CAPITAL INVESTMENT PROGRAMMING AND ITS FINANCIAL IMPLICATIONS

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: djones@gsd.harvard.edu

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: dcjones2@cox.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 semi-permanent 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 lifecycle 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 last-named 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
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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.

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. Therefore, costs in terms of resource use of any business or public activity2 should include properly recognized and recorded expenditures on the following: (a) (b) (c) (d) operation of the activity - in terms of the production of goods and services; maintenance of all premises, plant and equipment in a satisfactory condition to perform its operations in a safe and efficient manner for its entire working life; administration and management of the activities, together with the payment of taxes, necessary to ensure that operations are efficiently effected; and, the rental cost (capital cost recovery factors) of fixed and working capital, comprising, either (for property not owned) the market rent, or (for property owned): (i) (ii) (iii) consumption of capital, typically recognized as depreciation of premises, plant and equipment; 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); and, return on investment, including interest on debt and an expected and reasonable return on contributed (equity) capital, either by dividends to owners or by retained earnings.

After covering all the above, which are resource costs, it would be prudent to expect that the budgeted activity costs would also allow for an additional (albeit small) "surplus," over and above the expected and reasonable costs of capital. This would allow for periodical fluctuations in financial fortunes, more specifically: risk; uncertainty; new activity; and, longer-term stability.
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This concept is referred to elsewhere (e.g. in a set of training slides) as OMARS CAR. It reflects that the COSTS of any business or activity are synonymous with those of a taxi-owner (called Omar). His costs must cover: Operation; Maintenance; Administration & taxes; Rent (capital recovery) and Surplus. The Rent concept (CAR) covers: Consumption of capital (depreciation); Adjustment of Value (revaluation); and Return on Investment (interest, dividend and retained earnings).

Return on Investment Included as part of the "return on investment" is the provision for dividend and retained earnings, typically accruing to the owners (shareholders) of an entity. These are items which, according to "generally accepted accounting principles" are not treated as costs but as allocations of "profit." The distinction arises because financial accounts reflect property rights rather than economic principles. Thus, the interests of owners (shareholders) are reported as the earnings (profits) after all claims have been met from outside of the entity, including those of lenders. There is, however, common agreement among economists that what are considered to be "normal" profits are no more than a part of the "opportunity cost of capital." Only extra-ordinary earnings are typically regarded as true "profits." This is somewhat analogous to what is described as "surplus" in the above set of distinctions3. Furthermore, the standard practices of financial analysis deal explicitly with costs of capital, the return on total net assets, as the weighted consolidation of the separate and specific returns to debt and equity financing4. This has a parallel in the public sector. In some countries, notably in the USA and UK, 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. This usually had amortization periods closely related to the working life of the fixed assets acquired. However, even where all or part of these assets may have been financed from sources other than debt5, the funds used for this purpose still have an opportunity cost. Indeed, the financing of capital expenditure from general government revenues (local, state or central) will do one of two things. Either it will add to the overall "deficit," which will have to be borrowed, with interest, or it will eliminate some part of the overall "surplus," which will create a loss of interest on the related monetary investment. Even if the deficit is covered by increased taxes, the taxpayers (effectively the "shareholders" of the government) will (collectively) lose the equivalent in interest on what would otherwise have been their own money6. They will also forego the use of the principal sum. 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. For example, it affects, or is affected by: cost accounting systems; prices; allocation of overheads; budgetary management; fiscal deficits; maintenance of assets; and, inter-governmental transfers. Costs of service cannot be credibly stated, nor fully recovered, unless they include reference to all of these various factors.
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Economists sometimes refer to this as economic rent, a concept introduced by the classical economist, Ricardo. Equity includes "retained earnings." These are somewhat analogous to situations where borrowers retain compound interest, in that they are expected to earn returns. 5 This includes grant financing, of the type used for the various capital programs supported by state or local governments. 6 This is not an argument against the financing of fixed assets from taxes - only an explanation of its consequences.

Effective decisions on public service delivery, depend upon whether, and in what form, the costs of these are determined. Furthermore, cost recognition, to be consistent, should relate to the maintenance, use and consumption of resources and not to the manner in which these resources are originally financed. Sometimes, subsidies are appropriate, for economic or social reasons. However, unless costs are determined in an authentic fashion, there is no way to know whether, or to what extent, the subsidies already exist (such as in the initial capitalization) or are ultimately justified, as in transfers from other accounts, funds or governmental entities7.

An example is the Washington Metro-rail transit system. In many presentations (of this and other urban transit systems), costs are postulated only as operating costs, completely ignoring the impact of the costs of the use and deterioration of the fixed capital assets. Then, when these become pervasive, it is necessary to shop around for capital funding from constituent governments. An August 2004 press article, indeed, refers to Urgency Drives New Metro Pitch for Funds.

An example of the presentation and use of financial statements, incorporating full accounting for resource use costs, is given in the annual financial statements of the City of Birmingham, England8. As required by law, 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. These include stipulations for full accounting of all fixed assets, irrespective of the method of financing. It includes imputed rental, depreciation and interest costs, where appropriate at current (replacement) values. Government Grants Central governments, of many other countries, are attempting to encourage and support activity by the local government units. This includes activity that it favors or for which there is some clear justification on national grounds. However, the prime responsibility is, increasingly, that of the local government units. A most important means of financial support by the central government of local government units is the government grant. 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, but which can be collected more efficiently at national level (e.g. income tax, sales tax, VAT and customs duty); (b) support for services in which national government has an interest but which may be better performed locally, with input from local people (e.g. primary and secondary education, local roads and public health); (c) equalization, to some degree, of the needs and resources among different areas; (d) provision for specific burdens upon individual areas not shared generally; (e) encouragement of practices which are consistent with national social, economic or financial policies (and discouragement of those which are not); (f) enhancement of limited local resources to provide reasonable flexibility in decision-making on the provision of
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These statements are available separately.

services; (g) major shifts in political, economic or social characteristics of a nation, group of nations or region (e.g. the massive political changes resulting from the liberalization policies in Eastern Europe). There needs to be a great deal of common sense and political wisdom, as well as economic logic, in the administration of a grant structure. For example, whatever may be argued for the needs of a particular area, it may also be one of the most important commercial centers, with a great deal more economic potential than elsewhere. Thus, there might be a strong economic or equity-based case for a net transfer of resources away from the area, in favor of much poorer areas9. Capital Grants Grants may be given towards specific capital projects or to support recurrent operations. In principle, capital grants have a distinct disadvantage. They will tend to support new capital schemes, perhaps too soon, too large or even not justified at all, instead of encouraging the continuance of a service using existing available equipment and infrastructure. This is very serious in any country where capital resources, especially in foreign currency, are scarce and thus costly. Faced with a choice of spending its own resources on maintenance or getting a grant for new capital investment, a local government unit may be strongly tempted to opt for a capital grant. A more appropriate financial support for capital expenditure would be a loan, for the life of the new asset, at market interest rates. Then, the local government would be faced with a more even-handed financial choice. It would either continue to pay operation and maintenance costs for the old (probably inefficient) asset or pay debt service (more strictly, capital charges) on the new one. However, in practice, application of these principles may often be difficult, even inappropriate. First, much local infrastructure is in a very poor state and in urgent need of replacement. Indeed, there are some areas or communities that have been so disadvantaged that there is little or no decent infrastructure to begin with10. Second, there is no reasonable supply of market-driven medium-term or longterm capital. Even if there were, there is no satisfactory mechanism to administer it. Third, many local government units lack creditworthiness, at least until revenues are greatly stabilized and enhanced. Finally, with the meager and uncertain financial resources available to the central government, capital grants at least represent one-time payments for which there is no continuing obligation
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For example, the Northern Virginia suburbs of Washington DC, USA, arguably comprise the Nations wealthiest area. It makes good local politics (albeit, poor distributive economics) to complain of local tax revenues sent elsewhere in the state. 10 This is the situation in many formerly and still currently disadvantaged communities, emanating from socialist or other centrally-planned economies, such as those in the former Soviet Empire. Central governments sometimes use capital grants as pump-priming mechanisms, for installation of, or access to, infrastructure in areas where little or none had, hitherto, existed.

beyond the duration of a particular program11.

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This may not be exactly correct. Until local recurrent financial resources grow sufficiently robust to operate and maintain the new infrastructure, there may be a case for declining annual interim central government support towards this expenditure.

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Thus, capital grants offer the opportunity to assist with the initial installation, expansion, reconstruction and rehabilitation of infrastructure. They can also be highly selective, giving preference to areas of greatest need and with the poorest resources. Where used, they will almost always represent a proportion of an approved capital cost, after careful examination and appraisal of the project by central government officials, or those acting on their behalf (e.g. staff of a "development fund" or "municipal bank"). Sometimes, as an alternative, projects will qualify if they meet pre-determined conditions that apply to all similar and relevant circumstances. This suggests that the central government ministry responsible for local government should try to develop an improved capability for project appraisal. This could provide significant assistance to local government units in planning their development, even without grant support. Recurrent Grants However capital expenditure is financed or supported, there will usually be some need for continuing support of recurrent operations. Thus, methods must be found to provide this support. To some degree, at least, this may also need to be supplied by central or state government grants. Usually, there is a system which combines a local governments own revenue sources with recurrent grants from state or central governments. Some of the methods to be considered for the administration of a recurrent grant system are set out below. However, it must be realized that, at present, many would need to rely upon statistical information that is simply not available or reliable. The ministry of local government or of finance should, therefore, attempt to build a data-base for this and many other purposes. Possible assessment and distribution methods for recurrent grants are: (a) budget review central government reviews each local budget in turn, assesses its credibility and provides a grant to cover all or some of any expected recurrent deficit; (b) policy support central government undertakes to reimburse local government units for the costs of nationally mandated policies, such as nation-wide salary increases; (c) reimbursement central government effectively pays for the costs of delegated services, properly the primary responsibility of the central government;

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(d) revenue compensation central government covers losses resulting from curtailment of local revenues as a result of national policy (e.g. abolition of a local tax based on incomes or the imposition of rent controls affecting property tax valuations); (e) percentage central government provides a percentage of the cost of local services, with percentages, typically, varying from service to service; (f) population central government provides a lump sum per head of population, which could vary among age-groups to take account, for example, of the special needs of children and the elderly, with respect to education, health and welfare; (g) unit central government provides a lump sum per unit of service or potential service (eg. per mile of road, per patient at clinics, per refuse vehicle); (h) revenue potential central government compensates for potential loss of revenue, for example, based on property tax values or assessed incomes for graduated tax, relative to total population and national average tax potentials; (i) revenue sharing government designates all or part of nationally-collected revenues (eg. vehicle licences) to be shared among local government units; and (j) formula a variety of factors is taken into account to provide a grant structure which meets multiple objectives. All of these procedures are appropriate for most sets of circumstances, although only some of them may be chosen for practical use.

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STRATEGIC PLANNING FOR CAPITAL INVESTMENT Introduction When looking at a strategy for a Capital Investment Program, it might be well to remember some words used by John Muir, ecologist and environmentalist: When we try to focus on one thing by itself, we find it hooked to everything else in the universe. A local government unit, establishing a capital investment program, can hardly be so profound. However, it can surely do better than just to prepare a list of projects that then need to be, somehow, financed. In a local or regional community, failure to visualize linkages, among the various concerns, constraints and opportunities inherent in any community can lead to very serious shortcomings. This is especially the case with capital investment programs, because of the large expenditures, the significant consumption of space and time and the specialist and often single-purpose nature of the assets installed. Even in the physical sense, there are many, many, linkages. New buildings need new investments in roads, footpaths, surface drainage, water supply, sewerage, electricity supply, and telephone services. All of these infrastructures, if already at capacity use, will need to be either developed or expanded. If not, they will be overloaded, operating with increasing inefficiency. For example, the much-heralded Big Dig, for a $15 billion massive road improvement in Boston, USA, required huge expenditures for construction, realignment and compensation for objects and activities that had nothing to do, directly, with the actual road improvements. They were, however, impacted by the construction, realignment and tunneling for this. If social concerns are added, one must also recognize that buildings will almost always have occupants. Thus, there will be a need for shops, offices, schools, theatres, parks and many other developments to house or supply the goods and services needed by these people or their families. Also, if there is to be reasonable communication among residents, public or private transport systems will be needed. It might be argued that almost everything in a community is concerned with transportation, in one form or another. Indeed, one way of perceiving a community is as a giant transportation system: for people, goods, services, information and waste products. At least two other concerns will influence the development of a capital investment program within a community. Firstly, there is the history, tradition and heritage of the community. No community on earth just sprang up, in the middle of the night, so to say. Every community is

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coming from somewhere. It has history, traditions, heritage, habits and prejudices. Many of these are reflected in the buildings and other structures, some very beautiful, some quite ugly. By consensus among residents and with pressures and influences from outside of the community, some of these structures will be preserved; some will be destroyed or significantly altered. Change is inevitable and continuous. Change is the motivator for the other concern. That is the need for vision. Someone, or a small group of people, must have an idea about where the community is going. What will it become? How will its residents behave? What might have to be done to influence, sustain or curtail this behavior? How intrusive, coercive, supportive, permissive, benevolent, helpful, 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, even on a single issue, is difficult. Reaching consensus on a whole range of community issues often seems nearly impossible. The mechanisms for doing this, even at local level, are by their nature clumsy and inefficient. Full and free citizen participation must be matched with constitutional rights, legal requirements and effective government. Individual concerns must be tempered by sensible and efficient governance, planning, management and service delivery. All of these concerns form a background to strategic planning, as a precursor to the establishment and timing of a capital investment program. A major constraint will be that of finance. Indeed, as explained later in this document, if a capital project cannot be financed, it cannot be implemented. However, from a strategic perspective, 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. For example, if there is enough funding for a water supply extension, will there also be enough to deal with the inevitable increase in sewage disposal requirements? If so, will the potential adverse impacts on the environment be overcome. Finally, if sewerage is to be installed, it might require substantial and costly modifications to the internal plumbing of residences and other buildings. Unless this is affordable to the owners, the sewerage service will not be able to operate properly. Consequently, some understanding of the ability and willingness to pay, even for the private parts of the service, is necessary. Strategic Planning for Activity The management of a local government unit, or of almost anything else, will need to deal daily with predicaments. These arise from the local governments formal or informal mandate (long-term) its policies (medium-term) or its (short-term) provocations. Each will overlap and impact on the others. Each will create predicaments, which will need to be addressed in some way by the management.

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There are, perhaps three main reactions that can take place. Firstly, the managers may decide that they have no concern to deal with. This may be because it is beyond their mandate or contrary to their policy to become involved. Indeed, the predicament might be quite a serious one. However, it may not be one with which the local government unit is willing or able to become involved. Consequently, as an institution, it can be at peace. There is nothing for it to do. Secondly, the managers may decide that the provocation is the responsibility of the local government unit to deal with, as a concern. It comes under its mandate and is addressed by its policy. It may decide, however, for a variety of reasons, that it is either unable, unwilling or both, to address it as a concern, at this particular time. It therefore remains a problem and the people involved or affected by it will continue to suffer. Finally, the local governments management may decide that the provocation creates a predicament that the local government will address, at this time. It comes under its mandate, it can be dealt with under its policy and is accepted as a concern. Therefore, it must follow that there will be activity. Under the principles of activity-based management, incorporating activity-based budgeting and costing, the only phenomenon that operators and managers can be held accountable is activity. For example, it might be very interesting to know: what the mayor of a city thinks about a new water supply system; what a public works director feels about the road maintenance program; or, what a chief financial officer knows about accounting. However, what they will be held accountable for is what they do about these concerns. In other words, they are accountable for their activity: signing a contract for a water supply system; repairing potholes and other road damage; or, publishing a set of financial statements. Under the concepts of activity-based management, only activity can be budgeted, costed or held accountable for. Thoughts, ideas and concepts, however profound, do not find directly find places in the financial interpretations of activity. Activity begins with a purpose. If an activity has no purpose, it is relatively meaningless. Usually, money spent on it cannot be justified. The purpose should be carefully defined, both in tactical and strategic terms. From a tactical perspective, the purpose should indicate clearly and directly how the particular activity is expected to achieve it. From a strategic perspective, the purpose should indicate what it is that the activity, together with its tactical purpose, is expected to contribute to the wider vision, goal or perspective. In some respects, this is similar to the distinctions drawn between outputs and outcomes. The Vision Outputs achieve tactical purposes. Outcomes achieve strategic purposes. It is, typically, the outcomes that relate to the visions of those

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with the wider views on policies. For example, for the London Docklands Development to have succeeded, as it has done substantially to date, it is doubtful whether this could have been achieved just by any number of tactical activities, however well-coordinated. Its managers were faced with a ramshackle and moribund collection of derelict buildings, rusting ship-hulks, shabby storage sheds and polluted sites. Only a strategic vision of future possibilities could have served to create the resurrection and transformation of this. Therefore, 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.

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Purposes, Outputs and Outcomes When purposes have been established, resources must be assembled. These must be organized to work efficiently. Assessments need to be made about the time-span of the activities and also their spatial coverage. With capital development projects, rather than programs of operational activities, one is often talking about long time spans, with fairly narrow spatial coverage. The latter is often confined to a single site or project area. However, the strategic implications, as well as the operational impacts, could cover much wider spatial dimensions. They could be perceived of in shorter-term time packages, perhaps linked to much longer strategic time-frames. For example, a project to deliver additional electricity will confine its construction activity to the project site and to any new transmission facilities. It may well, however, be implemented over a five to ten year time frame. When completed, the operation and maintenance of the project will not be so isolated. Instead, it will be integrated within the entire system of electricity delivery. Concurrently, the supply of electricity will be perceived of in yearly or other relatively short-term time packages. Strategically, however, planning will need to be looking far ahead of the present, to identify new sites, new fuels, environmental concerns, growth of new areas and many other considerations. This will need to link up to predictions about the movements and demography of people, as well as about the operations of a variety of related activities. Design and implementation of a capital project will need to take account of its ultimate operations. Different modes of operation will apply in different circumstances, especially with respect to the prices and availability of (say): trained workers; raw materials; transport facilities; and, maintenance facilities. Much of this will be directed towards economic efficiency. This, again, needs to be both tactical and strategic in outlook. With respect to efficiency of operations, it will be necessary to examine the motivations and incentives of those involved, whether inside or outside of the primary activity. There are many stakeholders and all will expect to be considered. Finally, there is a need to keep abreast of evolving technologies. In modern times, some technological changes are unfolding with breath-taking speed. It is very hard to keep up with this phenomenon. Tactical Planning for Activity In the language of Capital Investment Programs, an activity is often referred to as a project. As already indicated, it is typically bounded by time, space and tactical purpose. It is, however, the unit of activity which can be implemented, budgeted and costed, to deal with a specific predicament or concern. Predicaments engender responses. These will often begin with feelings, then thoughts and ideas.

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Eventually, however, a response to a predicament must be in the form of activity. The first activities will likely be plans, programs and budgets. Then there may be intellectual and physical work on project implementation. Unfortunately, project implementation will hardly ever run smoothly. The activities, however well-planned or well-executed, are virtually certain to encounter obstacles. These may be political, technical, financial or of many other kinds. They will all need to be mitigated or resolved, so that the activity can continue and the purpose achieved. This can absorb, sometimes, a great deal of time, energy, money ad frustration. They may be as often administrative as physical. Hidden blockages may appear under the ground or in the office! Explosions may occur when blasting out rocks or blasting out people. All must be resolved and the funds to do this should have been allowed for. Activities, therefore, have many implications involving decisions. Each of these will have financial and operational implications. Sometimes, major tactics and even entire strategies will need to be revised. This will usually have even larger financial and operational implications. Each new situation, moreover, will become a new predicament. Each will have its own new set of tactical, strategic and other concerns, until the project is again brought into equilibrium or is finally completed.

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FINANCING OF PUBLIC SECTOR INFRASTRUCTURE Overall Financial Requirements 00000000From the overall perspective of various entities dealing with public utilities and infrastructure, it is clear that in many situations, world wide, future demands on public financial resources will be formidable. This will apply to the funding of ongoing public services as well as to capital investment. For example, in many situations, road-space, drainage and sewerage systems are totally inadequate to deal with even the current needs of residents. Underground piping is also old and worn. The development of new residential and commercial areas typically demands large inputs of primary infrastructure. Where cities are, as is common, located astride rivers, there is also need for substantial upgrading of river crossing facilities. Often, sites formerly used for other purposes, especially industrial ones, will need to be cleared and then made environmentally safe. Where underground rapid-rail systems are planned or under construction, capital-financing requirements will be huge. Moreover, subsequent operation and maintenance will likely require significant annual subsidies. Bus, streetcar, gas, electricity and water supply services often operate under policies dominated by public welfare considerations. Thus, prices are inadequate to cover operation, maintenance and capital-cost recovery. As a result, current budgets of municipal governments must often provide for heavy annual subsidies of these, too. Basic Capital Financing Principles The search for alternative financing of public services and infrastructure should clearly explore possible new approaches. In particular, there may be considerable potential to use leasing, sale or grant of concessions for publicly owned land, in exchange for private sector financing of public infrastructure. Indeed, it is likely that some attractive packages can be arranged, with both local and foreign investors. It should, however, be cautioned that the search for innovative financing options should not overshadow the need to apply some well-known and commonly used principles. These, valid in most situations in the world, must be the inevitable fallback positions, if more creative options are not available. These basic principles may be summarized as follows: a. long-term borrowing should be confined to the financing of investment in land, buildings, permanent works and equipment, intended to provide a future flow of benefit to the community;

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b. c. d.

borrowing periods should be related, as closely as possible, to the working lives of the assets to be financed and to their ability to efficiently deliver the future benefit flows12; long-term loans should be fully repaid, together with all interest, within the working lives of the assets financed; and, all expenditures relating to the current delivery of public services, including operation, maintenance and debt service on fixed assets should be met, on an annual basis, from stable and growing sources of local revenue, from either taxes or user charges.

