents commuting to local businesses); (c) remitted earnings by non-residents from local businesses; (d) external tourism by local residents; and, (e) investment earnings (including property rents) by non-residents in local financial markets or on local assets. Other outward funds-flows will likely arise from local taxes payable by residents to other than the local government (e.g. state and national taxes) and by welfare and subsidy payments out of the community. For working communities, whose retirees move elsewhere, there may well be net payments for pensions, to non-residents formerly working locally. Were all these transactions offset (in practice they are – it is just difficult or impossible to measure them!) an assessment could be made of the net current balance of the community. This would be the net amount owed, relative to the local community as a whole, by or to the rest of the economy30. Community Balance Of Payments (2) The first stage of any assessment of a community balance of payments will only show the net current balance. This is the result of the day-to-day transactions among business, household, government and utility entities. As the net balance relates, by definition, to claims against future satisfactions (goods and services) it must be held in some form until these future satisfactions are procured and paid for. The second stage of the community balance of payments, therefore, deals with capital transactions. These are not of a day-to-day nature. Instead, they result in some form of longer-term saving, investment, financing or borrowing.
A dramatization of this concept might help. Suppose all transactions to be in cash. Further suppose every member of a local community to have settled their accounts with one another and then brought to the "community hall" all their remaining invoices or money earned from transactions with those outside their own community. Using the available money to pay the invoices, all now owed to outside parties, what remains would be a smaller quantity of either invoices or money. If money, it would be the local "balance of payments" surplus, on current account. If invoices, it would be the current deficit. The money would represent an increased claim on the rest of the nation or the world for its future goods and services. Invoices would be a claim by the rest of nation or the world on future goods and services of the local community. (The local community might well be in a muddle about whose money had paid which invoices. This, however, would not be a balance of payments concern. It would be one to be resolved entirely locally. Indeed, official national balance of payments statements usually include large components for "errors and omissions.")
If the community accumulates a current surplus, this will facilitate the participation of its residents in: (a)purchases of property from non-residents31; (b)repayment of loans, earlier granted by non-residents, or non-resident financial institutions; (c) withdrawal of capital from local businesses by non-residents, perhaps (though not necessarily) being replaced by local capital32; and, (d) capital investments or loans by local residents and businesses or capital grants by local governments, all to non-residents or non-resident entities. If the community accumulates a current deficit, this will need to be covered by the participation of non-residents in the making of capital payments to resident households, businesses, governments or public utilities, for: (a)property purchases from residents33; (b) repayment of loans earlier made by resident financial institutions; (c) infusion of capital into local businesses, perhaps (though not necessarily) replacing local capital34; and, (d) local capital investments or loans by non-residents, or locally-used capital grants, by outside (e.g. national or state) governments. Community Economic Results A balance of payments for a local community deals only with flows of funds. It does not directly address the economic activity to which the funds relate. Thus, it is possible for a local community to derive a great deal of funding from outside, yet indulge in little or no economic
For balance of payments purposes, it is irrelevant whether the property is located within or outside the local community. Its purchase will absorb local cash, equal to its price. What is important is that the vendor be a non-local-community resident. 32 Local capitalization of local business is not a balance of payments activity. Thus, to the extent that external business capital is not replaced by local capital, the affected businesses will be de-capitalized. If they are over-capitalized already, this could be an advantage. If not, activities might have to be curtailed. 33 For “balance of payments” purposes, it is irrelevant whether property is located within or outside the local community. Its purchase will provide locals with cash, equal to its price. What is important is that the purchaser be a non-local-community resident. An analogy is that the US accumulated current balance of payments deficit is supported, to some extent, by holdings of US property by foreigners. However, a US balance of payments deficit could be (partially) covered by the sale of London (physical or financial) property by a US resident to a German resident. 34 Local de-capitalization of local business is not a balance of payments activity. To the extent that external capital does replace local capital, the affected businesses will be further capitalized. If they are under-capitalized already, this could be advantageous. If not, activities might be expanded. This would be an advantage only if there is potential increased demand for the local product.
activity. This sometimes occurs when a country is in receipt of foreign aid but has a moribund economy. The Russian Republic, or its local communities, were examples of such economies. Money was deposited elsewhere, or held by local banks, while the real economy lacked the funds to pay for labor goods or services for production. This is at variance with the situation in a more typical local community. In such a case, flows of funds will almost certainly be accompanied by real, economically productive, activity. It will also be accompanied by activity detrimental to the local community. To start with, the community's economy will be enhanced by the value of local production. To this will be added the use of imported goods and services. Further enhancement will take place as a result of real (non-inflationary) increases in property values, together with any improvements to the community as a result of environmental recovery. The latter might include, for example, the cleaning up of beaches or rivers. Enhancement of current community activity will result from the creation of future obligations, to be discharged from later economic production. For example, manufacturing capacity (and monetary profit) of a factory might be enhanced by allowing the postponement of costs to control pollution. The current community would gain economic benefit at the expense of its descendants35. Against these enhancements, the community would also suffer some economic deterioration. Most importantly, the export of goods and services, produced locally, would decrease those that could be used locally. Businesses and utilities would suffer depreciation of their productive plant, while housing and infrastructure property would also deteriorate. Furthermore, current environmental waste and degradation would exacerbate the local community deterioration. Additional deterioration of current satisfactions will also arise from a shift from current production into investment for the future. This will create a current economic sacrifice so as to pass on benefits to descendants. When current economic enhancement of satisfactions is balanced against current deterioration, the result will be either a net increase or net decrease in overall current satisfactions. Net increases in current satisfactions result in more enjoyment and less suffering now. Net decreases in satisfactions bring more suffering and less enjoyment now. The investments and obligations passed on to community descendants will represent an inter-generational trade-off. Inter-Generational Trade-Off – Introduction Borrowing from the future, in the form of increased future financial or material obligations, creates additional current satisfactions. On the other hand, lending to the future, in the form of increased investment, eliminates equivalent amounts of current satisfactions. The creation of intergenerational trade-offs will bring about both costly and beneficial outcomes in future time periods. The outcomes are not directly caused by the money investments or obligations brought forward. They derive, instead, from the activities which these assets and liabilities automatically generate.
Moreover, a local community might temporarily gain at the expense of other (national or international) communities. For example, there is a foreign-owned gold-production plant in Romania’s Baia Mara. This, no doubt, created some economic benefits for the local community, as well as profits for the owners. However, a spill of cyanide (February, 2000) from the plant eventually found its way into the Tisa River, causing costs and losses to residents of Hungary, Yugoslavia and Bulgaria, as well as the rest of Romania, all of which bordered the Danube River, of which the Tisa is a tributary.
Inter-Generational Trade-Off . debate still rages about the “costs” and “benefits” of ending World War II. For example." However. They merely transfer some of the claims to economic benefits from private households to the public domain. sales revenues. there will be a need to incur publicly financed costs of public services. investment in a new road may facilitate faster and safer passage for commercial trucks and improved access to work (economic infrastructure) as well as family visits or access to cultural and recreational locations (social infrastructure). This addresses not only the question of the “net overall benefit” but – in the process – just who is helped and who is hurt.Distinctions Reference is made in this section to investment in "economic" and "social" infrastructure and in "human capital. if the future scientist is engaged in developing (say) “weapons of mass destruction. increases in the tax base are not additional increases in economic benefits. by the dropping of the atomic bombs on Hiroshima and Nagasaki! Also. are they willing to do so and is that process socially or economically appropriate or desirable? [It also dramatically illustrates a well-known remark by Keynes: “In the long run. The incurrence of these costs will bring about beneficial outcomes. sixty years after the event. rents and an ability to pay local taxes. enhance immediate reading. 36 For example. everybody is dead!”] 37 However. It will also bring about improved economic efficiency. Investment in social infrastructure will also generate operation and maintenance costs. Then. Investment in residential construction will generate private operating costs. This may be costly to the households involved and also to the public authorities. It will bring about improved social welfare." It may also provide groundwork for its future education as a university professor to train scientists. relating to socio-economic analysis. Investment in economic infrastructure will bring about operation and maintenance costs. some of the benefits will not be fully realized for two or three generations! Moreover. owned or rented. as it contributes to more productive business activity. if the winners are able to compensate the losers. moreover. at one and the same time. In addition. many of these incurred by public sector entities. new residential construction on any large scale may create social disruption. contrary to what is commonly claimed. because it is virtually certain that Japanese lives were traded for American lives. This is because the same activity will be a combination of current consumption and investment. together with increases in the local tax bases. for current "consumption. Inter-Generational Trade-Off – Investment Activity Investment in business construction will (if business is to be sustained) generate privately financed operating costs and publicly financed costs of public service delivery. can be partly economic and partly social. by enhancement of the quality of community life.” who can say whether the ultimate – very longterm – benefits will be positive or negative?36. especially for real estate and sales taxes37. via taxes. in support of the new households. Thus. computational and social skills. 35 . a search for so-called objective definition of these concepts will prove futile. it dramatically illustrates a very common concern. Investment. More importantly. Incurrence of all these costs can be expected to bring additional accommodation. The teaching of a schoolchild will likely. It can be distinguished only by reference to concerns that it is assumed to address. as jobs.
To the extent settled. in the sense that it facilitates a greater participation by all. financial and economic. However. Past Obligations Monetary obligations brought forward from past activity will create the obvious costly outcome to settle these. human capital investment is intended to ensure. explicit or implicit. in an ever more fragile and changing socio-economic society. failure to deal with these obligations will incur effective. For example. for this settlement. be measured. though rarely recorded in account books. It will generate operation and maintenance costs but also facilitate the provision of housing or utility services. it will create an obligation for the costs of restoration. if ever. Where physical or environmental deterioration is brought forward from past activity. There will often be huge time lags between current investment in human capital and the beneficial outcomes. this might also be applied to some aspects of health and welfare services. 36 ." Increasingly. from that point onward. this will also eliminate the interest costs. settlement of past obligations will create an improved financial position from which to operate. Furthermore. what must be borne are the costs of continuing to operate with the greater economic inefficiency. health hazards and social disruption that these obligations impose. that no one is left out or left behind. the costs of training a teacher may only be fully fructified when students of that teacher enter the work force. there will be some revenues (some of it subsidized) from the sales of utility services and from housing rentals. In other words. in their striving to participate or advance in society. Expenditure on both property and operating costs for the delivery of education and training can be regarded partly as investment in the creation of "human capital. a community is incurring interest costs on the human capital expenditures until these are returned to society in enhanced output. the use of current resources. Effectively. This is also a productivity factor. real. of still carrying the obligation forward. Otherwise. (compounded) interest costs.Investment in public housing or public utility construction is intended to fulfill a variety of social and economic purposes. Such investment is also expected to create cultural enhancement. Furthermore. which may not all be provided by private sector activity. In return. renewal and renovation. some of them decades ahead. Timing and extent of this can rarely. This is because it is expected to raise longterm potential for future improved productivity. as far as possible. will deprive the community of their use for other current purposes. however defined or speculated. because the further neglect will likely generate additional deterioration.
fees and charges will directly support the operating expenditures of local governments and their public utility entities. This working capital facilitates the holding of inventories. which creates future debt service obligations and other expenditures. some of the national and state funding may assist local governments with financing for their capital projects. to facilitate day-to-day activities. Among the national institutions can be a capital development fund. They also supply. Much of this capital expenditure may have to be financed by borrowing. Supporting them is an intricate and inter-locking system of cash flows.GOVERNMENTAL CASH FLOWS . by direct capital grants or project lending. key activities will include the operation. through taxes fees and charges. They will also need to provide working capital. on a pay-as-you go basis. by retention of depreciation provisions. To deliver many of these services requires investment in property. Recurrent service delivery expenditures will normally include debt service (interest and amortization) as well as a medley of contributions to special funds. International institutions include the World Bank and the related regional development banks. These capital-funding sources may be augmented from "foreign" (i. through the capital budget. funding sources. within the framework of a recurrent budget. 37 . National and state taxes will sometimes provide funding which may be channeled to local government operating budgets. businesses and developers provide monetary revenues for local government operations. These may comprise funds for fixed asset replacement and future employee benefits. plant and equipment. including that of national (and even international) financial institutions. through savings. non-local community) lending. maintenance and administration of public services by a local government unit. through revenue-sharing and regular grants.e. granting of credit and having sufficient cash to pay current expenditures. Taxes. These local government activities are focal points. some contributions (saved cash flows) will come about indirectly. Uses of Funds – Cash Outflows Local government units will incur expenditures on service delivery. including pensions. This will require expenditures on these services. In addition. For utility entities. Moreover. contributions may be made towards capital investment expenditures. to be borrowed from financial markets. Sources of Funds – Cash Inflows Households.URBAN FINANCE Introduction With reference to urban finance.
where debt is to be repaid only at maturity. local currency loan proceeds will need to be exchanged for foreign currency earned elsewhere. betterment levies for infrastructure. Periodic interest payments will normally go directly to lenders38. exactions and proffers to compensate for planning approvals. Otherwise. from the foreign activities of commerce and industry. With installment debt. If foreign expenditures are to be incurred. The term “zero” applies only to the payment of the interest – not to the rate at which it is assessed! 38 .Capital Finance Capital expenditure will be on fixed assets for delivery of services. as in the case of bonds. derived from the same sources and invested until required. such borrowing will need to be in foreign currency. These could include (say): water and sewer hookup charges. Foreign debt service will require the acquisition of foreign currency. However. periodic payments will be made to sinking funds. This will usually be obtained through the commercial banking system. Debt Management The remainder of the capital funding sources will be borrowed. Capital funding may derive from some of the special funds (such as those for asset replacement). imprudently. as part of operating expenditures. capital funding may. This may be augmented by contributions from businesses or households. compounded and paid with the final redemption of principal. vesting of completed infrastructure. principal payments will also be paid directly to lenders. and. 38 An exception would be by the use of "zero-coupon bonds. Working capital for capital projects will also be required. contributions from current budgets and capital grants from state or central governments. invested to accumulate the cash for ultimate debt retirement. For foreign debt (unless the foreign exchange risk is to be postponed) sinking funds will also need to be built up from foreign currencies. effectively. This will again come from the reserves accumulated. be used to cover operating deficits in recurrent budgets. within the banking system." whereby interest is. Debt service financing will be derived from recurrent revenue sources. largely by commerce and industry. Sometimes. either from state and central government entities or in the financial markets.
the sinking fund interest rates are more conservatively set. This would normally be calculated on the basis of the nominal interest rate. these limitations fall most severely upon the searches for funds for capital improvement projects. Where capital markets function effectively. Only full indexing does this. There are. including an appropriate share of the fixed asset financing. Long Term Debt The most appropriate source of funding for capital expenditure. is that of long-term borrowing. The other objection concerns the effect of real cash flows. This is sometimes referred to as intergenerational equity. a standard "level" mortgagetype payment (annuity). in circumstances of high inflation and other national economic constraints. however. municipal government operations are seriously hampered by financial limitations. Since the priority must be to keep existing services running. For maturity debt. Thus. Uncertainties can (within certain limits) be allowed for by the charging of variable interest rates39. One is psychological. particularly with respect to interest rates. however. periodically adjusted to allow for changes in both inflation and real money costs. broadly related to the working lives of assets to be financed. when inflation is high. it can still be adjusted for in nominal interest rates. to repay bonds at maturity. Even more fundamental is the fact that capital markets are often non-existent – or at least non-responsive to the needs of local government and public utility entities. sinking funds are sometimes used40. However. Banks and lending agencies are. Debt service can then be annually financed. in principle. Users of services provided by public assets pay for this usage. the other substantive. to compensate for this. Even when nominal interest rates include relatively low real components. because the market is giving a psychological signal not to borrow at times of uncertainty and insecurity. sometimes considered as exploitative and so borrowing is avoided. This is not necessarily a bad thing.FINANCING CAPITAL EXPENDITURE Introduction 00000000In many countries. they often appear. Usually. longterm borrowing is often not available. 39 . Unfortunately. at least two serious problems to this. As stated. the standard market solution to the interest rate concern is to add the expected inflation rate to the real cost of money. Thus. at lower levels. the annual payment in the first year would be a much greater burden in real terms than the 39 40 Contrary to what might be assumed. such as bonds. variable interest rates do not adjust for inflation. The use of sinking funds. This is because of the gross uncertainty. therefore. is the mathematical equivalent of the annuity payment. either from internally generated funds (revenue-earning services) or from general revenues (tax-borne services). unconscionably high. over the full working lives of the facilities. is typical for long-term debt redemption. inclusive of principal and interest components. facing both lenders and borrowers. the periodic contributions must be somewhat higher. This method is regarded not only as financially efficient but also as socially equitable. to the average observer. provided that the interest on sinking fund investments is equal to that on the loans.
This is intended to prevent the crude rollover of all of the outstanding debt. 45 In the UK. However. as an alternative. and then to continuously roll over. attempts have sometimes been made to initially incur.5%. Second. this is not entirely correct. Alternatively. Indeed. for two reasons.one in (say) the twentieth year41. Where tried. assume a municipal government to borrow $1 million for 20 years at (say) 15. However. the front-end loading of the real cash flows will still be influenced by the extent to which the international market interest rates are inclusive of an inflation element. from the World Bank) the problem largely takes care of itself.g. it has sometimes been used to cover recurrent budgetary deficits. Further assume this nominal interest rate to include (by compounding) a 5% real rate and a (relatively modest) 10% inflation element. The adjustment will. it is mentioned 41 For example. They merely keep current nominal interest costs in line with market rates. the higher real impact of the debt burden on earlier service users will represent an economic "gift" to their successors. if foreign debt is raised to cover investment (capital) costs incurred in local currency. domestic loans could be linked to a stable foreign currency. therefore. 43 The annual cash-flows are slightly different by each method. to the extent that it can be raised at all. through the need for lower (real) borrowing requirements for an equivalent amount of (real) capital expenditure. with floating exchange rates. The (nominal) annual payment would be about $164. which will have unintended effects on the balance of payments. from current revenues. However. central government intervention would almost certainly be required. emanating from enthusiastic amateurs. U. much of a nation's municipal debt. but the discounted cash flow (DCF) rate of return is identical. First. short-term debt to finance capital expenditure. However. To introduce them. the "later" community benefits.000! At the prevailing inflation rates in many countries. usually within a single accounting period. these methods are not standard practice in the financial market-place. Where loans are actually raised and repaid in foreign currencies (e. to buy the foreign currency to service the debt 44. Thus. there must be an assumption of an open economy. must come from domestic sources. Variable interest rates do not allow for this. because this is sometimes encountered. It is possible to finesse the use of short-term borrowing for long-term capital expenditure. Either the principal sum or the annuity payments43 are indexed to the inflation rate. This is inappropriate." Thus. it has either led to complete financial disaster (e. In the absence of long-term debt. New York in 1976) or has had to be brought under control and funded by long-term debt (e. 40 . This concern42 can be (technically) overcome by indexation. by law. At the end of year one. the price index would be 110.K. In general this should be resisted. in the early 1960s)45. the real value of the annual payment would be only about $24. 44 Strictly speaking. local governments are required. reflect the net difference between local inflation and the inflation of the foreign currency of the loan.g. there will likely be an overwhelming temptation to use short-term (e. to set aside a “Minimum Revenue Provision” (MRP) every year. 42 This might not be considered a serious concern by all observers. commercial bank) debt. it might create a potential for the importation of other (consumption) foreign goods and services. Some might argue that high nominal rates offer an opportunity to trade away some of the "time-related equity" in exchange for greater financial prudence.000.g. because increasing amounts of local currency are required each year. so the level payment would be equal to only $149. to cover repayment of a proportion of outstanding debt. In some countries.000 in real terms. at declining exchange rates. The only valid use of short-term borrowing by municipal governments is normally to cover temporary shortfalls in cash for working capital. somewhat equivalent to the establishment of a "capital fund. This will possibly be offset by increased burdens for repair costs in the later years of asset life.g. at the end of year twenty. Worse. to be repaid as soon as that working capital is restored. distortions will be much greater than shown here. The likely net result would be creation of financial savings by the "earlier" community. with a price index of about 673.
such as property taxes. as well as professional support and advice. Consequently. Indeed. such arrangements require the existence of benign and experienced financial markets. in many parts of the world. which allocates to them both responsibilities and resources. consistent with the sometimes postulated concept that local governments should. However. When economic conditions improve. Sometimes it has been argued that long-term municipal debt should be secured only against socalled "own-source" revenues. The deeper causes of this should then be investigated and remedied. there is ample precedent for this. Any substantial and continued use of such a practice will normally be an admission of a fundamental breakdown of inter-governmental financial and political relations. could lead to severe public policy concerns. too.mainly to damn the practice with faint praise! Even if attempted." Without question. as it were. Revenue-sharing. however. will usually require central government leadership. It is appropriate for borrowing to be secured against either specific or general revenues. either within the municipalities themselves or from consulting specialists. because confiscation. in any country. Indeed. promulgated and administered by the central (or state) government. Also required is very sophisticated debt management capability. 41 . there can often be no objection to the central (or state) government withholding revenue shares from municipal governments. in the event of default. perpetuating the idea of revenue-sharing as "central government handouts. this should be only a temporary and emergency expedient. are. recognition of the partnership status among the various levels of government. These conditions are often not. therefore. It is normally inappropriate for public assets to be offered as security. not recommended. Accordingly. together with the use of other grant mechanisms. or are already stable. this. these revenues – other than specific capital grants – should be regarded as part of local government resources available for debt service. They are likely to be politically motivated – not just administrative concerns. as well as obvious practical difficulties. currently." It is. it is normally. "stand on their own (financial) feet. everything should be done to ensure that local governments are more accountable and financially autonomous. They are almost always established under national or state legislation. Within this context. it must also be appreciated that they are legal entities. guidance and participation. However. prevalent. opportunities will almost certainly exist for the possible pooling of medium-term and long-term loan instruments. in order to act as the agents of lenders in settling arrears of debt-service obligations. it is very rare for local government units to have constitutionally-based autonomy. This appears excessively harsh. However.