0It follows that municipal governments and public utilities must continuously operate within the framework of a balanced recurrent budget. Furthermore, the various revenues used to bring the recurrent budgets into balance must exclude revenues from sales of land and other public assets. They must also exclude other one-time financial inflows, such as capital grants and donations, public utility consumer contributions and receipts from the disposal of public enterprises to commercial interests. These funds flows are of a "windfall" nature. They should, thus, be reserved for capital expenditures13. Public Sector Institutions Based on institutional performance in many places, it is possible to postulate a number of options for service delivery entities, within the jurisdiction of a municipal government. 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. The options often postulate some form of corporate structure, to some degree separate from the overall administration of the municipal government. This has one important advantage. It allows the setting, by the national or municipal government, of a specific set of concerns to be addressed by each individual entity. Against these, it can be held accountable for both financial stewardship and operational performance. 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.
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It is often just as financially imprudent to finance long-life assets from short-term loans as to borrow for too long a period. It creates additional burdens on current finances, not justified by the longer utilization of the assets, but inevitable unless the loans can be rolled over or refinanced. This may preempt more important and urgent recurrent expenditures. Because short-term financing is often more readily available than that for longer terms, it creates a great temptation for municipal governments to rely upon it too heavily. 13 By contrast, 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.

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It is important to note, however, 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." This is frequently referred to in discussions about the restructuring of state owned enterprises. Instead, a circular set of discontinuities can be perceived. They concern: financial markets; ownership; control and management; and, institutional structure. First, capitalization from financial markets does not necessarily provide for effective ownership. Such capitalization may come from bonds (lending), rather than stocks (ownership). Furthermore, the issue of different classes of stock may result in the trade-off of decision-making power for security, as in the case of so-called "preference shares." Finally, holdings by minority stockholders may endow them with only nominal (legal) ownership, with no effective control or management. Thus, in the "Western" system, if there is really no intention to give effective ownership to investors, as in the case of publicly owned utility corporations, virtually all capitalization is from bond issues. Second, legal ownership, through stockholding, does not necessarily, imply effective control or management14. Apart from the potential ineffectiveness of minority stockholders, it is virtually impossible for the stockholders, as a group, to manage the day-to-day affairs of the corporation. This function must be delegated to a board, which may, in turn, be dominated by the chief executive and managers. Neither the board nor the managers necessarily have identical agendas to those of the (stockholder) owners15. For example, the principal goal of the stockholders may be that of profit, whereas the personal goals of the chief executive especially if not a substantial stockholder may concern benefits, power, control and "perks." Furthermore, where the public interest is present, the pure profit-seeking motive of the stockholders may be significantly over-ridden by regulation, of either operations or prices. This is particularly true when dealing with activities that are considered as "natural monopolies." Third, autonomous control or management need not necessarily imply the use of a corporate structure and certainly not in the "jointstock" form. In the public sector, there are many other forms of delegation to individual entities. These may range from the establishment of quasi-independent government departments or operational units (such as schools, hospitals or colleges) to wholly owned government corporations, with no private stockholdings and no intention to create them. In the UK, for example, some of these have been collectively designated as: quasi-autonomous national government organizations (QUANGOs); quasi-autonomous local government organizations (QUALGOs); and arms-length management organizations (ALMOs). Finally, a financially autonomous corporate structure may not necessarily imply the use of capital-market financing. It is quite common for public assets, within publicly-owned autonomous corporations, to be wholly financed from direct government loans or grants. Thus, the
14 15

There is a great deal of literature on the economics of the principal-agent situation. This has been dramatically illustrated by the disgraceful (and illegal) behavior of some US companies delivering public utility services (electricity, telephones, gas and solid waste management). Among the most notorious have been Enron, WorldCom and Waste Management Inc. The related demise of the accounting firm, Arthur Andersen is wellknown to all!

21

"equity interest" of the government is often merely a formal, legal, artifact, as with London Docklands Development. In summary, therefore, the establishment of financially autonomous entities, for the delivery of public services, offers a range of options which might be substantially different from what is commonly now known as "privatization." Some might involve corporate structures, some not. 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 appropriate, therefore, not to regard "privatization" as a panacea, because it most certainly is not. Instead, it should be regarded as one of the tools, albeit it an important and powerful one, for fulfilling the political and operational objectives of a local, state or national government.

22

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. Many activities offer opportunities for contracting, by open competition, for such services to be provided by enterprises outside of the direct control of a public entity. This could apply to both core governance activities, as well as those provided by autonomous enterprises. The normal "Western" practice would be to allow the public sector "direct service" units to participate in the tendering, after being formed into quasi-independent "direct service organizations." An essential feature of such re-structured units is the establishment of cost-accounting systems that are consistent with those of outside contracting entities, to ensure fair competition. 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. For such a system to work consistently, it must result in improved productivity in service delivery in the sense of more service for lower unit cost. Thus, opportunities must be present for the public sector to save on costs otherwise there would be no incentive to "contract out." It is, also, necessary for the commercial enterprise to earn profits otherwise, there would be no incentive to tender. Often, the savings and profits come about as a result of improvements in labor productivity. Whether or not this is always shared by workers, in terms of improved benefits, is often one of the more contentious issues. There is no shortage of examples of "contracting-out" where major "savings" to the contractor have been as a result of paying lower wages, with very few fringe benefits, to less-skilled staff, delivering a lower standard of service to the public. It is usually appropriate for "contracting out" to be approached gradually. Furthermore, it is often most useful to divide work in such a way that it can be delivered by several commercial enterprises, in competition with one another. If this is not done, there is a greater potential for a single commercial contractor to develop monopoly power of its own. This, it can do by gradually developing an incumbency position, especially by preempting the public sector's ownership of essential equipment. For example, if the garbage-collection service were to be fully "contracted-out" by (say) a municipal government to a single or very few commercial enterprises, these would, after a short time, own all the essential vehicles, plant and disposal sites, leaving the enterprises with a significant tendering advantage18. This would inhibit competition, on equal terms, by other competent contractors. It would also inhibit the
16 17

Conditions normally acceptable for efficient contracting-out of services are listed in Annex 2. Much is currently written about the merits of competition. This is not a panacea either, because under certain conditions, it may well create unacceptable quality for the lower prices. There may also be increased economic externalities. 18 Indeed, this has already occurred. For example, Waste Management Inc. has gained a significant foothold in the industry, which it then chose to abuse, in collusion with its auditors (Arthur Andersen), by presenting falsified financial statements.

23

return of the service to a restructured and more efficient local government unit. A very well-known technique is possible, where a quasimonopolist bids for individual small packages of work. This is loss-leading: under-pricing the initial bid to gain a foothold by using financial support from the bidders other operations There are other factors. The importance to a commercial enterprise of consistently winning the contract could make it vulnerable to "trade union" type pressures from its own work-force. The result could be the shifting of most of the cost-saving advantages away from the public sector, into the pockets of either workers or commercial enterprise shareholders. An additional cost, sometimes claimed in economic writings, is that referred to as "directly unproductive profit-seeking." 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. These are not all, or always, ethical. Indeed, they may be illegal. These have social costs in themselves. Furthermore, to those who win as well as to those who fail to win a particular contract, 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. Finally, with "contracting out" the public entity often cannot divest itself of the ultimate responsibility for efficient public service delivery. Thus, it will retain the risk that it will receive less than adequate service from its paid contractor. This, it will either have to remedy, at further public cost, or else allow the public to suffer the inevitable shortcomings. In "Western" systems, the enforcement of either financial penalties or performance obligations against recalcitrant contractors often proves costly, time-consuming, contentious and ineffective20. One important cost of "contracting out," often overlooked, is that of contract administration. The employment of many individual contractors will pose different management concerns to the service delivery entity than those for its direct labor. The means to address these concerns need to be learned, gradually and by experience. As the learning process results in improved managerial productivity, administrative costs of "contracting out" will gradually fall. However, if an increasing number of contracts are entered into, the overall administrative costs will, clearly, rise. As these costs, overall, become material, there will be an ever more urgent need for them to be accurately and appropriately accounted for.
19

This shift arises because there could be less real direct economic gain to the municipality and its public. Instead, there might be a shift of money to the lawyers, lobbyists, Mafia organizations, etc. who would then reap the related economic benefits. This contrasts to original expectations of the "contracting-out" arrangements, whereby direct economic gains to contractors, after deducting losses which might be suffered by (say) direct public employees, would result in greater net benefits to the local public. 20 For more on this, see: Allyson Pollock and David Price The public pays the price when contractors pull out of projects ( The Guardian, Tuesday July 27, 2004). It includes the words: The idea that PFI is a partnership between government and business looks a hollow joke, as private finance gets repaid while the public sector carries the extra cost of keeping services going and communities suffer. For all the political brouhaha about partnership, nothing can compel the private sector to ensure continuity of provision while governmentbacked compensation arrangements ensure that profits can be earned at little or no risk to investors.

24

Furthermore, in assessing the net benefits from the use of contracting, the extra administration costs must clearly be offset against the direct productivity savings in service delivery. Thus, the net benefits will arise only after all contract administration costs are fully allowed for.

25

In summary, therefore, public entities should exploit opportunities for alternative methods in the delivery of services and the performance of public activities. They should do so, however, not as seeking a panacea but with a prudent balancing of productivity improvements against risks, safeguards and administrative costs. Public Borrowing - Control and Allocation Whatever other financing methods are used, the financial resource requirements for public utilities and infrastructure will require significant borrowing. This will demand that attention be given, at the highest level of any municipal or other public sector entity, to suitable systems of control and regulation of borrowing, throughout the entire financial management domain under its control. Prudent financial management predicates that all public sector borrowing, for whatever purpose and by whatever subsidiary public entity, be brought firmly under the control of the central financial management function of the entity. Thus, 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. Moreover, it is a fundamental principle of democracy that only an elected council or board 21 may approve, by resolution, the raising of loans by a local government entity. This is of crucial importance when the borrowing is for services that will be wholly or mainly financed from general revenues, including taxes. 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. This could be especially burdensome, for example, for new rapid-rail transportation systems. Pending the establishment of efficient and effective financial markets, it may well be necessary for central governments to establish or adapt a centralized financing entity, through which to channel all or most of its public borrowing. For example, there might be the establishment of (say) a "Public Works Investment Corporation." This could well be designed to function as a "Consolidated Loans Fund," or "Capital Fund." Alternatively, it could manage such a fund, in addition to other activities and obligations. Such a fund would raise all public debt for the governmental, utility and infrastructure functions of the local governments, on whatever terms and conditions were available in the market place. It would then re-package this debt, so as to lend to the various municipalities or operational entities. This would be in exchange for obligations to service the principal and interest
21

Sadly, in the UK for example, much public expenditure is now controlled by organizations such as the QUALGOs and QUANGOs, whose boards have NOT been elected. Often, they have followed the traditional British practice of being appointed from among what are sometimes termed the great and the good of British society. Thus, among managements and boards of directors, knighthoods and peerages abound!

26

obligations, from either operational revenues or budgetary allocations. For a particular entity, this obligation would need to be undertaken in close consultation with the Director of Finance, to ensure that long-term charges on general revenues be given priority over new expenditures, especially new capital expenditures.

27

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 debtmanagement 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 nations 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.

28

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,
22

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

29

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 activity23. 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 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.
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.

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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.

0These will require much greater attention to financial management. Thus, accounting, auditing, budgeting and financial control practices will all require enhancement, throughout the governmental and operational entities of all communities. A key factor is to introduce a budgetary system that separates capital expenditure (and its financing) from recurrent revenues and expenditures. 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. However, more is required. Directors of finance must also concentrate on development of management accounting information, for all public sector activities, whether providing revenue-seeking or tax-borne services. It should be a responsibility of the finance department to organize and arrange flows of financial and other information to the operational units, so that their managements may make better-informed decisions24. This does not necessarily imply a centralized accounting or financial information system. In organizations of the size and diversity of large municipal governments, this is clearly inappropriate and inadvisable. What it does imply, however, is that finance departments retain and enhance their capability to hold the operational units fully accountable to the community as a whole. To achieve this, in a decentralized system, requires the development of appropriately standardized procedures that are still flexible enough to allow for the individual operating characteristics of the different entities. It will be important that a director of finance provide guidance, support, instruction, training and some degree of control to operational units, to facilitate both accounting for their managements and
24

A comprehensive textbook on these various aspects of accountability is "Municipal Accounting for Developing Countries" by David C. Jones ( Chartered Institute of Public Finance and Accountancy (UK) and World Bank 1982).

31

overall fulfillment of reporting requirements, to the municipality and its public. Also, training programs of finance department officials should include secondment to operational units. One feature of management accounting for decision-making is the use of "life-cycle-costing." Currently, many assets, such as buses and other operational vehicles, are required to be used for life spans determined by governmental edict. Often, this has proven to be far too long for economic operation, typically because of high repair costs in later years. 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. The use of management accounting will also provide information about the use of appropriate technology. For example, one can often be impressed by laborsaving achievements observed in (say) U.S.A., Japan and Western Europe, through the use of high technology equipment. The introduction and development of appropriate technology should be encouraged everywhere. However, there is no assurance that the same blend of capital and labor, as used elsewhere, will automatically be the best for a particular country or more specifically for an individual local community.

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Planning, Programming and Budgeting Governmental and operational entities should be encouraged in the use of appropriate procedures for planning, programming and budgeting of their activities, within the framework of an overall performance budgeting approach. Arrangements are also required for both tactical and strategic cash management, including the overall management of debt. It is important, for these procedures to reflect the predicted economic, physical, spatial, commercial, fiscal, population and social changes, especially significant growth or decline. Attention must also be paid to financial commitments that a municipal government - or any of its entities - will be "locked into" over significant time-periods. This would include debt-service and unavoidable subsidy obligations. Public Utility Pricing and Subsidy Some public utilities operate as natural monopolies, at least in the short term. To optimize the economic efficiency of their operations, and limiting demands upon scarce general revenues, all such entities, wherever possible, should be encouraged to charge economic efficiency prices. These should be consistent with full-cost recovery of economic resources and coverage of all financial requirements. Thus, in principle, public utility companies should set charges which are intended to cover operation, maintenance, depreciation (at current values) and a real return on assets, valued in current prices. The entities should also be required to generate funds from operations to cover debt service and to contribute towards expansion of facilities and plant. Where claims are made for subsidy, on grounds of economics, welfare or financial hardship, these should be carefully evaluated. They should, however, be allowed only where fully justified and can be implemented in an efficient manner. In general, the overall subsidy of service delivery systems is vastly more inefficient than the individual subsidy of deserving consumers. Where used, it is often because the individual consumers cannot readily be identified, evaluated and compensated. Moreover, the service characteristics should be conducive to a reasonable assurance that targeted consumers are most likely to benefit. Sometimes, because of administrative costs, the perfect is the enemy of the good. The principal justification for subsidies to entities lies in cases where there are high transaction costs, uncertainties or resentments in directing them to individuals. This may apply, for example, in the administration of "means tests." This concern applies to both economic efficiency and equity considerations. If care is not taken, 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. The situation is different where the direct recipient of the service is not assessed as the sole, or principal, beneficiary. This is an argument

33

sometimes applied, for example, to rapid rail systems, with respect to the diversion of road congestion, accident risk and air pollution. It is, however, even in this case, still very contentious. Moreover, even when there is broad agreement on the economic principles, there can often be serious disagreement about the extent and amounts of subsidies. To the extent that either publicly owned or commercial enterprises are in a position to charge monopoly prices, there should be provision for the regulation of such prices by independent national or local government agencies. These should have the power to over-ride both the political agendas of government and also the pure profit-seeking agendas of the enterprises, after holding public hearings on all applications for price adjustments. However, many witnesses seeking to be heard at such public hearings are less likely to be in favor of socio-economicefficiency pricing than in imposing their private agendas, or those of their interest groups. Thus, 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, as well as to ensure that legitimate equity considerations are dealt with fairly. Land Management A major asset, available to many developing cities, is the ownership, control or management of substantial public land. This can be exploited in a variety of ways, for the purpose of financing infrastructure. Increasingly, such land will be subject to activity based on commercial valuations. Sometimes, much of the land required for infrastructure development may already be in public hands. This results in significant potential savings, or financing opportunities, over situations found elsewhere, with the majority of required land in private ownership. The more that public land increases in value25, the more savings accrue to the public sector, in terms of the opportunity costs (or benefits) of its acquisition or disposal. In addition, there are notable savings in the transaction costs of land acquisitions, especially where this might otherwise involve compulsory purchase. For direct funding purposes, receipts from the sales of public land, not required for municipal purposes, can be used for related infrastructure costs. As alternatives to receiving all sales revenues in cash, contracts can be made with developers to provide a part of the sales price in the form of infrastructure. Prime development land is sometimes located in the vicinity of significant public infrastructure, such as a river bridge or a metro station. In such a case, it becomes possible for a developer to accept a parcel of land, at no cash cost, in exchange for the construction of the entire public infrastructure. The rest of the land can then be used for commercial facilities, for the developer's own benefit. Where such exchanges take place, it will be important for them to be properly evaluated and accounted for. As indicated, such one-time sales or exchanges should not be regarded as recurrent revenues. Cash proceeds not immediately used for development should be reserved for future capital expenditures.
25

This is particularly important where such public land is derived from abandoned or curtailed activities. Examples occur where land occupied by railway yards, shipping or military interests is no longer needed for its earlier purpose. Often, it has become derelict and unattractive, as well as having no public facilities and infrastructure suitable for new development. Thus, its initial value is very low.

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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, with the exception of property taxes26. It will kill the goose that lays the golden eggs! Thus, 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. This is another reason for careful matching of budgetary requirements to overall development activity. An important point is that as future real land values increase, rents in real terms can be adjusted to allow for this. Sale prices, by contrast, are fixed on a "once for all" basis. In the absence of a fully developed land-price information system, it might well be found that early disposal of land is in real terms under-priced. This would represent a partial gift to the purchaser, who is, effectively, purchasing the present value of all future real land rents. Where land is not disposed of by final sale, it will, of course, continue to yield rents to its public sector landlord. These, along with other revenues, will be available to the general (recurrent) revenue pool to finance debt service. Where the local government (or a development authority) has the power to grant planning (zoning) permission over privately-owned or rented land, this might be accompanied by a requirement that the owner (user) provide some degree of public facilities, in exchange for the valuable (monopoly) development right27. This cannot, however, be pressed too far. First, an excessive demand, causing a potential loss to the developer, will cause a backing away from the whole enterprise. Second, the local government or development authority may sell land, with planning permission already included in the price. To avoid disputes, it is important for the seller and the purchaser to be certain whether or not this is the case. In some cases, a municipality (or one of its entities) will own land rights in connection with the operation of public facilities. An example would be the air rights over a "metro" or mainline station entrance. These rights can, of course, be leased to developers to help cover the costs (or related debt service) on the principal facilities. The extent of this will be facilitated or curtailed, for example, by regulations regarding building height. Finally, when land is in the hands of commercial enterprises or is privately owned, it can be subject to property tax, either on the land alone or also on improvements. Even land owned by public sector entities should be subject to tax. This is not, usually, to bring in additional revenue, although the setting of public utility prices, to cover such taxes, will do just that. What the taxing of public facilities does achieve, however, is to militate against
26

Even these may be curtailed or postponed if the land is part of an "enterprise zone." Property taxes may then not be collected for several years into the future, to encourage developers to risk new activities on the land. 27 This is known, in the U.S.A., as an "exaction." Sometimes, state or local law forbids this. In such case, developers typically make offers to provide public facilities, then known as a "proffer." In Britain, authorities have had, until recently, very limited scope to secure developer contributions for infrastructure. The "Planning and Compensation Act 1991" changed that position dramatically. Developers can now be made to bear the costs of infrastructure and community facilities, as a condition of being granted planning permission.

35

distortions within the allocative process of the public sector. In particular, it will prevent hidden subsidies to (say) public utility enterprises that own substantial real property. In addition, taxation of public facilities will indicate the extent to which revenue is being foregone, by retaining them within the public domain. Environmental Accounting Increasingly, it will become necessary to provide in the accounts of public entities for potential costs to remedy current environmental degradation. This may arise from technologically inefficient operation of current service delivery. For example, if a sewage treatment works is operating without producing adequate effluent quality or disposal of sludge, this may create costs to be incurred in the future.