i. h. requiring. seeking tenders from private companies to "build maintain and operate" facilities. the process is used more for political posturing than for any sound economic purposes. however. c. and hopefully will – in stable economic conditions – be a mainstay of financing for the capital investment programs of municipalities. recourse can only be to alternatives. as a condition of zoning permission. e. j. even where borrowing was available. in some western societies. sometimes of a very particular nature46. This supports the economic rationale for allocating some of the revenues to alternative transport modes. Some of these would be appropriate. or alternatively requiring private developers to provide (or add to) community facilities. use of special funds. g. such as community centers. low-cost housing. often related to a formal pay-as-you-go strategy. in that high gasoline taxes may engender a reduction of vehicle use. paving of communal walkways and (if appropriate) re-housing or re-training of those who may have been disrupted by new developments. It can also be economically ambiguous. Often. "earmarking" of specially designated revenue sources as being only towards capital expenditures. in theory. requiring smaller (and more steadily incremental) units of capital funding than for massive extensions to main structures. f. parks. 46 A common example. levying development charges. They include the following: a. together with related off-site connections to the main (municipally-owned) infrastructure. as a corollary or variation to the use of intermediate construction. b.Capital Financing Sources .Other than Long Term Debt As indicated. allocation of planned (or even unexpected) budgetary surpluses from recurrent operations. typically financed by a pay-as-you-go strategy. d. as is the whole concept of the "earmarking" of public revenues. derived from the sales of public assets or from other "windfall" sources. established out of (regular or sporadic) contributions from recurrent budgets. negotiating with – or requiring – land developers to construct on-site infrastructure for their owned developments. well managed long-term debt can. However. using intermediate technology (such as small-scale treatment works or pumping stations for localized sewer or water networks). 42 . less road space rather than more of it. this is a contentious issue among public finance specialists. use of unapplied capital receipts. generation of internal funds within the framework of revenue-earning (public utility) enterprises. using a staged approach. Others are merely "second best" opportunities. Until this is so. is the designation of gasoline taxes towards road construction or (sometimes) other public transportation systems.
and. as frontagers. These will be enjoyed mainly by the (passing) road users. this also applies to money allocated from general revenues. by pay-as-you-go) instead of by using loans. purchase of divisible packages of capital expenditure (e. establishing "special tax districts" for areas deemed to receive local but generalized benefits from specific infrastructure improvements or installations. contracting out the entire operation of the service. in exchange for some secure legal obligation (e. permitting the collection of what is sometimes known as "betterment levies"47. use of capital grants from the central government. r.e. thus being the near equivalent to borrowing. 47 This is a contentious issue. with a different label on its envelope! 43 . 0Although fairly common practice. permanent re-assessment of properties adjoining specific public works improvements. p. For example. some frontagers may suffer economic losses – such as being cut off from adjoining property or by having business customers re-routed away. A more economically efficient option would be for the municipality to assess the cost of keeping its existing assets in better repair. either by allowing the contractors to levy service charges or by making contract payments from public funds. it does not really provide immediate funding for the up-front costs. because a capital fund is really just a separated part of the current surplus. This would then be compared with the annual costs of debt service against borrowing (or the costs of otherwise allocating scarce resources48) to finance a new asset. Some form of collective borrowing mechanism would still be required to cover these. Indeed. such as hook-up fees for water and sewer systems and frontage charges for road improvements. targeted to purposes in which the central government has a political or beneficial interest.g.allowing them to keep some (or in appropriate circumstances – all) of the revenues. collecting one-time contributions from those assessed to be beneficiaries of public works improvements. 48 For example. which can sometimes lead to bizarre and unjust results. Yet. n. l. engaging in neighborhood partnership agreements. using leasing devices. whereby private suppliers will undertake to capitalize the acquisition or construction of public assets. o. q. if the betterment levy is to be on an annual basis. for a new asset. Moreover. In principle.g. the use of central government grants to finance capital expenditure can result in serious mis-allocation of resources. the use of money otherwise held in a capital fund will (a) deprive of its use for alternative purposes and (b) cause a permanent loss of interest earnings. which may be either not available at all or for which other types of assets should be given priority. replacement of bus fleets) by from current revenues (i. they may still be surcharged. This is because a central government grant represents a virtual free resource to a local government. immediate frontagers of major road improvements may receive virtually no benefit from the works. m. whereby residents voluntarily agree to share infrastructure costs with a municipal government. a take-or-pay contract) for the local government to use them. k.
as the “Private Finance Initiative” (PFI).” Wisely and carefully put together. established policies that would give far more responsibility to private sector institutions to finance. in Virginia. In the United Kingdom. almost world-wide. Also "general obligation" bond issues (borrowing against tax revenues) by state and county governments requires a public referendum. There are many and varied 49 Several major countries of the European Union. as now asserted. mainly for political. macro-economic and international reasons. After all. Some of these funding procedures have been used as opportunities to introduce what are referred to as “Public Private Partnerships. collectively. a principal economic adviser to the Thatcher government. after the initial selection of the private contractors. under Conservative and Labour administrations. inter-generational equity accompanies public borrowing for capital expenditure. came to be known. the subject of major public criticism. have subsequently shown a substantial inability to keep within the established limits. This. It therefore gradually established itself as virtually “the only game in town. conservative policies of the government were subsequently enhanced and reinforced by stringent macro-economic limits placed on public sector borrowing by the European Union. in principle. despite significant manipulation of fiscal reporting. a quite sound accounting device – analogous to loans pooling. 50 This was made very clear in statements by Sir Alan Walters. from all shades of political opinion in the United Kingdom. 44 . in some form or another. delighted fiscal conservatives in government as well as the new cadre of evolving private sector institutions that were offering to perform the PFI activities. These funding operations. a lower level of public sector debt can only be counter-balanced by higher debt. the state government and some local governments have established quasi-autonomous "property corporations" which have raised "revenue bonds. or other capitalization. whilst politically satisfying. for the private sector50. implement and subsequently operate. Moreover. as stated elsewhere. from the early 1980s. have proven to have been both economically and socially flawed49. Thus. for example. Consequently.” for the funding of much expensive capital expenditure. there was severe capital rationing. it has proven itself to be a very robust and necessary constituent of sound public policies – not." chargeable against the rents receivable from the state or local government. These restrictions or controls are common. or enforced upon. USA. This is. Moreover. These limits have been largely continued by. The consequent dearth of public capital expenditure would have been much worse. including France and Germany. public facilities. Its introduction coincided with a substantial reduction in public sector borrowing. the PFI is now. For example. the Thatcher government. where funding limitations would otherwise have prevented it. Moreover. whereas "revenue" bonds (borrowing against specific revenue flows from charges) do not. these partnerships have sometimes provided for necessary and important capital investment. with public debt within historically tight bounds. where the public institution does not have an equity stake. Its shortcoming lies only in apparent attempts to circumvent (what are claimed to be) onerous approvals or limitations. naturally. The severe limits on public sector borrowing. later governments. To finance the provision of new public buildings.There is a moral hazard issue here! The use of leasing procedures is sometimes used as a legal artifact to circumvent borrowing restrictions. a major impediment. itself. There was often no public sector participation at all. without PFI. there are overall debt limitations on the state government.
This can sometimes be used for derelict sites or many other situations where private initiative might not be forthcoming without public encouragement. or at least uncomfortable. communications and residential districts. evaluations or assertions. It is called “The triumph of Politics. Where this has occurred. it allows supporters of these arrangements to continue to make significant and influential claims for success. accounting. it takes a special kind of talent to convince commercial developers that a disused and run-down railroad yard. tough budgetary management. to be valuable on their own. However. A local government may be encourage private developers. elsewhere. could be transformed into (say) modern business. a (disillusioned) Budget Director of the former US president. advertising. Almost all publicly available data is “ex ante. That there is no substantive body of systematic evidence about the results. for example. nor the main parliamentary watchdog. suggests a very severe breakdown in accountability. In these cases. have chosen to find out.. or derelict buildings. Ronald Reagan. so as to reach a "critical mass" of interlocking economic activity. Thus.” 45 .51 Municipal Orchestration of Capital Improvement Programs Many of the capital financing devices can be combined. What has been suggested is basically a "supply-side" approach. shareholder returns had been evaluated in only one such operational scheme. this minute quantity of available hard evidence seems to support those who are skeptical. Sometimes. a limited amount of capital investment by a local government can increase land values from "unimproved" to "improved.assertions that the PFI has frequently failed to deliver on its promises. hardheaded but flexible negotiation. costing the public sector millions of pounds in losses. it has usually taken a broad combination of skills. Care must be taken. public relations. Moreover. however. This was illustrated in the USA by the under-utilization of commercial development 51 An apposite characterization of this phenomenon is in the title of a book by David Stockman. Well over five hundred PFI deals had been signed by April 2003. because neither the government itself. financial reporting and auditing. Perhaps most importantly. however outrageous and undocumented these may be. the National Audit Office. no one really knows the true costs involved. Supply of building or infrastructure development does not always create its own demand. This is a very important lesson for all those engaged in the funding of capital finance. with the local government providing "orchestration" for public-private sector partnerships. which would otherwise be too specialized or too limited of access. to ensure that planning activities are not carried away by enthusiasm and euphoria. by April of 2004. including costs and benefits." making the sites ultimately more attractive to private investors. It also requires competent capital and recurrent budgeting. there is a need for persistence and vision by a few really dedicated and public-spirited individuals. innovative and creative financing. public education. to combine efforts in a large development project. made when the schemes were submitted for governmental approval. including those of: strategic spatial economic. In this way. and. often against bureaucratic and political obstacles. These were sixty per cent above projections and not justified by risk transfer. more productive and coordinated use can be made of individual sites.” largely taken from the “value for money” promises. compensating expenditure and economic inefficiencies. or neighborhood residents. of PFI. Unfortunately. with the outcomes. financial and social planning.
in the nineteen-eighties52. the London Docklands development went through many such crises. 46 . before it could claim to have significantly fulfilled its promise. 52 In England. Its “flagship” developer went bankrupt and there were major transport access and financing concerns.
Often. These grants are then sometimes ignored. Thus. 47 . It will also require clearer differentiation and bounding of the financial operations of trading (enterprise) activities. it is important to make reference to productivity. arising from the lower tax revenues available to support the under-utilized public facilities. Thus. the public sector will also bear some costs. However. Analysis of the allocation and use of real resources should enhance this." It can also mean – in the context of grant-funding from a central (or state) government – that another unit of government. establishing clearer distinctions between "operations" and "capital investment" in the accounting and budgetary processes. on funds flows. there must often be some transformation of the budgetary processes from those that are cashbased to those which are cost-based. There will also be social costs. such as those delivering utility services. almost exclusively. with only operation and maintenance expenditures covered from user charges. in particular. efficiency and effectiveness of service delivery. it will result in lower profits or increased losses. by improvements in the economy. Budgeting Many systems of budgetary management concentrate. Urban public transit systems are prime examples. This will necessitate. in setting prices to recover or contribute to the capital costs.To the extent that this phenomenon represents a private sector risk. arising from unemployment or under-employment of an intended enhanced labor force on the new site. capital expenditures have been funded from general taxation sources. was encouraged (or even coerced) into paying some of the capital costs. or even the private sector. apparent "savings" can often mean "poor or diminished service delivery. In exclusively cash-based budgetary systems.
however professionally competent. prior to making loans. however well a project is appraised. dealing with major metropolitan transport investments. nobody really knows for certain how it will eventually turn out. At the same time. this is often part of the formal process. whereby feasibility studies are performed and then designs are prepared. failure to appreciate the full financial. equity finance or grants to project implementing entities. analysis and appraisals consume time. it is also concerned with the overall economy. For example. A principal role of project appraisal is to protect the interests of investors. because the questions posed by project financiers are also those which the project entity should be putting to itself. is that of the Major Investment Study (MIS). efficiency and effectiveness of projects. do not usually build projects. it must also be regarded as an activity to be performed by internal specialists. loans or other capital funding. useful and successful over the very long term. in the USA. coupled with the leadership and dedication of a few key people. even though project appraisal can be seen as an independent assessment. There are many well-known approaches to project appraisal. There is. before anything begins to be built. Accountants and financial analysts. lenders and grantors. the US Federal Government from time to time establishes procedures for the examination of potential projects for the purpose of making federal grants for investment projects to be implemented by state and local governments. A very well-known international example is the intensive appraisal work performed by the World Bank. because one cannot efficiently appraise something that is not prepared to a reasonably advanced stage. If a project is inadequately or incompetently designed. An example of such an approach. possibly leading to the curtailment or abandonment of popular schemes. government departments and others. for this reason. money. Project appraisal. appraisal is seen as a delaying or limiting function. failure to provide intended services and potential political embarrassment. Internal project appraisal is also implicit in the preparation of applications for grants. the entity risks financial loss. Although project appraisal might be carried out by investors. however. administrative or commercial vision. it might sometimes be a contribution to posterity. before an appraisal takes place. by outside observers. as described in this and other literature. Indeed.PROJECT APPRAISAL – INTRODUCTION General Observations Project appraisal is typically performed by financial institutions. waste of economic resources. useful or economically efficient. may appear to be a rigid and specific process. something of a dilemma here. There is at least one other dilemma. the institution bearing the major risk is usually the implementing entity itself. Examples might include some of the US railroads and the 48 . in serving the common good. Thus. These are usually derived from political. implemented or operated. and resources. to protect the interests of the entity. Project preparation. Furthermore. In an integrated system of governance. even if a project bankrupts the initial investors. Indeed. Sometimes. economic and other factors involved is not very sensible. as well as because of political and other pressures.
except for the learning process that can be assumed to be implicit in all meaningful work. Indeed. For example. In particular. in turn. or the more uncertain the financing. (Formerly: VP & Chief Economist. are based upon an uncritical and unconstrained view of current public service operations. the less likely is the project ever to be implemented. the time at which they should be increased. this benevolence is sometimes achieved only by the use of large subsidies from general public funds. Frequently. at least in the short term. are the most economically efficient use of funds and resources. be largely wasted. for as long as possible. their design work must be carried out within a mental background of concern as to potential costs and financing. Political considerations are often paramount – usually directed at keeping prices down and postponing. February 2000. the project appraisal process will be described as if performed by an independent team of professionals. although they will not necessarily understand the detailed techniques of project appraisal. Firstly. One example of such a text is "Economics of the Public Sector" by Nobel Laureate Joseph E. Secondly. project financial appraisal is limited mainly to revenue generation. They should bear in mind that the higher the cost. that general public revenues. no objection to the use of general public revenues to finance project implementation and operation. Of course. they must learn to open and to sustain meaningful conversations with those who do. However. of the extent proposed. together with immediate budgetary impacts of projects coming into operation. There is. Their designs will. as far as possible."Channel Tunnel. with a narrow focus upon pricing and taxation policies. creating a misallocation of resources. also. 53 These questions are dealt with at length in the many texts on public sector economics and finance. the setting of prices and local taxes at the lowest possible levels is typically perceived of as being in the best interests of consumers. Setting tariffs and taxes is frequently directed only at covering immediate and short-term cash requirements. therefore. because of a shortage of funds. Stiglitz. necessarily. elicited from simplistic budgetary procedures. such projects deal with economic "externalities" and other circumstances where users of services are not. either within the project implementing entity or from outside. These. An important thing is to determine. these are necessary for services that do not generate (or cannot reasonably be financed from) individual user charges. with little or no prospect of upgrading or expansion. producing (actual or claimed) economic benefits. World Bank) Third Edition. 49 . It is an often overlooked principle that it is usually more economically efficient to subsidize deserving people than deserving activities. the lowering (or holding down) of transit fares might attract more people away from cars and onto public transport. the sole or principal beneficiaries53. in principle." "merit" or "collective" goods." There is a consequence of all this for project designers and implementers. With these concerns understood. Appraisal Concerns and Purposes Far too often. These include categories of services which economists refer to as "public. low prices and charges are associated with poor service delivery.
Much more attention should. These improvements. with full regard to technical. were it always possible. be directed at those who would need the most financial incentive to garage their cars. so the lower fares will be charged to all. inter-city." This is not. thus undeserving of subsidy55. 54 55 More rigorously. The underlying premise is that pricing and cost recovery practices should be examined within the much broader context of these overall assessments. in turn. They might well be the more affluent. therefore. economic and other implications. In any case. Unfortunately. this might be done by the use of classes (first and standard). thus giving an appearance of social unfairness. for commuter transit this has not usually proven practical or efficient. transport journeys. Pricing and cost recovery policies can then be related to more efficient service delivery institutions. Consumers and citizens are almost always resistant to price and tax increases. there will be a need for appraisal of actual development projects. as well as to well-designed and feasible protects. this resistance can be greatly mitigated by perceptions of better service. there should be a complete appraisal of new development projects. The first activity. will keep down costs and limit the extent of price and tax increases. Then. there is no practical way56 in which they can be identified and charged. If the purpose is to get car-users off the roads. Some of these passengers might be of higher incomes. based on improved productivity. However. However. more strictly. 50 . Most commuter systems are one class. operational. Financial policy decisions can then be related to longer-term economic and financial requirements and implications. much of any "subsidy" used to keep down the fares will benefit those who might ride the public transit system anyhow and would be prepared to do so at higher fares 54. In addition. this is the concept of "consumers' surplus. therefore. strictly correct. financial. it would be more economically efficient. is to establish a process for appraising the management capability of service delivery institutions. even if there are separate classes for longer. the subsidy should. to charge car-users the full economic cost of using the roads. despite an inherent economic efficiency. be given to review of the financial performance and management of project operating entities.However. 56 In principle.
for a private entity. together with appropriate auditing practices. as they often seriously affect: cash flow. and. the most likely accounting standards to be followed. One example of such a change would be the possible expansion of operations through an externally financed development project. capital structure. For a public sector entity. financing organizations. This type of review is often concerned with pricing policies and with other revenue-generating activity. together with audit. with the added burden of the proposed project. A sound system of accounting is a necessary pre-condition for the effective monitoring of performance. such an appraisal is not directed towards the viability of the project itself. Normal operations can usually be handled. In the international context. are often disruptive. a substantial change in its manner and level of operations. This body has also promulgated International Auditing Standards. both internal and external. Thus. It is also a central feature in any well-developed system of financial control. both of present operations and of potential future operations. it will be able to adapt itself to its new situation without undue financial and management stress. and to what extent. Financial performance is concerned with financial viability. it is attempting to determine whether. 51 . 57 Outside of the USA.APPRAISAL OF PROJECT ENTITY MANAGEMENT CAPABILITY Introduction The appraisal of the financial management capability of a public utility or governmental institution often comes about as a result of a request for. Projects. profitability. promulgated by the International Federation of Accountants (IFAC). The US Federal Government will normally insist that state and local governments follow the recommendations of the Governmental Accounting Standards Board. as what is called conditionality. the enterprise operates optimally at present and whether. such as the World Bank. the appropriate standards would be the International Public Sector Accounting Standards. This requirement will typically be included. Emphasis on financial administration is concerned with budgetary management. would be based on those of the International Accounting Standards Board (IASB). Instead it focuses upon the overall viability of the project entity. in the project loan agreements. by contrast. Such an appraisal is concerned with financial administration and with financial performance. including those of the intended development project. or a perceived need for. will often expect to see the implementation of appropriate systems of accounting and auditing as a part of project preparation or implementation 57. in a "steady state" mode. financially. financial control and reporting capability. Although a proposed project investment may provide the incentive for the appraisal of financial management capability.
promptly. which is often missing altogether. intended to substitute for good. steps should be taken. any proposed legal changes may be out of the hands of those most directly interested in the entity's operations. 52 . together with those of the general manager and the top management team. whilst imposing adequate controls. state or regional. duties and influence of the chief financial officer58. with particular reference to the power. for example. to initiate the necessary legal changes to permit such operations. An early judgment must be made as to whether the legal requirements allow sufficient flexibility. a set of detailed and irksome financial procedures. in the case of the political or administrative manager. This necessitates a review of the organization of the sector and the role of various levels of government (federal or national. However. A crucial question is the extent to which the entity has the autonomy to operate free of higher levels of governmental controls. While some controls over public enterprises are necessary and almost inevitable. 58 In UK local government. there is a legal requirement that a professionally qualified person be so designated. Among the key financial practices to be considered are the status and role of the chief financial officer. an all-powerful general administrator. for these reasons alone. central or state government legislators may find it lacking in urgency and even in conflict with what they consider as more important concerns. within which the entity may carry out its intended expanded role or scale of operations. or a strong technical or engineering specialist.The Administrative Environment A perquisite to the review of financial management is an examination of the administrative environment within which the entity operates. excessive controls can often be stifling of any management initiative. This will include a review of the powers and duties of the council or management board. need to be postponed. well-trained and experienced financial management. Many organizations in the public sector become a source of domination by a powerful politician (such as an elected mayor). financial reporting requirements. It will be necessary to examine the legal basis under which the enterprise operates. Thus. internal controls and audit. the scope and limitations of its operations and its financial policies and controls. Laws or regulations may prescribe its organization and management structure. These legal requirements must be regarded as minimum. An intended project might. high-level. The management structure will be reviewed. General Management The next matter to consider is the general management of the entity. Whilst the need may be obvious. one sometimes finds. and local) in the affairs of the entity or enterprise. financial management policies. financial performance expectations. modified or abandoned. They are also bounds. within which the entity must operate. If not.
Senior professionals of an entity may too easily be narrowly categorized by appraisers within specialist disciplines. There is another matter that is often overlooked. nor often in their nature. facilitating more useful and effective conversations with colleagues in other activities. Moreover. leading to further investigations. requires vision and leadership. Indeed. skills. If key staff cannot perform. it is also important to underline the efficiency and effectiveness of individual staff. who might resent such interrogation from professional peers. Sometimes. consideration should be given to their removal. However. The technical specialist. or even to discipline them. new and more competent staff must be recruited.Alternatively. Key concerns. maintenance. Yet often the opportunity to dismiss staff. these professionals will only have reached their positions because they have developed broader. will sometimes seek to humor the financial specialist – and even to show off – by answering seemingly “stupid” questions. 53 . as well as the running of services. indeed. typically. Sometimes. is constrained by bureaucracy. he sometimes perceives his role only as to build things quickly or to run services effectively – but without regard to cost. or in addition. in the selection of top managers. particularly managers. He or she perceives the financial specialist only as a source of funds. he may reveal matters which might otherwise never have been questioned. one does not. they are so closely related to it as to be essential features of any financial investigation. commonsense. funds availability or economic efficiency. trade union power or even nepotism. an impediment to efficient operation of public sector entities is over-staffing. in dealing with operations. there is considerable merit in the financial investigator asking questions about technical or operational matters. training or transfer. perhaps by a technical colleague of the financial investigator.leading to yet another stage in the investigative process. That is the physical operation of the entity and the provision and marketing of its products. What goods or services does it provide? To whom are they provided? How are they produced? What is the pattern and growth of demand? How are costs recovered? What opportunities exist for more efficient cost recovery? What new services or products are proposed or are in demand? And. In doing so. Operations One more important item must be examined before narrowing down to the financial matters. are often salary administration and personnel management policies generally -. As well as looking at management and staffing structures. repair and replacement of physical facilities and equipment? How are operating decisions made? Although many of these matters are not under the control of the financial management. concerning personnel matters. where a technical specialist dominates. what are the important aspects and constraints with regard to construction. he or she is sometimes considered as a nuisance. coupled with low pay. look for this among financial managers. not really as part of the management. None of this should detract from the fact that project implementation. Otherwise. because that is not their principal responsibility. typically. operation. They usually will have a good working knowledge of other specializations than their own.
do not to carry the sense of seniority and comprehensiveness that is necessary for such a position. alone. assessment. accounts officer or revenue officer. It is often desirable to find financial operations under a single manager – a director of finance. for example. be easy to collect and difficult to evade. about which reference will be made elsewhere. relations with taxpayers or customers. may seriously diminish the prospects of a local public entity from operating in a financially viable manner. Often. The customer or taxpayer must be treated with courtesy. record keeping. The initiation for payment will often come from a department that is responsible for the work that the authority undertakes. respect and fairness. remedies for non-payment should be firmly enforced. This situation. He or she will have some very specific responsibilities. economic utilization of properties. if possible. central or federal government involvement is considerable. around which the department should be organized. hazard insurance. does not usually begin within the finance department. procedures for the follow-up of non-payment. and. Financial Administration It will also be necessary to examine the financial administration itself. it may control or authorize the setting of charges or taxes. One of the most important financial functions is revenue collection. not be under the control of the finance department but will lead back into a review of the general management process. Some payments will. A completely separate unit of the finance department from that concerned with revenue collection should. In parallel with the collection of revenue comes its disbursement. arise from contracting procedures and tendering arrangements. land management policies. This title is used advisedly. among the slowest and least responsive of debtors. state. The often-used designations of chief accountant. Expenditure. The director of finance must be a key member of the top management team. Charges and taxes must. It is normally concerned with disbursement of funds provided for in budgets. This embraces: taxing or charging policies. write-off of bad debts. and. of course. as far as is practicable. themselves. On the other hand. record and collection of revenues. A common initiation procedure for payments is the official order system. if only out of consideration for those against whom they are not needed. is that dealing with the employment 54 . One of the most important contractual payments. These may. of course. together with that of light plant and tools. sometimes. with payment of obligations made as convenient and painless as possible. naturally. An investigation of financial management should be concerned as to whether this system (and others fulfilling similar purposes) result in efficient and economical buying procedures and adequate controls over the outflow of funds. handle this.Examination of the structures and operations of the enterprise will lead. However. Along the same lines should be a review of the management of stores and equipment. to inquiry about how its properties are managed. it – or several of its agencies – may be principal beneficiaries of services and yet. measurement. of course. Such an investigation can include rent-or-buy assessments. On the one hand.