36

To the extent that these are only delayed but eventually inevitable they resemble future "debt service" on current "borrowing." Another example would be future closing costs of currently operating garbage disposal sites. In this particular case, it is ecological, rather than financial, borrowing. However, the future resource demands, from either charges or taxes, will be virtually identical. Tightening of environmental standards will as a direct outcome increase the costs of such ecological borrowing. Necessary Improvements The means to achieve economic development and reform do not necessarily, or principally, lie in the restructuring of institutions. Furthermore, many of the activities to be undertaken by the municipal governments or development authorities will have to be coordinated with many departments, agencies, bureaus and commissions of a central or state government. Indeed, policies of institutional reform and restructuring, including privatization, 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. For example, 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. If the latter can be achieved under public ownership, institutional change might not be necessary, appropriate or desirable. However, 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. A great deal of institutional, administrative, financial and operational reform must often be undertaken. In addressing overall goals of reform, as contrasted with specific activities or reorganizations, the following should rank as among the most important: a. b. c. d. e. f. mobilization of resources for both recurrent and capital expenditures; identification, exploitation and implementation of alternative methods of infrastructure financing; improvement and consolidation of debt management; overall management and administrative efficiency; economy, efficiency and effectiveness in the delivery of public services; where appropriate and feasible, recoveries of full costs of service from direct users, by economic efficiency pricing;

37

g. h. i. j.

introduction and use of appropriate technology; use of "market-friendly" approaches in the procurement of the factors of production, in the form of goods and services; limitation of otherwise unconstrained demands upon the general revenues of the public budgets; and, maximization of the operational autonomy of entities, consistent with optimal accountability for both stewardship of resources and performance of activities.

0 Finally, as much of the activity under the control of public entities is clearly concerned with government and public service delivery, it is essential that their activities be (and be seen to be) consistent with the prevailing political agenda.

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FINANCIAL, ECONOMIC AND SOCIAL IMPACTS ON LOCAL COMMUNITIES Community Balance Of Payments (1) Within the overall national and international economy, a local community must either sustain itself from its own production and exchange of satisfactions or else be supported by transfers from elsewhere, usually governmental. If neither of these occur to a sufficient extent, the community's economic and social structure will deteriorate. This will often leave in its wake a declining physical infrastructure and derelict buildings, together with a discouraged and increasingly disadvantaged populace28. The oft-perceived, though commonly simplistic, remedy is the creation of more job opportunities for the local populace. This can be sustained, however, only by the maintenance of a substantial balance between financial flows of funds into and out of the local community. This concept is more intuitive than statistical, because economic data gathering does not normally encompass a detailed analysis of this type, by individual communities. It is made more difficult, indeed virtually impossible, by the concern of making distinctions as to what constitutes a community29. However, for each development decision or strategy, it should be possible to assess (or at least to intelligently speculate) some of the local "balance of payments" effects. Even an educated guess as to the likely direction of net incremental funds flows will be of decision-making value. This can be done only if all the principal flows are examined. They can then be used, refined or discarded, depending on their reliability and the concerns to be addressed. Commercial activity will bring inflows of funds to a community (from community non-residents) as a result of: (a)external work locations; (b) remitted earnings from outside the community; (a) tourism within the community by non-residents;

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. Porter of the Harvard Business School. 29 It is important not to be misled into a perception that the funds are flowing though a particular official entity, such as the local government unit or a particular bank. They are not. The balance of payments is an assessment of the net flow of funds - if it could be measured for all community transactions with the outside economy, arising separately and independently in the normal course of personal, commercial, and governmental activity. These will include (but not wholly comprise) payments to and by banks and governments. Even transfers between different branches of the same government entity or commercial enterprise are included.

39

(b) local taxes; and, (c) investment earnings by community residents (including rents) from financial markets and assets elsewhere.

40

The same kind of commercial activity will also bring about outflows of funds (to community non-residents) 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 dayto-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.
30

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.")

41

42

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)
31

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.

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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 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
35

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 Romanias 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.

44

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 inter-generational 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. Inter-Generational Trade-Off - Distinctions Reference is made in this section to investment in "economic" and "social" infrastructure and in "human capital." However, a search for so-called objective definition of these concepts will prove futile. This is because the same activity will be a combination of current consumption and investment. Investment, moreover, can be partly economic and partly social. It can be distinguished only by reference to concerns that it is assumed to address. For example, 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). The teaching of a schoolchild will likely, at one and the same time, enhance immediate reading, computational and social skills, for current "consumption." It may also provide groundwork for its future education as a university professor to train scientists. Thus, some of the benefits will not be fully realized for two or three generations! Moreover, if the future scientist is engaged in developing (say) weapons of mass destruction, who can say whether the ultimate very long-term benefits will be positive or negative?36. Inter-Generational Trade-Off Investment Activity
36

For example, sixty years after the event, debate still rages about the costs and benefits of ending World War II, by the dropping of the atomic bombs on Hiroshima and Nagasaki! Also, because it is virtually certain that Japanese lives were traded for American lives, it dramatically illustrates a very common concern, relating to socio-economic analysis. This addresses not only the question of the net overall benefit but in the process just who is helped and who is hurt. Then, if the winners are able to compensate the losers, 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, everybody is dead!]

45

Investment in business construction will (if business is to be sustained) generate privately financed operating costs and publicly financed costs of public service delivery. The incurrence of these costs will bring about beneficial outcomes, as jobs, sales revenues, rents and an ability to pay local taxes. Investment in residential construction will generate private operating costs. More importantly, there will be a need to incur publicly financed costs of public services, in support of the new households. In addition, new residential construction on any large scale may create social disruption. This may be costly to the households involved and also to the public authorities. Incurrence of all these costs can be expected to bring additional accommodation, owned or rented, together with increases in the local tax bases, especially for real estate and sales taxes37. Investment in economic infrastructure will bring about operation and maintenance costs, many of these incurred by public sector entities. It will also bring about improved economic efficiency, as it contributes to more productive business activity. Investment in social infrastructure will also generate operation and maintenance costs. It will bring about improved social welfare, by enhancement of the quality of community life. Investment in public housing or public utility construction is intended to fulfill a variety of social and economic purposes. It will generate operation and maintenance costs but also facilitate the provision of housing or utility services, which may not all be provided by private sector activity. In return, there will be some revenues (some of it subsidized) from the sales of utility services and from housing rentals. 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." Increasingly, this might also be applied to some aspects of health and welfare services. This is because it is expected to raise long-term potential for future improved productivity, however defined or speculated. Such investment is also expected to create cultural enhancement. This is also a productivity factor, in the sense that it facilitates a greater participation by all, in an ever more fragile and changing socio-economic society. In other words, human capital investment is intended to ensure, as far as possible, that no one is left out or left behind, in their striving to participate or advance in society. There will often be huge time lags between current investment in human capital and the beneficial outcomes. For example, the costs of training a teacher may only be fully fructified when students of that teacher enter the work force, some of them decades ahead. Effectively, though rarely recorded in account books, a community is incurring interest costs on the human capital expenditures until these are returned to society in enhanced output. Timing and extent of this can rarely, if ever, be measured. Past Obligations
37

However, contrary to what is commonly claimed, increases in the tax base are not additional increases in economic benefits. They merely transfer some of the claims to economic benefits from private households to the public domain, via taxes.

46

Monetary obligations brought forward from past activity will create the obvious costly outcome to settle these. Furthermore, the use of current resources, financial and economic, for this settlement, will deprive the community of their use for other current purposes. However, settlement of past obligations will create an improved financial position from which to operate, from that point onward. To the extent settled, this will also eliminate the interest costs, explicit or implicit, of still carrying the obligation forward. Where physical or environmental deterioration is brought forward from past activity, it will create an obligation for the costs of restoration, renewal and renovation. Otherwise, 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. Furthermore, failure to deal with these obligations will incur effective, real, (compounded) interest costs, because the further neglect will likely generate additional deterioration.

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GOVERNMENTAL CASH FLOWS - URBAN FINANCE Introduction With reference to urban finance, key activities will include the operation, maintenance and administration of public services by a local government unit. This will require expenditures on these services, within the framework of a recurrent budget. To deliver many of these services requires investment in property, plant and equipment, through the capital budget. Much of this capital expenditure may have to be financed by borrowing, which creates future debt service obligations and other expenditures. These local government activities are focal points. Supporting them is an intricate and inter-locking system of cash flows. Sources of Funds Cash Inflows Households, businesses and developers provide monetary revenues for local government operations, through taxes fees and charges. They also supply, through savings, funding sources, to be borrowed from financial markets. These capital-funding sources may be augmented from "foreign" (i.e. non-local community) lending, including that of national (and even international) financial institutions. Among the national institutions can be a capital development fund. International institutions include the World Bank and the related regional development banks. Taxes, fees and charges will directly support the operating expenditures of local governments and their public utility entities. National and state taxes will sometimes provide funding which may be channeled to local government operating budgets, through revenue-sharing and regular grants. Moreover, some of the national and state funding may assist local governments with financing for their capital projects, by direct capital grants or project lending. Uses of Funds Cash Outflows Local government units will incur expenditures on service delivery. They will also need to provide working capital, to facilitate day-to-day activities. This working capital facilitates the holding of inventories, granting of credit and having sufficient cash to pay current expenditures. In addition, on a pay-as-you go basis, contributions may be made towards capital investment expenditures. Recurrent service delivery expenditures will normally include debt service (interest and amortization) as well as a medley of contributions to special funds. These may comprise funds for fixed asset replacement and future employee benefits, including pensions. For utility entities,

48

some contributions (saved cash flows) will come about indirectly, by retention of depreciation provisions.

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Capital Finance Capital expenditure will be on fixed assets for delivery of services. Working capital for capital projects will also be required. Sometimes, capital funding may, imprudently, be used to cover operating deficits in recurrent budgets. Capital funding may derive from some of the special funds (such as those for asset replacement), contributions from current budgets and capital grants from state or central governments. This may be augmented by contributions from businesses or households. These could include (say): water and sewer hookup charges; betterment levies for infrastructure; exactions and proffers to compensate for planning approvals; and, vesting of completed infrastructure. Debt Management The remainder of the capital funding sources will be borrowed, either from state and central government entities or in the financial markets. If foreign expenditures are to be incurred, such borrowing will need to be in foreign currency. Otherwise, local currency loan proceeds will need to be exchanged for foreign currency earned elsewhere, largely by commerce and industry. This will usually be obtained through the commercial banking system. Debt service financing will be derived from recurrent revenue sources, as part of operating expenditures. Periodic interest payments will normally go directly to lenders38. With installment debt, principal payments will also be paid directly to lenders. However, where debt is to be repaid only at maturity, as in the case of bonds, periodic payments will be made to sinking funds, invested to accumulate the cash for ultimate debt retirement. Foreign debt service will require the acquisition of foreign currency. This will again come from the reserves accumulated, within the banking system, from the foreign activities of commerce and industry. For foreign debt (unless the foreign exchange risk is to be postponed) sinking funds will also need to be built up from foreign currencies, derived from the same sources and invested until required.

38

An exception would be by the use of "zero-coupon bonds," whereby interest is, effectively, compounded and paid with the final redemption of principal. The term zero applies only to the payment of the interest not to the rate at which it is assessed!

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FINANCING CAPITAL EXPENDITURE Introduction 00000000In many countries, municipal government operations are seriously hampered by financial limitations. Since the priority must be to keep existing services running, these limitations fall most severely upon the searches for funds for capital improvement projects. Long Term Debt The most appropriate source of funding for capital expenditure, in principle, is that of long-term borrowing, broadly related to the working lives of assets to be financed. Debt service can then be annually financed, either from internally generated funds (revenue-earning services) or from general revenues (tax-borne services). This method is regarded not only as financially efficient but also as socially equitable. Users of services provided by public assets pay for this usage, including an appropriate share of the fixed asset financing, over the full working lives of the facilities. This is sometimes referred to as inter-generational equity. Unfortunately, in circumstances of high inflation and other national economic constraints, long-term borrowing is often not available. This is because of the gross uncertainty, facing both lenders and borrowers, particularly with respect to interest rates. 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. Where capital markets function effectively, the standard market solution to the interest rate concern is to add the expected inflation rate to the real cost of money. Uncertainties can (within certain limits) be allowed for by the charging of variable interest rates 39, periodically adjusted to allow for changes in both inflation and real money costs. There are, however, at least two serious problems to this. One is psychological, the other substantive. Even when nominal interest rates include relatively low real components, they often appear, to the average observer, unconscionably high. Banks and lending agencies are, therefore, sometimes considered as exploitative and so borrowing is avoided. This is not necessarily a bad thing, because the market is giving a psychological signal not to borrow at times of uncertainty and insecurity. The other objection concerns the effect of real cash flows. As stated, when inflation is high, it can still be adjusted for in nominal interest rates. However, a standard "level" mortgage-type payment (annuity), inclusive of principal and interest components, is typical for long-term debt redemption. This would normally be
39

Contrary to what might be assumed, variable interest rates do not adjust for inflation. Only full indexing does this.

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calculated on the basis of the nominal interest rate. For maturity debt, such as bonds, sinking funds are sometimes used40. Thus, the annual payment in the first year would be a much greater burden in real terms than the one in (say) the twentieth year41. Variable interest rates do not allow for this. They merely keep current nominal interest costs in line with market rates. This concern42 can be (technically) overcome by indexation. Either the principal sum or the annuity payments43 are indexed to the inflation rate. Alternatively, domestic loans could be linked to a stable foreign currency. However, these methods are not standard practice in the financial market-place. To introduce them, central government intervention would almost certainly be required. Where loans are actually raised and repaid in foreign currencies (e.g. from the World Bank) the problem largely takes care of itself, because increasing amounts of local currency are required each year, at declining exchange rates, to buy the foreign currency to service the debt44. However, much of a nation's municipal debt, to the extent that it can be raised at all, must come from domestic sources. Indeed, if foreign debt is raised to cover investment (capital) costs incurred in local currency, it might create a potential for the importation of other (consumption) foreign goods and services, which will have unintended effects on the balance of payments. In the absence of long-term debt, there will likely be an overwhelming temptation to use short-term (e.g. commercial bank) debt, as an alternative. In general this should be resisted. The only valid use of short-term borrowing by municipal governments is normally to cover temporary shortfalls in cash for working capital, to be repaid as soon as that working capital is restored, usually within a single accounting period. In some countries, attempts have sometimes been made to initially incur, and then to continuously roll over, short-term debt to finance
40

The use of sinking funds, to repay bonds at maturity, is the mathematical equivalent of the annuity payment, provided that the interest on sinking fund investments is equal to that on the loans. Usually, however, the sinking fund interest rates are more conservatively set, at lower levels. Thus, the periodic contributions must be somewhat higher, to compensate for this. 41 For example, assume a municipal government to borrow $1 million for 20 years at (say) 15.5%. Further assume this nominal interest rate to include (by compounding) a 5% real rate and a (relatively modest) 10% inflation element. The (nominal) annual payment would be about $164,000. At the end of year one, the price index would be 110, so the level payment would be equal to only $149,000 in real terms. However, at the end of year twenty, with a price index of about 673, the real value of the annual payment would be only about $24,000! At the prevailing inflation rates in many countries, distortions will be much greater than shown here. 42 This might not be considered a serious concern by all observers. 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. Thus, the higher real impact of the debt burden on earlier service users will represent an economic "gift" to their successors. This will possibly be offset by increased burdens for repair costs in the later years of asset life. The likely net result would be creation of financial savings by the "earlier" community, somewhat equivalent to the establishment of a "capital fund." Thus, the "later" community benefits, through the need for lower (real) borrowing requirements for an equivalent amount of (real) capital expenditure. 43 The annual cash-flows are slightly different by each method, but the discounted cash flow (DCF) rate of return is identical. 44 Strictly speaking, this is not entirely correct, for two reasons. First, there must be an assumption of an open economy, with floating exchange rates. Second, 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. The adjustment will, therefore, reflect the net difference between local inflation and the inflation of the foreign currency of the loan.

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capital expenditure. Worse, it has sometimes been used to cover recurrent budgetary deficits. This is inappropriate. Where tried, it has either led to complete financial disaster (e.g. New York in 1976) or has had to be brought under control and funded by long-term debt (e.g. U.K. in the early 1960s)45. It is possible to finesse the use of short-term borrowing for long-term capital expenditure. However, because this is sometimes encountered, emanating from enthusiastic amateurs, it is mentioned mainly to damn the practice with faint praise! Even if attempted, in any country, such arrangements require the existence of benign and experienced financial markets. Also required is very sophisticated debt management capability, either within the municipalities themselves or from consulting specialists. These conditions are often not, currently, prevalent. Consequently, it is normally, not recommended. When economic conditions improve, or are already stable, opportunities will almost certainly exist for the possible pooling of medium-term and long-term loan instruments. However, this, too, will usually require central government leadership, guidance and participation, as well as professional support and advice. It is appropriate for borrowing to be secured against either specific or general revenues. It is normally inappropriate for public assets to be offered as security, because confiscation, in the event of default, could lead to severe public policy concerns, as well as obvious practical difficulties. Sometimes it has been argued that long-term municipal debt should be secured only against so-called "own-source" revenues, such as property taxes. This appears excessively harsh, perpetuating the idea of revenue-sharing as "central government handouts." It is, however, consistent with the sometimes postulated concept that local governments should, as it were, "stand on their own (financial) feet." Without question, everything should be done to ensure that local governments are more accountable and financially autonomous. However, it must also be appreciated that they are legal entities, promulgated and administered by the central (or state) government, which allocates to them both responsibilities and resources. Indeed, it is very rare for local government units to have constitutionally-based autonomy. They are almost always established under national or state legislation. Revenue-sharing, together with the use of other grant mechanisms, are, therefore, recognition of the partnership status among the various levels of government. Accordingly, these revenues other than specific capital grants should be regarded as part of local government resources available for debt service.

45

In the UK, local governments are required, by law, to set aside a Minimum Revenue Provision (MRP) every year, to cover repayment of a proportion of outstanding debt, from current revenues. This is intended to prevent the crude rollover of all of the outstanding debt.

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Within this context, there can often be no objection to the central (or state) government withholding revenue shares from municipal governments, in order to act as the agents of lenders in settling arrears of debt-service obligations. Indeed, there is ample precedent for this, in many parts of the world. However, this should be only a temporary and emergency expedient. 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. The deeper causes of this should then be investigated and remedied. They are likely to be politically motivated not just administrative concerns.

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Capital Financing Sources - Other than Long Term Debt As indicated, well managed long-term debt can, and hopefully will in stable economic conditions be a mainstay of financing for the capital investment programs of municipalities. Until this is so, however, recourse can only be to alternatives. Some of these would be appropriate, even where borrowing was available. Others are merely "second best" opportunities. They include the following: a. b. c. d. e. f. g. use of special funds, established out of (regular or sporadic) contributions from recurrent budgets; use of unapplied capital receipts, derived from the sales of public assets or from other "windfall" sources; allocation of planned (or even unexpected) budgetary surpluses from recurrent operations, often related to a formal pay-asyou-go strategy; generation of internal funds within the framework of revenue-earning (public utility) enterprises; "earmarking" of specially designated revenue sources as being only towards capital expenditures, sometimes of a very particular nature46; negotiating with or requiring land developers to construct on-site infrastructure for their owned developments, together with related off-site connections to the main (municipally-owned) infrastructure; using intermediate technology (such as small-scale treatment works or pumping stations for localized sewer or water networks), requiring smaller (and more steadily incremental) units of capital funding than for massive extensions to main structures; as a corollary or variation to the use of intermediate construction, using a staged approach, typically financed by a pay-asyou-go strategy;

h.

46

A common example, in some western societies, is the designation of gasoline taxes towards road construction or (sometimes) other public transportation systems. However, this is a contentious issue among public finance specialists, as is the whole concept of the "earmarking" of public revenues. Often, the process is used more for political posturing than for any sound economic purposes. It can also be economically ambiguous, in that high gasoline taxes may engender a reduction of vehicle use, requiring, in theory, less road space rather than more of it. This supports the economic rationale for allocating some of the revenues to alternative transport modes.

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i. j. k. l. m. n. o. p.

as a condition of zoning permission, levying development charges, or alternatively requiring private developers to provide (or add to) community facilities, such as community centers, low-cost housing, parks, paving of communal walkways and (if appropriate) re-housing or re-training of those who may have been disrupted by new developments; seeking tenders from private companies to "build maintain and operate" facilities, allowing them to keep some (or in appropriate circumstances all) of the revenues; contracting out the entire operation of the service, either by allowing the contractors to levy service charges or by making contract payments from public funds; using leasing devices, whereby private suppliers will undertake to capitalize the acquisition or construction of public assets, in exchange for some secure legal obligation (e.g. a take-or-pay contract) for the local government to use them; collecting one-time contributions from those assessed to be beneficiaries of public works improvements, such as hook-up fees for water and sewer systems and frontage charges for road improvements; engaging in neighborhood partnership agreements, whereby residents voluntarily agree to share infrastructure costs with a municipal government; permanent re-assessment of properties adjoining specific public works improvements, permitting the collection of what is sometimes known as "betterment levies"47; purchase of divisible packages of capital expenditure (e.g. replacement of bus fleets) by from current revenues (i.e. by payas-you-go) instead of by using loans, which may be either not available at all or for which other types of assets should be given priority; establishing "special tax districts" for areas deemed to receive local but generalized benefits from specific infrastructure improvements or installations; and,

q.

47

This is a contentious issue, which can sometimes lead to bizarre and unjust results. For example, immediate frontagers of major road improvements may receive virtually no benefit from the works. These will be enjoyed mainly by the (passing) road users. Indeed, some frontagers may suffer economic losses such as being cut off from adjoining property or by having business customers re-routed away. Yet, as frontagers, they may still be surcharged. Moreover, if the betterment levy is to be on an annual basis, it does not really provide immediate funding for the up-front costs. Some form of collective borrowing mechanism would still be required to cover these.

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r.

use of capital grants from the central government, targeted to purposes in which the central government has a political or beneficial interest.

0Although fairly common practice, the use of central government grants to finance capital expenditure can result in serious mis-allocation of resources. This is because a central government grant represents a virtual free resource to a local government, for a new asset. A more economically efficient option would be for the municipality to assess the cost of keeping its existing assets in better repair. 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. There is a moral hazard issue here! The use of leasing procedures is sometimes used as a legal artifact to circumvent borrowing restrictions. For example, in Virginia, USA, there are overall debt limitations on the state government. Also "general obligation" bond issues (borrowing against tax revenues) by state and county governments requires a public referendum, whereas "revenue" bonds (borrowing against specific revenue flows from charges) do not. To finance the provision of new public buildings, the state government and some local governments have established quasiautonomous "property corporations" which have raised "revenue bonds," chargeable against the rents receivable from the state or local government. This is, in principle, a quite sound accounting device analogous to loans pooling. Its shortcoming lies only in apparent attempts to circumvent (what are claimed to be) onerous approvals or limitations. These restrictions or controls are common, in some form or another, almost world-wide. Some of these funding procedures have been used as opportunities to introduce what are referred to as Public Private Partnerships. Wisely and carefully put together, these partnerships have sometimes provided for necessary and important capital investment, where funding limitations would otherwise have prevented it. In the United Kingdom, for example, the Thatcher government, from the early 1980s, established policies that would give far more responsibility to private sector institutions to finance, implement and subsequently operate, public facilities. There was often no public sector participation at all, after the initial selection of the private contractors. These funding operations, where the public institution does not have an equity stake, came to be known, collectively, as the Private Finance Initiative (PFI). Its introduction coincided with a substantial reduction in public sector borrowing, mainly for political, macro-economic and international reasons. Moreover, conservative policies of the government were subsequently enhanced and reinforced by stringent macroeconomic limits placed on public sector borrowing by the European Union. These limits have been largely continued by, or enforced upon, later governments, under Conservative and Labour administrations. Consequently, with public debt within historically tight bounds, there was severe capital rationing. The consequent dearth of public capital
48

For example, 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, thus being the near equivalent to borrowing. In principle, this also applies to money allocated from general revenues, because a capital fund is really just a separated part of the current surplus, with a different label on its envelope!

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expenditure would have been much worse, without PFI. It therefore gradually established itself as virtually the only game in town, for the funding of much expensive capital expenditure. This, naturally, delighted fiscal conservatives in government as well as the new cadre of evolving private sector institutions that were offering to perform the PFI activities. The severe limits on public sector borrowing, whilst politically satisfying, have proven to have been both economically and socially flawed 49. After all, a lower level of public sector debt can only be counter-balanced by higher debt, or other capitalization, for the private sector50. Moreover, as stated elsewhere, inter-generational equity accompanies public borrowing for capital expenditure. Thus, it has proven itself to be a very robust and necessary constituent of sound public policies not, as now asserted, a major impediment. Moreover, the PFI is now, itself, the subject of major public criticism, from all shades of political opinion in the United Kingdom. There are many and varied assertions that the PFI has frequently failed to deliver on its promises, costing the public sector millions of pounds in losses, compensating expenditure and economic inefficiencies. Unfortunately, no one really knows the true costs involved, because neither the government itself, nor the main parliamentary watchdog, the National Audit Office, have chosen to find out. Almost all publicly available data is ex ante, largely taken from the value for money promises, evaluations or assertions, made when the schemes were submitted for governmental approval. Well over five hundred PFI deals had been signed by April 2003. However, by April of 2004, shareholder returns had been evaluated in only one such operational scheme. These were sixty per cent above projections and not justified by risk transfer. Thus, this minute quantity of available hard evidence seems to support those who are skeptical, or at least uncomfortable, with the outcomes. That there is no substantive body of systematic evidence about the results, including costs and benefits, of PFI, suggests a very severe breakdown in accountability. This is a very important lesson for all those engaged in the funding of capital finance. Moreover, it allows supporters of these arrangements to continue to make significant and influential claims for success, however outrageous and undocumented these may be.51 Municipal Orchestration of Capital Improvement Programs Many of the capital financing devices can be combined, with the local government providing "orchestration" for public-private sector partnerships. This can sometimes be used for derelict sites or many other situations where private initiative might not be forthcoming without public encouragement. In these cases, a limited amount of capital investment by a local government can increase land values from "unimproved" to "improved," making the sites ultimately more attractive to private investors.
49

Several major countries of the European Union, including France and Germany, have subsequently shown a substantial inability to keep within the established limits, despite significant manipulation of fiscal reporting. 50 This was made very clear in statements by Sir Alan Walters, a principal economic adviser to the Thatcher government. 51 An apposite characterization of this phenomenon is in the title of a book by David Stockman, a (disillusioned) Budget Director of the former US president, Ronald Reagan. It is called The triumph of Politics.

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A local government may be encourage private developers, or neighborhood residents, to combine efforts in a large development project, so as to reach a "critical mass" of interlocking economic activity. In this way, more productive and coordinated use can be made of individual sites, which would otherwise be too specialized or too limited of access, to be valuable on their own. Where this has occurred, elsewhere, it has usually taken a broad combination of skills, including those of: strategic spatial economic, financial and social planning; innovative and creative financing; hard-headed but flexible negotiation; advertising; public relations; public education; and, tough budgetary management. It also requires competent capital and recurrent budgeting, accounting, financial reporting and auditing. Perhaps most importantly, there is a need for persistence and vision by a few really dedicated and public-spirited individuals, often against bureaucratic and political obstacles,. Sometimes, it takes a special kind of talent to convince commercial developers that a disused and rundown railroad yard, or derelict buildings, for example, could be transformed into (say) modern business, communications and residential districts. Care must be taken, however, to ensure that planning activities are not carried away by enthusiasm and euphoria. What has been suggested is basically a "supply-side" approach. Supply of building or infrastructure development does not always create its own demand. This was illustrated in the USA by the under-utilization of commercial development in the nineteen-eighties52.

52

In England, the London Docklands development went through many such crises, before it could claim to have significantly fulfilled its promise. Its flagship developer went bankrupt and there were major transport access and financing concerns.

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To the extent that this phenomenon represents a private sector risk, it will result in lower profits or increased losses. However, the public sector will also bear some costs, arising from the lower tax revenues available to support the under-utilized public facilities. There will also be social costs, arising from unemployment or under-employment of an intended enhanced labor force on the new site. Budgeting Many systems of budgetary management concentrate, almost exclusively, on funds flows. Analysis of the allocation and use of real resources should enhance this. Thus, it is important to make reference to productivity, by improvements in the economy, efficiency and effectiveness of service delivery. In exclusively cash-based budgetary systems, apparent "savings" can often mean "poor or diminished service delivery." It can also mean in the context of grant-funding from a central (or state) government that another unit of government, or even the private sector, was encouraged (or even coerced) into paying some of the capital costs. These grants are then sometimes ignored, in setting prices to recover or contribute to the capital costs. Urban public transit systems are prime examples. Thus, there must often be some transformation of the budgetary processes from those that are cash-based to those which are cost-based. This will necessitate, in particular, establishing clearer distinctions between "operations" and "capital investment" in the accounting and budgetary processes. It will also require clearer differentiation and bounding of the financial operations of trading (enterprise) activities, such as those delivering utility services. Often, capital expenditures have been funded from general taxation sources, with only operation and maintenance expenditures covered from user charges.

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PROJECT APPRAISAL INTRODUCTION General Observations Project appraisal is typically performed by financial institutions, government departments and others, prior to making loans, equity finance or grants to project implementing entities. There are many well-known approaches to project appraisal. For example, 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. An example of such an approach, in the USA, is that of the Major Investment Study (MIS), dealing with major metropolitan transport investments. A very well-known international example is the intensive appraisal work performed by the World Bank. A principal role of project appraisal is to protect the interests of investors. In an integrated system of governance, it is also concerned with the overall economy, efficiency and effectiveness of projects, in serving the common good. Although project appraisal might be carried out by investors, lenders and grantors, the institution bearing the major risk is usually the implementing entity itself. If a project is inadequately or incompetently designed, implemented or operated, the entity risks financial loss, waste of economic resources, failure to provide intended services and potential political embarrassment. Thus, even though project appraisal can be seen as an independent assessment, by outside observers, it must also be regarded as an activity to be performed by internal specialists, to protect the interests of the entity. Internal project appraisal is also implicit in the preparation of applications for grants, loans or other capital funding, because the questions posed by project financiers are also those which the project entity should be putting to itself. Project appraisal, as described in this and other literature, may appear to be a rigid and specific process, whereby feasibility studies are performed and then designs are prepared, before an appraisal takes place. Indeed, this is often part of the formal process, because one cannot efficiently appraise something that is not prepared to a reasonably advanced stage. There is, however, something of a dilemma here. Project preparation, analysis and appraisals consume time, money, and resources, before anything begins to be built. Sometimes, for this reason, as well as because of political and other pressures, appraisal is seen as a delaying or limiting function, possibly leading to the curtailment or abandonment of popular schemes. At the same time, failure to appreciate the full financial, economic and other factors involved is not very sensible, useful or economically efficient. There is at least one other dilemma. Accountants and financial analysts, however professionally competent, do not usually build projects. These are

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usually derived from political, administrative or commercial vision, coupled with the leadership and dedication of a few key people. Furthermore, however well a project is appraised, nobody really knows for certain how it will eventually turn out. Indeed, even if a project bankrupts the initial investors, it might sometimes be a contribution to posterity, useful and successful over the very long term. Examples might include some of the US railroads and the "Channel Tunnel." There is a consequence of all this for project designers and implementers. Firstly, although they will not necessarily understand the detailed techniques of project appraisal, they must learn to open and to sustain meaningful conversations with those who do. Secondly, their design work must be carried out within a mental background of concern as to potential costs and financing. They should bear in mind that the higher the cost, or the more uncertain the financing, the less likely is the project ever to be implemented. Their designs will, therefore, be largely wasted, except for the learning process that can be assumed to be implicit in all meaningful work. With these concerns understood, the project appraisal process will be described as if performed by an independent team of professionals, either within the project implementing entity or from outside. Appraisal Concerns and Purposes Far too often, project financial appraisal is limited mainly to revenue generation, with a narrow focus upon pricing and taxation policies. Setting tariffs and taxes is frequently directed only at covering immediate and short-term cash requirements, elicited from simplistic budgetary procedures. These, in turn, are based upon an uncritical and unconstrained view of current public service operations, together with immediate budgetary impacts of projects coming into operation. Political considerations are often paramount usually directed at keeping prices down and postponing, for as long as possible, the time at which they should be increased. Of course, the setting of prices and local taxes at the lowest possible levels is typically perceived of as being in the best interests of consumers, at least in the short term. However, this benevolence is sometimes achieved only by the use of large subsidies from general public funds, creating a misallocation of resources. Frequently, also, low prices and charges are associated with poor service delivery, with little or no prospect of upgrading or expansion, because of a shortage of funds. There is, in principle, no objection to the use of general public revenues to finance project implementation and operation. Indeed, these are necessary for services that do not generate (or cannot reasonably be financed from) individual user charges. These include categories of services which economists refer to as "public," "merit" or "collective" goods. In particular, such projects deal with economic "externalities" and other circumstances where users of services are not, necessarily, the sole or principal beneficiaries53. An
53

These questions are dealt with at length in the many texts on public sector economics and finance. One example of such a text is "Economics of the Public Sector" by Nobel Laureate Joseph E. Stiglitz. (Formerly: VP & Chief Economist, World Bank) Third Edition, February 2000.

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important thing is to determine, as far as possible, that general public revenues, of the extent proposed, are the most economically efficient use of funds and resources. It is an often overlooked principle that it is usually more economically efficient to subsidize deserving people than deserving activities. For example, the lowering (or holding down) of transit fares might attract more people away from cars and onto public transport, producing (actual or claimed) economic benefits.

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However, 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 fares54. Some of these passengers might be of higher incomes, thus undeserving of subsidy55. Unfortunately, there is no practical way56 in which they can be identified and charged, so the lower fares will be charged to all. Consumers and citizens are almost always resistant to price and tax increases. However, this resistance can be greatly mitigated by perceptions of better service, based on improved productivity. These improvements, in turn, will keep down costs and limit the extent of price and tax increases. Much more attention should, therefore, be given to review of the financial performance and management of project operating entities. In addition, there should be a complete appraisal of new development projects, with full regard to technical, operational, financial, economic and other implications. Pricing and cost recovery policies can then be related to more efficient service delivery institutions, as well as to well-designed and feasible protects. The first activity, therefore, is to establish a process for appraising the management capability of service delivery institutions. Then, there will be a need for appraisal of actual development projects. The underlying premise is that pricing and cost recovery practices should be examined within the much broader context of these overall assessments. Financial policy decisions can then be related to longer-term economic and financial requirements and implications.

54 55

More rigorously, this is the concept of "consumers' surplus." This is not, strictly correct. If the purpose is to get car-users off the roads, the subsidy should, more strictly, be directed at those who would need the most financial incentive to garage their cars. They might well be the more affluent, thus giving an appearance of social unfairness, despite an inherent economic efficiency. In any case, it would be more economically efficient, were it always possible, to charge car-users the full economic cost of using the roads. 56 In principle, this might be done by the use of classes (first and standard). However, for commuter transit this has not usually proven practical or efficient. Most commuter systems are one class, even if there are separate classes for longer, inter-city, transport journeys.

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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, or a perceived need for, a substantial change in its manner and level of operations. One example of such a change would be the possible expansion of operations through an externally financed development project. Such an appraisal is concerned with financial administration and with financial performance. Emphasis on financial administration is concerned with budgetary management, financial control and reporting capability, together with audit, both internal and external. Financial performance is concerned with financial viability, both of present operations and of potential future operations, including those of the intended development project. This type of review is often concerned with pricing policies and with other revenue-generating activity. A sound system of accounting is a necessary pre-condition for the effective monitoring of performance. It is also a central feature in any well-developed system of financial control. The US Federal Government will normally insist that state and local governments follow the recommendations of the Governmental Accounting Standards Board, together with appropriate auditing practices. In the international context, financing organizations, such as the World Bank, will often expect to see the implementation of appropriate systems of accounting and auditing as a part of project preparation or implementation57. This requirement will typically be included, as what is called conditionality, in the project loan agreements. Although a proposed project investment may provide the incentive for the appraisal of financial management capability, such an appraisal is not directed towards the viability of the project itself. Instead it focuses upon the overall viability of the project entity. Thus, it is attempting to determine whether, and to what extent, the enterprise operates optimally at present and whether, with the added burden of the proposed project, it will be able to adapt itself to its new situation without undue financial and management stress. Normal operations can usually be handled, financially, in a "steady state" mode. Projects, by contrast, are often disruptive, as they often seriously affect: cash flow; profitability; and, capital structure.

57

Outside of the USA, the most likely accounting standards to be followed, for a private entity, would be based on those of the International Accounting Standards Board (IASB). For a public sector entity, the appropriate standards would be the International Public Sector Accounting Standards, promulgated by the International Federation of Accountants (IFAC). This body has also promulgated International Auditing Standards.

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The Administrative Environment A perquisite to the review of financial management is an examination of the administrative environment within which the entity operates. This necessitates a review of the organization of the sector and the role of various levels of government (federal or national, state or regional, and local) in the affairs of the entity or enterprise. 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, excessive controls can often be stifling of any management initiative. It will be necessary to examine the legal basis under which the enterprise operates. Laws or regulations may prescribe its organization and management structure, the scope and limitations of its operations and its financial policies and controls. Among the key financial practices to be considered are the status and role of the chief financial officer, financial performance expectations, financial reporting requirements, financial management policies, internal controls and audit. These legal requirements must be regarded as minimum. They are also bounds, within which the entity must operate. An early judgment must be made as to whether the legal requirements allow sufficient flexibility, whilst imposing adequate controls, within which the entity may carry out its intended expanded role or scale of operations. If not, steps should be taken, promptly, to initiate the necessary legal changes to permit such operations. However, any proposed legal changes may be out of the hands of those most directly interested in the entity's operations. Whilst the need may be obvious, central or state government legislators may find it lacking in urgency and even in conflict with what they consider as more important concerns. An intended project might, for these reasons alone, need to be postponed, modified or abandoned. General Management The next matter to consider is the general management of the entity. This will include a review of the powers and duties of the council or management board, together with those of the general manager and the top management team. The management structure will be reviewed, with particular reference to the power, duties and influence of the chief financial officer58. Many organizations in the public sector become a source of domination by a powerful politician (such as an elected mayor), an all-powerful general administrator, or a strong technical or engineering specialist. Thus, one sometimes finds, in the case of the political or administrative manager, a set of detailed and irksome financial procedures, intended to substitute for good, high-level, well-trained
58

In UK local government, for example, there is a legal requirement that a professionally qualified person be so designated.

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and experienced financial management, which is often missing altogether.

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Alternatively, where a technical specialist dominates, he sometimes perceives his role only as to build things quickly or to run services effectively but without regard to cost, funds availability or economic efficiency. He or she perceives the financial specialist only as a source of funds, not really as part of the management. Indeed, he or she is sometimes considered as a nuisance. None of this should detract from the fact that project implementation, as well as the running of services, requires vision and leadership. Moreover, one does not, typically, look for this among financial managers, because that is not their principal responsibility, nor often in their nature. Key concerns, in the selection of top managers, are often salary administration and personnel management policies generally -- leading to yet another stage in the investigative process. Sometimes, an impediment to efficient operation of public sector entities is over-staffing, coupled with low pay. Yet often the opportunity to dismiss staff, or even to discipline them, is constrained by bureaucracy, trade union power or even nepotism. As well as looking at management and staffing structures, it is also important to underline the efficiency and effectiveness of individual staff, particularly managers. If key staff cannot perform, consideration should be given to their removal, training or transfer. Otherwise, or in addition, new and more competent staff must be recruited. Operations One more important item must be examined before narrowing down to the financial matters. 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, what are the important aspects and constraints with regard to construction, operation, maintenance, 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, they are so closely related to it as to be essential features of any financial investigation. Sometimes, indeed, there is considerable merit in the financial investigator asking questions about technical or operational matters. The technical specialist, who might resent such interrogation from professional peers, will sometimes seek to humor the financial specialist and even to show off by answering seemingly stupid questions. In doing so, he may reveal matters which might otherwise never have been questioned, leading to further investigations, perhaps by a technical colleague of the financial investigator. There is another matter that is often overlooked, concerning personnel matters, in dealing with operations. Senior professionals of an entity may too easily be narrowly categorized by appraisers within specialist disciplines. However, typically, these professionals will

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only have reached their positions because they have developed broader, commonsense, skills. They usually will have a good working knowledge of other specializations than their own, facilitating more useful and effective conversations with colleagues in other activities.