These might be employees of the finance department. as well as monetary investment specialists. Reporting and Auditing One principal function within the finance department will be accountancy. it should be recognized that a generalist financial investigator is probably not well qualified to make detailed examinations of pension fund management. These reports will need to go to the finance director. to optimize liquidity and safety with earnings. However. However. Linking the processes of payment and receipt of money will be the function of cash (treasury) management. Just as important. codification and classification of receipts and payments of money. Many of the records of staff activities will be maintained in a personnel department.of staff. Where pension funds are in use. Arrangements will also needed to ensure that the deductions that are made from staff payments for tax. Among the reports that must be prepared are those for internal financial management. Cash management is also concerned with the management of short-term and long-term debt. fully and promptly. to lenders. but often not so frequent or so urgent. the finance department will also need to keep vigorously updated all matters relating to staff affecting the amounts that they are paid for their services. record of assets and liabilities. This should preferably be in a section of the finance department separate from either the "collections" or "payments" sections. to the general manager (mayor or chief executive) and to the executive board (or finance committee) of the entity. 55 . to their intended beneficiaries. This will frequently require the services of actuaries. with a minimum of further adjustment and preparation. and. among other things. Accounting. preparation of various kinds of financial reports. However. to investors and to the government. A basic concern of the accountancy section will be to analyze and classify financial data. This should be done in such a way that various kinds of reports needed for different purposes are all readily available from the financial data. they are much more likely to be outside specialists. the management of these should also be of concern. Their responsibilities will include: bringing together. to the public. with maintaining day-to-day cash resources to enable the entity to efficiently function. Cash management is concerned. pension funds and other matters are properly disposed of. This function also deals with investment of surplus funds. Here it will be that the more qualified and senior personnel are likely to work. is the preparation of the periodic financial statements through which the entity will report its overall activities to the outside world. Included in the process of debt management will be the timing and frequency of the raising and repayments of loans and the making of advance provision for the contractual obligations to pay principal and interest obligations on specific due dates.
Thus. rather than the mere slavish following of detailed rules and regulations. This type of accounting is. 56 . to continue with detailed analysis and allocation. This can sometimes be to the point where the overheads become more significant than the prime costs to which they relate. a decision will be needed as to the form in which the annual financial statements will be prepared. The full extent to which such principles exist. is not addressed in this document. As a generality. there is plenty of scope for compromise between these two systems and others. Frequently. full accrual accounting. in the interest of meaningful financial reporting. However logical a system of classification. In some countries. is becoming increasingly the norm under internationally recognized accounting principles59. including the newly independent states and restructured economies of the former Soviet system.orientated. 59 The expression “internationally recognized accounting principles” is used here as a generalization. one often runs up against the question of whether this should be an independent commercial auditor or a government auditor. concentration on the allocation of overheads becomes more important than base primary costs. However. such as an auditor-general or state auditor. or for what purpose. As a consequence of this. in essence. However. Preparation of accounts for management purposes may well demand that there be a separate unit within the accountancy function. by whom. This is obviously an area requiring professional judgment. it should be capable of being carried out with independence. it seems pointless. even for non-revenue-seeking activities.” In other cases. it is necessary to seek out and to use the best and most appropriate standard practices currently available.Depending on the legal status and operational characteristics of the entity. Coupled with external financial reporting goes the question of external audit. merely to produce an elaborate output in which no-one is interested! There is a corollary to this. beyond a certain stage. The greater the details of analysis. there has been reliance upon a central “court of accounts. efficiency and promptness. because financial reports cannot become fully acceptable unless they are regarded by those who receive them as credible and authentic. Moreover. internationally. a system of recording and classifying activities in such detail as is necessary to enable managers to make better decisions. No matter who does the audit. a commercial type of audit is considered more appropriate. even at current valuations. The fairly recent emphasis on “activity-based” accounting. the more it becomes necessary to arbitrarily allocate overheads of various kinds. it is probably true that revenue-earning enterprises will more appropriately produce accounts on commercial lines. currently. tend to produce fund-oriented accounts. are recognized. Non-revenue-earning enterprises will. This should be the guiding principle of cost-accounting systems. cost-accounting should be user. public enterprises and entities are required by law to have their accounts audited by public officials. This is true. using auditing standards that are acceptable within the profession and consistent with best practices. When one considers who is best qualified to give such an assurance. at all times. budgeting and costing recognizes that many activities have become less physical and more information-based. dealing specifically with management or cost accounting.
as a whole. earlier. There is. However.. whilst allowing the internal auditor. It should address how the financial management system. Risk management might be placed into two main categories. such verification should be routinely carried out by those within the respective payments and receipts sections of the finance department. not least because the auditor might. To quote from a former president of the Chartered Institute of Public Finance and Accountancy (UK). instead. however.. among other things. It must not be overlooked that an internal audit might uncover concerns relating to the chief executive personally. discretion and subtlety will be necessary. eventually. to go “over the head” of the chief financial officer and report directly to the chief executive. with regard to the management of property.. an internal auditor must discover ways to be “. Instead. to be able to disagree without being disagreeable. to ensure that they achieve their intended purposes.friendly to all and too friendly to none. The second risk is sometimes referred to as “public liability” obligations or “third party” insurance.” Risk Management Before leaving the subject of financial administration. The responsibility of an internal auditor is. This seems wrong. The former requirement may facilitate greater awareness and comprehension of financial complexities: the latter may promote a broader overview and possibly swifter (and more decisive) action to remedy shortcomings. is the projection of the entity's own properties. which affect the financial activities of the entity. be a more "lean and mean" organization. an internal auditor's role is seen mainly as confined to verification of receipts and (especially) payments. The first risk is often dealt with by what is referred to as “hazard insurance. In such a case. The second concerns the protection of the entity's financial position against claims by outside parties. as already indicated. reporting directly to the chief financial officer.” covering damage resulting from such things as fire. In some public entities. 57 . there are many other aspects of risk management. The internal audit section should. to continuously appraise and review the systems of internal management and control. prove to have been wrong. performs. This was touched on briefly. The first.. This could be where the chief financial officer is perceived to have a conflict of interest in directly receiving the report. some contention as to whether an internal auditor should normally report to the chief financial officer (the auditor's professional peer and supervisor) or directly to the chief executive (of greater independence).Complexities and interrelationships within a finance department can only be kept in context and looked at in their entirety if there is an efficient system of internal audit. attention should be given to the question of risk management within the organization. A compromise might be to require routine reports to go to the chief financial officer. in appropriate circumstances. or to the chief executive. floods and theft. or too zealous.
This will usually be translated into an operating or recurrent budget. of course. machinery and equipment. as modified. so that the operational policies and the financial implications of these may be brought into equilibrium. such as budgets or accounts. as well as their sustenance. Financial Performance One turns now from an evaluation of financial administration to that of financial performance. The financial implications of the programs and plans must be brought to the attention of the entity's management. Closely related to the planning and budget activity is the question of the entity's overall financial performance. so the entity may well wish to receive specialized advice on the management of its various types and levels of risk. Secondly. Insurance is only one way by which risk management may be dealt with. Over-insurance can sometimes be just as costly as under-insurance. For this purpose. First. a judgment must be made as to whether the risk. In addition. programs and budgets for this performance.Risk management and insurance management are not the same. Inside the bounds of those policies. that these are up-to-date. will require plans and programs for capital investment in land. are usually unsuitable to use for permanent database systems. operating departments and technical specialists should have prepared plans and programs to carry on the operations within defined limits of resources. A starting point for this is often a preparation of pro-forma financial statements and forecasts. to evaluate (in detail and in total) the various components of operating and capital budgets and the relationships among then. provided. Then. therefore. 60 Spreadsheet systems. One reason is that the flexibility of spreadsheets makes it difficult to establish audit trails or to recover from errors. decisions must be taken as to how the risks might be minimized by appropriate management action. It will be the responsibility of financially and economically trained staff. Using this device. Mention of computers implies that no analysis of financial management capability can be complete without thorough review of the management information system as a whole and of the computer processes within which it will operate. A budget may be described as the financial interpretation of a plan to put into effect the policies of management. infrastructure. must go back to an assessment of the basic policies which management has (or should have) laid down for the entity’s operations. plant. buildings. 58 . These activities will usually result in a capital budget. in the finance department or in a separate budget department. Since financial performance reflects the operations of the entity. is acceptable to the entity and whether (or to what extent) it should bear the risk from its own resources or through a system of insurance. While the budget is often a key document within a public enterprise or governmental unit. used with microcomputers. though excellent for analysis. its preparation is often done in ways that leave much to be desired. the growth of operations. For past activities these statements can usually be derived from the accounting information and financial statements. a useful tool is the electronic spreadsheet. it seems appropriate to examine the system whereby the entity plans. the risks must be identified. Preparation of a useful budget. it becomes relatively easy to test any number of operating scenarios to determine their financial implications60.
Financial forecasts will normally be based upon the plans. if a local government unit. The above company. they should be modified. Decisioneering. These must be used with caution and only to measure what is related 61 Forecasting software is now available for this purpose. there are special rates for teaching institutions. with the increasing and less costly use of more sophisticated computerization. Among the means used to measure and monitor the effectiveness of financial policies will be appropriately designed accounting ratios. the accountancy system probably was the management information system. Sometimes. What should such recommendations concentrate on? An overriding concern would undoubtedly be that the entity will have a continuous supply of material. by local or national revenue sources. A key ingredient is the establishment of the present financial position of the entity. The appraisal would also be concerned with organization. prices and personal remuneration).g. investors and lenders. organization. be highly speculative.decisioneering.com/orderchoice_index. accounting. of course.” 59 . statistical. therefore. higher levels of government. Among policies to be considered are those related to financial performance. 62 Risk analysis software is also available for this purpose. In the past. customers of the entity. or at least most of it. Future financial performance can. policies and skills. economic. and. It is. human and financial resources to sustain its intended level of operations. particularly with regard to revenue generation61. to determine whether this is a sound base from which to go forward into new and expanded activity. the public at large. appropriate to examine a number of possible scenarios. Recommendations for Project Institutions Appraisal of financial management capability should obviously result in a series of recommendations. Although this software is expensive. perhaps attention should be directed at four main issues: motivation. even within well defined policies. These will including a decision about the extent to which it should be financed by debt or equity or. One example of this (CB Predictor) may be obtained from an organization called Decisioneering: (www. the accountancy system is seen as only one module in total management information systems dealing with financial. This will enable judgments to be made as to whether the entity will be able to operate with margins of safety. in an increasingly integrated fashion. both within the entity itself and within the administrative and financial environment within which it operates. technical and other data.html). Within this overall concern. taking account of operational policies. supplies “Crystal Ball. programs and budgets. Now. pricing and financing of the enterprise. for many enterprises. A review of past statements will give an indication of the extent to which the entity has met its past obligations with regard to its financial objectives. Included in those to be motivated are: the entity's own staff. using sensitivity and risk analysis procedures62. to the extent that they exercise control. other motivations are necessary. for the future. It may also indicate whether those financial objectives were realistic or whether. motivation can be facilitated or enhanced by monetary incentives (e. Sometimes. No good ideas for the improvement of operations are likely to succeed unless those concerned with implementing or supporting those ideas can be properly motivated.
60 . perhaps. comes full circle to motivation. This. staff development and personnel policies.to them. Focus upon skills draws attention to needs for training. for it is only through the employment of dedicated and well-motivated people that public entities will fulfill their intended objectives.
61 . Such an appraisal demonstrates the limitations. becomes an important feature of internal and external monitoring. to the extent that needed goods and services can be more efficiently provided in ways that are more economic. postponement or elimination of projects. Projects. accounting represents only one input to the appraisal process. requires skill and judgment going well beyond accounting. as well as the strengths. though based upon available financial information. however. necessary for an appraisal team to be able to empathize with project owners and promoters. It is clearly in the interests of both the promoters and the public for the appraisers to be objective and professional. Thus. enthusiasm and leadership. albeit an essential and important one. even if negatively. planners and other technical specialists. as already indicated. It should be the least-cost feasible solution to the problem being solved and should expect to produce net economic and/or social benefits. It should also have a feasible and flexible financing plan. financial performance. appraisal should be concerned with the curtailment. To some extent. An appraisal is clearly intended to be critical and constraining.APPRAISAL OF DEVELOPMENT PROJECTS Introduction The appraisal of financial management capability is often a prerequisite to the appraisal of a development project. are engendered from vision. if the project is not expected to make sense. In the last resort. rather than merely finding ways to damn it and to criticize it. a development project cannot usually be considered acceptable unless it is economically. technically and institutionally sound. However. with the courage to report fairly. it should be so reported. Financial and managerial specialists can largely carry out appraisal of financial management capabilities. efficient and economical. measured through the accounting process. Considerable emphasis should be directed at producing a project that is more effective. as the project is implemented. It is. of financial information systems and the need to relate these to other disciplines. typically engineering and economics. Nonetheless. In addition to being financially viable. whose practical skills lie in the evaluation of the technical and economic soundness of whatever is to be constructed or operated. or to work effectively and efficiently. it is almost impossible to appraise a development project without the assistance of engineers. with adequate margins of safety. it is not the purpose of the appraisal team to provide this. Forecasting of probable results. Furthermore.
a water supply project was designed for the remote operation of "source of supply" facilities by an expensive buried cable. By the time of construction. as well as engineering and technical. In the age of rapidly changing technology. Huge ontract savings thus provided for some needed additions to the corporate offices. using financial or economic analysis.An important aspect of this process is the perspective or "accounting stance. valuation or assessment of economic costs and benefits. 62 . There is also. the professionals that carry out the appraisal must have regard to all of the inputs referred to. (c) (d) Technical Appraisal It is not the purpose of this document to detail how technical specialists carry out their own professional functions with regard to development projects. However. necessary to understand broadly what they are responsible for. due to age or lack of repair and maintenance. and. space – a project perceived of as dealing with issues within one set of spatial boundaries may have different outcomes when perceived of within a different one. legal and commercial skills. as indicated. due to obsolescence64. and. this task could be much more economically performed by radio. usually results in the construction or acquisition of physical infrastructure (or other building or engineering structures) intended to provide additional capacity in meeting the service for which the entity is responsible. a need for empathy with project leadership. 63 64 This has been encapsulated in the idiom "Where one stands often depends upon where one sits!" In one situation. This does not necessarily mean that individual professionals in all these skills need be concerned with the appraisal. economic. almost by definition. through deterioration. This additional capacity may be either to meet growth in demand or merely to replace existing capacity that is falling out of use. accountability – the viability of a project may be judged from different methods of accountability. A development project. Among the skills required for the appraisal of development projects.63" This has at least four principal dimensions: (a) (b) perspective – a project not seen as viable for one group of promoters or observers may be perceived as viable for another. for example: straightforward financial profitability. projects may be more concerned with the replacement of welloperating facilities that have yet become too slow or cumbersome. managerial. It is however. including or omitting economic externalities. not easily quantified in money terms. so that the financial professional can carry out his or her duties within the right context. are financial. time – a project perceived of as a success (or failure) over one time frame may produce a different result over a different time frame.
rather than a one-time event. a railroad may run more frequent or longer trains on the same track. This. What this may really mean is that the appraisal process should be a continuous one. unfortunate that the substantive work of the financial specialist can hardly begin until engineers. this provides time which the financial specialist will need. This is also an unfortunate dilemma from the economic perspective of “sunk costs. It is. up to its capacity. This may be. However. While the technical specialists are concerned with the physical project. or. because its gradually declining marginal costs are comparable with the total costs of all the other choices. because these consist only of the costs remaining to be incurred. architects or planners have done a considerable amount of technical work. A water supply system may use service reservoirs to handle daily peaks. peaks in one part of the system can be compensated for by slack demand elsewhere. Otherwise. if the upgraded system is to meet every conceivable demand placed upon it. kilowatt-hours (and kilowatts of maximum demand) of electricity. for example: numbers of passengers (per-hour or at peak times) on a bus or rail system. This process has already been described. the project under consideration is more and more likely to be chosen. 63 . Assessment of Demand and Capacity Among the first things that the technical specialist must examine is the estimated physical demand for the service or product provided by the entity. with the appraisal process merely perfunctory and relatively meaningless. project implementation will become a foregone conclusion. sensitive to prices intended to be charged. Consequently. On the other hand. cubic meters (gallons) of water. however. non-revenue-earning projects. such as roads. can be turned to advantage. Electricity systems must usually provide for all the peaks to be met from increases in generation capacity. How the peak is to be handled is very dependent upon the operating characteristics of the service. adding to the source of supply only for seasonal peaks. of course. the use of a national (or regional) grid means that increased capacity is needed only for simultaneous peaks in the system as a whole. to examine the management capability of the project entity. For this reason. be a fully reliable guide for the sizing of projects. it is important for project appraisal to take place early in the evaluation or decision process. on feasibility and design. and hopefully use. These. has been performed. as a prerequisite to carrying out a financial and economic analysis of the project itself. Demand estimates based on purely physical requirements will not.” When much design work.There is an important time dimension to a relationship between technical specialists and financial specialists in the appraisal of physical development projects. relate to revenue-earning enterprises and are. will require assessments of demand derived from traffic counts and an overview of real estate development prospects for different areas where roads will be used. as stated later. to some extent. For example. and some initial physical work. in these circumstances. Otherwise. Peak loads and average demands are both important. The estimated peak load largely determines the design size of the project. this lowers the “marginal” costs of the project. since it is relatively easy and inexpensive to transport electricity (or balance the loads) over long distances.
may well need to be traded against specific goals for raising revenue66. Overall economic efficiency. thus increasing the unit charge. it is important to appreciate that these revenues must still be raised -. it might become more economic to keep down tolls than to extend the rest of the road system. either as staff or consultants. though these are somewhat curtailed when the system is not operating at full capacity.g. Therefore. Peak load largely determines the system costs.Peaks on roads65 will be constrained (to a limited extent) by traffic congestion and might (also to a limited extent) be dealt with by tolls. Capital costs and related financing costs are. are largely a function of average demand and sales. Instead. it is also of concern to the financial analysis. Although revenues are not direct charges upon consumers. Here again. he will become involved at a stage usually referred to as a "feasibility" stage. This will postulate its size. The appraising engineer will examine these proposals with the entity's engineers to determine whether they are. are strongly influenced by system size. almost entirely. this might create more costly congestion on another part of the road system. but to a less dramatic extent. it will not be the appraising engineer's responsibility to carry out the detailed physical design of the project structures. feasible. Alternatively. designs are influenced by peak demands. which might be considered as of greater economic benefit. 64 . on the other hand. the more is the excess-capacity cost. also.from limited tax resources. Thus. in both quantity and time. Many of these taxpayers might not use the (e. Normally. when dealing with roads. (subsidized) trains and other urban infrastructure improvements. broad design parameters and the timetable for implementation. peaks on roads relate to the entire system. An examination will be made of the technical soundness of the proposed construction and also of the plans for carrying out the construction in the most economical way. although they may still benefit from it being used by others Physical Structures It is principally by engineering analysis that the physical demand for services will be related to the existing capacity to provide them and the incremental capacity needed to add to the existing supply. train) system at all. within an urban environment. Road tolls are a special example of peak pricing. Engineers employed by the project entity itself. Differential fares might (to a limited extent) deal with peak loading on buses and trains. as well as the need for rehabilitation of other structures. Revenues. indeed. 66 If a higher toll deters motorists from using an under-used toll road. determined by the overall capacity. Whilst the question of peak loading is crucial to system design capacity. Also to be examined are the capabilities and requirements for maintenance of the structures once they are completed. This can sometimes be mitigated by the use of differential peak-pricing systems – but these are often impractical or expensive to operate. the greater the divergence between peak and average demand. Users choose to pay either the peak charge (the toll) or nothing! Equally important is to establish demand for services of a non-revenue nature. Operating costs. such a policy might deter the use of shared rides. because traffic congestion induces some motorists to take roads that they would not normally use at less-congested times. larger non-revenue-earning projects will usually mean higher taxes per head on a limited number of taxpayers. not just the particular road. will have prepared an analysis of the need for a particular type of development project. Whereas larger revenue-earning projects may often increase sales and therefore revenues. borne by the average user of the service. intended to operate 65 As for electricity grids.
such as pumps or transformers. Sometimes social benefits result from the project. absent well-appraised projects and complete information. Furthermore. because the investors in the safer ones. Once the least-cost feasible solution has been determined (and this is not as easy as it sounds) another step in the economic analysis is to determine. be invested. 65 . illusory. the interrelationship of costs. too. postulate a target discount rate) to several decimal places is. that however soundly constructed the project and however financially viable it is likely to be. Joseph Stiglitz (former Chief Economist of the World Bank) questions the efficient allocation of capital by the free market. a key determinant to going ahead with it is a satisfactorily economic and/or social cost benefit analysis. as far as possible. an attempt is made to measure the return from the project against possible returns from other projects into which the capital might. which are almost impossible to measure at all. at least in theory. which is perceived as in excess of the "opportunity cost of capital" that will be invested in the project67. It is also not at all unlikely that the proposed solution does not necessarily represent the least economically costly way of solving the problem. To imagine that economic analysis can yield a single rate of return number (or. is to establish an economic rate of return. The appraising engineer (or other specialist) must therefore examine a number of feasible solutions. Whether or not this is valid. for it frequently requires the assessment of benefits that are difficult to measure in monetary terms. He or she must analyze the overall costs and the timing of such costs. it does provide a good argument for sound project appraisal. indeed. rather than relying on investor speculation or even on the crude judgment of banks. It can be said. with lower expected returns. alternatively. is often far from easy. banks will raise interest rates. One of the first things to determine is that the project proposed represents the least (economic) cost and feasible solution to the concern being addressed. together with the costs of inspection of assets that are safety or health hazards. It is highly unlikely that there is only one sound technical solution to the problem. These might turn out to be those investing in riskier projects." One aim of economic analysis. to determine which of the solutions has the least present value in economic terms. Cost estimates will be required for the interim replacement of shorter-life assets within the project. But. 67 One economist.in harmony with the proposed project. may have dropped out. Put another way. the economic rate of return likely to result from the project. the banks will then lend only to those willing to pay higher rates. This. benefits and prices and how they affect one another means that it is often difficult to operate on the basis that "all other things are equal. such as dams or smokeemitters. Economic Evaluation This physical appraisal is an important prerequisite. more correctly. The common implication that economic analysis is somewhat theoretical should not detract from its usefulness. If the demands of borrowers outstrips the supply of funds. explaining his concern through the mechanism of interest rates. and is closely related to. almost categorically. economic evaluation of the project.