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Examination of the structures and operations of the enterprise will lead, naturally, to inquiry about how its properties are managed. Such an investigation can include rent-or-buy assessments; record keeping; hazard insurance; land management policies; and, economic utilization of properties. Along the same lines should be a review of the management of stores and equipment, together with that of light plant and tools. Financial Administration It will also be necessary to examine the financial administration itself. It is often desirable to find financial operations under a single manager a director of finance. This title is used advisedly. The often-used designations of chief accountant, accounts officer or revenue officer, for example, do not to carry the sense of seniority and comprehensiveness that is necessary for such a position. The director of finance must be a key member of the top management team. He or she will have some very specific responsibilities, around which the department should be organized. One of the most important financial functions is revenue collection. This embraces: taxing or charging policies; relations with taxpayers or customers; assessment, measurement, record and collection of revenues; procedures for the follow-up of non-payment; and, write-off of bad debts. Often, state, central or federal government involvement is considerable. On the one hand, it may control or authorize the setting of charges or taxes. On the other hand, it or several of its agencies may be principal beneficiaries of services and yet, sometimes, among the slowest and least responsive of debtors. This situation, alone, may seriously diminish the prospects of a local public entity from operating in a financially viable manner. Charges and taxes must, as far as is practicable, be easy to collect and difficult to evade. The customer or taxpayer must be treated with courtesy, respect and fairness, with payment of obligations made as convenient and painless as possible. However, remedies for non-payment should be firmly enforced, if only out of consideration for those against whom they are not needed. In parallel with the collection of revenue comes its disbursement. A completely separate unit of the finance department from that concerned with revenue collection should, if possible, handle this. Expenditure, of course, does not usually begin within the finance department. It is normally concerned with disbursement of funds provided for in budgets, about which reference will be made elsewhere. The initiation for payment will often come from a department that is responsible for the work that the authority undertakes. A common initiation procedure for payments is the official order system. 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

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controls over the outflow of funds. Some payments will, of course, arise from contracting procedures and tendering arrangements. These may, themselves, not be under the control of the finance department but will lead back into a review of the general management process. One of the most important contractual payments, of course, is that dealing with the employment of staff. Many of the records of staff activities will be maintained in a personnel department. However, 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. Arrangements will also needed to ensure that the deductions that are made from staff payments for tax, pension funds and other matters are properly disposed of, to their intended beneficiaries, fully and promptly. Where pension funds are in use, the management of these should also be of concern. However, it should be recognized that a generalist financial investigator is probably not well qualified to make detailed examinations of pension fund management. This will frequently require the services of actuaries, as well as monetary investment specialists. These might be employees of the finance department. However, they are much more likely to be outside specialists. Linking the processes of payment and receipt of money will be the function of cash (treasury) management. This should preferably be in a section of the finance department separate from either the "collections" or "payments" sections. Cash management is concerned, among other things, with maintaining day-to-day cash resources to enable the entity to efficiently function. Cash management is also concerned with the management of short-term and long-term debt. 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. This function also deals with investment of surplus funds, to optimize liquidity and safety with earnings. Accounting, Reporting and Auditing One principal function within the finance department will be accountancy. Here it will be that the more qualified and senior personnel are likely to work. Their responsibilities will include: bringing together, codification and classification of receipts and payments of money; record of assets and liabilities; and, preparation of various kinds of financial reports. 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, with a minimum of further adjustment and preparation.

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Among the reports that must be prepared are those for internal financial management. These reports will need to go to the finance director, to the general manager (mayor or chief executive) and to the executive board (or finance committee) of the entity. Just as important, but often not so frequent or so urgent, is the preparation of the periodic financial statements through which the entity will report its overall activities to the outside world, to the public, to lenders, to investors and to the government.

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Depending on the legal status and operational characteristics of the entity, a decision will be needed as to the form in which the annual financial statements will be prepared. As a generality, it is probably true that revenue-earning enterprises will more appropriately produce accounts on commercial lines. Non-revenue-earning enterprises will, currently, tend to produce fund-oriented accounts. However, there is plenty of scope for compromise between these two systems and others, in the interest of meaningful financial reporting. Moreover, full accrual accounting, even at current valuations, is becoming increasingly the norm under internationally recognized accounting principles59. This is true, even for non-revenue-seeking activities. Coupled with external financial reporting goes the question of external audit, because financial reports cannot become fully acceptable unless they are regarded by those who receive them as credible and authentic. When one considers who is best qualified to give such an assurance, one often runs up against the question of whether this should be an independent commercial auditor or a government auditor. Frequently, public enterprises and entities are required by law to have their accounts audited by public officials, such as an auditor-general or state auditor. In some countries, including the newly independent states and restructured economies of the former Soviet system, there has been reliance upon a central court of accounts. In other cases, a commercial type of audit is considered more appropriate. No matter who does the audit, it should be capable of being carried out with independence, efficiency and promptness, using auditing standards that are acceptable within the profession and consistent with best practices, internationally. Preparation of accounts for management purposes may well demand that there be a separate unit within the accountancy function, dealing specifically with management or cost accounting. This type of accounting is, in essence, a system of recording and classifying activities in such detail as is necessary to enable managers to make better decisions. This should be the guiding principle of cost-accounting systems. As a consequence of this, cost-accounting should be user- orientated. However logical a system of classification, it seems pointless, beyond a certain stage, to continue with detailed analysis and allocation, merely to produce an elaborate output in which no-one is interested! There is a corollary to this. The greater the details of analysis, the more it becomes necessary to arbitrarily allocate overheads of various kinds. This can sometimes be to the point where the overheads become more significant than the prime costs to which they relate. This is obviously an area requiring professional judgment, rather than the mere slavish following of detailed rules and regulations. The fairly recent emphasis on activity-based accounting, budgeting and costing recognizes that many activities have become less physical and more information-based. Thus, concentration on the allocation of overheads becomes more important than base primary costs.
59

The expression internationally recognized accounting principles is used here as a generalization. The full extent to which such principles exist, are recognized, by whom, or for what purpose, is not addressed in this document. However, at all times, it is necessary to seek out and to use the best and most appropriate standard practices currently available.

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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. The responsibility of an internal auditor is, among other things, to continuously appraise and review the systems of internal management and control, to ensure that they achieve their intended purposes. In some public entities, an internal auditor's role is seen mainly as confined to verification of receipts and (especially) payments. This seems wrong. Instead, such verification should be routinely carried out by those within the respective payments and receipts sections of the finance department. The internal audit section should, instead, be a more "lean and mean" organization, reporting directly to the chief financial officer, or to the chief executive. It should address how the financial management system, as a whole, performs. There is, however, 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). 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. A compromise might be to require routine reports to go to the chief financial officer, whilst allowing the internal auditor, in appropriate circumstances, to go over the head of the chief financial officer and report directly to the chief executive. This could be where the chief financial officer is perceived to have a conflict of interest in directly receiving the report. It must not be overlooked that an internal audit might uncover concerns relating to the chief executive personally. In such a case, discretion and subtlety will be necessary, not least because the auditor might, eventually, prove to have been wrong, or too zealous. To quote from a former president of the Chartered Institute of Public Finance and Accountancy (UK), an internal auditor must discover ways to be ...friendly to all and too friendly to none; to be able to disagree without being disagreeable... Risk Management Before leaving the subject of financial administration, attention should be given to the question of risk management within the organization. This was touched on briefly, earlier, with regard to the management of property. However, there are many other aspects of risk management, which affect the financial activities of the entity. Risk management might be placed into two main categories. The first, as already indicated, is the projection of the entity's own properties. The second concerns the protection of the entity's financial position against claims by outside parties. The first risk is often dealt with by what is referred to as hazard insurance, covering damage resulting from such things as fire, floods and theft. The second risk is sometimes referred to as public liability obligations or third party insurance.

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Risk management and insurance management are not the same. Insurance is only one way by which risk management may be dealt with. First, the risks must be identified. Secondly, decisions must be taken as to how the risks might be minimized by appropriate management action. Then, a judgment must be made as to whether the risk, as modified, 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. Over-insurance can sometimes be just as costly as under-insurance, so the entity may well wish to receive specialized advice on the management of its various types and levels of risk. Financial Performance One turns now from an evaluation of financial administration to that of financial performance. Since financial performance reflects the operations of the entity, it seems appropriate to examine the system whereby the entity plans, programs and budgets for this performance. While the budget is often a key document within a public enterprise or governmental unit, its preparation is often done in ways that leave much to be desired. A budget may be described as the financial interpretation of a plan to put into effect the policies of management. Preparation of a useful budget, therefore, must go back to an assessment of the basic policies which management has (or should have) laid down for the entitys operations. Inside the bounds of those policies, operating departments and technical specialists should have prepared plans and programs to carry on the operations within defined limits of resources. This will usually be translated into an operating or recurrent budget. In addition, the growth of operations, as well as their sustenance, will require plans and programs for capital investment in land, infrastructure, buildings, plant, machinery and equipment. These activities will usually result in a capital budget. It will be the responsibility of financially and economically trained staff, in the finance department or in a separate budget department, to evaluate (in detail and in total) the various components of operating and capital budgets and the relationships among then. The financial implications of the programs and plans must be brought to the attention of the entity's management, so that the operational policies and the financial implications of these may be brought into equilibrium. Closely related to the planning and budget activity is the question of the entity's overall financial performance. A starting point for this is often a preparation of pro-forma financial statements and forecasts. For past activities these statements can usually be derived from the accounting information and financial statements, provided, of course, that these are up-to-date. For this purpose, a useful tool is the electronic spreadsheet, used with microcomputers. Using this device, it becomes relatively easy to test any number of operating

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scenarios to determine their financial implications60. 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. Financial forecasts will normally be based upon the plans, programs and budgets, taking account of operational policies, particularly with regard to revenue generation61. 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. It may also indicate whether those financial objectives were realistic or whether, for the future, they should be modified. A key ingredient is the establishment of the present financial position of the entity, to determine whether this is a sound base from which to go forward into new and expanded activity. Future financial performance can, of course, even within well defined policies, be highly speculative. It is, therefore, appropriate to examine a number of possible scenarios, using sensitivity and risk analysis procedures62. This will enable judgments to be made as to whether the entity will be able to operate with margins of safety. In the past, for many enterprises, the accountancy system probably was the management information system, or at least most of it. Now, with the increasing and less costly use of more sophisticated computerization, the accountancy system is seen as only one module in total management information systems dealing with financial, economic, statistical, technical and other data, in an increasingly integrated fashion. Recommendations for Project Institutions Appraisal of financial management capability should obviously result in a series of recommendations. What should such recommendations concentrate on? An overriding concern would undoubtedly be that the entity will have a continuous supply of material, human and financial resources to sustain its intended level of operations. Within this overall concern, perhaps attention should be directed at four main issues: motivation, organization, policies and skills. 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. Included in those to be motivated are: the entity's own staff; investors and lenders; customers of the entity; the public at large; and, higher levels of government, to the extent that they exercise control. Sometimes, motivation can be
60

Spreadsheet systems, though excellent for analysis, are usually unsuitable to use for permanent database systems, such as budgets or accounts. One reason is that the flexibility of spreadsheets makes it difficult to establish audit trails or to recover from errors. 61 Forecasting software is now available for this purpose. One example of this (CB Predictor) may be obtained from an organization called Decisioneering: (www.decisioneering.com/orderchoice_index.html). Although this software is expensive, there are special rates for teaching institutions. 62 Risk analysis software is also available for this purpose. The above company, Decisioneering, supplies Crystal Ball.

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facilitated or enhanced by monetary incentives (e.g. prices and personal remuneration). Sometimes, other motivations are necessary. The appraisal would also be concerned with organization, both within the entity itself and within the administrative and financial environment within which it operates. Among policies to be considered are those related to financial performance, accounting, pricing and financing of the enterprise. These will including a decision about the extent to which it should be financed by debt or equity or, if a local government unit, by local or national revenue sources. Among the means used to measure and monitor the effectiveness of financial policies will be appropriately designed accounting ratios. These must be used with caution and only to measure what is related to them. Focus upon skills draws attention to needs for training, staff development and personnel policies. This, perhaps, comes full circle to motivation, for it is only through the employment of dedicated and well-motivated people that public entities will fulfill their intended objectives.

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APPRAISAL OF DEVELOPMENT PROJECTS Introduction The appraisal of financial management capability is often a prerequisite to the appraisal of a development project. Such an appraisal demonstrates the limitations, as well as the strengths, of financial information systems and the need to relate these to other disciplines, typically engineering and economics. In addition to being financially viable, a development project cannot usually be considered acceptable unless it is economically, technically and institutionally sound. 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, with adequate margins of safety. Forecasting of probable results, though based upon available financial information, requires skill and judgment going well beyond accounting. Thus, accounting represents only one input to the appraisal process, albeit an essential and important one. Furthermore, as the project is implemented, financial performance, measured through the accounting process, becomes an important feature of internal and external monitoring. Financial and managerial specialists can largely carry out appraisal of financial management capabilities. However, it is almost impossible to appraise a development project without the assistance of engineers, planners and other technical specialists, whose practical skills lie in the evaluation of the technical and economic soundness of whatever is to be constructed or operated. To some extent, appraisal should be concerned with the curtailment, postponement or elimination of projects, to the extent that needed goods and services can be more efficiently provided in ways that are more economic. Projects, as already indicated, are engendered from vision, enthusiasm and leadership. Nonetheless, it is not the purpose of the appraisal team to provide this. An appraisal is clearly intended to be critical and constraining. It is, however, necessary for an appraisal team to be able to empathize with project owners and promoters. Considerable emphasis should be directed at producing a project that is more effective, efficient and economical, rather than merely finding ways to damn it and to criticize it. It is clearly in the interests of both the promoters and the public for the appraisers to be objective and professional, with the courage to report fairly, even if negatively. In the last resort, if the project is not expected to make sense, or to work effectively and efficiently, it should be so reported.

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An important aspect of this process is the perspective or "accounting stance.63" This has at least four principal dimensions: (a) (b) (c) (d) perspective a project not seen as viable for one group of promoters or observers may be perceived as viable for another; 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; time a project perceived of as a success (or failure) over one time frame may produce a different result over a different time frame; and, accountability the viability of a project may be judged from different methods of accountability, for example: straightforward financial profitability; using financial or economic analysis; including or omitting economic externalities; and, valuation or assessment of economic costs and benefits, not easily quantified in money terms.

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. It is however, necessary to understand broadly what they are responsible for, so that the financial professional can carry out his or her duties within the right context. Among the skills required for the appraisal of development projects, as well as engineering and technical, are financial, economic, managerial, legal and commercial skills. There is also, as indicated, a need for empathy with project leadership. This does not necessarily mean that individual professionals in all these skills need be concerned with the appraisal. However, the professionals that carry out the appraisal must have regard to all of the inputs referred to. A development project, almost by definition, 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. This additional capacity may be either to meet growth in demand or merely to replace existing capacity that is falling out of use, through deterioration, due to age or lack of repair and maintenance. In the age of rapidly changing technology, projects may be more
63

This has been encapsulated in the idiom "Where one stands often depends upon where one sits!"

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concerned with the replacement of well-operating facilities that have yet become too slow or cumbersome, due to obsolescence64.

64

In one situation, 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, this task could be much more economically performed by radio. Huge ontract savings thus provided for some needed additions to the corporate offices.

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There is an important time dimension to a relationship between technical specialists and financial specialists in the appraisal of physical development projects. It is, to some extent, unfortunate that the substantive work of the financial specialist can hardly begin until engineers, architects or planners have done a considerable amount of technical work, on feasibility and design. This is also an unfortunate dilemma from the economic perspective of sunk costs. When much design work, and some initial physical work, has been performed, this lowers the marginal costs of the project, because these consist only of the costs remaining to be incurred. Consequently, the project under consideration is more and more likely to be chosen, because its gradually declining marginal costs are comparable with the total costs of all the other choices. For this reason, it is important for project appraisal to take place early in the evaluation or decision process. Otherwise, project implementation will become a foregone conclusion, with the appraisal process merely perfunctory and relatively meaningless. What this may really mean is that the appraisal process should be a continuous one, rather than a one-time event. This, however, can be turned to advantage. While the technical specialists are concerned with the physical project, this provides time which the financial specialist will need, and hopefully use, to examine the management capability of the project entity, as a prerequisite to carrying out a financial and economic analysis of the project itself. This process has already been described. 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. This may be, for example: numbers of passengers (per-hour or at peak times) on a bus or rail system; kilowatt-hours (and kilowatts of maximum demand) of electricity; or, cubic meters (gallons) of water. These, of course, relate to revenue-earning enterprises and are, as stated later, sensitive to prices intended to be charged. Demand estimates based on purely physical requirements will not, in these circumstances, be a fully reliable guide for the sizing of projects. On the other hand, non-revenue-earning projects, such as roads, 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. Peak loads and average demands are both important. The estimated peak load largely determines the design size of the project, if the upgraded system is to meet every conceivable demand placed upon it. How the peak is to be handled is very dependent upon the operating characteristics of the service. For example, a railroad may run more frequent or longer trains on the same track, up to its capacity. A water supply system may use service reservoirs to handle daily peaks, adding to the source of supply only for seasonal peaks. Electricity systems must usually provide for all the peaks to be met from increases in generation capacity. However, since it is

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relatively easy and inexpensive to transport electricity (or balance the loads) over long distances, the use of a national (or regional) grid means that increased capacity is needed only for simultaneous peaks in the system as a whole. Otherwise, peaks in one part of the system can be compensated for by slack demand elsewhere. 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. Differential fares might (to a limited extent) deal with peak loading on buses and trains. Overall economic efficiency, within an urban environment, may well need to be traded against specific goals for raising revenue66. Whilst the question of peak loading is crucial to system design capacity, it is also of concern to the financial analysis. Peak load largely determines the system costs. Capital costs and related financing costs are, almost entirely, determined by the overall capacity. Operating costs, also, are strongly influenced by system size, though these are somewhat curtailed when the system is not operating at full capacity. Revenues, on the other hand, are largely a function of average demand and sales. Therefore, the greater the divergence between peak and average demand, in both quantity and time, the more is the excess-capacity cost, borne by the average user of the service, thus increasing the unit charge. This can sometimes be mitigated by the use of differential peak-pricing systems but these are often impractical or expensive to operate. Road tolls are a special example of peak pricing. 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, when dealing with roads, (subsidized) trains and other urban infrastructure improvements. Here again, designs are influenced by peak demands. Although revenues are not direct charges upon consumers, it is important to appreciate that these revenues must still be raised -- from limited tax resources. Whereas larger revenue-earning projects may often increase sales and therefore revenues, larger non-revenue-earning projects will usually mean higher taxes per head on a limited number of taxpayers. Many of these taxpayers might not use the (e.g. train) system at all, 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. Normally, it will not be the appraising engineer's responsibility to carry
65

As for electricity grids, but to a less dramatic extent, peaks on roads relate to the entire system, not just the particular road, because traffic congestion induces some motorists to take roads that they would not normally use at less-congested times. 66 If a higher toll deters motorists from using an under-used toll road, this might create more costly congestion on another part of the road system. Thus, it might become more economic to keep down tolls than to extend the rest of the road system. Alternatively, such a policy might deter the use of shared rides, which might be considered as of greater economic benefit.

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out the detailed physical design of the project structures. Instead, he will become involved at a stage usually referred to as a "feasibility" stage. Engineers employed by the project entity itself, either as staff or consultants, will have prepared an analysis of the need for a particular type of development project. This will postulate its size, broad design parameters and the timetable for implementation. The appraising engineer will examine these proposals with the entity's engineers to determine whether they are, indeed, feasible. 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. Also to be examined are the capabilities and requirements for maintenance of the structures once they are completed, as well as the need for rehabilitation of other structures, intended to operate in harmony with the proposed project. Cost estimates will be required for the interim replacement of shorter-life assets within the project, such as pumps or transformers, together with the costs of inspection of assets that are safety or health hazards, such as dams or smoke-emitters. Economic Evaluation This physical appraisal is an important prerequisite, and is closely related to, economic evaluation of the project. It can be said, almost categorically, that however soundly constructed the project and however financially viable it is likely to be, a key determinant to going ahead with it is a satisfactorily economic and/or social cost benefit analysis. 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. It is highly unlikely that there is only one sound technical solution to the problem. It is also not at all unlikely that the proposed solution does not necessarily represent the least economically costly way of solving the problem. The appraising engineer (or other specialist) must therefore examine a number of feasible solutions. He or she must analyze the overall costs and the timing of such costs, to determine which of the solutions has the least present value in economic terms. 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, as far as possible, the economic rate of return likely to result from the project. This, too, is often far from easy, for it frequently requires the assessment of benefits that are difficult to measure in monetary terms. Sometimes social benefits result from the project, which are almost impossible to measure at all. Furthermore, the interrelationship of costs, 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." One aim of economic analysis, at least in theory, is to establish an economic rate of return, which is perceived as in excess of the

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"opportunity cost of capital" that will be invested in the project67. Put another way, an attempt is made to measure the return from the project against possible returns from other projects into which the capital might, alternatively, be invested. The common implication that economic analysis is somewhat theoretical should not detract from its usefulness. To imagine that economic analysis can yield a single rate of return number (or, more correctly, postulate a target discount rate) to several decimal places is, indeed, illusory.

67

One economist, Joseph Stiglitz (former Chief Economist of the World Bank) questions the efficient allocation of capital by the free market, explaining his concern through the mechanism of interest rates. If the demands of borrowers outstrips the supply of funds, banks will raise interest rates. But, absent well-appraised projects and complete information, the banks will then lend only to those willing to pay higher rates. These might turn out to be those investing in riskier projects, because the investors in the safer ones, with lower expected returns, may have dropped out. Whether or not this is valid, it does provide a good argument for sound project appraisal, rather than relying on investor speculation or even on the crude judgment of banks.