” This can be tested against the current price and the future price possibly chargeable. representing what every likely consumer is prepared to pay (at the margin) as a minimum. for a (natural) monopoly. by way of extra revenues. in determining real or economic values69. This is explained. further. Finally. or part of it. these additional economic benefits will not be translated into improved financial performance. 69 This is not always strictly accurate. this may not much matter. revenues from sales of the output from the project are likely to be used as surrogates for the benefits to the consumers. If prices are set to equate the (marginal) benefits to the (marginal) costs. The determination of the least cost solution implies the use of the discounted cash flow methodology. With many public utility projects. If project costs and expected system maintenance (perhaps involving foreign costs) are expected to rise at a faster rate than (say) customer revenues. any significant increases in price are likely to result in reductions in demand for the service. in turn. unless adjustments are made in the calculations for differential rates of inflation – such as cost and wage inflation. whereas the financial analysis will need to be done in current prices. this confuses people! Confusion can. if all quantifiable benefits have been assessed. With the advent of the new development project. this implies a certain amount of circular reasoning. Thus. one should also allow for different exchange rates.” The project rate of return will be the discount rate at which the net present value of the project is zero. 66 . They are based. This. however. often perfectly reasonable to seek a number adequate within a range of one or two percent on either side. Depending upon demand elasticities also. This sometimes leads to difficulties. Unless the "consumers' surplus". As already indicated. can be captured by the entity through a system of differential prices. to reflect funds requirements. This turns quantities exactly into money values. instead. In theory. From a financial viewpoint. with such a wide disparity between the existing and likely future prices. the non-quantifiable or social benefits of the project can be judged for their adequacy within much narrower limits. rather than money values. the economic analysis is based upon a minimum measure of benefits. on an assumed willingness to pay. Although completely valid. Furthermore. both with regard to their amount and their timing. is to calculate the “average incremental (marginal) cost price. WARNING: The calculation involves the discounting of quantities of (say) water or electricity. in turn. perhaps held down by economic privation. without altering the amounts. the marginal cost is likely to be even higher. implies the use of a specific discount rate. derived from the quantification of all measurable data. the revenues used in an economic forecast can hardly be said to be based on observed willingness to pay by the consumer. in a later section. they take no account of the possible willingness to pay of individual consumers above the average price. Thus. however. representing an “opportunity cost of capital. which is a far less rigorous concept. economic analysis will normally be carried out in constant prices to eliminate the effect of inflation upon both costs and benefits. fixed far below the marginal cost of providing the service. at least by acknowledging these as risk or sensitivity factors. forecasts made at constant prices will tend to overstate the project’s financial (and consequently economic) benefits. One remedy. be mitigated by assuming each physical unit of the quantities to be sold at a price of one currency unit. Costs and benefits can then be tested for sensitivity and risk. meaning that prices of services are almost certain to have to be raised. which will act as a focal point. The first one arises because often the existing service is being provided at sub-optimal prices. The Cost Estimate and Financing Plan 68 There is an anomaly here. require a redesign or postponement of the project. The prices assumed for the revenue calculations will be average prices68. Thus.It is. This might. no allowance is made for the so-called "consumers' surplus.
both with regard to the amount and the timing of their availability. The first alternative is to regard the project as standing on its own and to develop a financing plan which meets the construction costs of that particular project. to facilitate the cutting-back or postponement of the project itself or perhaps of other less essential parts of the investment program. as the project proceeds over several years. In addition. indeed. it may be (at best) less economically efficient or (at worst) not really work at all! Moreover. a project must be either finished or abandoned. any reduction in its components is likely to make it. the project will.The linking of the economic analysis to the physical evaluation of the project. Price escalation must also be included. Sometimes. Technical contingencies must be included. After all. In this case. with the availability of funding in the financing plan itself. is whether additional funding can be made available from other sources. This is certainly not as easy as it sounds. at least on reasonable terms. in money values. Intended sources of finance will have to be assessed. likely. in such an emergency. the costs of its inputs are likely to rise. There is no point. to some extent. Sometimes. The financing plan cannot be too tightly drawn but should leave adequate margins of safety. This should be broken down by components and include adequate provision for technical contingencies and price escalation. The development of a financing plan can be done from two alternative perspectives. hard choices must be made and there are no more viable alternatives. in building half a dam or a road to nowhere! 67 . in case something should go seriously wrong with the cost or timing of project implementation or. One thing to consider. however. there should be a fallback position. at least for the period of project construction. If additional funding. sub-optimal to its intended purpose. In other words. moreover. The other alternative is to regard the project as merely one component in the overall investment program of the project entity. including the investment requirements of the project and any necessary increases in working capital. Many of the components of this may be inter-dependent. be more expensive than that considered originally. if a project has been finely designed as an integrated package. the financing plan will be addressed to providing all of the funds necessary to meet the entire investment program of the entity. This additional funding may. for example. is unlikely. of course. or it may be more administratively irksome to obtain. not initially envisioned. This is because. then a contingency plan would be necessary. It may also be linked with unpalatable or onerous conditions. This would be particularly true if the additional funding were to be from governmental sources or from an international entity. jumps ahead of some of the aspects of financial appraisal and analysis. Cost estimates should be separated into cost components and phased over the years of project implementation. be just one component of an entire capital investment program. due to inflation. at least temporarily. allowing for changes in physical construction that almost inevitably occur and are beyond the control of either the contractor or the project entity. A most important outcome from the technical analysis is the preparation of a cost estimate.
The financial plan must be examined for its effect upon the revenues of the project entity. that ninety percent of project funding is in fixed contractual terms. maintenance and debt service requirements for its ongoing activities. When the net internal sources of funds have been ascertained in this way and matched against investment requirements. This is sometimes referred to as a “time-slice” financing plan. Provision for debt service will be needed. this will be a (national. These will include forecasts. These will only be available after the enterprise has covered all of its operation. the expected revenues will. This is particularly so with regard to both additional debt service and the operation and maintenance of the new facilities. The expenditure will include operation. even in the event of substantial cost overruns. for example. the analysis is not complete. For a revenue-earning enterprise. for example. In such circumstances even a modest ten percent increase in project cost would double the contribution of the government. 68 . result from charges to customers for goods and services. of internally generated funds. for financing plans to be highly levered against a residual provider of funds. to cover full project cost.Sources of funds for a financing plan can include borrowing. One other important source can often be that of internally generated funds. state or local) government. creating a serious situation. For a non-revenue-earning enterprise it will be necessary for additional costs. with the (state or local) government undertaking to provide the remaining ten-percent and to meet any cost over-runs. both for debt already current and also for debt expected to be incurred as a result of the current and future investment program. already hard pressed to come up with a minimum contribution to match those of others. At this point. derived from income statements. a summary of the cash flow statement for the period of project construction or implementation can quite often be used as the financing plan. repairs. They might sometimes include contributions from customers or participating enterprises. Indeed. Suppose. equity contributions or grants from governmental sources. including that of the project itself. It is not uncommon. It would need to cover all financial aspects of the project entity. maintenance. Often. Financial Forecasts Even if a satisfactory package of funds can be assembled. through the raising of additional taxes or from some other appropriate sources. to be covered from additional revenues. In assessing the quality of the various sources of funds. resulting from the project and other investment activity. of course. Cash flow forecasts will also be necessary. Forecasts of operating statements will need to have regard to revenues and expenditures. These may be highly sensitive to the prices currently being set (or intended to be set) for the sale of its products. administrative costs and (especially for a revenue-earning enterprise) depreciation. it will be possible to determine the amount and timing of external financing needed. one thing to be concerned about is the extent to which any or all of them are contractually fixed. it will usually become necessary for the financial analyst to prepare a complete set of financial statements and forecasts stretching into the future beyond the intended startup date of the project.
Unless there is a continuous and constant level of capital works. worth noting that private contractors may well be able to pay to employ cleverer or slicker lawyers (or accountants) than are available – or wished to be available – to the public sector! 69 . discussed earlier. discussions with the banking system or with macro-economists may prove to be inevitable. Procurement of Goods and Services Of particular importance to financial performance is the manner in which goods and services for the project are to be procured. The employment of a large direct labor force causes somewhat the same problems as the meeting of peak demand. For the rest of the time. Discussions with governments may also be essential where pricing policies are subject to government controls. of course. therefore. will be carried out by contractors and how much (if any) by the project entity's own staff. it will probably be important to get a commitment from the project entity to change these policies. both to cover operating costs and also to contribute towards investment. These must be prevented or investigated to the greatest possible extent. 70 It is. are inter-linked with the overall financial market of the country and in turn to its macro-economic policies. Sometimes. This will include the examination of present and proposed prices or tax levels and also collection efficiencies. their selection should be on the basis of competitive bidding. with the project entity. there is often an advantage to making the bidding international. These. Later contracts will either allow for this directly or else include financial “booby-traps” for the employing entity 70. Moreover. Indeed. albeit fairly to the contractor. in the sense that “the devil makes work for idle hands. it will be necessary for the financial specialist to analyze. be examined to ensure that they operate to the maximum advantage of the enterprise. There is no long-term merit in trying to “ambush” a contractor with unexpected obligations or expenses. it is imperative that a local government or public utility establish a reputation – and a public example – for fair dealing and straight talk. This may sometimes be done as a condition precedent to financing the project or to going ahead with construction or implementation. It may also be potentially disruptive of labor harmony. its revenue policies. and which components. Where foreign exchange costs are involved. In this case. pricing policies will be directly concerned with interest rates. part of the force will remain idle. Contracting procedures should. Decisions will be necessary as to how much of the project. The staff can only be fully and efficiently employed during peak construction periods. The overriding principle should be to get greatest value for money. It is unlikely that the interest rate policies and practices of a single entity can be changed without reference to the financial sector as a whole. which is costly. perhaps. If existing policies and practices are unlikely to result in the necessary generation of funds. capital construction contracts are notorious sources of corruption and fraud.To ensure that adequate revenues are available.” Where contracts are used. it probably makes sense to contract out most of the work.
70 . The financial professional will also need to be concerned with whether there will be a satisfactory project accounting system which. will be properly audited. in turn.Implementing Capacity Finally. administrative and financial capability of the project entity to undertake the project. a review should be made of the overall managerial technical. This will include a review similar to that conducted for general financial management capability.
This is because projects. just to generate revenues. the complex nature of inter-governmental financial relationships will often focus attention upon where the financing will be coming from.does it make sense. Furthermore. environmental and institutional consequences. are difficult to curtail. In particular. some costs may not appear.FINANCIAL. it needs to be consistent with national and/or local government policy. although this must be taken into account in the financial and economic analysis. key factors in judging the viability of a proposed public sector project are: (a) sensibility . implementation of a development project demands a good deal of prior planning and investigation. and (b) feasibility . these revenues often prove inadequate to cover the capital and recurrent costs71. they will typically provide only crude financial information on which to base decisions. there is sometimes misplaced prioritization of projects that may be capable of earning revenue. Judgments must be made with reference to (among others) political. before any physical or contractual commitments are undertaken. Furthermore. once started. Put very simply. 71 Under many accounting systems currently in use. commercial. rather than how it will be used. If government policy is towards upgrading less-developed areas. Political Feasibility However appropriate a project may be from other points of view. especially those pertaining to the use or cost of capital. bad choices can have serious financial and economic consequences. Indeed. This can result in the implementation of otherwise low-priority projects. because projects tend to be large and long-lasting. financial. The problems of choice are often exacerbated by inadequate accounting systems. let alone provide a surplus for other services. ECONOMIC AND OTHER ASPECTS OF CAPITAL INVESTMENT Basic Concepts As already indicated. Since public sector accounting systems are often cash-based. For example. Most public sector development projects will not have the primary purpose of earning revenue. Fundamental to public sector investment is the question of whether a project will provide or enhance a needed service. economic. better-off locations should not expect much priority. However. 71 .will it work. legal. over those of more social or indirect economic benefit. resources will be used up (or tied up) which might have been put to better use. A project that is essentially out of tune with political reality is virtually doomed from the start. for public bodies to propose investment in commercial ventures when the prevailing political climate favors privatization is not very sensible. Each will now be considered. social. technical. Revenue-earning potential is usually secondary.
or perhaps. deliberately ignored! Furthermore. A common example would be a search for a least-cost feasible solution. than another by an alternative route. The massive interstate highway system of the USA was partially justified on the basis of military readiness. if the proposal is strongly supported by a key group of political supporters. The fact that complete accuracy is not possible is not an excuse for ignoring economic reality. employment. A most important factor in such analysis is that it focuses attention upon the economic effect on society as a whole. Nonetheless. a project cannot be considered if it is against the law. the levy of a tax or even budgetary appropriation may all be constrained by statutory or administrative law. Where governments. The mere process of carrying out such an analysis will often force attention on important matters which might otherwise be overlooked -. the borrowing of money. The principal concerns are how to accurately assess the financial costs and benefits and how to evaluate those of a non-financial nature. However. easements. This reflected poor experiences in the two World Wars. though different. For example. Legal Feasibility Clearly. financial. The law must also be considered (and. might well be all biased in the same direction. one that is especially emphasized by experienced international financing institutions. or perhaps offers significant military advantages. Suppose a proposed road construction project to be much less economically and financially attractive. adhered to) relative to contracting. land acquisition. Support for it would also have come from the motor industry and petroleum producers. outweigh the economic costs of its implementation and operation? Easy to assert. but often difficult to determine. 72 . Economic Feasibility A basic premise of project analysis. more importantly. industrial safety. Will the economic benefits of the project. It could be. to the exclusion of common sense. I and II. also. it may well be chosen instead of the otherwise more attractive alternative. that whilst the proposed project itself is legal. problems of inaccuracy of data are often mitigated if economic analysis is used for comparison among choices. not merely on the implementing entity. there is a serious danger of being carried away by the attraction of numbers and formulae. local authorities and other bodies operate under legislation. where the data for each of the choices. and many other aspects of project implementation and subsequent management. Conversely. or much more technically difficult. technical or other criteria may sometimes be carried out for purely political reasons. this must require or allow the project activity. the value of economic analysis rests not only upon the accuracy of conclusions (which are likely dubious anyhow!) but also in the rigor of the analysis leading to them. overall. intended funding sources or revenue-generation may not be. is economic viability. these concepts have been subject to much discussion and argument among economists and other professionals.A project that does not meet sound economic. by some.
During the five-year period. the numbers." the commerce relating to the road could be simulated as follows: Cost and profit to producer of one widget = $100 Cost of vehicle for one return journey to market. be recovered. eventually. however. though economic in origin will affect the financial analysis (see below). coupled with high unemployment. There is. of course. Take. where costs are to be recovered from future service charges. almost exclusively. is rarely true. inflation is ignored) because it is concerned not with money but with the real value of goods and services that money will buy. the simplicity of the illustration. in turn. another major reconstruction will be necessary. water and transport) services or urban development. especially if imported from elsewhere in the economy. The purpose is to illustrate an overall financial and economic strategy. a danger in this. where there may be shortages of construction inputs engendering high prices for these. 72 One should not be deterred by. for the transport of commodities to the market for sale. For greater detail on the tactical aspects of borrowing. This will be an upgrading of a road. reference should be made to another RTI participants’ manual “Capital Investment Programming and Financial Planning. perhaps by widening it or improving the surface or loadbearing capacity. money values and time periods used will not be particularly realistic. for example. This. a capital construction project for (say) housing. This might well not be so. 73 . Assuming an average unit of local production and transport to be represented by a "widget. Many lessons may be learned from it. the minimum sale price in the retail market = $(100 + 200) = $300 Assume the road to be in poor condition and to carry 500 vehicles per day. A proposed project to reconstruct the road is estimated to cost $500 million. which. To illustrate the principles of economic analysis.” Consideration will be given to a simple but typical project to be executed by a local government entity.e. especially in some economically depressed areas.g. It will be assumed that the road is used. rents or taxes. tax rates and utility charges. Economic analysis also makes the very bold assumption of all other things being unchanged – which. Yet it will be these personal incomes – falling in relative terms – from which costs must. property sales. carrying 100 widgets = $20. or disdainful of. To highlight the principles. Such a procedure is only truly credible if all inflationary costs are estimated to increase at the same rate. A relative shortage of capital inputs and their growing real costs. After that. without becoming bogged down in computational problems. may well bring about price rises which are significantly in excess of increases in personal incomes – held down by the unemployment. it does not begin to address the administrative and political problems of adjusting tax-bases.. Furthermore. public utility (e. consider a greatly simplified but obvious example of a road improvement project72. will often have serious political consequences.Economic analysis is usually carried out in constant prices (i.000 Transport cost per widget = ($20.000/100) = $200 Thus. resulting in low wages. $18 million per year will be required for maintenance. and to last for about 5 years.
10% is used for simplicity. In the South." or paved with limestone or other rock. during British colonial rule. Even by Ramanujan's time. Thus. bullock cart and canal boat. These are. The net annual economic benefit would be: $(m) 150 18 ---132 ---Assuming the original capital cost ($500 million) to have been borrowed at a real cost of 10%74 (i. not reflected here. the market rate of interest is the real rate.000 per truckload per day. the increased benefits – economic. transportation in India. following oft-used practices of international entities. the trip took one day. normally planned on carrying two-thirds the load at two-thirds the speed. financial – are incalculably immense. however. By the following year. Therefore. the first lines had been laid in 1853. 74 . the improvement in driving conditions is estimated to cut vehicle-operating costs by 5%. this might not necessarily be a realistic assumption. of course.000 per day for the 500 trucks. shown later in the text. had been painfully slow. apposite to a developing country situation. over 5 years would be almost exactly $132 million. It was the crowning engineering achievement of the British Raj. who writes as follows. gross benefits. $1. They are described in the Book "The Man Who Knew Infinity" by Robert Kanigel. Roads were terrible. 74 When compared with the nominal rates of interest for project financing. Thus. The difference was considerable. with inflation ignored) the annual debt service. and in 1874 they began pushing south from Madras. India. "The coming of the railroad had changed Indian life. Twenty-five miles was a good day's journey. Jones. As economists say. This totals to a daily saving of $500. for Project Evaluation and Analysis" by David C. which influence both real and nominal interest rates.However. In principle. which would need to be offset against the costs. Thus. economic costs would be covered by economic benefits. emerging in the mid-nineteenth century to knit the far-flung country together. with the line to Vizagapatnam still unfinished. The more usual and formal way of setting out the discounted cash-flow statement75 in this case would be (millions of dollars): Year Gross Gross Discount Discounted Discounted Cost Benefit Factor Cost Benefit 73 Savings in marketing costs Less annual road maintenance costs More dramatic examples. This would be a saving of $10 per widget. it can be seen that a simple improvement of the road surface could improve productivity by more than double (2/3 * 2/3 = load * speed = 0. If there were (say) 300 working days per year. in the first paragraph. rather than a metalled [tarmac] one.or from the instructional books of financial calculators. Using the Discounted Cash Flow Methodology. could be found in the Region of Madras. the total saving would be $150 million73. at a 10% interest (or discount) rate. "For eons. Reference may also be made to "The Use and Limitations of Net Present Value and Rate of Return Concepts. the project would have an "economic rate of return" of 10%. commonly used in economic analysis. Cart drivers forced to travel on bumpy dirt roads thickly covered by dust or mud. It also avoids complicating the calculations. This is a very simple example of the discounted cash-flow technique (DCF).e. political. In 1892. to get there from Kumbakonam could still take three weeks by train. construction now complete.44). each widget would cost only $190 for transport and thus sell for a minimum of $290. only about an eighth of the Tanjore District's seventeen hundred miles of road were "metalled. In the second paragraph. adjusted upwards for inflation. by bullock cart or the one-horse vehicle known as a jutka. 75 Detailed explanation of discounted cash-flow methodology can be obtained from standard texts on financial and economic analysis . There are many factors. social.
followed by an outlay of $18 million per year (ignoring inflation) with no direct revenue. in the public sector.00000 500 1 18 150 .75131 14 113 4 18 150 . additional road users will also add to the operation and maintenance costs of the road. Indeed. there would be a real net economic benefit. the lower costs of travel would likely attract more road users.90909 16 136 2 18 150 . there would also be an opportunity for a local government to increase property taxes or business taxes. Secondly. retailer and final consumer .(PV@10%) __________________________________________________________________ $ $ $ $ $ 0 500 1. though claiming to seek aggregate and overall economic efficiency of resource use. as already indicated.82645 15 124 3 18 150 . They are. thus. to appropriate money for public use. assumes that the road reconstruction is carried out at the least economic cost for the nation or community as a whole. It thus assumes an economically optimal use 76 Unfortunately. which must be covered by taxation. They arise from political decisions by governments.68301 12 102 5 18 150 . Firstly. economic analysis. is indifferent as to where the benefits fall within the economy as a whole. a financial loss.” To impose these costs with impunity makes one a “free-rider!” 75 . However. a property tax or business tax increase would. thus increasing their economic benefits76. the necessary tax revenues may best be realized. indeed. All the above analysis. otherwise than by tolls or deteriorating user costs for their own vehicles. as new users cannot be excluded. Moreover. to the government. Market forces would probably operate so that every party . More likely. In principle. Thus. Economics. transporter. there will have been is an initial financial outlay of $500 million. if levied.manufacturer. This serves to illustrate two main points. because the lower price might well result in more widgets being sold.62092 11 93 --------590 750 568 568 --------Clearly. congestion or physical and personal hazard) do not influence their own behavior (except to the extent that they rebound onto themselves!). local tax revenues are not particularly buoyant with respect to improved economic activity – even where a local government authority (as in this example) has played the major role (and incurred almost the total cost) in stimulating it. local authority or public utility. Additional economic benefits would probably accrue to other road users. referred to as “externalities. taxes are not a measure of benefits at all. unless tolls are levied. not occur. therefore. and somewhat perversely from the viewpoint of a local government entity. It is. This is partly because the costs which users impose on other users (such as pollution. Increases in income or business profits would likely result in larger tax revenue to the national (or state) government through higher income or corporation taxes. almost certainly. in both the public and private sectors. does not particularly care who is helped and who is hurt! It is also indifferent as to where. there may yet be a net economic loss from the “new user” component.would all share the benefits. This could be greater than first indicated.
sufficient. Secondly. 78 This method of amortization is similar to a house mortgage. A $50 million loan.87 million. is not. Furthermore. an economically sound project may still subject the public sector to severe financial stress. So. materials. a financial analysis must also be undertaken. Financial Feasibility Economic analysis. 77 It is not always the case that local (or even national domestic) inputs are the least economic cost. whilst necessary. by the authorities concerned. The 6% loan from the state government is assumed to be repaid by the annuity (level payment) method. Foreign goods and services may sometimes be more economically priced or more efficiently operated. Annual inflation will be assumed at 4%. such as a local government authority. estimated to cost $500 million. repaid by this method. Firstly. applied to the maintenance costs. the financial outcome of the investment must be manageable. over 5 years78. 76 . relative to that which could come from other areas of the country or abroad77. by itself. would require an annual level payment of $11. That is one reason for the efficacy of international competitive bidding. there must be an assurance that funds will be available for the investment. Assume there to be a federal government grant for 20% of the total ($100 million) and that the remainder will be financed as follows: $(m) State Government (Subsidized) Loan (6%) 50 Local Government’s own Capital Fund (currently invested at 5%) 50 Bond Issue (8%) 300 ---$400(m) ---Arbitrary assumptions will be made about the breakdown of various project expenditure categories. services and equipment.of local labor. Continue the example of the road improvement. Because the economic costs and benefits do not necessarily accrue to a single entity. inflation affects money values much more than economic values. taking account of administrative constraints.
50 1.00 30.00 10. is analogous to a loan.The amortization schedule would be as follows: YEAR ANNUITY $m 0 11.97 10.50 OUTSTANDING WITHDRAWAL $m 50.76 11. at the "coupon" rate of 8%.31 0. The capital fund replenishment table would be as follows: YEAR CAPITAL FUND REPLENISHMENT $m 0 10. These are sometimes known as “trustee” securities. depriving it of interest earnings.56 11. The 5% loss of interest is analogous to interest on a loan. but these do not affect the basic principles.00 41.40 9.67 PRINCIPAL AMORTIZATION $m 0 8. This depends on financial policies. there will be such a cost somewhere in the system.00 20.00 10.00 0.20 BALANCE OUTSTANDING $m 50. equaling $24 million. sometimes exceedingly so. Bond interest is more usually paid half-yearly. It is assumed that the withdrawal is replenished annually.20 0 0 1 2 3 4 5 The withdrawal of $50m from the capital fund.87 11.13 31.00 40.00 INTEREST FOREGONE $m 0 2. It reduces annually as the fund is replenished79.87 9. invested in trustee securities80 at a (conservatively estimated) interest rate of 5%.00 10. 79 A project may not always be required to repay (or to pay interest on) capital fund withdrawals.00 0 0 1 2 3 4 5 The bonds are assumed to be issued at par and redeemed at maturity from an accumulating sinking fund.90 1. by a $10 million contribution for each of the five years. 77 .73 21.87 11. Nonetheless. 81 This is for simplicity of understanding.50 2. in economic terms. Each annual interest payment would thus be 8% of $300 million. to emphasize the nature of the public trust assumed by the investors.00 1.47 1. such as national government bonds.00 2. Repayment methods are usually also more complex.87 11.87 INTEREST $m 0 3. It is just a question of which account (or who in the economy) will bear it! 80 Laws in many countries require public funds required for special purposes to be invested in safe funds.87 11.00 10. Interest on the bonds is assumed to be paid annually81.00 10.
4 $m Yr.3 $m Yr.01 300.71 5.30 171.56 11.29 54.70 ACCUMULATED BALANCE $m 0 54.29 111.57 8.1 FUNDS REQUIREMENTS: Capital costs Land Civil Works Equipment Materials Administration Maintenance: Contractors Direct Service Supervision Debt-service: State Government: Interest (6%) Amortization Bonds: Interest (8%) Sinking Fund (5%) Capital fund: Interest loss (5%) Replenishment TOTALS $m 50 200 75 150 25 11 6 1 3 9 24 54 3 10 --121 === 11 6 1 3 9 24 54 2 10 --120 === 12 6 1 2 10 24 54 2 10 --121 === 12 7 1 1 11 24 54 1 10 --121 === 13 7 1 1 11 24 54 1 10 --122 === Yr.6 $m --500 === FUNDS SOURCES: 78 .5 $m Yr.The sinking fund table would be as follows: YEAR SINKING FUND CONTRIBUTION $m 0 54.16 234.29 INVESTMENT INTEREST $m 0 0 2.29 54.2 $m Yr.29 54.00 0 1 2 3 4 5 A simplified financial analysis of cash flows (in $millions) might show: Yr.29 54.
in the case illustrated. in recognition of the benefit deemed to be derived from improved access. coupled with appropriate revenue-sharing. For example. For example. Furthermore. Thus. Either of these would have serious consequences. its new debt-incurring capacity would be very credible. as 79 . compounded. Provision in the financial analysis is made for some of the annual expenditures to be covered by grants. project costs might have risen. on the earlier construction project. It would require new grant and loan finance. with interest. The annual tax burdens might be reduced or eliminated by the use of up-front user contributions or other financing techniques. the main beneficiaries would likely be the manufacturers of (and customers for) widgets. at the time of the next reconstruction.local or national taxes. Thus. Also. it is quite common. staff might get paid only at the expense of deteriorating infrastructure and loss of credit-worthiness. It would also have replaced its capital fund. maintain and renew it. the frontagers might not derive much benefit. may represent the only feasible way of sharing the cost burden among the local. the local government would have paid off all of its debt. Project financial analysis should. to levy frontage charges on the properties abutting the road. there is an implicit commitment to continue to operate. in year 6. as illustrated. lead to forecasts of the incremental cash flows necessary to sustain operations. the cash flows resulting from the project will be merged with the overall general cash flows of the government or project entity. when roads are first upgraded. However. unless the beneficiaries can be readily identified -perhaps easier in this simplistic example than in real situations -. the additional tax burden would be significant. by the 4% per annum. Once a commitment is made to invest in an asset.Federal Grant State Loan Capital Fund Bond Issue Local taxes. However. other local revenues or government grants TOTALS 100 50 50 300 121 --121 === 120 --120 === 121 --121 === 121 --121 === 122 --122 === --500 === Clearly. from higher (state or federal) levels of government. The manufacturing or marketing facilities might not adjoin the road at all. Thus. to over $544 million. regional or national communities. at least in the short run. However. Assets cannot be viewed in isolation but as part of an expanded service. an overall funds shortage could mean a cut back of maintenance or default on debt-service. This illustrates another aspect of project planning. It would likely get a good credit rating for new loans. reimbursing the interest lost by the withdrawal. The details are not addressed.
Its rate of return would then be lower than the cost of capital and thus would be rejected on economic grounds. Commercial Feasibility For every project. Moreover. and telephones. largely un-quantifiable. The likely social costs and benefits. These. 80 . they are political. there will be a variety of commercial activities to be considered. Consideration of social benefits can well influence policy decisions on whether.these would be derived from state or national government policy decisions. recruitment and employment of labor forces. diverted or prioritized in the investment program to serve projects that are basically private but which are claimed to provide local social or economic benefits. water. social and financial issues are then sometimes downplayed. theme parks and sports stadiums. Principal among these will be: a) b) c) d) e) procurement of goods and services within the country and (sometimes) abroad. in addition to carrying the commercial traffic. as well as from political negotiations. especially those for health and education. to carry out a project. Sometimes. before a project is started. intended or otherwise. There will also be social costs. Take. it might be that the road. including the one in the example. sometimes constituting significant parts of election platforms. distorted or ignored. provided access to a hospital. Social Feasibility Many projects. Economic. might be judged adequate to still justify the project. school or national park. or how. benefits. and availability of utility services such as electricity. civil works contracting. are intended to promote social benefits. must be taken into account and quantified as far as possible. The issues of who "benefits" and who "bears the costs" of (marginal) public expenditures are often complex and contentious. However. This has been especially true for such items as convention centers. for example. roads (and other transport systems) are redesigned. cash management and other banking transactions. a situation where the road construction project produced benefits for only four years.
lost or destroyed by a development project. Environmental Feasibility Increasing attention is paid to the environmental impact of projects. with materials and equipment complementary to those provided under the project. It must have the necessary staff. These are required within the entity itself and also in the public and administrative environment within which it operates. Environmental concerns create a significant linkage to project financing. standards. will be significantly damaged. where external costs are deemed created. acquisition. of adequate quality. and all necessary skills. There is obviously a direct relationship between technical feasibility on the one hand and economic and financial feasibility on the other. desecrated. Sometimes the impacts are clear. however. if usage is intended to be encouraged. Additionally. as in the case of the polluting factory. it might be easy to reach agreement that a potentially polluting factory should be built only on condition that it includes specific safeguards. Institutional Feasibility Whenever a project is implemented. Often.Technical Feasibility Clearly. adequate resources. sensible organization. It is essential that technical feasibility be directed towards determining the least (economic) cost feasible solution to the problem addressed. perhaps for economic or social reasons. it is very likely to cost more to construct and to maintain. This normally involves feasibility studies and appraisal by engineers and specialists in the type of project being implemented. every project must be technically feasible. For example. either physically or aesthetically. and technologies which are most appropriate for local circumstances. without adding significantly to the economic (or other) benefits. typically becoming political issues. If a project is over-designed. Institutional proficiency therefore. environmental concerns are complex and contentious. For example. demands sound policies. waste disposal sites made safe for future use. including construction. mechanical plant may need to be dismantled and scrapped. This is especially true with respect to any perceived potential for a project to pollute the environment. maintenance and even final disposal82. or part of the national heritage. planning approvals may 82 For example. This will attempt to ensure the use of materials. proper motivation. It is much more difficult to substantiate a claim that (say) an area of natural beauty. demanding remedies which can built into the project construction and operation. from a technical perspective. operation. An otherwise economically sound project may thus become uneconomic and also load unnecessary financial burdens upon the taxpaying or feepaying public. higher prices will prevent this from happening. This is especially true if the project can only be made “profitable” – or generate positive economic “benefits” – if environmental costs or remedies are ignored. This cannot be done if the institution responsible for that service is inadequate or incompetent. This requires that the project be examined with respect to its complete life-cycle. its purpose is to give a service. 81 .
include conditionality for environmental safeguards. They may also require the construction by a project owner, at his own expense, of mitigating facilities. Alternatively, they may limit the otherwise fuller use of the property for its intended purpose. Finally, planning conditionality might impose development charges upon the owners, intended to compensate for environmental (and other) costs that might otherwise have to be borne as a public cost. These matters are especially contentious, as they affect the issue of private property rights, as against concerns for the public good. Cases before the courts have produced several fine distinctions as to what degrees of interference will be permitted to public regulating authorities. A 1994 case before the United States Supreme Court (Dolan v. Tigard)83 concerned a requirement by a local government for an owner to donate part of his property for public use, as a condition for receiving a building permit. The court ruled that such a requirement may constitute a "taking" of private property for public use, without just compensation. This is prohibited by the American Constitution. Local governments must therefore show (on the facts of each case) that the land request "is related both in nature and extent to the impact of the proposed development." In other words, local governments cannot just use projects as excuses to appropriate private land for public purposes. Cost Estimates Before a project can be considered, cost estimates must be prepared. In the example of the road improvement, two simplifying assumptions were used. First, the project was considered to have been provided all at once. Second, no provision was included for cost over-runs. Both assumptions are unrealistic. Assume, instead, that another project – for (say) roads, housing or water supply – is initially intended to be implemented over two years. Preparation of cost estimates would include: a) b) c) d) e) basic costs; provision for time delay; provision for unforeseen work (physical contingency); provision for price changes (price or financial contingency); and, provision for financing the project until it is disposed of or brought into use.
Provision for time delay will be made by assuming a longer implementation period. Assume this to be three years, instead of two. The remaining adjustments will be numerical, incorporated into the cost table which follows:
This is, of course, an American case, the ruling on which might well not apply elsewhere.
TOTAL YEAR 1 ESTIMATE D COST $m $m 25 75 80 ----180 25 10 ----215 21 ----236 5 ----241 10 ----231 ===== $m 100 60 ----160 25 10 ----195 20 ----215 13 ----228 28 ----256 ===== $m 50 60 ----110 25 5 ----140 14 ----154 16 ----170 44 ----214 ===== YEAR 2 YEAR 3
Land Civil Works Equipment & Materials Sub-total Engineering & Supervision Administration Net Base Cost Physical Contingency Gross Base Cost Price Contingency Gross Cost Interest During Construction Total Financing
25 225 200 -----450 75 25 -----550 55 -----605 34 -----639 82 -----721 ======
Land costs have been included in the first year, although these may have been incurred before the project's physical works begin. The purchase, appropriation or other acquisition of land (or of easements or rights through, over or under land) will be a factor in almost every project for public infrastructure development. Even where land is already in the possession of the public sector, its appropriation away from another purpose represents a real economic cost, which should be allowed and accounted for. It should be included, for example, in the economic analysis, as well as the cost estimates and financing plan84. In addition to the basic costs of civil works and equipment, the project will incur costs of engineering services, typically for feasibility studies, design, preparation of contract documents, supervision of procurement, construction and hand-over, together with regular measurements of progress for interim payments.
If best practices of public sector accounting are followed, it is also appropriate for land transfers between funds and/or uses to be accounted for, usually at current market values.
Provision will also be needed for the administrative overheads - such as legal, financial and general administration. In the example, the costs of the latter have been skewed somewhat towards the earlier phases, as would usually be the case in practice. Provision for unforeseen work has been set, year by year, at 10% of net base costs. When these are added in, the result is a total estimated cost, in constant prices - ignoring inflation and financing costs. It is this cost which would normally form the basis of the economic analysis. This is because it represents the project cost in constant prices and also because the financing aspects are imputed from the discounted cash flow methodology. Added to the base costs would then be provision for inflation. The example assumes inflation to be 4% p.a. In the absence of specific information, a common simplifying assumption is that expenditures will occur regularly throughout each year, so that, on average, all expenditure is deemed to occur on the middle day of each year - July 2. By this date, one-half of the expected inflation is assumed to have occurred, so provision is made in each of the successive years for 1/2, 1-1/2 and 2-1/2 years of inflation, respectively. After adding the provision for inflation – the price contingencies – the result is an estimated gross project cost. In this example, as with all development projects, there is a time-period between the first incurrence of expenditure and the time that the assets come into operation, or are disposed of, by sale or otherwise. They may, as in the case of a water supply or urban transit system, be brought into operation to earn revenue. Alternatively, as with roads, for example, they may perform nonrevenue-earning public services. Disposal of the assets may be by sales, as with sites or houses, or they may be handed over to the entity responsible for their public use. In all of these circumstances, interest will be payable, during the construction period, on any loans raised to finance construction. The financial, economic and pricing implications of interest during construction are important and complex. For example, all the costs of the above project are assumed to have been financed by an 8% bank loan, with an open line of credit. This is quite typical for construction finance, which would later be repaid either from sale proceeds or from the raising of longer-term finance, such as a bond issue for public works. As with the adjustments for inflation, expenditure is assumed to have taken place on the middle day of each year, with the loan to finance it raised on the same day. This then compensates for the earlier and later payments during the year, which are assumed to balance out each other. The Project Cycle85 From the inception of a project, until its completion, there is a series of steps that will be followed. This is often referred to as the “project cycle,” as follows: a)
concept – the project is conceived in terms of meeting specific objectives.
A more detailed example of the project cycle (for a sewage disposal works) appears in Chapter15 of "Municipal Accounting for Developing Countries" by David C. Jones.
Financial agencies or banks may be involved. approval of a bond issue for project financing might require a public referendum. Necessary goods and services will be purchased within the country or (sometimes) abroad.g. and cost information86. design – engineers and technical specialists will prepare the detailed designs for project construction or acquisition. as already described. which will be priced in detail for preparation of cost estimates and tendering documents. to repair defects in construction. final approval – the appropriate authority will approve design. e) f) g) h) i) j) k) 86 87 There are many efficient computer packages for project management that will handle this kind of information. In some jurisdictions. in quantitative and qualitative terms. cost and financing: if necessary. feasibility – the proposed project is examined for the various aspects of feasibility. especially in the USA. if financing the project. of the physical and social demands for the project. cost estimates – design will be translated into specifications of inputs (often with bills of quantities). to facilitate location (if hidden – e. some authority will need to give provisional approval to the project. as appropriate. especially with reference to financing87. supervision – technical supervision will be carried out by engineers and financial supervision by financial specialists. completion and hand-over – the contractors and/or suppliers will hand over ownership and responsibility for the project -. for a guarantee period. together with the financial implications of its operation and maintenance. outline approval – usually. throughout its implementation period. operation and maintenance of the newly completed assets.b) c) d) demand – an assessment is made. implementation – the project will be constructed or implemented. seeking confirmation from a superior authority. phased implementation of procurement or implementation. These will need to include (as appropriate) work breakdown schedules. "As-built" drawings will be prepared.usually being required to accept contractual obligations. financial plan – financing specialists must prepare a firm budget for financing the project cost. by contract or by direct labor. including authorization of the next stages of the expenditure. underground). Gantt charts. CPM/PERT-type diagrams. 85 . either at this point or before the feasibility studies.
quantity surveyors and financial auditors. by engineers. m) 88 Alternatively. the assets are sold to private (or other public) owners. technical specialists. operation and maintenance – the appropriate local or public authority takes over the assets88. 86 . after careful examination (as appropriate). operates and maintains them and begins (or continues) to make financial provision for debt-service on the capital cost and/or for asset renewal or replacement.l) final account – the final account of the contractor or supplier will be settled.
imposing higher real costs on later budgets. will represent a financial saving. local government authorities will have rights to: (a) buy and sell land. (c) provide infrastructure. If this increase in value exceeds the holding costs. Often. there will be a financial gain for the authority. routine land transactions may sometimes be considered as part of the responsibility of (say) an urban development authority. (b) lease land to and from other parties. its value may have substantially increased by the time it is used. Most land transactions for public purposes will. minus acquisition and holding costs." This establishes the sovereignty of public over private interests. Land Transactions An important feature of land management by many public sector entities is the right of "eminent domain. For any land disposed of. housing board or new town corporation. Normally. on. for example.” This provides no implication whatsoever for other countries. (d) regulate the use and occupation by others of land. 89 In the U. This will sometimes. Some of these may result in revenues . even where advance purchases make economic or financial sense. budgetary limitations and other pressing needs may prevent them. this "compulsory purchase" procedure would normally be used only as a last resort.A. if necessary without their consent. 87 . prove to have been a false economy. buildings.others in costs. this is specifically provided for under the Constitution. asserting that land required for public purposes may be expropriated and acquired from private landowners. For land retained. Typically. waterways and forests. In general. However. Whether this definition accords with that of "fair market value" depends upon legal systems 89 or standard practices. the vendor is typically entitled to "just compensation". because it is legally tedious and frequently results in bad publicity. or in excess of. requirements. therefore..LAND MANAGEMENT RELATING TO CAPITAL INVESTMENT 00000000Financial complexities may arise for local governments because of their rights and duties with respect to land. the excess will be in the form of a net inflow of cash revenue. together with a Supreme Court ruling that “just compensation” should normally be interpreted to mean “the market price. the public sector entity will be perceived as heartless or the property owner as obstructive. its current market value. above or under land. seek to be in the open market.S. Often. and. Even where land is acquired compulsorily. in retrospect. Clearly. which will equate to revenue. Where land is purchased in advance of. local and public authorities are not in the business of buying and selling land for profit. a public sector entity will buy land only to fulfill its statutory functions and will sell any land that becomes surplus to its requirements.
possible inundation by water. However. One way of looking at this is to assume a plot of land. of course. For cash-strapped public authorities. Some plots may be reserved for specific target groups. Some of the land may. such as actual or intended occupancy or activity on adjacent land. such as low-income families. the public entity would have lost $1. for a public entity to acquire land. the cost of the land used by the public sector will be. opportunities exist. in appropriate circumstances.426 over the same period. the development costs on the land handed back. install the infrastructure for the entire site and then hand back some agreed or adjudicated proportion of the serviced area to the original owner. which doubles in value to (say) $20. security. Such infrastructure normally comes under the jurisdiction of the public sector. The private developers may then use the share returned. Each parcel of land is unique – as to location. to planning (zoning) permission and any conditions attached. drainage. Thus. as compensation for the ceding or taking of land. when required. 88 . potential compensation (or alternative accommodation) for displacement of present occupants.Land values can be considerably enhanced by the provision of development infrastructure. The most important of these will usually be interest. Additional costs of holding land.426. for their own (profitable or other) purposes – subject. Alternatively. install the basic infrastructure and then re-sell all or part of it back to the private sector for further development. grass-cutting. could include temporary fencing and drainage. and that required for public buildings and public open spaces. There are sometimes opportunities to "cross-subsidize" the sale prices of these plots from the profits on sales to higher-income residential and commercial interests.000. for another purpose. including the road and footpath areas. Thus. water supply and sewerage. any investment in the purchase of land will incur a payment or loss of interest. of course. Unfortunately. if nothing else. it may be necessary to purchase land when available – or else see it lost forever. land management is not so straightforward. In deciding whether to buy and hold land in advance (or in excess) of requirements. timing of its purchase may be affected by a variety of influences.000 after 8 years. if the original sum expended on the land had been invested at (say) 10% per annum (or. squatter occupancy. to be added to the interest. remain with the public sector. in effect. footpaths. had accrued interest at 10%) it would have amounted to $21. So. depending on how it is financed. at its then market value. Thus. It might have been better (financially) to have invested the money and purchased the land. if borrowed." The public authority will initially acquire land (voluntarily or compulsorily) without cash payment. tree-trimming and administrative overheads. opportunities sometimes exist for the acquisition of land without up-front monetary payments. costing (say) $10. account must be taken of holding costs. The system typically used is known as "land exchange" or "land adjustment. Private sector purchasers can range all the way from commercial developers to individual residential plot-holders. Although this may not explicitly appear in the books of account. and. such as roads.