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It is, however, often perfectly reasonable to seek a number adequate within a range of one or two percent on either side, which will act as a focal point, derived from the quantification of all measurable data. Costs and benefits can then be tested for sensitivity and risk, both with regard to their amount and their timing. Furthermore, if all quantifiable benefits have been assessed, the non-quantifiable or social benefits of the project can be judged for their adequacy within much narrower limits. With many public utility projects, revenues from sales of the output from the project are likely to be used as surrogates for the benefits to the consumers. This sometimes leads to difficulties. The first one arises because often the existing service is being provided at sub-optimal prices, fixed far below the marginal cost of providing the service. With the advent of the new development project, the marginal cost is likely to be even higher, meaning that prices of services are almost certain to have to be raised. Thus, with such a wide disparity between the existing and likely future prices, the revenues used in an economic forecast can hardly be said to be based on observed willingness to pay by the consumer. They are based, instead, on an assumed willingness to pay, which is a far less rigorous concept. Depending upon demand elasticities also, any significant increases in price are likely to result in reductions in demand for the service. This might, in turn, require a redesign or postponement of the project. The prices assumed for the revenue calculations will be average prices68, representing what every likely consumer is prepared to pay (at the margin) as a minimum. As already indicated, they take no account of the possible willingness to pay of individual consumers above the average price. Thus, no allowance is made for the so-called "consumers' surplus. Thus, the economic analysis is based upon a minimum measure of benefits. From a financial viewpoint, this may not much matter. Unless the "consumers' surplus", or part of it, can be captured by the entity through a system of differential prices, these additional economic benefits will not be translated into improved financial performance, by way of extra revenues. Finally, whereas the financial analysis will need to be done in current prices, to reflect funds requirements, economic analysis will normally be carried out in constant prices to eliminate the effect of inflation upon both costs and benefits, in determining real or economic values69. This is explained, further, in a later section.
68

There is an anomaly here. The determination of the least cost solution implies the use of the discounted cash flow methodology. This, in turn, implies the use of a specific discount rate, representing an opportunity cost of capital. The project rate of return will be the discount rate at which the net present value of the project is zero. If prices are set to equate the (marginal) benefits to the (marginal) costs, this implies a certain amount of circular reasoning. One remedy, for a (natural) monopoly, is to calculate the average incremental (marginal) cost price. This can be tested against the current price and the future price possibly chargeable. WARNING: The calculation involves the discounting of quantities of (say) water or electricity, rather than money values. Although completely valid, this confuses people! Confusion can, however, be mitigated by assuming each physical unit of the quantities to be sold at a price of one currency unit. This turns quantities exactly into money values, without altering the amounts. 69 This is not always strictly accurate. If project costs and expected system maintenance (perhaps involving foreign costs) are expected to rise at a faster rate than (say) customer revenues, perhaps held down by economic privation, forecasts made at constant prices will tend to overstate the projects financial (and consequently economic) benefits, unless adjustments are made in the calculations for differential rates of inflation such as cost and wage inflation. In theory, one should also allow for different exchange rates, at least

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The Cost Estimate and Financing Plan The linking of the economic analysis to the physical evaluation of the project, to some extent, jumps ahead of some of the aspects of financial appraisal and analysis. A most important outcome from the technical analysis is the preparation of a cost estimate. This should be broken down by components and include adequate provision for technical contingencies and price escalation. Technical contingencies must be included, allowing for changes in physical construction that almost inevitably occur and are beyond the control of either the contractor or the project entity. Cost estimates should be separated into cost components and phased over the years of project implementation. Price escalation must also be included. This is because, as the project proceeds over several years, the costs of its inputs are likely to rise, in money values, due to inflation. The development of a financing plan can be done from two alternative perspectives. 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. The other alternative is to regard the project as merely one component in the overall investment program of the project entity, at least for the period of project construction. In this case, the financing plan will be addressed to providing all of the funds necessary to meet the entire investment program of the entity, including the investment requirements of the project and any necessary increases in working capital. Intended sources of finance will have to be assessed, both with regard to the amount and the timing of their availability. The financing plan cannot be too tightly drawn but should leave adequate margins of safety. In addition, there should be a fallback position, in case something should go seriously wrong with the cost or timing of project implementation or, indeed, with the availability of funding in the financing plan itself. One thing to consider, in such an emergency, is whether additional funding can be made available from other sources. This additional funding may, of course, be more expensive than that considered originally, or it may be more administratively irksome to obtain. It may also be linked with unpalatable or onerous conditions, not initially envisioned. This would be particularly true if the additional funding were to be from governmental sources or from an international entity. If additional funding, at least on reasonable terms, is unlikely, then a contingency plan would be necessary, to facilitate the cutting-back or postponement of the project itself or perhaps of other less essential parts of the investment program. This is certainly not as easy as it sounds. After all, if a project has been finely designed as an integrated package, any reduction in its components is likely to make it, at
by acknowledging these as risk or sensitivity factors.

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least temporarily, sub-optimal to its intended purpose. In other words, it may be (at best) less economically efficient or (at worst) not really work at all! Moreover, the project will, likely, be just one component of an entire capital investment program. Many of the components of this may be inter-dependent. Sometimes, however, hard choices must be made and there are no more viable alternatives. Sometimes, moreover, a project must be either finished or abandoned. There is no point, for example, in building half a dam or a road to nowhere! Sources of funds for a financing plan can include borrowing, equity contributions or grants from governmental sources. They might sometimes include contributions from customers or participating enterprises. One other important source can often be that of internally generated funds. These will only be available after the enterprise has covered all of its operation, maintenance and debt service requirements for its ongoing activities. These may be highly sensitive to the prices currently being set (or intended to be set) for the sale of its products. In assessing the quality of the various sources of funds, one thing to be concerned about is the extent to which any or all of them are contractually fixed, even in the event of substantial cost overruns. It is not uncommon, for example, for financing plans to be highly levered against a residual provider of funds. Often, this will be a (national, state or local) government, already hard pressed to come up with a minimum contribution to match those of others. Suppose, for example, that ninety percent of project funding is in fixed contractual terms, with the (state or local) government undertaking to provide the remaining ten-percent and to meet any cost over-runs. In such circumstances even a modest ten percent increase in project cost would double the contribution of the government, creating a serious situation. Financial Forecasts Even if a satisfactory package of funds can be assembled, to cover full project cost, the analysis is not complete. The financial plan must be examined for its effect upon the revenues of the project entity. This is particularly so with regard to both additional debt service and the operation and maintenance of the new facilities. At this point, 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. It would need to cover all financial aspects of the project entity, including that of the project itself. Forecasts of operating statements will need to have regard to revenues and expenditures. The expenditure will include operation, maintenance, repairs, administrative costs and (especially for a revenue-earning enterprise) depreciation. Cash flow forecasts will also be necessary. These will include forecasts, derived from income statements, of internally generated funds. Provision for debt service will be needed, both for debt already current and also for debt expected to be incurred as a result of the

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current and future investment program. When the net internal sources of funds have been ascertained in this way and matched against investment requirements, it will be possible to determine the amount and timing of external financing needed. Indeed, a summary of the cash flow statement for the period of project construction or implementation can quite often be used as the financing plan. This is sometimes referred to as a time-slice financing plan. For a revenue-earning enterprise, the expected revenues will, of course, result from charges to customers for goods and services. For a non-revenue-earning enterprise it will be necessary for additional costs, resulting from the project and other investment activity, to be covered from additional revenues, through the raising of additional taxes or from some other appropriate sources.

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To ensure that adequate revenues are available, both to cover operating costs and also to contribute towards investment, it will be necessary for the financial specialist to analyze, with the project entity, its revenue policies. This will include the examination of present and proposed prices or tax levels and also collection efficiencies. If existing policies and practices are unlikely to result in the necessary generation of funds, it will probably be important to get a commitment from the project entity to change these policies. This may sometimes be done as a condition precedent to financing the project or to going ahead with construction or implementation. Sometimes, pricing policies will be directly concerned with interest rates. These, of course, are inter-linked with the overall financial market of the country and in turn to its macro-economic policies. 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. In this case, discussions with the banking system or with macro-economists may prove to be inevitable. Discussions with governments may also be essential where pricing policies are subject to government controls. 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. Decisions will be necessary as to how much of the project, and which components, will be carried out by contractors and how much (if any) by the project entity's own staff. Unless there is a continuous and constant level of capital works, it probably makes sense to contract out most of the work. The employment of a large direct labor force causes somewhat the same problems as the meeting of peak demand, discussed earlier. The staff can only be fully and efficiently employed during peak construction periods. For the rest of the time, part of the force will remain idle, which is costly. It may also be potentially disruptive of labor harmony, in the sense that the devil makes work for idle hands. Where contracts are used, their selection should be on the basis of competitive bidding. Where foreign exchange costs are involved, there is often an advantage to making the bidding international. The overriding principle should be to get greatest value for money. Contracting procedures should, therefore, be examined to ensure that they operate to the maximum advantage of the enterprise, albeit fairly to the contractor. There is no long-term merit in trying to ambush a contractor with unexpected obligations or expenses. Later contracts will either allow for this directly or else include financial booby-traps for the employing entity 70. Moreover, it is imperative that a local government or public utility establish a reputation and a public example for fair dealing and straight talk. Indeed, capital construction contracts are notorious sources of corruption and fraud. These must be prevented or investigated to the greatest possible
70

It is, perhaps, 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!

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extent.

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Implementing Capacity Finally, a review should be made of the overall managerial technical, administrative and financial capability of the project entity to undertake the project. This will include a review similar to that conducted for general financial management capability. The financial professional will also need to be concerned with whether there will be a satisfactory project accounting system which, in turn, will be properly audited.

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FINANCIAL, ECONOMIC AND OTHER ASPECTS OF CAPITAL INVESTMENT Basic Concepts As already indicated, implementation of a development project demands a good deal of prior planning and investigation, before any physical or contractual commitments are undertaken. This is because projects, once started, are difficult to curtail. Furthermore, because projects tend to be large and long-lasting, bad choices can have serious financial and economic consequences. In particular, resources will be used up (or tied up) which might have been put to better use. Most public sector development projects will not have the primary purpose of earning revenue. Indeed, there is sometimes misplaced prioritization of projects that may be capable of earning revenue, over those of more social or indirect economic benefit. This can result in the implementation of otherwise low-priority projects, just to generate revenues. However, these revenues often prove inadequate to cover the capital and recurrent costs71, let alone provide a surplus for other services. The problems of choice are often exacerbated by inadequate accounting systems. Since public sector accounting systems are often cashbased, they will typically provide only crude financial information on which to base decisions. Furthermore, the complex nature of intergovernmental financial relationships will often focus attention upon where the financing will be coming from, rather than how it will be used. Fundamental to public sector investment is the question of whether a project will provide or enhance a needed service. Revenue-earning potential is usually secondary, although this must be taken into account in the financial and economic analysis. Put very simply, key factors in judging the viability of a proposed public sector project are: (a) sensibility - does it make sense; and (b) feasibility - will it work. Judgments must be made with reference to (among others) political, legal, economic, financial, social, commercial, technical, environmental and institutional consequences. Each will now be considered.

71

Under many accounting systems currently in use, some costs may not appear, especially those pertaining to the use or cost of capital.

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Political Feasibility However appropriate a project may be from other points of view, it needs to be consistent with national and/or local government policy. A project that is essentially out of tune with political reality is virtually doomed from the start. For example, for public bodies to propose investment in commercial ventures when the prevailing political climate favors privatization is not very sensible. If government policy is towards upgrading less-developed areas, better-off locations should not expect much priority. A project that does not meet sound economic, financial, technical or other criteria may sometimes be carried out for purely political reasons. Suppose a proposed road construction project to be much less economically and financially attractive, or much more technically difficult, than another by an alternative route. Nonetheless, if the proposal is strongly supported by a key group of political supporters, or perhaps offers significant military advantages, it may well be chosen instead of the otherwise more attractive alternative. The massive interstate highway system of the USA was partially justified on the basis of military readiness. This reflected poor experiences in the two World Wars, I and II. Support for it would also have come from the motor industry and petroleum producers. Legal Feasibility Clearly, a project cannot be considered if it is against the law. Where governments, local authorities and other bodies operate under legislation, this must require or allow the project activity. It could be, also, that whilst the proposed project itself is legal, intended funding sources or revenue-generation may not be. For example, the borrowing of money, the levy of a tax or even budgetary appropriation may all be constrained by statutory or administrative law. The law must also be considered (and, more importantly, adhered to) relative to contracting, employment, land acquisition, easements, industrial safety, and many other aspects of project implementation and subsequent management. Economic Feasibility A basic premise of project analysis, one that is especially emphasized by experienced international financing institutions, is economic viability. Will the economic benefits of the project, overall, outweigh the economic costs of its implementation and operation? Easy to assert, but often difficult to determine, these concepts have been subject to much discussion and argument among economists and other professionals. The principal concerns are how to accurately assess the financial costs and benefits and how to evaluate those of a non-financial nature.

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However, 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. The mere process of carrying out such an analysis will often force attention on important matters which might otherwise be overlooked -- or perhaps, by some, deliberately ignored! Furthermore, problems of inaccuracy of data are often mitigated if economic analysis is used for comparison among choices. A common example would be a search for a least-cost feasible solution, where the data for each of the choices, though different, might well be all biased in the same direction. The fact that complete accuracy is not possible is not an excuse for ignoring economic reality. Conversely, there is a serious danger of being carried away by the attraction of numbers and formulae, to the exclusion of common sense. A most important factor in such analysis is that it focuses attention upon the economic effect on society as a whole, not merely on the implementing entity.

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Economic analysis is usually carried out in constant prices (i.e., inflation is ignored) because it is concerned not with money but with the real value of goods and services that money will buy. There is, however, a danger in this. Such a procedure is only truly credible if all inflationary costs are estimated to increase at the same rate. This might well not be so, especially in some economically depressed areas, where there may be shortages of construction inputs engendering high prices for these, coupled with high unemployment, resulting in low wages. Take, for example, a capital construction project for (say) housing, public utility (e.g. water and transport) services or urban development, where costs are to be recovered from future service charges, property sales, rents or taxes. A relative shortage of capital inputs and their growing real costs, especially if imported from elsewhere in the economy, may well bring about price rises which are significantly in excess of increases in personal incomes held down by the unemployment. Yet it will be these personal incomes falling in relative terms from which costs must, eventually, be recovered. Economic analysis also makes the very bold assumption of all other things being unchanged which, of course, is rarely true. Furthermore, it does not begin to address the administrative and political problems of adjusting tax-bases, tax rates and utility charges, which, though economic in origin will affect the financial analysis (see below). This, in turn, will often have serious political consequences. To illustrate the principles of economic analysis, consider a greatly simplified but obvious example of a road improvement project 72. To highlight the principles, without becoming bogged down in computational problems, the numbers, money values and time periods used will not be particularly realistic. The purpose is to illustrate an overall financial and economic strategy. For greater detail on the tactical aspects of borrowing, reference should be made to another RTI participants manual Capital Investment Programming and Financial Planning. Consideration will be given to a simple but typical project to be executed by a local government entity. This will be an upgrading of a road, perhaps by widening it or improving the surface or load-bearing capacity. It will be assumed that the road is used, almost exclusively, for the transport of commodities to the market for sale. Assuming an average unit of local production and transport to be represented by a "widget," 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, carrying 100 widgets = $20,000 Transport cost per widget = ($20,000/100) = $200 Thus, the minimum sale price in the retail market = $(100 + 200) = $300
72

One should not be deterred by, or disdainful of, the simplicity of the illustration. Many lessons may be learned from it.

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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, and to last for about 5 years. After that, another major reconstruction will be necessary. During the five-year period, $18 million per year will be required for maintenance.

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However, the improvement in driving conditions is estimated to cut vehicle-operating costs by 5%. Thus, each widget would cost only $190 for transport and thus sell for a minimum of $290. This would be a saving of $10 per widget, $1,000 per truckload per day. This totals to a daily saving of $500,000 per day for the 500 trucks. If there were (say) 300 working days per year, the total saving would be $150 million73. 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.e. with inflation ignored) the annual debt service, over 5 years would be almost exactly $132 million. Thus, at a 10% interest (or discount) rate, economic costs would be covered by economic benefits. As economists say, the project would have an "economic rate of return" of 10%. This is a very simple example of the discounted cash-flow technique (DCF), commonly used in economic analysis. The more usual and formal way of setting out the discounted
73

Savings in marketing costs Less annual road maintenance costs

More dramatic examples, apposite to a developing country situation, could be found in the Region of Madras, India, during British colonial rule. They are described in the Book "The Man Who Knew Infinity" by Robert Kanigel, who writes as follows. "For eons, transportation in India, by bullock cart or the one-horse vehicle known as a jutka, had been painfully slow. Roads were terrible. Even by Ramanujan's time, only about an eighth of the Tanjore District's seventeen hundred miles of road were "metalled," or paved with limestone or other rock. The difference was considerable. Cart drivers forced to travel on bumpy dirt roads thickly covered by dust or mud, rather than a metalled [tarmac] one, normally planned on carrying two-thirds the load at two-thirds the speed. Twenty-five miles was a good day's journey. "The coming of the railroad had changed Indian life. It was the crowning engineering achievement of the British Raj, emerging in the mid-nineteenth century to knit the far-flung country together. In the South, the first lines had been laid in 1853, and in 1874 they began pushing south from Madras. In 1892, with the line to Vizagapatnam still unfinished, to get there from Kumbakonam could still take three weeks by train, bullock cart and canal boat. By the following year, construction now complete, the trip took one day. Thus, in the first paragraph, 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 = 0.44). In the second paragraph, the increased benefits economic, social, political, financial are incalculably immense. These are, of course, gross benefits, which would need to be offset against the costs. 74 When compared with the nominal rates of interest for project financing, shown later in the text, this might not necessarily be a realistic assumption. In principle, the market rate of interest is the real rate, adjusted upwards for inflation. There are many factors, however, which influence both real and nominal interest rates, not reflected here. Therefore, 10% is used for simplicity, following oft-used practices of international entities. It also avoids complicating the calculations.

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cash-flow statement75 in this case would be (millions of dollars): Year Gross Gross Discount Discounted Discounted Cost Benefit Factor Cost Benefit (PV@10%) __________________________________________________________________ $ $ $ $ $ 0 500 1.00000 500 1 18 150 .90909 16 136 2 18 150 .82645 15 124 3 18 150 .75131 14 113 4 18 150 .68301 12 102 5 18 150 .62092 11 93 --------590 750 568 568 --------Clearly, to the government, local authority or public utility, there will have been is an initial financial outlay of $500 million, followed by an outlay of $18 million per year (ignoring inflation) with no direct revenue, unless tolls are levied. It is, indeed, a financial loss, which must be covered by taxation. However, there would be a real net economic benefit. This could be greater than first indicated, because the lower price might well result in more widgets being sold. Moreover, the lower costs of travel would likely attract more road users, thus increasing their economic benefits76. Market forces would probably operate so that every party - manufacturer, transporter, retailer and final consumer - would all share the benefits. Additional economic benefits would probably accrue to other road users, in both the public and private sectors. In principle, there would also be an opportunity for a local government to increase property taxes or business taxes, if levied. More likely, and somewhat perversely from the viewpoint of a local government entity, a property tax or business tax increase would, almost certainly, not occur.
75

Detailed explanation of discounted cash-flow methodology can be obtained from standard texts on financial and economic analysis - or from the instructional books of financial calculators. Reference may also be made to "The Use and Limitations of Net Present Value and Rate of Return Concepts, Using the Discounted Cash Flow Methodology, for Project Evaluation and Analysis" by David C. Jones. 76 Unfortunately, additional road users will also add to the operation and maintenance costs of the road. Thus, as new users cannot be excluded, otherwise than by tolls or deteriorating user costs for their own vehicles, there may yet be a net economic loss from the new user component. This is partly because the costs which users impose on other users (such as pollution, congestion or physical and personal hazard) do not influence their own behavior (except to the extent that they rebound onto themselves!). They are, thus, referred to as externalities. To impose these costs with impunity makes one a free-rider!

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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. This serves to illustrate two main points. Firstly, 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. Secondly, economic analysis, as already indicated, is indifferent as to where the benefits fall within the economy as a whole. Economics, though claiming to seek aggregate and overall economic efficiency of resource use, does not particularly care who is helped and who is hurt! It is also indifferent as to where, in the public sector, the necessary tax revenues may best be realized. Indeed, taxes are not a measure of benefits at all. They arise from political decisions by governments, to appropriate money for public use. All the above analysis, therefore, 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 of local labor, materials, services and equipment, relative to that which could come from other areas of the country or abroad77. Financial Feasibility Economic analysis, whilst necessary, is not, by itself, sufficient. Because the economic costs and benefits do not necessarily accrue to a single entity, such as a local government authority, an economically sound project may still subject the public sector to severe financial stress. Furthermore, inflation affects money values much more than economic values. So, a financial analysis must also be undertaken. Firstly, there must be an assurance that funds will be available for the investment. Secondly, the financial outcome of the investment must be manageable, by the authorities concerned, taking account of administrative constraints. Continue the example of the road improvement, estimated to cost $500 million. 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 Governments own Capital Fund (currently invested at 5%) 50 Bond Issue (8%) 300 ---77

It is not always the case that local (or even national domestic) inputs are the least economic cost. Foreign goods and services may sometimes be more economically priced or more efficiently operated. That is one reason for the efficacy of international competitive bidding.

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$400(m) ---Arbitrary assumptions will be made about the breakdown of various project expenditure categories. Annual inflation will be assumed at 4%, applied to the maintenance costs. The 6% loan from the state government is assumed to be repaid by the annuity (level payment) method, over 5 years 78. A $50 million loan, repaid by this method, would require an annual level payment of $11.87 million.

78

This method of amortization is similar to a house mortgage.