with certainty. just to prevent activity upon it. However. However. a public authority will often be in a position to derive revenues from rents. even at a financial loss. application will be made for a designated change of use – sometimes called a re-zoning – of the area. such as shopping centers. indicating which zones or sites have been set aside for various kinds of occupancy and use. it is not unknown for considerable sums of money. rather than net revenue. museums and theaters and for public open space. The same principle often applies to the renting of space in a municipal market. Indeed. this provision has almost always been on a subsidized basis. Typical zones would be for agricultural. so that every additional rental unit will represent an incremental net financial cost. a development – even on a single plot – will require planning (zoning) permission from the local government.such as grants from other governments. the renting or leasing of property may be fully consistent with the exercise. need not be a source of 89 . controlled growth. political parties and public officials. residential. which may be assessed as not to be in the long-term public interest. By contrast. Thus. in return for assistance in gaining planning approvals. especially those that will permit a more lucrative use of the property. Land Regulation In addition to engaging in land transactions. of: sensible town-planning and balanced development. railways and footpaths. for example. has been to forecast the rental income against only the operation and maintenance costs. this willingness to pay. to employees or to low-income families. aesthetic and environmental considerations. However. An urban area will often have a "town plan". at the time it is taken. Usually. the rents will relate to the temporary occupancy of land or property. paid by developers. This could occur. a public authority may make advance land purchases. If not. and harmonious community behavior. horticultural. In any case. of land or buildings. This will examine whether the intended use is consistent with that prescribed for the area. public entities will derive genuine profits from renting. pending its substantive use. Land will also be designated for roads. either interest rates or land values. As well as revenue from buying and selling of land. sometimes encouraging sub-optimal investment decisions. to find its way into the pockets of politicians. on the part of intending developers. Sometimes. This is in the interests. can clearly be very valuable. provision would be made for public offices. At first sight. The same mistakes have also been made for other revenue-generating operations.Indeed. a common error. Thus. Sometimes. commercial or industrial use. libraries. bus stations and offices. for example. many local and public authorities will have the legal duty to regulate the public and private use of property. by the authority. when leasing commercial property. Planning approvals. in assessing the potential financial viability of rented properties. a good example is the provision of public housing. the decision is only a speculation. Capital development costs have typically been ignored. of its legal duties and powers. potential loss-making operations appear to be profitable. especially where these have been financed from concessionary funding sources . no one can forecast. creating a temptation for corruption. public health and safety. This is sometimes known as "zoning". In addition.
to facilitate connection to the public networks and to ensure safety and public acceptability. drains. with respect to new developments. On the one hand. Sometimes. In either case. to encourage developers to initiate activity on otherwise unproductive sites. Development Expenditures When a site is developed privately. For example. Where the law does not permit such demands – but allows developers to make offers of public improvement – this may be known as "proffering". sewers. Also included will be on-site public open spaces. it represents revenue-in-kind. the law may permit the public authority to urge. Also. a local government may be faced with difficult choices. it is sometimes known as "exaction". As a result of all these considerations. It is constrained by . non-financial leverage available to a local government. Moreover. developers will make cash contributions for laudable public purposes. footpaths. the developer might be encouraged to provide. On the other hand. for almost any purpose. The courts may also set limits on coercion. Regulation will include that of internal plumbing and wiring.potential corruption. public parks or cultural facilities such as libraries or museums. in the decision already referred to above [Dolan v. from (say) more financially lucrative development schemes. it may exercise greater regulatory control. additions to (or upgrading of) roads. with potentially large profits to be made by developers. such as being responsible for street cleaning. Where such a contribution can legally be demanded of the developer. such as low-cost housing or worker re-training. The extent to which a local government can derive revenue from the exercise its planning or zoning powers is not unlimited. Tigard (1994)] the US Supreme Court ruled that local governments must demonstrate. Instead. it may seek to maximize revenues. will depend on their profit potentials. they could represent a "taking of private property for public use" requiring "just compensation" under the US Constitution. Plot-owners or developers will normally pay the costs of connection to the public systems. Some jurisdictions refer to such payments as development charges.the revenue/cost ratios associated with different types of development. water mains. that the developer make a material contribution to public facilities. on-site infrastructure will normally become vested in the appropriate public-sector 90 . footpaths. a local government may be in a better situation to demand concessions than during a period of economic downturn. the planning authority may need to offer concessions. a local government's bargaining power may be limited by the state of an urban economy. others call them “linkage” payments. that the restrictions or exactions are "related in both nature and extent to the impact of the proposed development. power-cables and telephone lines." Otherwise. in exchange for planning permission.and may vary with . to encourage schemes that may be less financially attractive but considered more socially beneficial. because they are linked to planning approvals. If there is a boom. the owner or developer will normally pay the costs of provision of all on-site infrastructures. Building and plot development will be regulated. on the facts of each case. When the latter occurs. For example. Furthermore. This will include roads. as part of (or adjacent to) the proposed development. Developers may also offer to operate and maintain the facilities.
trunk water-mains. In addition. but it is also true that each new development is a contribution to the community. In developing country situations. If 91 . and major expansions of telephone lines. It is. another important reason for not borrowing is that there are just no loan funds available. sewerage. together with costs of operation and maintenance. This (classical) approach is often adopted. However. increasingly frowned upon by international lending entities and aid agencies. or in increasing service charges or tax rates. or at least attempted. for expansion of education. of course. This is especially true for lending aid emanating from the USA or the European Union. cultural and social services. Thus. Except where exemptions apply. with the potential to create an overload. such as banking or mortgage institutions. paving the way for the provision of future funds to operate and maintain new or expanded public facilities and to cover debt-service costs on them. also known as "consumer contributions". Another might be the outcome of earlier. imprudent. periodically. water supply and other public utilities. They. This approach seems based upon the perception that every new development is an unwelcome intrusion into the "status quo". some people assert that owners or developers should pay an "up-front" charge towards the potential costs of expanding the networks. pumping and transformer stations. also. the overall indebtedness of the authority may be at or approaching an unsatisfactory level. through their regular payments of taxes and service charges. to the use of these facilities. The alternative. A residence will almost always house productive and income-earning workers. "hook-up" charges are levied. power and gas transmission systems. debt management. and traffic signals.entity. this will eventually trigger a need for additional: power stations. Thus. Nonetheless. First. in the form of goods and services. for subsequent operation and maintenance. recreation. the only sources of capital may be from the owners and developers. treatment works and telephone exchanges. there may be convincing reasons why public authorities may wish to expand their facilities without incurring further debt. set at a high enough level to cover the debt-service. if there are any. This will eventually trigger the new construction of: main roads. borrowing from the central government. each new development will impose an additional load on the overall systems for traffic management. for public utility networks. because of policies grounded in so-called “free market economics. The growing community would then contribute. all new developments will potentially increase the property-tax base. One of these might be failure or difficulty in updating the property tax base. might have financed themselves from private sector financing.” Subnational governments are increasingly required or encouraged to borrow in capital markets. drainage. or other capital-cost recovery. A commercial development will add facilities needed by the public. There may either be no capital market or else the market may not be accessible to local or public authorities. welfare. sewers and drains. developments will affect the planning and operational strategy of the community. This may be so. for a variety of causes. financed by long-term loans or other capital funding sources. Many specialists in public sector management argue that the classical and logical solution to these problems is for the expanded strategic facilities to be provided as community (public or private) capital expenditure. Taken together. health. Most particularly. may be constrained by budgetary limits. These are all matters relating to individual plots or sites.
its effects will be virtually the same for the public authority. This is the severe shortage of public funds. This fails to eliminate the equity question of whether. a closer analogy to the tertiary water system. perhaps. In such cases. made under new policies that did not apply to earlier (perhaps better off) residents. conceptually. It will expect to pay metered water charges for future supplies. it would be inconceivable for the storeowners to seek capital contributions. it might be that newcomers would eventually pay off the full costs for their own plot charges. take the example of a new grocery store. together with the almost insatiable demands upon them. Anything shifting the burden earlier and more directly to private funding is surely welcome. This is sometimes exacerbated when the charges are.g. the strategic financial burdens created by new developments should be borne only by them. Groceries are supplied under competition among many stores. as well as contributing (through general taxes) to the debt service on facilities provided for earlier developments. there is often one over-riding concern. which is to be connected to the public water-supply system. To illustrate the anomaly or consumer contributions. enabling the water utilities to exploit their market power. However. beyond that pertaining to the individual reputations of stores. If a potential customer were asked for a capital contribution. 92 . low-income) groups. which will.this method is adopted. despite the logical arguments. from taxation or borrowing. the debt-service will fall only upon the final purchasers of the properties against which the development charges have been levied. However. This becomes an exceptionally vexed question where plot charges are levied upon newcomers that are from disadvantaged (e. It might also seem an acceptable practice for the storeowners to be asked for an up-front contribution to the costs of the water supply facilities. and to what extent. however pragmatic the system. mitigating strongly in favor of consumer contributions. from its future retail customers. there is virtually no doubt that he or she would shop elsewhere! However. their checkout counters! This is because water is almost always supplied under monopoly conditions. towards the increased costs of their wholesale delivery network! Or. have borrowed funds by proxy. which thus have very little market power.
the expression: “borrowing to add to the reserves. c. or.” In this case. often favored by economists. b. and e. emergency or urgent expenditures which cannot be met from funds currently available. slow-downs in collection of taxes and charges and emergency expenditures resulting from (say) natural disaster relief. the expression “reserves” connotes “cash balances." Such a definition. One hears. to create what is sometimes referred to as a "public sector borrowing requirement" (PSBR). capitalization of state-owned enterprises. The former is governed by the ability to service the debt from future revenues. capitalization of public utilities and other state-owned enterprises. d. delays or shortfalls in the receipt of expected revenues. 0Frequently. 90 Sometimes terminology becomes ludicrous. permanent works and equipment. for example. the latter. claimed as needed for immediate expenditures.” In accordance with generally accepted accounting principles. borrow for one principal purpose – to cover shortages of cash. simplicity often reinforced by the rudimentary practices of governmental accounting90. is necessarily simplistic. For example. The decision to borrow is based on two principal strategic concerns: financial prudence and macroeconomic wisdom.DEBT MANAGEMENT Introduction 00000000Public sector entities. In strictly cash terms. The latter deals with the extent to which the borrowing (and its related debt servicing) affects the overall performance of: the economy. Because borrowing typically incurs interest and other related expenses. overall deficits in budgets. which should be an integral function of every public entity finance department. including (where appropriate) by construction. including governments and state-owned enterprises. while increasing cash balances. acquisition of land. All these would combine. these purposes overlap. are supposed to be part of the surplus of assets (including cash) over liabilities (including loans). in fact. Also the distinctions are as much a matter of perception as of definition. Borrowing does not change this! 93 . it would not normally be sensible to borrow. buildings. Among these are: a. Cash shortages may arise from a variety of situations. This can usually be assessed by competent treasury management. the entity. always adds to an entity’s “liabilities” and not to its “reserves.” Borrowing. the public or private community. irrespective of how caused. the nation. this is a close analogy to a "budgetary deficit. a central government deficit might have been caused by a combination of capital expenditures. unless there was such a need.
mathematically. especially by laypersons. it is claimed that constant adjustments for inflation create a selffulfilling prophecy. if the market rate were 8% and the current inflation rate were 10%. Thus. However. interest rates have usually been fixed. 92 This is not necessarily true when borrowing in a foreign currency. there is no particular incentive towards price discipline. economists might refer to a "negative real rate" of about 2%91. rate of interest. it contributes to a lack of required “transparency. a (supposedly) real interest rate is charged on the adjusted balance and an appropriate proportion of this adjusted balance is repaid. In practice. increasingly. legal. when real rates are being assessed. Indexing is relatively uncommon. Now. They may also be influenced by differing perceptions of 91 Loan interest is likely to be grounded in reference to an expected rate of future inflation. Principal matters influencing debt service will be: amount of the loan. giving a market rate that is "nominal". However. In this case the loan principal is indexed to the (assessed) inflation rate. Finally. the changing rates of exchange often serve as an indexing factor in these cases. earlier in this document. Financial markets are not necessarily efficient in the allocation of capital. For example. Firstly. Thus. These are motivated by accounting. accidentally or deliberately to misrepresent the true situation. it suffers from three disadvantages. although nominal rates are always positive. an interest rate is the combination of the "real" expected return – in resource claims – and the expected inflation rate. This effectively deceives the public. notably in Brazil. 93 Such equilibrium may be of a monetary nature only. Secondly.” Consequently. Nonetheless. will influence the subsequent magnitude and timing of the debt service. it is often frowned upon by most Western capital market institutions. repayment method. at the end of each interest period. and. the complexity of the calculations. or private sector financial institutions. Thus.The Borrowing Decision Given these matters to be addressed. Borrowing also deals with a number of tactical concerns. the borrowing entity must consider the amount to be borrowed. which might be different from that originally expected. real rates may be assessed as negative. Indeed. the outstanding loan balance is adjusted upwards for inflation. Also the adjustments themselves become part of the inflation regime. a more logical system than using nominal interest rates 92. In the past. the source of funds and the least acceptable terms and conditions. contractual and commercial practices. coupled with the relative unreliability of the data on which they are based. Furthermore. providing additional flexibility – but also uncertainty – for both lenders and borrowers. These. However. In some countries. the market rates are influenced by many other factors – including the tax regime. the adjustment calculations are quite complex to make and difficult to understand. the interest rate and the inflation rate have. see the views of Joseph Stiglitz. for the entire period of a loan contract. is an open invitation for careless or unscrupulous monetary authorities. been treated separately – at least in principle. it is questionable whether to use such a system. period of repayment. for example. interest rates may be variable. these may make reference to the current inflation rate. In principle. If lenders and borrowers know that there will always be such adjustments. albeit in the claimed interest of national economic well being. in lieu of allowing the market place to bring about the necessary equilibrium93. 94 . in the past. it is.
which may not necessarily coincide. lenders and independent observers. 95 .borrowers.
can lead to quite complex calculations of bond prices and yields – especially the "yield to maturity (YTM). often with a prohibition upon any delegation to committees or officials. it is a very common requisite for approval to be demanded of a public official or ministry of a central (or state) government. bonds issued or traded at a premium (above the face value) will show a YTM 94 Many countries have not yet established viable secondary markets. although public bond issues are often sought by borrowers (and even urged on them – by advisers not devoid of conflicts of interest!) they are not the panacea sometimes claimed or hoped for. at whatever price subsequently prevails. some states have requirements for public referenda. The issue will be attractively priced – a combination of interest rate and issue price – but may also be underwritten. be a provision in the nation's constitution for a special procedure. again for a fee.For example. 96 . The issue is normally arranged. For foreign borrowing. Types of Borrowing Long term borrowing. Authority to Borrow Public sector borrowing is almost always subject to some kind of special authority. Conversely. because of the long-term capital gain from issue (or traded) price to maturity." Demonstration of these calculations is beyond the scope of this paper. approval by the central bank or a ministry of finance might be a very likely condition. by a specialist issuing house. It should be noted that if a bond is issued – or subsequently traded – at a discount (below its face value). In the USA. which can be defined as any with a repayment period of more than one year. the International Monetary Fund might be concerned with overall economic performance. There may. For central governments. somewhat more precarious and more costly than if there were efficient markets. especially for local government issues. suppose a multi-lateral lending institution – say. will be either repaid at maturity or by installments. The international institution might be principally concerned with the fulfillment of an individual development project. They are. either for individual borrowings or – more likely – of an upper limit for overall debt. for a fee. especially for general-obligation bonds. the nation's central bank with its foreign exchange reserves and a purchaser of bonds with investment earnings. Furthermore. typically payable half-yearly. normally raised in money markets or by private placement. agree to take up the bonds that are not subscribed to by the public. Thus. inevitably. such as a joint resolution of both houses of the parliament or a higher than simple majority – (say) two thirds. They will then attempt to re-sell them in the secondary market94. its true yield – the YTM – is higher than the "flat" yield. However. but may be found in many standard financial texts. the borrowing government with its budgetary deficit. Such issues carry a "coupon" rate of interest. furthermore. such as a merchant bank. The combination of the "issue price" – not always the bonds' face value – with the coupon rate and the various maturity periods. For local governments and public authorities. there will usually be a necessity for parliamentary approval. Maturity loans will commonly be bond issues. These are uncommon in other countries. the World Bank – guaranteed the issue of bonds by a member government. there will almost certainly be a requirement for a specific resolution of the council or board. The underwriters.
a sinking fund were set up to provide for eventual bond redemption. 97 . In the unlikely event of the market rate being lower than that of the sinking fund. Again.at the end of every interest period.typically decided by lot . this has no direct effect upon the gross cost of borrowing to the government or authority which issues them. by the use of employees. The yields to investors. including commissions to investment bankers and underwriters 95. likely those with a greater availability of funds for investment. However." The potential advantage of bonds and notes is that they are (or can be) a marketable security. local government and public utility bond issues are free of central government taxes. They are bought and sold in the capital market at prices reflecting (then) current interest rates and are redeemable at par on maturity. with the sinking fund carrying only the notional interest. a government will act as a guarantor or underwriter for debt issues by municipalities or public utilities. Current thinking is not in favor of this 95 In addition. Sometimes. Instead. if any. They may sometimes be issued tax-free.by repurchase . in effect. Bonds are normally issued for maturities of ten or more years. This is because the authority has the use only of the funds remaining after payment of the issue expenses. Excess market earnings will then be paid into the general fund. Success with this approach has been varied. Its obligation remains to pay the periodic "coupon" interest rate and to redeem the bonds at face value upon maturity. If.before final maturity. Market rates might. by a variety of methods. also. maturity may be as high as thirty years. much shorter maturities (say 3-5 years) are both common and necessary. is a matter not further considered here. the general fund would “top up” the sinking fund with the difference. these subordinate entities rely extensively upon central government funding. Bond issues may include options to allow the issuing authority to redeem them . the financial effect is somewhat similar to that of an installment loan. the assessment of issue costs. serial bonds are issued. Although bond yields may vary widely from time to time in the secondary (money) markets. There are far fewer cases where bonds are issued by local and public authorities. It also. This provides a similar advantage to investors as tax-free central government issues.at less than the flat yield. Instruments for less than about ten years are sometimes referred to as "notes. are lower than the costs to the issuing authority. indirectly. provides a central government subsidy to the local government or utility entities. This occurs because that part of the interest that would otherwise be paid in income tax is neither paid (as interest) by the local or public authority nor collected (as taxes) by the central government. In this case. in high inflation situations. permitting redemption of a number of bonds . costs will be incurred. perhaps encouraging their purchase by those in high tax brackets. although strong secondary markets are often lacking. intended never to be higher than any market rates likely to be encountered. Sometimes. goods and services engaged or used in the issue of debt. for example. Sometimes. affect the net cost of borrowing. internally by the entity itself. Sometimes. the interest earnings on the investment of the fund would be affected by fluctuations in the marketplace96. Many central governments in developing countries issue bonds. 96 It is sometimes considered prudent to set the interest rate for a sinking fund at a low (conservative) level. however.
89%. Thus. as it would have needed to fund the resulting deficit in its own budgetary accounts. 97 A related matter concerns the public issues of stock (share capital) by the United Kingdom Government for its newly privatized public companies. If this resulted in a price of $9. the issue was underwritten by the central government. the issue. up-front. The government disposed of its real "community plant" and credited the proceeds to its current revenues – akin to "selling the house to pay for the groceries!" (See. Thus.)] More recently. the $900 would be interest on the $9. This is basically a short-term instrument. artificial and potentially embarrassing issue of the bonds. not without grounding. in terms of simple economics. might be offered for sale to the highest bidders. to speculative buyers who were often employees or officials of the former publicly owned enterprises. also. to the advantage of the public entity and to its customers or taxpayers. Cynics have claimed. in terms of the diminished reputation of the borrowing entity for subsequent debt issues.practice. Standard practice normally assesses a bond issue to have been successful if it is many times "over-subscribed" at the time of issue. in the capital market sense. as well as creating price or interest rate disparities. several years ago. some public assets of the former Soviet Union have been sold on very dubious terms. This might cause the underwriters – next time – to increase commission rates or to insist on more attractive issue terms97. A $10. 98 . Typical examples might be a central. an issue substantially left with (private) underwriters might well be considered as more finely priced. of course. [Not to belabor the subject – but these were also examples of inappropriate and arbitrary accounting practices. the lower price would have been adequate to induce underwriters to take up the issue.000 twelve-month treasury bill.100 and repaid it. after one year. indicating that the price – the interest rate yield – is too high. without attracting into the market an over-abundance of lenders. The other main types of loans are the installment repayments. However.100. or twelve months. Its mechanism differs from that of the bond or the note. typically issued for maturities of one. to the local government unit. effectively. was a complete failure.100. Market borrowing is therefore encouraged by international lending entities. $900." This meant that the central government had to put up nearly all of the money in the (seemingly vain) hope of re-selling the bonds later.” Thus. three. in that the "interest" is taken. Instead. therefore. which is thought to discourage accountability at the subordinate level of government. These are much more common when finance is provided by a public sector entity. it could not find any private sector underwriters. given away. for example. public assets – to the extent of the claimed "under-pricing" – were. the central government had borrowed the money itself. payable in advance. In effect. Nonetheless. For example. the discount. This raises an interesting distinction. However. Over 95% of the issue was "left with the underwriters. the governmental unit would have borrowed the net amount of $9. state or regional government loan to a local or public authority or a loan to a government by an international lender. the municipal government of a major city in a developing country made a bond issue. with interest. After all. There might. represents a “crude” 9% interest. at the expense of the general taxpayer. This is an interest rate (yield) of 9. "Selling the Family Silver Has Privatization Worked?" by Colin Chapman. thus avoiding the costly. nominally. More correctly. this indicates a supply (of loan funds) substantially in excess of demand. that the apparent huge successes of these issues resulted from studiously crafted “under-pricing. be hidden costs. Another form of maturity lending is the treasury bill. The central government might just as well have made a straight loan.