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The amortization schedule would be as follows: YEAR ANNUITY $m 0 11.87 11.87 11.87 11.87 11.87 INTEREST $m 0 3.00 2.47 1.90 1.31 0.67 PRINCIPAL AMORTIZATION $m 0 8.87 9.40 9.97 10.56 11.20 BALANCE OUTSTANDING $m 50.00 41.13 31.73 21.76 11.20 0

0 1 2 3 4 5

The withdrawal of $50m from the capital fund, depriving it of interest earnings, is analogous to a loan. It is assumed that the withdrawal is replenished annually, by a $10 million contribution for each of the five years. The 5% loss of interest is analogous to interest on a loan. It reduces annually as the fund is replenished79. The capital fund replenishment table would be as follows: YEAR CAPITAL FUND REPLENISHMENT $m 0 10.00 10.00 INTEREST FOREGONE $m 0 2.50 2.00 OUTSTANDING WITHDRAWAL $m 50.00 40.00 30.00

0 1 2

79

A project may not always be required to repay (or to pay interest on) capital fund withdrawals. This depends on financial policies. Nonetheless, in economic terms, there will be such a cost somewhere in the system. It is just a question of which account (or who in the economy) will bear it!

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3 4 5

10.00 10.00 10.00

1.50 1.00 0.50

20.00 10.00 0

The bonds are assumed to be issued at par and redeemed at maturity from an accumulating sinking fund, invested in trustee securities80 at a (conservatively estimated) interest rate of 5%. Interest on the bonds is assumed to be paid annually81, at the "coupon" rate of 8%. Each annual interest payment would thus be 8% of $300 million, equaling $24 million.

80

Laws in many countries require public funds required for special purposes to be invested in safe funds, such as national government bonds. These are sometimes known as trustee securities, to emphasize the nature of the public trust assumed by the investors. 81 This is for simplicity of understanding. Bond interest is more usually paid half-yearly. Repayment methods are usually also more complex, sometimes exceedingly so, but these do not affect the basic principles.

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The sinking fund table would be as follows: YEAR SINKING FUND CONTRIBUTION $m 0 54.29 54.29 54.29 54.29 54.29 INVESTMENT INTEREST $m 0 0 2.71 5.57 8.56 11.70 ACCUMULATED BALANCE $m 0 54.29 111.30 171.16 234.01 300.00

0 1 2 3 4 5

A simplified financial analysis of cash flows (in $millions) might show: Yr.1 FUNDS REQUIREMENTS: Capital costs Land Civil Works Equipment Materials Administration Maintenance: Contractors Direct Service Supervision Debt-service: State Government: Interest (6%) $m 50 200 75 150 25 11 6 1 3 11 6 1 3 12 6 1 2 12 7 1 1 13 7 1 1 Yr.2 $m Yr.3 $m Yr.4 $m Yr.5 $m Yr.6 $m

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Amortization Bonds: Interest (8%) Sinking Fund (5%) Capital fund: Interest loss (5%) Replenishment TOTALS --500 ===

9 24 54 3 10 --121 ===

9 24 54 2 10 --120 ===

10 24 54 2 10 --121 ===

11 24 54 1 10 --121 ===

11 24 54 1 10 --122 ===

FUNDS SOURCES: Federal Grant State Loan Capital Fund Bond Issue Local taxes, other local revenues or government grants TOTALS 100 50 50 300 121 --121 === 120 --120 === 121 --121 === 121 --121 === 122 --122 ===

--500 ===

Clearly, the additional tax burden would be significant. Also, at the time of the next reconstruction, in year 6, project costs might have risen, by the 4% per annum, compounded, to over $544 million. It would require new grant and loan finance. However, the local government would have paid off all of its debt, with interest, on the earlier construction project. It would also have replaced its capital fund, reimbursing the interest lost by the withdrawal. Thus, its new debt-incurring capacity would be very credible. It would likely get a good credit rating for new loans.

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This illustrates another aspect of project planning. Once a commitment is made to invest in an asset, there is an implicit commitment to continue to operate, maintain and renew it. Assets cannot be viewed in isolation but as part of an expanded service. Project financial analysis should, as illustrated, lead to forecasts of the incremental cash flows necessary to sustain operations. However, the cash flows resulting from the project will be merged with the overall general cash flows of the government or project entity. Thus, an overall funds shortage could mean a cut back of maintenance or default on debt-service. Either of these would have serious consequences. For example, staff might get paid only at the expense of deteriorating infrastructure and loss of credit-worthiness. The annual tax burdens might be reduced or eliminated by the use of up-front user contributions or other financing techniques. For example, it is quite common, when roads are first upgraded, to levy frontage charges on the properties abutting the road, in recognition of the benefit deemed to be derived from improved access. However, in the case illustrated, the main beneficiaries would likely be the manufacturers of (and customers for) widgets. The manufacturing or marketing facilities might not adjoin the road at all. Furthermore, the frontagers might not derive much benefit, at least in the short run. Thus, unless the beneficiaries can be readily identified -- perhaps easier in this simplistic example than in real situations -- local or national taxes, coupled with appropriate revenue-sharing, may represent the only feasible way of sharing the cost burden among the local, regional or national communities. Provision in the financial analysis is made for some of the annual expenditures to be covered by grants, from higher (state or federal) levels of government. The details are not addressed, as these would be derived from state or national government policy decisions, as well as from political negotiations. Social Feasibility Many projects, especially those for health and education, are intended to promote social benefits. There will also be social costs. The likely social costs and benefits, intended or otherwise, must be taken into account and quantified as far as possible, before a project is started. Consideration of social benefits can well influence policy decisions on whether, or how, to carry out a project. Take, for example, a situation where the road construction project produced benefits for only four years. Its rate of return would then be lower than the cost of capital and thus would be rejected on economic grounds. However, it might be that the road, in addition to carrying the commercial traffic, provided access to a hospital, school or national park. These, largely un-quantifiable, benefits, might be judged adequate to still justify the project.

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Sometimes, roads (and other transport systems) are redesigned, 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. This has been especially true for such items as convention centers, theme parks and sports stadiums. The issues of who "benefits" and who "bears the costs" of (marginal) public expenditures are often complex and contentious. Moreover, they are political, sometimes constituting significant parts of election platforms. Economic, social and financial issues are then sometimes downplayed, distorted or ignored. Commercial Feasibility For every project, including the one in the example, there will be a variety of commercial activities to be considered. Principal among these will be: a) b) c) d) e) procurement of goods and services within the country and (sometimes) abroad; civil works contracting; cash management and other banking transactions; recruitment and employment of labor forces; and availability of utility services such as electricity, water, and telephones.

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Technical Feasibility Clearly, every project must be technically feasible. This normally involves feasibility studies and appraisal by engineers and specialists in the type of project being implemented. It is essential that technical feasibility be directed towards determining the least (economic) cost feasible solution to the problem addressed. This requires that the project be examined with respect to its complete life-cycle, including construction, acquisition, operation, maintenance and even final disposal82. This will attempt to ensure the use of materials, standards, and technologies which are most appropriate for local circumstances. There is obviously a direct relationship between technical feasibility on the one hand and economic and financial feasibility on the other. If a project is over-designed, from a technical perspective, it is very likely to cost more to construct and to maintain, without adding significantly to the economic (or other) benefits. An otherwise economically sound project may thus become uneconomic and also load unnecessary financial burdens upon the taxpaying or fee-paying public. Additionally, if usage is intended to be encouraged, perhaps for economic or social reasons, higher prices will prevent this from happening. Institutional Feasibility Whenever a project is implemented, its purpose is to give a service. This cannot be done if the institution responsible for that service is inadequate or incompetent. It must have the necessary staff, of adequate quality, with materials and equipment complementary to those provided under the project. Institutional proficiency therefore, demands sound policies, adequate resources, sensible organization, proper motivation, and all necessary skills. These are required within the entity itself and also in the public and administrative environment within which it operates. Environmental Feasibility Increasing attention is paid to the environmental impact of projects. This is especially true with respect to any perceived potential for a project to pollute the environment, either physically or aesthetically. Sometimes the impacts are clear, demanding remedies which can built into the project construction and operation. Often, however, environmental concerns are complex and contentious, typically becoming political issues. For example, it might be easy to reach agreement that a potentially polluting factory should be built only on
82

For example, mechanical plant may need to be dismantled and scrapped; waste disposal sites made safe for future use.

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condition that it includes specific safeguards. It is much more difficult to substantiate a claim that (say) an area of natural beauty, or part of the national heritage, will be significantly damaged, desecrated, lost or destroyed by a development project. This is especially true if the project can only be made profitable or generate positive economic benefits if environmental costs or remedies are ignored. Environmental concerns create a significant linkage to project financing. For example, where external costs are deemed created, as in the case of the polluting factory, planning approvals may 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)
83

basic costs;

This is, of course, an American case, the ruling on which might well not apply elsewhere.

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b) c) d) e)

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: ITEM TOTAL YEAR 1 ESTIMATE D COST $m Land Civil Works Equipment & Materials Sub-total Engineering & Supervision Administration Net Base Cost 25 225 200 -----450 75 25 -----550 $m 25 75 80 ----180 25 10 ----215 $m 100 60 ----160 25 10 ----195 $m 50 60 ----110 25 5 ----140 YEAR 2 YEAR 3

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Physical Contingency Gross Base Cost Price Contingency Gross Cost Interest During Construction Total Financing

55 -----605 34 -----639 82 -----721 ======

21 ----236 5 ----241 10 ----231 =====

20 ----215 13 ----228 28 ----256 =====

14 ----154 16 ----170 44 ----214 =====

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. 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
84

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.

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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 non-revenue-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)
85

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.

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b) c) d) e)

demand an assessment is made, in quantitative and qualitative terms, of the physical and social demands for the project. feasibility the proposed project is examined for the various aspects of feasibility, as already described. outline approval usually, some authority will need to give provisional approval to the project, either at this point or before the feasibility studies, including authorization of the next stages of the expenditure. design engineers and technical specialists will prepare the detailed designs for project construction or acquisition. These will need to include (as appropriate) work breakdown schedules; phased implementation of procurement or implementation; Gantt charts; CPM/PERT-type diagrams; and cost information86. cost estimates design will be translated into specifications of inputs (often with bills of quantities), which will be priced in detail for preparation of cost estimates and tendering documents. financial plan financing specialists must prepare a firm budget for financing the project cost, throughout its implementation period, together with the financial implications of its operation and maintenance. final approval the appropriate authority will approve design, cost and financing: if necessary, seeking confirmation from a superior authority, especially with reference to financing87. implementation the project will be constructed or implemented, by contract or by direct labor, as appropriate. Necessary goods and services will be purchased within the country or (sometimes) abroad. supervision technical supervision will be carried out by engineers and financial supervision by financial specialists. Financial agencies or banks may be involved, if financing the project. completion and hand-over the contractors and/or suppliers will hand over ownership and responsibility for the project

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, especially in the USA, approval of a bond issue for project financing might require a public referendum.

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-- usually being required to accept contractual obligations, for a guarantee period, to repair defects in construction. "Asbuilt" drawings will be prepared, to facilitate location (if hidden e.g. underground), operation and maintenance of the newly completed assets. l) m) final account the final account of the contractor or supplier will be settled, after careful examination (as appropriate), by engineers, technical specialists, quantity surveyors and financial auditors. operation and maintenance the appropriate local or public authority takes over the assets88, 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.

88

Alternatively, the assets are sold to private (or other public) owners.

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LAND MANAGEMENT RELATING TO CAPITAL INVESTMENT 00000000Financial complexities may arise for local governments because of their rights and duties with respect to land. Some of these may result in revenues - others in costs. Typically, local government authorities will have rights to: (a) buy and sell land; (b) lease land to and from other parties; (c) provide infrastructure, on, above or under land; and, (d) regulate the use and occupation by others of land, buildings, waterways and forests. Land Transactions An important feature of land management by many public sector entities is the right of "eminent domain." This establishes the sovereignty of public over private interests, asserting that land required for public purposes may be expropriated and acquired from private landowners, if necessary without their consent. Clearly, this "compulsory purchase" procedure would normally be used only as a last resort, because it is legally tedious and frequently results in bad publicity. Often, the public sector entity will be perceived as heartless or the property owner as obstructive. Most land transactions for public purposes will, therefore, seek to be in the open market. Even where land is acquired compulsorily, the vendor is typically entitled to "just compensation". Whether this definition accords with that of "fair market value" depends upon legal systems89 or standard practices. In general, local and public authorities are not in the business of buying and selling land for profit. Normally, a public sector entity will buy land only to fulfill its statutory functions and will sell any land that becomes surplus to its requirements. However, routine land transactions may sometimes be considered as part of the responsibility of (say) an urban development authority, housing board or new town corporation.

89

In the U.S.A., for example, this is specifically provided for under the Constitution, together with a Supreme Court ruling that just compensation should normally be interpreted to mean the market price. This provides no implication whatsoever for other countries.

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Where land is purchased in advance of, or in excess of, requirements, its value may have substantially increased by the time it is used. If this increase in value exceeds the holding costs, there will be a financial gain for the authority, which will equate to revenue. For land retained, its current market value, minus acquisition and holding costs, will represent a financial saving. For any land disposed of, the excess will be in the form of a net inflow of cash revenue. Often, even where advance purchases make economic or financial sense, budgetary limitations and other pressing needs may prevent them. This will sometimes, in retrospect, prove to have been a false economy, imposing higher real costs on later budgets. Land values can be considerably enhanced by the provision of development infrastructure, such as roads, footpaths, drainage, water supply and sewerage. Such infrastructure normally comes under the jurisdiction of the public sector. Thus, opportunities exist, in appropriate circumstances, for a public entity to acquire land, install the basic infrastructure and then re-sell all or part of it back to the private sector for further development. Private sector purchasers can range all the way from commercial developers to individual residential plot-holders. Some plots may be reserved for specific target groups, such as low-income families. 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. Some of the land may, of course, remain with the public sector, including the road and footpath areas, and that required for public buildings and public open spaces. For cash-strapped public authorities, opportunities sometimes exist for the acquisition of land without up-front monetary payments. The system typically used is known as "land exchange" or "land adjustment." The public authority will initially acquire land (voluntarily or compulsorily) without cash payment, install the infrastructure for the entire site and then hand back some agreed or adjudicated proportion of the serviced area to the original owner, as compensation for the ceding or taking of land. Thus, the cost of the land used by the public sector will be, in effect, the development costs on the land handed back. The private developers may then use the share returned, for their own (profitable or other) purposes subject, of course, to planning (zoning) permission and any conditions attached. In deciding whether to buy and hold land in advance (or in excess) of requirements, account must be taken of holding costs. The most important of these will usually be interest. Although this may not explicitly appear in the books of account, any investment in the purchase of land will incur a payment or loss of interest, depending on how it is financed. One way of looking at this is to assume a plot of land, costing (say) $10,000, which doubles in value to (say) $20,000 after 8 years. However, if the original sum expended on the land had been invested at (say) 10% per annum (or, if borrowed, had accrued interest at 10%) it would have amounted to $21,426 over the same period. Thus, the public entity would have lost $1,426. It might have been better (financially) to have invested the money and purchased the land, when required, at its then market value. Additional costs of holding land, to be added to the interest, could include temporary fencing and drainage, security, grass-cutting, tree-trimming and administrative overheads.

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Unfortunately, land management is not so straightforward. Each parcel of land is unique as to location, if nothing else. So, it may be necessary to purchase land when available or else see it lost forever, for another purpose. Alternatively, timing of its purchase may be affected by a variety of influences, such as actual or intended occupancy or activity on adjacent land; possible inundation by water; squatter occupancy; and, potential compensation (or alternative accommodation) for displacement of present occupants.

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Indeed, a public authority may make advance land purchases, even at a financial loss, just to prevent activity upon it, which may be assessed as not to be in the long-term public interest. In any case, no one can forecast, with certainty, either interest rates or land values. Thus, at the time it is taken, the decision is only a speculation. As well as revenue from buying and selling of land, a public authority will often be in a position to derive revenues from rents, of land or buildings. Sometimes, the rents will relate to the temporary occupancy of land or property, pending its substantive use. By contrast, the renting or leasing of property may be fully consistent with the exercise, by the authority, of its legal duties and powers. At first sight, a good example is the provision of public housing, to employees or to low-income families. However, this provision has almost always been on a subsidized basis, so that every additional rental unit will represent an incremental net financial cost, rather than net revenue. The same principle often applies to the renting of space in a municipal market. Sometimes, public entities will derive genuine profits from renting. This could occur, for example, when leasing commercial property, such as shopping centers, bus stations and offices. However, a common error, in assessing the potential financial viability of rented properties, has been to forecast the rental income against only the operation and maintenance costs. Capital development costs have typically been ignored, especially where these have been financed from concessionary funding sources - such as grants from other governments. Thus, potential loss-making operations appear to be profitable, sometimes encouraging sub-optimal investment decisions. The same mistakes have also been made for other revenue-generating operations. Land Regulation In addition to engaging in land transactions, many local and public authorities will have the legal duty to regulate the public and private use of property. This is in the interests, for example, of: sensible town-planning and balanced development; controlled growth; public health and safety; aesthetic and environmental considerations; and harmonious community behavior. An urban area will often have a "town plan", indicating which zones or sites have been set aside for various kinds of occupancy and use. This is sometimes known as "zoning". Typical zones would be for agricultural, horticultural, residential, commercial or industrial use. In addition, provision would be made for public offices, libraries, museums and theaters and for public open space. Land will also be designated for roads, railways and footpaths. Usually, a development even on a single plot will require planning (zoning) permission from the local government. This will examine whether the intended use is consistent with that prescribed for the area. If not, application will be made for a designated change of use sometimes called a re-zoning of the area. Planning approvals, especially those that will permit a more lucrative use of the property, can

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clearly be very valuable, creating a temptation for corruption. Indeed, it is not unknown for considerable sums of money, paid by developers, to find its way into the pockets of politicians, political parties and public officials, in return for assistance in gaining planning approvals. However, this willingness to pay, on the part of intending developers, need not be a source of potential corruption. Instead, the law may permit the public authority to urge, in exchange for planning permission, that the developer make a material contribution to public facilities. For example, the developer might be encouraged to provide, as part of (or adjacent to) the proposed development, additions to (or upgrading of) roads, footpaths, public parks or cultural facilities - such as libraries or museums. Sometimes, developers will make cash contributions for laudable public purposes, such as low-cost housing or worker re-training. Developers may also offer to operate and maintain the facilities, such as being responsible for street cleaning. Where such a contribution can legally be demanded of the developer, it is sometimes known as "exaction". Where the law does not permit such demands but allows developers to make offers of public improvement this may be known as "proffering". In either case, it represents revenue-in-kind. Some jurisdictions refer to such payments as development charges; others call them linkage payments, because they are linked to planning approvals. The extent to which a local government can derive revenue from the exercise its planning or zoning powers is not unlimited. It is constrained by - and may vary with - the revenue/cost ratios associated with different types of development. Also, non-financial leverage available to a local government, with respect to new developments, will depend on their profit potentials. The courts may also set limits on coercion. For example, in the decision already referred to above [Dolan v. Tigard (1994)] the US Supreme Court ruled that local governments must demonstrate, on the facts of each case, that the restrictions or exactions are "related in both nature and extent to the impact of the proposed development." Otherwise, they could represent a "taking of private property for public use" requiring "just compensation" under the US Constitution. Moreover, a local government's bargaining power may be limited by the state of an urban economy. If there is a boom, with potentially large profits to be made by developers, a local government may be in a better situation to demand concessions than during a period of economic downturn. When the latter occurs, the planning authority may need to offer concessions, to encourage developers to initiate activity on otherwise unproductive sites. As a result of all these considerations, a local government may be faced with difficult choices. On the one hand, it may seek to maximize revenues, from (say) more financially lucrative development schemes. On the other hand, it may exercise greater regulatory control, to encourage schemes that may be less financially attractive but considered more socially beneficial.