000 . using one or other of the methods shown above. which balances the principal and interest components. The annuity repayment system. A loan of (say) $1. The last payment also $117. in real terms. It is the system used. whereby the annual payment would be (approximately) $117. The principal sum is divided by the number of repayments and the resultant amount is repaid at the end of each period. is very well known. is gradually declining. These would likely include multi-lateral agencies. It should also include debt-rating agencies.000 of interest but only $17. at 10%. 99 . a periodical payment is calculated. There is also a small commitment fee on un-disbursed balances of loans. the “front-end-loaded” cash flows are exacerbated. able to advise potential investors about the quality and risk of various debt instruments. with loans repayable by installments. Interest is paid.Loan repayments normally fall into two main categories. will normally lend for fixed periods – usually in excess of ten years – at fixed or variable interest rates. the "level payment" or "annuity" system is used. the outstanding balances diminish.000. in periods of inflation.460 of principal. These are intended to soften the impact on the borrowing country’s balance of payments. many developing countries do not yet have such facilities. Unfortunately. it will undoubtedly look to this for the source of much of its borrowing. each successive interest payment is lower than the previous one.460 .460. concurrently with principal repayments. Clearly. together with interest of $100. Thus.678 and principal repayment of $106. Interest rates are usually at or close to market rates 99. When this interest is added to each equal installment of principal. The first would include the original $100. treasury bill – sometimes known as discount – brokers and secondary market facilities for trading the various debt instruments.000 of principal but only $5.000. They are thus forced to borrow from international sources. Financing is usually either for development projects or specific development purposes. For this reason. such as the World Bank. the total cash payment. The market would typically provide the services of bond issuing houses and underwriters. Loans often carry rigorous conditions.000. because the later payments are being made in less and less valuable currencies. This contrasts with an annuity system. Borrowing Sources If a country has a viable capital market. period by period.000. almost universally. the projects financed are thoroughly prepared and appraised.000. 99 World Bank loans carry an interest rate linked to the London Interbank Offered Rate (LIBOR) for US dollar single currency loans. to ensure that the total periodic payments remain constant. though somewhat more complex than the simple installment system. The final repayment would be only $55. The two systems can be compared by a simple example. friendly foreign governments and foreign commercial banks.000 of interest. instead. as the principal is repaid. would result in a first annual repayment of $50. by equal installments of principal. by requiring higher payments during the earlier years of the debt service98. This has the potential to create significant cash-flow problems for the repaying entity. repayable over 20 years. on balances outstanding from time to time.782.still $50. Using rather complicated mathematical formulae. Multi-lateral agencies. not to subsidize individual projects. making a total of $150.would include interest of $10. to enforce discipline over the project implementation process and over the operation of the 98 Moreover. frequently. These are at highly subsidized interest rates and have very long repayment periods. The World Bank Group also makes loans from its International Development Association. The first is straightforward. for home mortgages. Typically.
Always. funds are made available interest-free or at subsidized rates.K. of course. they may be passed on as market-rate loans with projectrelated repayment terms. Department of International Finance and Development (DFID) will cooperate with international entities. except to cover IDA administrative costs (such as mission expenses) incurred within the country of the contributed currency. unless a currency is freely convertible. Thus. There is no interest. Instead. Some bi-lateral lending is for clear political or commercial purposes. by lending convertible currencies. IDA contributions are made in a country's own currency. financed by longer-term loans. the International Development Association (IDA). Sometimes. These could include changes in (or removal of restrictions on) an exchange rate or public-pricing policies. Consequently. A country like (say) Malawi (a so-called "Part 2" country) makes only a token contribution. results in only the currencies of the stronger. on the need to increase tax collections and to balance public sector recurrent budgets (or at least come closer to doing so). countries being available for the foreign lending – which is exactly the intended position. However. after an initial grace period of 10 years. a service charge of 1/2% p. Furthermore. many bi-lateral agencies. Many structural adjustments have now been seen to be incapable of bringing about short-term resolution of economic concerns. is charged. in countries like Russia. This organization. They are not intended to subsidize otherwise uneconomic projects. Funds for the IDA are contributed by the member countries of the World Bank. IDA-financed projects are appraised to the same high standards as those of the World Bank. Thus. Their purpose is to alleviate the drain on the part of a nation's foreign exchange reserves that is used for debt service. Bi-lateral lending is made on a country to country basis. equity to public utilities or (if appropriate) grants or subsidized loans to (say) municipalities. The International Monetary Fund does not lend for specific projects. Instead. in providing co-financing or matching funds towards a combined operation. An example would be that of the World Bank's subsidiary. freeing of trade restrictions and restructuring of public sector employment. such as the United States Agency for International Development (USAID) or the U. This. too. some adjustment activity has now been taken over by the World Bank. such as the World Bank and the IMF.borrowing entity. such lending is accompanied by stiff requirements relating to economic adjustments. Loans may be granted in 100 . IDA credits are required to be passed on by governments to other national public sector entities without regard to the lenient terms at which they have been made available. Consequently. roughly in proportion to their economic strength. the use of a contribution is effectively sterilized. lends for projects in the poorer countries. Loans – known as "IDA credits" – are repayable over 30 years. industrialized. has met with only limited success. however. using the same staff and procedures as the World Bank. emphasis is being placed. Currently. This. countries like the USA and Japan (so-called "Part 1" countries) contribute a great deal. it provides short-term support for balance of payments deficits. IDA credits are made exclusively to governments. to cover processing costs.a.
Loans may be at market rates or may be highly subsidized. 101 . depending on the motivation.exchange for political concessions – such as the stationing of military bases – or to assist the purchase of goods and services from suppliers in the assisting country.
unlike (say) IDA credits. of course. Another disadvantage of commercial bank loans is that the banks attempt to make a significant proportion of their profits from transaction fees. without regard for disciplines that would. particularly by public utilities. related to the net funds available for use.7 years. loans from commercial banks are normally for relatively short periods. one might have a water supply project. Consequently. However. instead. say a maximum of 5 . appraised by (say) the World Bank. Banks sometimes put together syndicated loan packages. variable-rate long-term loans from the World Bank are currently (1999) linked to LIBOR rates. vehicles and plant – from (say) Germany and Sweden under international competitive bidding (a World Bank condition). as is usually the case." has become a benchmark for the setting of international commercial lending rates101. coupled with the perceived and actual risk of doing business in developing countries. have led to interest rates which are high. This. These. The openly commercial nature of the lending. the total of the costs and losses. Otherwise. even the relatively short nominal repayment periods are compressed. a water or electricity enterprise. they have been used for this. because if the borrower is not satisfied with an interest rate increase. derived from transactions among banks in so-called "Euro-currencies. These charges serve to lower the amount of net cash actually received by borrowers. they are relatively unsuitable for financing large projects with long useful lives. bi-lateral loans made on "soft" terms may well be passed on to downstream project entities. at market rates. for example. this creates a very short-term instrument. or to provide facilities that are too costly. Nonetheless. The water entity could – concurrently – be engaged in the purchase of (say) pumps and water treatment equipment from lending or supply entities in (say) Japan. 101 Indeed. often “obscured in the small print. 102 . be imposed by the international entities. even combining resources from different countries and in different currencies. procuring goods and services – say pipes. more typically. described in paragraph 28 (above). would be encouraged to set customer prices that are too low. typically based on a "spread" above the London Interbank Offered Rate (LIBOR).Furthermore. perhaps every quarter. there is little option but to continue the loan on the new terms. Serious problems have occurred with borrowing from commercial banks. This has a similar affect upon effective100 interest rates as a discounted bill. because the rates are changed frequently. for example. This rate. It is. except for a simple loan. Thus. in turn would cause wastes. including (indeed. even much less. of both water and electricity or the capital goods used in their production.” frequently high and often not validated by (nor verifiable against) their cost drivers. Consequently. France or UK. Interest rates are usually variable. financed by a commercial-type loan. much less well appraised for suitability of purpose and directly financed by “below-market rate" loans. Commercial banks are another source of foreign lending. When interest rates are variable.” and receivable “up-front. it must repay the loan. are limited. 100 An “effective” interest rate is rarely the one quoted. using discount factors to generate an annual equivalent. These often directly subsidize their operations. especially) the transaction costs. relative to alternative sources. In effect.
been required in foreign currency. often by borrowing itself.000/1. Examples of national entities providing both finance and insurance are the Export-Import Bank (USA) and the Export Credit Guarantee Department (UK). there is the option of borrowing from the central bank. inflation will likely be triggered. Call these units by a favorite term used by economists – widgets. its terms are sometime quoted as part of an overall contract for the supply of the goods and services. 103 . This is because the lender has the option to recall the loan. it may have to be "rolled over" – continued on new terms. also. through its central bank. Finally. Furthermore. previously "broke" – why else would it borrow? – now "owns" one-eleventh of the currency (Ð100. other than central governments. Of course. sometimes with the guarantee of special government agencies in the supplier's country. at the end of (say) five years. This usually involves the creation of additional money – so-called "printing money. Thus. Typically.100. there will be Ð1. The lenders. rigorously scrutinized by the central government. A simplistic example will illustrate. This form of financing is usually provided by (or through) commercial banks. moreover. Then. This applies to public utilities. may significantly dictate these terms102. If the government "prints" another Ð100. the central government must find the finance to make these loans. because of a lack of funds for repayment. Sometimes. widgets might be priced at Ð1 each. other state-owned enterprises and local governments. "printing money" works by the government increasing the money supply. along with their counterparts in other countries. It is. Suppose the economy produces 1 million units of output. Under standard principles of monetary formulas. over a loan period often linked to project life. So it can appropriate this proportion of 102 Some loans in Russia. suppliers of goods and services may grant credit. This is known as "supplier" or "contractor" financing.000. that there are 1 million units of currency in circulation – say doables – in cash and bank deposits. it is common for a central government to be their lender. the borrower is in an additional bind. repayment of the debt has. Unlike (say) a bond issue. Moreover. Interest rates may be subsidized or at market rates.000). have sometimes engaged in "credit wars" to out-subsidize each other's products.10 each. loans will be for specific projects. other countries of the Former Soviet Union and the Eastern bloc have suffered from this concern.1 million chasing 1 million widgets. These institutions. Unless this brings about matching increases in production. The government. Repayment will typically be by installments. especially for specific components of projects. in equilibrium. so that the "nominal" terms may be somewhat obscured by the pricing. cannot provide enough foreign currency to redeem or service the foreign debts. for central governments. in terms of the physical quantity of goods and services. passing from party to party at the same velocity as the widgets. where resources are transferred from lender to borrower. prices of widgets would likely rise to Ð1. tied to specific imports from specific countries. Assume. almost always.When the nominal repayment term expires. depending on government policies and other political pressures. so that it appropriates the additional resources to itself. At comparable velocities of circulation. by definition. This concern may be compounded if the nation. it normally suffers from the same disadvantages as direct commercial bank financing. with no increase in production. For public sector entities." largely a misnomer.
104 . for example. This foreign bank account would then become part of the nation's general foreign exchange reserves. Sometimes. by a monetary instrument. without the need for tax assessments or “internal revenue departments. the government would have taxed its public. Indeed. Yen. Dollars. hitherto. as well as by such sources as "suppliers credits. It is also likely to cause (or induce decisions about) devaluation of the national currency. would provide it with 90. to lend to the project entity. if the money were needed to finance the import of goods and services. thus creating a selffulfilling prophecy and making the devaluation (or the subsequent devaluations) even greater. This will raise the price of the latter (e.” whereby holders of their own currencies sell them. In exchange. at Ð1. this is the principal purpose of lending by multi-lateral and bi-lateral entities. As there will now be more doubles (Ð) chasing widgets. The borrower would then pay this foreign currency to the foreign lender. as well as all the foreign costs. in any case. after the first) is expected by the markets. The World Bank will (actually or effectively) purchase local currency from the developing country's central bank. the central bank would “sell” the foreign currency to a (public or private) local borrower for local currency.the economic output to its own use. been available. In effect. In practice.g. Pounds or Swiss Francs) and lower the price of (i.909 of them. This is sometimes known as "monetizing" the debt. devalue) the Ð. there will be greater than otherwise demand for the other foreign currencies. for which the necessary foreign currency had not. it would have transferred to the central bank of the borrowing country a foreign currency deposit at (say) the Federal Reserve Bank of New York or the Bank of England.” The result would be the same as when historical monarchs "clipped the coinage" for seignorage. the World Bank would have acquired and established a local currency bank account in the borrowing country – which it would then have transferred.10 each.e. to the borrowing entity. some foreign borrowing may be undertaken merely to raise loan funds simply not available from domestic sources. of course. transferring the foreign bank account to it. thus disposing of the “reserves” held by the central bank." However. This provides a benefit for the national economy as well as to the entity financed. Thus. be used to repay outstanding foreign debt. This would be necessary. the World Bank will include a component in a project loan to cover a proportion of local costs. and hold foreign currencies instead. at the ruling exchange rate. especially for the poorer countries. Its purchase of widgets. This phenomenon is typically linked to “capital flight. It might. there will also be more Ð chasing convertible foreign currencies. which will then use the money to pay for local project inputs – such as locally manufactured furniture for (say) a school. with a value equal to the local currency purchased. Foreign Borrowing Some of the borrowing sources explained above would be foreign sources. to be used for other imports of goods and services. If the devaluation (or a further one.
Deprived of independent market access and short of professional skills. they might advise their client borrowers about the suitability of their projects and related operations. Otherwise. The debt service expenditures can be charged against the specific public service for which the asset is employed and the revenues from that service. its management consists of dealing with the debt service. recourse must be had to the general pool of public revenues. Concurrently. However. The extent to which the latter can be done depends. Accounting for earmarked debt is greatly facilitated if the loans are repayable by installments. it is important to be aware of the capital recovery costs of public services. To the extent that the accounting is flawed or incomplete. including the pooling of loans. they have typically relied upon meager central government funding and operated like government departments. Where a particular loan – such as a project loan – can be specifically identified with the assets financed. annual debt service expenditures will include only interest. Debt Management After raising debt. 105 . involving a large number of municipal governments or commercial enterprises. If these remain unidentified and unallocated. this is sometimes known as "earmarking" the debt. governments establish financial intermediaries to receive loan proceeds on a "wholesale" basis and to "retail" these loans to individual borrowers. as well as the operating costs." "national housing banks. to raise funds in bulk. inevitably. often becoming moribund. upon the accounting practices103." These intermediaries might develop experience in dealing with national and international money markets. Even where there are no earmarked revenues. have not lived up to their expectations. Indeed. in support of a multi-faceted project for (say) urban development or industrial expansion. This would provide for the coverage of the operating and administrative expenses – as well as a loan loss provision – of the intermediary. This involves raising the necessary funds and also allocating the costs for the appropriate purposes. Jones. to some extent. it would not be reasonable to expect the World Bank to enter into (say) twenty separate lending operations. capital recovery costs are often a dominating feature of public sector operations. be flawed. Examples would be "development finance corporations. will be affected by these costs." "municipal funds. decisions made by reference to the resulting financial reports will. as they frequently are. in developing countries." "municipal banks." and "public works loans boards. including the capital costs. if any. It would then add an additional percentage – say one or two percent – as a "spread." to establish a lending rate to sub-borrowers. A financial intermediary will normally pool its funding to produce a weighted average of its costs of capital. 15 & 17-21 of “Municipal Accounting for Developing Countries” by David C. with no provision for 103 For a detailed explanation of accounting practices relating to debt management. refer to Chapters 14. competent intermediaries are often important. especially for international borrowing. The integrity and credibility of the accounting will determine the extent to which the users of the assets financed by the debt will – or should – pay for the costs of that usage. In practice. many of these institutions.Financial Intermediaries Sometimes. For example.
sufficient funds to repay the loan. Instead. These funds will then be made available to finance capital development projects as "internal loans. all loans (or sometimes only those of a specified character or for a specified purpose) will be pooled. loans will be raised (in the market place and from other sources) on whatever best terms are available. Indeed. money is periodically set aside and separately invested. so that debt can be retired. when investment interest is added into the sinking fund. become complex. Thus. 106 . they tend to rely on their sovereign right to borrow and to tax. similar to those used for annuity loans. bills and money creation. municipal accounting practice includes the concept of "pooling. as a surrogate for the amortization payments. Central governments use sinking funds much less commonly. do not – indeed cannot – use earmarking or pooling systems. because of the crudity of their cash-accounting systems. The sinking fund contributions would be charged against the service using the assets. however. on operations and development. at the end of its term. 104" through the establishment of "loans pools. Instead. the market availability of funds for capital development may not provide a matching of loan repayment periods with the working lives of the related assets. In theory.principal repayment. It would then become a “capital development fund” system. might be included in a pooling system. such as a loan or an item of debt service. is explained in "Municipal Accounting for Developing Countries" (Jones). As already indicated. from internally generated funds. a 104 The "pooling" concept. central government borrowing may be by a mixture of local bonds. Municipal governments commonly use sinking funds. they are used by state-owned enterprises. they will need to be repaid partly out of – by then." "consolidated loans funds" or "capital funds." These act. perhaps in favor of greater equity. Depending on the extent and detailed design of the pooling system. in effect. Thus. at least for domestic borrowing. like an internalized financial intermediary. its final chapter is a virtual handbook for accounting by financial intermediaries. The administration of sinking funds can. Interest and other debt management expenses will be apportioned to the "borrowing accounts" in relation to their outstanding balances "owed" to the pool. Sometimes. enhanced by various foreign sources. inadequate – sinking funds and partly out of re-borrowing. on maturity. First. this will be due in a single payment. On the external borrowing side. from taxes. if loans are raised for shorter terms. exceed expected revenues. together with interest on existing debt. Sometimes other capital financing. Where used." These will carry strict repayment schedules. related to asset working lives. at the same time as the periodic interest payments are made. is in the totality of transactions. Cash deficits are also created by the need to repay existing debt. The sums set aside are calculated by the use of compound interest formulas. as in the case of a bond. They can also rely on what is known as “the law of inertia of large numbers. Instead. fees and charges. as a means of "earmarking" cash flow.” This means that their cash flows are usually so huge that any single transaction. Where there are many projects and loans. a relatively insignificant item. Then. as explained below. Typically. central governments. This situation is often overcome by the use of sinking funds. it will have accumulated. as it matures. These potential cash deficits are increased whenever expected expenditures. they borrow continuously to cover potential cash deficits. the potential for administrative overwhelm is considerable. including central government grants.
105 In fact. It is sometimes a useful safeguard against the cost of services provided by a revenue-earning public enterprise being subsidized by government contributions from general revenues.g." This is an acknowledgement of a government's general power to tax its public for the necessary funds. specific revenues can sometimes be raised from the activities enhanced or sustained by the related usage of the community plant or other assets. and.” Sometimes. the issue of a specific debt instrument will be specifically securitized against the revenues resulting from the use of the related assets. Simply stated. water and electricity supplies or even property tax surcharges in special development areas. if sold (e. Security for the service of public debt is usually based on what is referred to as the "full faith and credit" of a government or on the "general taxes and revenues.g. In the USA. might be considerable. from selling certain public assets to the private sector. Debt Service Funding Funds for debt service expenditures will normally come from taxes. not to say public outrage. not be usable for their original purpose (e." The likely private sector alternative. albeit that they are a historical anachronism 107 . called Consols. This is because many assets held by governments would: often have no value to the private sector. Where earmarking is used. there are some British central government debt instruments. at a minimum.g. fees and charges. military bases or equipment) or. the mortgaging of property for security of local government loans might well be deemed as “contrary to public policy. are inter-mingled with central government borrowing. fulfill a purpose usually reserved exclusively to government (e. Macro-economic concerns. the political fall-out. have strategic security importance (e. Examples might include toll roads and bridges. loans with this kind of security would include "general obligation bonds. This is particularly appropriate for state-owned enterprises. this requires: a limit of long-term borrowing to the financing only of property acquisitions. with repayment periods linked to the working lives of these assets. they would probably do better to subject themselves to the same standards of debt management discipline that they customarily impose on other public sector entities. a public road). public transport or water supply. Examples might include loans raised for public housing construction. public schools). More prudently. sea or river defense works). mortgages against real property. that pay interest but have no redemption date. would mostly be inappropriate. governments should pay at least a part of their interest payments. temporary borrowing only pending the imminent receipt of funds from other sources. Consequently.central government can go on borrowing forever and never repay105.g. however. These are beyond the scope of this paper. In practice. Furthermore.
as illustrated by the earlier and still ongoing "budget deficit" deliberations in the US Federal Government. It now seems that the initial estimates grossly understated the strength of Britain's economy in 1986-88 and misled [it] into running and unduly lax monetary policy. without successfully distinguishing economics from politics. This process. institutions like the World Bank. it is questionable whether to dispense with the financial disciplines. the changing structure 106 A most serious misunderstanding. at best. in earlier years.. in these circumstances. First.. debt service will be funded – in a somewhat haphazard and random fashion – from general revenue sources or from further borrowing. from the Social Security Trust Fund. Indeed. was that the US Federal Government then had a budgetary “surplus” which could be applied towards other needed public concerns or to allow cuts in taxes. In fact. confusion and misunderstanding106. including the Federal Reserve. It also engenders political opportunism! The only assessments that can be made. There are two common causes. In fact. However. Official statistics steal headlines. In recent years. which could flow from more rigorous accounting practices. to pay for prescribed benefits. Macroeconomic policy is. Although highly appropriate to subject central government borrowing to such an economic overview.As an alternative to revenue bonds. that created the illusion that there was a budgetary surplus. and becomes scarier if the dials are wonky and the mirror cracked. macro-economic data are obtained from statistical measurements. moreover. has become prone to revision after revision of its official numbers. These are becoming significantly less reliable even than accounting information. Britain's national accounts for example. capable general management and sound financial administration. an article in the "Economist" began as follows: Numbers not worth crunching Britain's statistics badly need independent quality control A "Good Statistics Guide" would never make the best-seller lists. relying upon a common theme of some economists that “deficits don’t matter!” This in not a position acceded to by many others. too. by the general fund of the Federal Government. Accounting practices are. It was only the borrowing. are macro-economic ones such as the relationship of the size of the debt burden (or debt service requirements) to the Gross National (or Domestic) Product. there was a net budget surplus only in one single year. However. America.” This is set up as a separate account into which “earmarked” social security taxes are deposited. 108 . More's the pity. the US Federal Government appears to have abandoned even a pretence at fiscal discipline. flawed. like driving a car with a blackened windscreen and only the speedometer and the rear-view mirror as guides. are so riddled with holes and revisions that the true state of its economy is anybody's guess.. when lending to a revenueearning enterprise. Britain is not alone in this predicament. leads to indiscipline. it is impossible to sensibly comment. wipe billions off shares and defeat governments. yet all too often the numbers are ropey. all of the (imagined) surplus – and much more besides – effectively “belonged” to the “Social Security Trust Fund. will include specific provisions in the loan agreement requiring a minimum standard of financial performance. These financial performance conditions will be backed by requirements for the competent operation and maintenance of plant. In the absence of earmarking. admittedly. This is often measured by a rate of return on assets or by a minimum coverage of debt service from internally generated funds. even when pooled with social security money.
Statisticians' machinery is still geared up to measure steel and coal rather than financial services and consultancy. For example. takes a long time to construct. two of the speediest de-regulators. "national" economic statistics. have the loudest complaints about numbers. Neither the Russian nor the British system produces initially “objective” data. half-yearly interest payments would be due.of economies makes them more difficult to track. regional or local government to serve as a basis for negotiation of intergovernmental financial transfers or spending limits. for budgetary or accounting purposes. they are used by politicians and public officials from different levels of central. more correctly. Moreover. 109 . The additional electric power. At the completion of the construction. They are. In the meantime. makes it harder to monitor inflows and outflows. the Russian Republic now uses complex economic statistics to calculate “Minimum Social Standards” to support claims against public funds for certain social expenditures. Capitalized Interest Sometimes. might not be available for at least as long as (say) five years.” These are used in the allocation of the “Revenue Support Grant” – Britain’s main general local government grant. which has blocked off sources of data. Accounts result from a rigorous identifying and recording – however imperfect the methods and analysis – of each and every financial transaction. so balance-of-payments figures have become murkier. They are also used to “cap” or limit total budgeted expenditures by individual local government units. An obvious example would be the construction of a hydroelectric power station. incorporating a dam. following principles espoused by the former Soviet Union. process to determine “Standard Spending Assessments. This might occur where a development project. what are frequently referred to (as in the above extract) as "national accounts" are not accounts at all – certainly not the accounts of the government. albeit simpler. In America just three car companies account for $150 billion worth of sales in the car industry.000 firms. Instead. financed by debt to be serviced from operating revenues. It may be no coincidence that America and Britain. The second blight has been deregulation. the UK Government uses a somewhat similar. The scrapping of foreign exchange controls. To confuse matters even more. either from the original lenders or from others would cover these interest payments. borrowing takes place to cover all or part of the interest costs on earlier borrowing. added in and periodically compounded. Additional borrowing. 107 These concerns about statistics might serve as a warning not to rely upon them too much. Statistics are derived from samples only107. plus all interest charges. yet the service sector now accounts for 60% or more of most modern economies. the full outstanding loan to be serviced would be the borrowings for the construction itself. for example. which would be sold to obtain revenues. gradually increasing as additional loan moneys were drawn for construction and working capital. Things you can drop on your toe are easier to find and count. to arrive at the same output for the restaurant and drinks sector would require a survey of 189.
to compensate it for the administrative costs of providing the money in tranches and also against the potential losses from temporary cash-management. potential default can always be covered by new borrowing. where the World Bank or the IMF. in other words. with a potential loss of interest. capitalized interest can arise where a government merely borrows more money to pay all or part of its interest costs.06 billion in maturing bills. This might occur with an issue of bonds. banks will make a commitment charge. It will still be necessary. perhaps incorporating a net increase in indebtedness.Much more crudely. The easiest and most obvious will be by a straight deposit of the loan proceeds into the bank account of the borrowing entity. International lending entities will usually disburse loan moneys against specific project procurement of goods and services. together with administrative expenses. It is highly appropriate if (say) central government debt is being rolled over. That.45 billion in new cash Thursday by selling a record $10. Sometimes. there will be idle cash to administer. A typical report in the Wall Street Journal.5 billion in 52-week bills and redeeming $9. when all borrowing is within the 110 . cutting public payrolls or changing interest rates. such as project financing. For public utilities or local governments. Between each disbursement. Taking the hydroelectric power station example.The Treasury plans to raise $1. cash-flow problems will occur during the construction period. exactly. an increase in interest rates . This will affect the lender's investment return and the borrower's credit rating. notes or bills. it is inappropriate to draw down the entire loan proceeds at once. as already indicated. for example.would add to debt servicing costs. a shortfall in tax revenues or service charges would inhibit full and prompt service of debt. might state: "WASHINGTON . the borrowing country would be expected to have fulfilled some pre-determined promises related to structural reform. make loans for "structural adjustment" they will disburse the funds in "tranches." Where debt is being raised for specific purposes. usually as a small percentage on the undisbursed balance of a commitment. Risk The principal risk attached to a borrowing operation is that the terms of the loan agreement will not be fulfilled. this could lead to default. for financing to be secured (contracted for) before construction begins." These risks can only be contained and managed. of course.on variable rates or loan renewal . Thus. it is clear that all of the funding would not be required up-front. is what compound interest is! Debt Drawdown Debt funding can be made available to public sector entities in a variety of ways. for example. future interest costs will include the interest on the new borrowing. Thus. Similarly. Naturally. For central governments. These might include exchangerate adjustments. In addition. it might be better to draw down the loan funds as the work proceeds." perhaps covering the importation of specific goods. however. albeit by "printing money. Otherwise. interest on the interest. Otherwise. as work begins.
ports and oil companies. the government has a dilemma. from foreign commercial banks. especially with respect to monetary management. 111 . It introduces two further risks.5 masons to the US$. When foreign borrowing is involved. Consequently. instead of having its residents eat the food themselves. there would be a one-third increase in Masonia's debt (measured in its own currency) to M2 million. Indeed. If Masonia's currency is further under pressure. it must choose whether to "peg" the rate of exchange. The public sector may. Secondly. its local currency debt equivalent would be M1. perhaps causing a net disadvantage for its overall earnings of foreign currency. closely related to the first. The first is the risk of adverse changes in the exchange rate. this can create increased personal suffering and a risk of governmental instability. at a rate of exchange of (say) 1. the situation is different. is that there will be a shortage of foreign currency. have been principal causes of the international debt crises. thus going hungry or even risking starvation. Even worse. some economists argue that for the country as a whole. in the form of monetary instruments. With poverty all-pervasive in many developing countries. the public sector – normally a net user of foreign currency – will be competing with the private sector – often a net earner of foreign currency. the public debt is just money owed by one set of residents to another set. in the same proportion. relating to foreign borrowing. including its tourism industry. residents may perceive the government to be mismanaging the economy. which are political. There are two additional problems. in local currency. however. This. First. it could well be that the public sector is borrowing. This is because more masons would be required to purchase the foreign currency for the debt service. For example. debt service would also increase. instead of making it available to the local economy for development. If the rate of exchange later worsened to (say) 2 masons to the US$. therefore – possibly in contravention of exchange controls – to hold foreign currency (privately) outside of the country. which can have very serious consequences. This will include official foreign aid and the foreign earnings of nationalized industries such as airlines. Masonia. have certain access to foreign currency not available to the private sector. to avoid worsening its debt service obligations still further. as well as economic. canceling itself out. import of foreign goods and services or enhanced consumption. Indeed. would affect the terms of trade for its exports. of course. borrowed US$1 million. foreign exchange deposited as so-called "flight capital" by the country's own residents! These matters. if priority is to be given to the service of foreign debt. In this respect.country. local residents will be deprived of the economic benefits otherwise likely to be gained from the import of goods and services – including those needed for capital development. however.5 million. The second risk. They have sometimes created the need for debt relief. Some will attempt. To the extent that it has any option. nations may need to export foodstuffs to earn foreign currency. if the government of an imaginary country.
However. in recent years.S. One obvious solution is that of forgiveness. in that those who are insured have less concern about potential loss or damage than those who must pay for the loss or damage from their own pockets. Moreover. Consequently debt relief has proceeded in an ad hoc and haphazard manner. This plan largely foundered. In the 1980s the so-called "Baker Plan" called for new lending by the commercial banks. there is no way in which they may be (officially and legally) declared "bankrupt" – given a new start. Thus. It might. thus. and the U. only moderately successful in resolving the problem. However. Indeed. because of the unwillingness of the foreign commercial banks to go along with it. be less prudent than if they are to be fully held to account. so far. This. Unlike governments. does not mean forgiveness. This is done as a preference to recording the loss when the debtor actually defaults. Some countries are now. Thus. to recognize the probability of non-collection of a proportion of the outstanding debt. The economics of this position seem unassailable. currently. of commercial banks. Furthermore. indeed. It takes the position that if current loans are too readily forgiven.” 112 . technically. insolvent – unable to service their foreign debts.K. This is particularly true in the health and car insurance industries. that it took money from poor people in rich countries and gave it to rich people in poor countries. to stimulate economic growth by developing countries.” This is derived from the insurance industry.e. however. clean) audit. be required as a condition of an unqualified (i. leaving the opportunity for subsequent financial statements to show enhanced profits. "taking a hit" on their balance sheets. including the write-off of debt. The concept has now been appropriated by the international lending community. against book profits. It is simply an accounting distinction. However. following standard practices. It has also been used. it merely removes some value from the stated loan in the balance sheet. they have no "full faith and credit. forgiven some bilateral debt." based on a sovereign right to tax. They will. including commercial banks. This. by firms wishing to get rid of bad news in one fell swoop. there are no “morals. It now seems that defenses against moral hazard are to take money from poor people in poor countries to give to rich people in rich countries. by those sneering at foreign aid. despite the fact that past imprudence in lending by such banks was a significant cause of the concern in the first place! Other initiatives have been. albeit with only limited overall success. one now hears more and more often about the phenomenon of “moral hazard. especially in the U. with respect to foreign debt. individual governments have in fact. much has been heard. establishes a reserve and charges the resultant loss.Debt Relief Developing countries have been seeking debt relief for a number of years. potential future borrowers will develop some assumptions that the forgiveness has become endemic. Incidentally. it does not do much to help the countries whose people must continue to endure more than their fair share of suffering108. there is certainly “hazard” but. international entities like the World Bank must rely mainly upon the rating of their bonds in the market-place to maintain the interest-rate edge which can be passed on to their borrowers. like most of economics. 108 It used to be argued. as a part of “window-dressing” strategy. This was intended to lead to increased foreign exchange earnings and consequent service of foreign debt. it is easier for this to be done by governments than by private sector entities.
The purpose is to provide some temporary relief." virtually the same as capitalization of interest. In effect. from an already thin level. re-lending. resulting from its accumulated budget deficit. in turn. The local currency. current foreign purchases. in cooperation with the international aid community. but by itself does nothing to assist the borrowers. These include. whilst the developing country undergoes structural adjustment. This measure can only be a temporary palliative. it is just a market reflection of the (actual or hypothetical) accounting adjustments in the books of the lenders. it is sometimes easier to offer a new loan than to write off the interest. with new interest rates. This provides opportunities for original foreign lenders to dispose of their debt obligations – albeit at a loss – to those who speculate that these may be undervalued. for it results in a net increase in the debt principal. It gives a better appearance. as an accounting artifact. provide debt relief." As already indicated. In this case. If market interest rates are to be maintained. either voluntarily or involuntarily. the opportunity for reducing the amortization. therefore.Other standard forms of debt relief have occurred. the only option is to spread out the repayment period. Indeed. 109 In accounting jargon. in effect. whereby as the loans mature – and cannot be repaid – they are rolled over. Unfortunately. in the lender’s balance-sheet109. some borrowers claim that the high public sector borrowing requirement of the USA. a foreigner who is a potential investor in a developing country would buy some of its official or commercial foreign debt at a discount – in the secondary market – and then offer the instrument to the issuing public entity or corporation in the developing country. then interest rate reduction – or an interest subsidy – is about the only remaining option. However. A further reduction in cash flows could then only be achieved through "negative amortization. the borrower declares an inability or difficulty with repayment and requests a new – and hopefully more favorable – contract. an increasing amount of lending by international entities has been directed at "structural adjustment. Thus. this provides loan funding for what are. Finally. would then be available to the foreign investor to purchase local assets or an equity interest in a local company. all or part of the accumulated unpaid interest will be rolled into the new loan. It does. The purchase of discounted debt instruments has sometimes led to a procedure called a debt/equity swap.but in local currency. If re-lending or re-scheduling runs up against the above concern. this is a repatriation of flight capital. is bleak. In this case. The lender often has no choice. Effectively. for both the borrower and the borrowing country's economy. rather than those for capital development. much of the current debt service schedule may already be in the form if interest. increases international interest rates and that the developing countries are footing some of the bill! A substantial secondary market has developed in developing country debt instruments. Frequently. This process helps the lenders. depending on the existing interest rate and period. A similar method is that of debt rescheduling. this is just another example of “window-dressing!” 114 . This would be redeemed for its face value . which prices them at discounts from their original face value. of course. The implementation of the structural changes is made a condition of the borrowing.
in that more water will be used at lower prices.Owner/Developer." "exactions. 3. Public subsidy may provide more or may provide less social equity. 115 . 1.Owner/Developer. Sewerage. 3. to cover the cost for each type of activity.User charge &/or public subsidy (after vesting).User charge &/or public funds (after vesting). COMMENTS Water Supply: Immediate Access 1. instead of cash payments. (unlike water supply) is not clearly a "market good.Public funds (central/local) 2. Full cost recovery is possible and desirable by using economic pricing. 111 Development fees may be imposed by legal authority or might result from agreement between owners/residents and the planning authority.Plot charge (before vesting). It may be economically inefficient. Thus. Thus. Local revenues are often derived from national government budgets and some taxes may be shared revenues. 2.Plot charge (before vesting). 112 "Public funds" connote general revenues from either local or national resources.g.Foreign aid grants.Public funds 112 (central/local).Plot charge (before vesting). 1. it may be appropriate 110 The options shown in the tables are not mutually exclusive. Water Supply: On-site 1. such as "proffers.Owner/developer. it is sometimes rather meaningless to presume a clear distinction between "local" and "national" revenues.Foreign aid grants." or "betterment levies. Several methods may be combined.Land sale profit (public land) & development fees111 (public & private land). Sewerage: On-site 1." Users may have less expensive options which create higher public costs (e. 3.Loans (local & foreign). 1.User charge &/or public subsidy (after vesting).User charge &/or public subsidy. "User charge" could be a surcharge on water supply or a property-based charge. OPERATION & MAINTENANCE. septic tanks). 4. They can include other types of payments.Land sale profit (public land) & development fees (public & private land). 2. Maintenance and Debt Service110 TYPE OF INFRASTRUCTURE EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE.Land sale profit (public land) & development fees (public & private land). "work in kind" might be provided.Loans (local & foreign).Owner/developer." In addition. 2. 1. Water Supply: Trunk/Treatment 1. 2. 2.ANNEX 1 CAPITAL DEVELOPMENT PROGRAMS FINANCIAL IMPLICATIONS ------------Options for Funding of Capital Expenditure and Coverage of Annual Expenses for Operation. 2. 3.
A surcharge on water is.Public funds (central/local). 2.Public funds (after COMMENTS Roads & Drainage: On-site 1. Sewerage: Trunk/Treatment 1. OPERATION & MAINTENANCE. 4. TYPE OF INFRASTRUCTURE EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE.Land sale profit (public land) & development fees (public & private land).Plot charge (before vesting). This can be done by making charges whenever the public system is accessible or by covering costs from public funds.User charge &/or public funds.Plot charge (before vesting).Land sale profit (public land) & development fees (public & private land). OPERATION & MAINTENANCE. 1.Loans (local & foreign). There is often no opportunity for tolls in 116 .Owner/developer.Foreign aid grants.Owner/Developer. 1. in principle. a sales tax . 3. 2.Foreign aid grants. 2.User charge &/or public funds (after vesting). COMMENTS to compel use of a public system.TYPE OF INFRASTRUCTURE EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. User charges are usually neither possible nor appropriate. Sewerage: Immediate Access 1.even if levied by a private entity. 2. 2. 3. 3.Public funds (central/local).Loans (local & foreign) 1.
One concern to be avoided is too readily to concede that fuel taxes are only user charges for roads.Land sale profit (public land) & development fees (public & private land).Loans (local & foreign).Public funds (after vesting). 2. 117 . Roads & Drainage: Immediate Access 1. 3.Public funds (central/local).TYPE OF INFRASTRUCTURE EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE.Foreign aid grants. 2.Foreign aid grants. in support of other public costs. 1. OPERATION & MAINTENANCE.Public funds.Loans (local & foreign). COMMENTS congested urban systems. Roads & Drainage: Main/Trunk 1. Full economic pricing of motor fuel can reduce the use of private vehicles. to be earmarked for construction and operation.Public funds (central/local) 3.Plot charge (before vesting). although road pricing is now becoming more likely. vesting). Also fuel taxes are good proxies for pollution charges. 4. 1. They may also contribute to general public revenues. 2.
Public funds (central/local). by making charges whenever the public system is accessible or by covering costs from public funds.User charge &/or public funds (after vesting).Simple plot or house fees for households that have no less costly systems and/or are motivated to safe/full disposal. 2.Owner/Developer. 4.Public funds. 1. 2. [Only minor expenditure . [Waste disposal is not clearly a "market good. COMMENTS Solid Wastes: Neighborhood 1. 2. Charge can be: 1.Foreign aid grants." Users may have less expensive options.Plot charge (before vesting). 3. Solid Wastes: 1.Public Funds.Owner/developer.TYPE OF INFRASTRUCTURE EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE.Privatization or contractingout . It may be better to compel use of the public system. Solid Wastes: Collection 1.Loans (local or foreign). with institutions which have no less costly collection or disposal.like communal bins or hand-carts]. 2. 3. 5. illegal or unsanitary dumping). which create public costs (e. 2. 1.User charge &/or public 118 .User charge &/or public funds (after vesting).Plot charge (before vesting). OPERATION & MAINTENANCE.Land sale profit (public land) & development fees (public & private land). Clean public spaces creates a public good. 3. Collection from Specific Premises 1.implicit rent of equipment from contractor. Cleaning of Streets and Public Open Space 1.Contract for commercial wastes.g.Public funds (central/local).Equipment lease.
Loans (local) for landfill. Electricity: Main/Generation 1. 1.User charge &/or public subsidy (after vesting).Private ownership of disposal sites or systems. 4. 3.Loans (local & foreign). 2. 2.User charge &/or public subsidy (after vesting). Public subsidy may provide more or less social equity.Loans (local & foreign). funds. 3. 4. 119 . 2.Land sale profit (public land) & development fees (public & private land).Foreign aid grants. 3. 1. Electricity: On-site 1. in that more electricity will be used at the lower (subsidized) price.Owner/Developer.User charge &/or public subsidy.Fee to private parties or contractors for use of private disposal facility. 4.Owner/Developer (Bulk fee to electricity utility .Loans (foreign) [likely only for imported equipment or full systems].TYPE OF INFRASTRUCTURE EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. 2.Public funds (central/local).Public funds (central/local) 2. Electricity: Immediate Access 1.before vesting).Foreign aid grants.Land sale profit (public land) & development fees (public & private land). OPERATION & MAINTENANCE. Full cost recovery is possible and desirable on the basis of economic efficiency pricing. It is also economically inefficient. 1. COMMENTS Disposal 2.Recycling profit from selected types of wastes. 3.Foreign aid grants [likely only for imported equipment or full disposal systems].
4. Urban Transport Mains & Depots 1.Owner/Developer 2. 1. 3.User charges (passenger fares) &/or public funds (after vesting). However.like bus shelters and (possibly) turning circles]. as well as adding environmental benefits.Plot charge (before vesting). Full cost recovery may be possible on the basis of economic pricing. 2. [Only minor expenditure .TYPE OF INFRASTRUCTURE EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE.User charge (bus fares) &/or public subsidy.Foreign aid grants. to reflect actual or claimed public benefits from reduction of pollution.Public funds (central/local) 2. it is common for urban transport to be subsidized. COMMENTS Urban Transport On-site 1. OPERATION & MAINTENANCE.Land sale profit (public land) & development fees (public & private land).implicit rent of equipment from contractor. congestion and hazard. 1.Privatization or contracting out . The poor state of many urban roads suggests that a public subsidy which reduces car use might be in the public interest. 120 .Loans (local & foreign).
" by definition to be met from taxes. 2. [Only minor expenditure .Foreign aid grants. User charges likely to be minimal and not aimed at cost recovery. 3. 7. Health.Land sale profit (public land) & development fees (public & private land). A well motivated community may provide cash or work contributions for some facilities. Ambulances. COMMENTS Social Services (Education. 6.Owner/Developer. OPERATION & MAINTENANCE.Loans (local & foreign). Parks. clinics and street lights].implicit rent of equipment from contractor.) 1. Most social services are "merit goods.Privatization or contracting out .TYPE OF INFRASTRUCTURE EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE.Public funds (central/local) 5.Joint community contributions. Fire. 121 . 1.like local parks. Welfare. Street Lights etc. Cemeteries.User charge &/or public funds. 4.
Loans (local & foreign).User charge &/or public subsidy .Foreign aid grants. 4. rather than reduce profit further or take a loss.Development fees (public & private land). 1. 4.Land sale profit (public land) & development fees (public & private land) from another site.Owner/developer. 2.Public funds (central/local).TYPE OF INFRASTRUCTURE EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE.Loans (local & foreign).Plot charges. 2. This will need to be imposed by a "linkage" agreement. 3.depending on nature of service. grants & NGO funds. [Low-cost housing is a complex and vexatious issue].Foreign aid grants. by the sale of all plots for their highest and best use. appropriated for this purpose. 3. 2. Upgrading: Trunk Infrastructure 1.Loans (local & foreign).Owner/Developer of another site (as an outcome of a "linkage" agreement.User rent &/or public subsidy. Low-Income Housing: Off-site 1. OPERATION & MAINTENANCE.Owner/Developer. 6. Upgrading: Immediate Access 1. 3.Land sale profit (public land) & development fees (public & private land). 5. 2. 5. COMMENTS Low-Income Housing: On-site 1.User charge &/or public subsidy . Annual O & M may need to be subsidized. 4. 1.Public funds (central/local). 3. 1.Plot charge 2. 5. 1. 2.depending on nature of service. 2. Otherwise the owner will maximize revenue from the site.Foreign aid. Use of the potential surplus (for housing) can reduce its availability for infrastructure and there is a point at which the developer or owner will "walk away" from the development.User rent &/or public subsidy. Contributions by owners or developers can come out of monopoly rents from use of a specific site. 122 .Foreign aid grants & NGO funds.Loans (local & foreign).Public funds (central/local).Owner/developer.Public funds (central/local).Community participation.
6. mitigating potential for private contractor financial savings to become additional public costs (e. reliable and useful. d. conspicuous and immediate public dissatisfaction. Efficient and Effective Implementation 1. c. and potential political threats to declared mandates of key elected officials. Avoidance of fragmentation in the overall strategic delivery and management of public 11. disruption or distortion of public policy goals. 2. order and government. fair and dignified. in the event of contractor or supervisory shortcomings. Inability of contractor to conceal or obscure long-term costs. 8. 4. including those of depreciation and maintenance. Relatively easy and inexpensive execution. actual or near monopoly and therefore subject to meaningful competition and a potential for exit. Service not potentially prone to crisis conditions. causing: a. Relatively swift. Service not a natural. Bidding and contract evaluation which ensures that selection based on price is also consistent with acceptable quality. welfare payments to compensate for meager employee benefits or economic externalities or inequities resulting from less effective or efficient service standards). including return on capital and reasonable profit. Willingness (or requirement) of private contractors to follow employment practices which are decent. Fees paid by the government to cover all business costs of the contractor. 3. administration and supervision of contracts. Economic overview. 9. 10. law. 5. breakdown of security. 123 .ANNEX 2 CONTRACTING OUT OF PUBLIC SERVICES Conditions Likely to Facilitate Economic. Credible and comprehensive accounting systems. which may not be obvious from accounting or management information systems nor from reasonable and customary physical observation. including cost accounting for this. 7. b. easy and inexpensive recovery in the event of contractor failure to deliver. safety.g. including withdrawal from contracts and reinstatement of alternative delivery systems. which ensure that comparison of alternative in-house costs (including administrative overheads) with contracting-out (including regulatory costs) is meaningful.
Resulting overall economic and social outcomes which are compatible with the prevailing political discourse.services. 124 . 12. creating administrative or economic costs exceeding those saved by contracting out.