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Development Expenditures When a site is developed privately, for almost any purpose, the owner or developer will normally pay the costs of provision of all on-site infrastructures. This will include roads, footpaths, drains, sewers, water mains, power-cables and telephone lines. Also included will be on-site public open spaces. Building and plot development will be regulated, to facilitate connection to the public networks and to ensure safety and public acceptability. Regulation will include that of internal plumbing and wiring. Plot-owners or developers will normally pay the costs of connection to the public systems. Furthermore, on-site infrastructure will normally become vested in the appropriate public-sector entity, for subsequent operation and maintenance. These are all matters relating to individual plots or sites. Taken together, developments will affect the planning and operational strategy of the community. Most particularly, each new development will impose an additional load on the overall systems for traffic management, drainage, sewerage, water supply and other public utilities. This will eventually trigger the new construction of: main roads; trunk water-mains, sewers and drains; power and gas transmission systems; and major expansions of telephone lines. In addition, this will eventually trigger a need for additional: power stations, treatment works and telephone exchanges; pumping and transformer stations; and traffic signals. 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, financed by long-term loans or other capital funding sources. The growing community would then contribute, periodically, to the use of these facilities, through their regular payments of taxes and service charges, set at a high enough level to cover the debt-service, or other capital-cost recovery, together with costs of operation and maintenance. This (classical) approach is often adopted, or at least attempted, for expansion of education, health, welfare, recreation, cultural and social services. However, for public utility networks, some people assert that owners or developers should pay an "up-front" charge towards the potential costs of expanding the networks. Thus, "hook-up" charges are levied, also known as "consumer contributions". This approach seems based upon the perception that every new development is an unwelcome intrusion into the "status quo", with the potential to create an overload. This may be so, but it is also true that each new development is a contribution to the community. A commercial development will add facilities needed by the public, in the form of goods and services. A residence will almost always house productive and income-earning workers. Except where exemptions apply, all new developments will potentially increase the property-tax base, 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. Nonetheless, there may be convincing reasons why public authorities may wish to expand their facilities without incurring further debt. First, the overall indebtedness of the authority may be at or approaching an unsatisfactory level, for a variety of causes. One of these might be

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failure or difficulty in updating the property tax base, or in increasing service charges or tax rates. Another might be the outcome of earlier, imprudent, debt management. In developing country situations, another important reason for not borrowing is that there are just no loan funds available. There may either be no capital market or else the market may not be accessible to local or public authorities. The alternative, borrowing from the central government, may be constrained by budgetary limits. It is, also, increasingly frowned upon by international lending entities and aid agencies. This is especially true for lending aid emanating from the USA or the European Union, because of policies grounded in so-called free market economics. Sub-national governments are increasingly required or encouraged to borrow in capital markets, if there are any. Thus, the only sources of capital may be from the owners and developers. They, of course, might have financed themselves from private sector financing, such as banking or mortgage institutions. If this method is adopted, its effects will be virtually the same for the public authority, which will, conceptually, have borrowed funds by proxy. However, the debt-service will fall only upon the final purchasers of the properties against which the development charges have been levied. This fails to eliminate the equity question of whether, and to what extent, the strategic financial burdens created by new developments should be borne only by them. This becomes an exceptionally vexed question where plot charges are levied upon newcomers that are from disadvantaged (e.g. low-income) groups. This is sometimes exacerbated when the charges are, perhaps, made under new policies that did not apply to earlier (perhaps better off) residents. In such cases, it might be that newcomers would eventually pay off the full costs for their own plot charges, as well as contributing (through general taxes) to the debt service on facilities provided for earlier developments. To illustrate the anomaly or consumer contributions, take the example of a new grocery store, which is to be connected to the public water-supply system. It will expect to pay metered water charges for future supplies. 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. However, it would be inconceivable for the storeowners to seek capital contributions, from its future retail customers, towards the increased costs of their wholesale delivery network! Or, a closer analogy to the tertiary water system, their checkout counters! This is because water is almost always supplied under monopoly conditions, enabling the water utilities to exploit their market power. Groceries are supplied under competition among many stores, which thus have very little market power, beyond that pertaining to the individual reputations of stores. If a potential customer were asked for a capital contribution, there is virtually no doubt that he or she would shop elsewhere! However, despite the logical arguments, there is often one over-riding concern, mitigating strongly in favor of consumer contributions. This is the severe shortage of public funds, from taxation or borrowing, together with the almost insatiable demands upon them. Anything shifting the burden earlier and more directly to private funding is surely welcome, however pragmatic the system.

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DEBT MANAGEMENT Introduction 00000000Public sector entities, including governments and state-owned enterprises, borrow for one principal purpose to cover shortages of cash, claimed as needed for immediate expenditures. Because borrowing typically incurs interest and other related expenses, it would not normally be sensible to borrow, unless there was such a need. This can usually be assessed by competent treasury management, which should be an integral function of every public entity finance department. Cash shortages may arise from a variety of situations. Among these are: a. overall deficits in budgets, irrespective of how caused; b. c. d. e. acquisition of land, buildings, permanent works and equipment, including (where appropriate) by construction;

capitalization of public utilities and other state-owned enterprises; delays or shortfalls in the receipt of expected revenues; and emergency or urgent expenditures which cannot be met from funds currently available.

0Frequently, these purposes overlap. Also the distinctions are as much a matter of perception as of definition. For example, a central government deficit might have been caused by a combination of capital expenditures, capitalization of state-owned enterprises, slow-downs in collection of taxes and charges and emergency expenditures resulting from (say) natural disaster relief. All these would combine, to create what is sometimes referred to as a "public sector borrowing requirement" (PSBR). In strictly cash terms, this is a close analogy to a "budgetary deficit." Such a definition, often favored by economists, is necessarily simplistic; simplicity often reinforced by the rudimentary practices of governmental accounting90.
90

Sometimes terminology becomes ludicrous. One hears, for example, the expression: borrowing to add to the reserves. In this case, the expression reserves connotes cash balances. Borrowing, in fact, while increasing cash balances, always adds to an entitys liabilities and not to its reserves. In accordance with generally accepted accounting principles, the latter, are supposed to be part of the surplus of assets (including cash) over liabilities (including loans). Borrowing does not change this!

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The decision to borrow is based on two principal strategic concerns: financial prudence and macro-economic wisdom. The former is governed by the ability to service the debt from future revenues. The latter deals with the extent to which the borrowing (and its related debt servicing) affects the overall performance of: the economy; the entity; the public or private community; or, the nation.

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The Borrowing Decision Given these matters to be addressed, the borrowing entity must consider the amount to be borrowed, the source of funds and the least acceptable terms and conditions. These, will influence the subsequent magnitude and timing of the debt service. Principal matters influencing debt service will be: amount of the loan; rate of interest; period of repayment; and, repayment method. In the past, interest rates have usually been fixed, for the entire period of a loan contract. Now, increasingly, interest rates may be variable, providing additional flexibility but also uncertainty for both lenders and borrowers. In principle, an interest rate is the combination of the "real" expected return in resource claims and the expected inflation rate, giving a market rate that is "nominal". In practice, the market rates are influenced by many other factors including the tax regime. Furthermore, although nominal rates are always positive, real rates may be assessed as negative. Thus, for example, if the market rate were 8% and the current inflation rate were 10%, economists might refer to a "negative real rate" of about 2%91. In some countries, notably in Brazil, the interest rate and the inflation rate have, in the past, been treated separately at least in principle. In this case the loan principal is indexed to the (assessed) inflation rate. Thus, at the end of each interest period, the outstanding loan balance is adjusted upwards for inflation, a (supposedly) real interest rate is charged on the adjusted balance and an appropriate proportion of this adjusted balance is repaid. Indexing is relatively uncommon. Indeed, it is often frowned upon by most Western capital market institutions. Nonetheless, it is, mathematically, a more logical system than using nominal interest rates 92. However, it suffers from three disadvantages. Firstly, it is claimed that constant adjustments for inflation create a self-fulfilling prophecy. If lenders and borrowers know that there will always be such adjustments, there is no particular incentive towards price discipline. Also the adjustments themselves become part of the inflation regime. Secondly, the adjustment calculations are quite complex to make and difficult to understand, especially by laypersons. Finally, the complexity of the calculations, coupled with the relative unreliability of the data on which they are based, is an open invitation for careless or unscrupulous monetary authorities, or private sector financial institutions, accidentally or deliberately to misrepresent the true situation. This effectively deceives the public, albeit in the claimed interest of national economic well being. Thus, it contributes to a lack of required transparency. Consequently, it is questionable whether to use such a system, in lieu of allowing the market place to bring about the necessary equilibrium93.
91

Loan interest is likely to be grounded in reference to an expected rate of future inflation. However, when real rates are being assessed, these may make reference to the current inflation rate, which might be different from that originally expected. 92 This is not necessarily true when borrowing in a foreign currency. However, the changing rates of exchange often serve as an indexing factor in these cases. 93 Such equilibrium may be of a monetary nature only. Financial markets are not necessarily efficient in the allocation of capital. For example, see the views of Joseph Stiglitz,

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Borrowing also deals with a number of tactical concerns. These are motivated by accounting, legal, contractual and commercial practices. They may also be influenced by differing perceptions of borrowers, lenders and independent observers, which may not necessarily coincide.

earlier in this document.

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For example, suppose a multi-lateral lending institution say, the World Bank guaranteed the issue of bonds by a member government. The international institution might be principally concerned with the fulfillment of an individual development project. However, the International Monetary Fund might be concerned with overall economic performance, the borrowing government with its budgetary deficit, the nation's central bank with its foreign exchange reserves and a purchaser of bonds with investment earnings. Authority to Borrow Public sector borrowing is almost always subject to some kind of special authority. For central governments, there will usually be a necessity for parliamentary approval, either for individual borrowings or more likely of an upper limit for overall debt. There may, furthermore, be a provision in the nation's constitution for a special procedure, such as a joint resolution of both houses of the parliament or a higher than simple majority (say) two thirds. For local governments and public authorities, there will almost certainly be a requirement for a specific resolution of the council or board, often with a prohibition upon any delegation to committees or officials. Furthermore, it is a very common requisite for approval to be demanded of a public official or ministry of a central (or state) government. In the USA, some states have requirements for public referenda, especially for general-obligation bonds. These are uncommon in other countries. For foreign borrowing, approval by the central bank or a ministry of finance might be a very likely condition. Types of Borrowing Long term borrowing, which can be defined as any with a repayment period of more than one year, will be either repaid at maturity or by installments. Maturity loans will commonly be bond issues, normally raised in money markets or by private placement. Such issues carry a "coupon" rate of interest, typically payable half-yearly. The issue is normally arranged, for a fee, by a specialist issuing house, such as a merchant bank. The issue will be attractively priced a combination of interest rate and issue price but may also be underwritten, especially for local government issues. The underwriters, again for a fee, agree to take up the bonds that are not subscribed to by the public. They will then attempt to re-sell them in the secondary market94, at whatever price subsequently prevails. The combination of the "issue price" not always the bonds' face value with the coupon rate and the various maturity periods, can lead to quite complex calculations of bond prices and yields especially the "yield to maturity (YTM)." Demonstration of these calculations is
94

Many countries have not yet established viable secondary markets. Thus, 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. They are, inevitably, somewhat more precarious and more costly than if there were efficient markets.

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beyond the scope of this paper, but may be found in many standard financial texts. It should be noted that if a bond is issued or subsequently traded at a discount (below its face value), its true yield the YTM is higher than the "flat" yield, because of the long-term capital gain from issue (or traded) price to maturity. Conversely, bonds issued or traded at a premium (above the face value) will show a YTM at less than the flat yield. Bonds are normally issued for maturities of ten or more years. However, in high inflation situations, much shorter maturities (say 3-5 years) are both common and necessary. Sometimes, maturity may be as high as thirty years. Instruments for less than about ten years are sometimes referred to as "notes." The potential advantage of bonds and notes is that they are (or can be) a marketable security. They are bought and sold in the capital market at prices reflecting (then) current interest rates and are redeemable at par on maturity. They may sometimes be issued tax-free, perhaps encouraging their purchase by those in high tax brackets, likely those with a greater availability of funds for investment. Although bond yields may vary widely from time to time in the secondary (money) markets, if any, this has no direct effect upon the gross cost of borrowing to the government or authority which issues them. Its obligation remains to pay the periodic "coupon" interest rate and to redeem the bonds at face value upon maturity. The yields to investors, however, are lower than the costs to the issuing authority. This is because the authority has the use only of the funds remaining after payment of the issue expenses, including commissions to investment bankers and underwriters95. Again, the assessment of issue costs, by a variety of methods, is a matter not further considered here. Market rates might, indirectly, affect the net cost of borrowing. If, for example, a sinking fund were set up to provide for eventual bond redemption, the interest earnings on the investment of the fund would be affected by fluctuations in the marketplace96. Bond issues may include options to allow the issuing authority to redeem them - by repurchase - before final maturity. Sometimes, serial bonds are issued, permitting redemption of a number of bonds - typically decided by lot - at the end of every interest period. In this case, the financial effect is somewhat similar to that of an installment loan. Sometimes, also, local government and public utility bond issues are free of central government taxes. This provides a similar advantage to investors as tax-free central government issues. It also, in effect, 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.
95 96

In addition, costs will be incurred, internally by the entity itself, by the use of employees, goods and services engaged or used in the issue of debt. It is sometimes considered prudent to set the interest rate for a sinking fund at a low (conservative) level, intended never to be higher than any market rates likely to be encountered. Excess market earnings will then be paid into the general fund, with the sinking fund carrying only the notional interest. In the unlikely event of the market rate being lower than that of the sinking fund, the general fund would top up the sinking fund with the difference.

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Many central governments in developing countries issue bonds, although strong secondary markets are often lacking. There are far fewer cases where bonds are issued by local and public authorities. Instead, these subordinate entities rely extensively upon central government funding. Sometimes, a government will act as a guarantor or underwriter for debt issues by municipalities or public utilities. Success with this approach has been varied. Current thinking is not in favor of this practice, which is thought to discourage accountability at the subordinate level of government, as well as creating price or interest rate disparities. Market borrowing is therefore encouraged by international lending entities. For example, several years ago, the municipal government of a major city in a developing country made a bond issue. However, it could not find any private sector underwriters. Instead, therefore, the issue was underwritten by the central government. Nonetheless, the issue, in the capital market sense, was a complete failure. Over 95% of the issue was "left with the underwriters." 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. The central government might just as well have made a straight loan, to the local government unit, thus avoiding the costly, artificial and potentially embarrassing issue of the bonds. In effect, the central government had borrowed the money itself, as it would have needed to fund the resulting deficit in its own budgetary accounts. This raises an interesting distinction. Standard practice normally assesses a bond issue to have been successful if it is many times "oversubscribed" at the time of issue. However, in terms of simple economics, this indicates a supply (of loan funds) substantially in excess of demand, indicating that the price the interest rate yield is too high. Thus, an issue substantially left with (private) underwriters might well be considered as more finely priced, to the advantage of the public entity and to its customers or taxpayers. After all, the lower price would have been adequate to induce underwriters to take up the issue, without attracting into the market an overabundance of lenders. There might, of course, be hidden costs, in terms of the diminished reputation of the borrowing entity for subsequent debt issues. This might cause the underwriters next time to increase commission rates or to insist on more attractive issue terms97. Another form of maturity lending is the treasury bill. This is basically a short-term instrument, typically issued for maturities of one, three, or twelve months. Its mechanism differs from that of the bond or the note, in that the "interest" is taken, nominally, up-front. A $10,000
97

A related matter concerns the public issues of stock (share capital) by the United Kingdom Government for its newly privatized public companies. Cynics have claimed, not without grounding, that the apparent huge successes of these issues resulted from studiously crafted under-pricing. Thus, public assets to the extent of the claimed "underpricing" were, effectively, given away, at the expense of the general taxpayer. [Not to belabor the subject but these were also examples of inappropriate and arbitrary accounting practices. 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, also, "Selling the Family Silver - Has Privatization Worked?" by Colin Chapman.)] More recently, some public assets of the former Soviet Union have been sold on very dubious terms, to speculative buyers who were often employees or officials of the former publicly owned enterprises.

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twelve-month treasury bill, for example, might be offered for sale to the highest bidders. If this resulted in a price of $9,100, the discount, $900, represents a crude 9% interest, payable in advance. More correctly, the governmental unit would have borrowed the net amount of $9,100 and repaid it, with interest, after one year. Thus, the $900 would be interest on the $9,100. This is an interest rate (yield) of 9.89%. The other main types of loans are the installment repayments. These are much more common when finance is provided by a public sector entity. Typical examples might be a central, state or regional government loan to a local or public authority or a loan to a government by an international lender.

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Loan repayments normally fall into two main categories. The first is straightforward. The principal sum is divided by the number of repayments and the resultant amount is repaid at the end of each period. Interest is paid, concurrently with principal repayments, on balances outstanding from time to time. Clearly, as the principal is repaid, the outstanding balances diminish. Thus, each successive interest payment is lower than the previous one. When this interest is added to each equal installment of principal, the total cash payment, period by period, is gradually declining. This has the potential to create significant cash-flow problems for the repaying entity, by requiring higher payments during the earlier years of the debt service98. For this reason, the "level payment" or "annuity" system is used, frequently, instead. The annuity repayment system, though somewhat more complex than the simple installment system, is very well known. It is the system used, almost universally, for home mortgages. Using rather complicated mathematical formulae, a periodical payment is calculated, which balances the principal and interest components, to ensure that the total periodic payments remain constant. The two systems can be compared by a simple example. A loan of (say) $1,000,000, repayable over 20 years, by equal installments of principal, at 10%, would result in a first annual repayment of $50,000, together with interest of $100,000, making a total of $150,000. The final repayment would be only $55,000 - still $50,000 of principal but only $5,000 of interest. This contrasts with an annuity system, whereby the annual payment would be (approximately) $117,460. The first would include the original $100,000 of interest but only $17,460 of principal. The last payment - also $117,460 - would include interest of $10,678 and principal repayment of $106,782. Borrowing Sources If a country has a viable capital market, it will undoubtedly look to this for the source of much of its borrowing. The market would typically provide the services of bond issuing houses and underwriters, treasury bill sometimes known as discount brokers and secondary market facilities for trading the various debt instruments. It should also include debt-rating agencies, able to advise potential investors about the quality and risk of various debt instruments. Unfortunately, many developing countries do not yet have such facilities. They are thus forced to borrow from international sources. These would likely include multi-lateral agencies, friendly foreign governments and foreign commercial banks. Multi-lateral agencies, such as the World Bank, will normally lend for fixed periods usually in excess of ten years at fixed or variable interest rates, with loans repayable by installments, using one or other of the methods shown above. Interest rates are usually at or close to market rates99. Financing is usually either for development projects or specific development purposes. Typically, the projects financed are
98

Moreover, in periods of inflation, the front-end-loaded cash flows are exacerbated, in real terms, because the later payments are being made in less and less valuable currencies. 99 World Bank loans carry an interest rate linked to the London Interbank Offered Rate (LIBOR) for US dollar single currency loans. There is also a small commitment fee on un-disbursed balances of loans. The World Bank Group also makes loans from its International Development Association. These are at highly subsidized interest rates and have

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thoroughly prepared and appraised. Loans often carry rigorous conditions, to enforce discipline over the project implementation process and over the operation of the borrowing entity. Sometimes, funds are made available interest-free or at subsidized rates. An example would be that of the World Bank's subsidiary, the International Development Association (IDA). This organization, using the same staff and procedures as the World Bank, lends for projects in the poorer countries. Loans known as "IDA credits" are repayable over 30 years, after an initial grace period of 10 years. There is no interest. Instead, a service charge of 1/2% p.a. is charged, to cover processing costs. IDA credits are made exclusively to governments. Their purpose is to alleviate the drain on the part of a nation's foreign exchange reserves that is used for debt service. They are not intended to subsidize otherwise uneconomic projects. IDA-financed projects are appraised to the same high standards as those of the World Bank. Furthermore, 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. Thus, they may be passed on as marketrate loans with project-related repayment terms, equity to public utilities or (if appropriate) grants or subsidized loans to (say) municipalities. Funds for the IDA are contributed by the member countries of the World Bank, roughly in proportion to their economic strength. Thus, countries like the USA and Japan (so-called "Part 1" countries) contribute a great deal. A country like (say) Malawi (a so-called "Part 2" country) makes only a token contribution. IDA contributions are made in a country's own currency. Consequently, unless a currency is freely convertible, the use of a contribution is effectively sterilized, except to cover IDA administrative costs (such as mission expenses) incurred within the country of the contributed currency. This, of course, results in only the currencies of the stronger, industrialized, countries being available for the foreign lending which is exactly the intended position. The International Monetary Fund does not lend for specific projects. Instead, it provides short-term support for balance of payments deficits, by lending convertible currencies. Always, such lending is accompanied by stiff requirements relating to economic adjustments. These could include changes in (or removal of restrictions on) an exchange rate or public-pricing policies, freeing of trade restrictions and restructuring of public sector employment. Currently, emphasis is being placed, in countries like Russia, on the need to increase tax collections and to balance public sector recurrent budgets (or at least come closer to doing so). Many structural adjustments have now been seen to be incapable of bringing about short-term resolution of economic concerns. Consequently, some adjustment activity has now been taken over by the World Bank, financed by longer-term loans. This, too, however, has met with only limited success. Bi-lateral lending is made on a country to country basis. However, many bi-lateral agencies, such as the United States Agency for
very long repayment periods. These are intended to soften the impact on the borrowing countrys balance of payments, not to subsidize individual projects.

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International Development (USAID) or the U.K. Department of International Finance and Development (DFID) will cooperate with international entities, such as the World Bank and the IMF, in providing co-financing or matching funds towards a combined operation. Some bi-lateral lending is for clear political or commercial purposes. Loans may be granted in 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. Loans may be at market rates or may be highly subsidized, depending on the motivation.

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Furthermore, unlike (say) IDA credits, bi-lateral loans made on "soft" terms may well be passed on to downstream project entities. These often directly subsidize their operations, without regard for disciplines that would, more typically, be imposed by the international entities. Consequently, a water or electricity enterprise, for example, would be encouraged to set customer prices that are too low, or to provide facilities that are too costly. This, in turn would cause wastes, of both water and electricity or the capital goods used in their production. Thus, for example, one might have a water supply project, appraised by (say) the World Bank, procuring goods and services say pipes, vehicles and plant from (say) Germany and Sweden under international competitive bidding (a World Bank condition), financed by a commercial-type loan, at market rates. 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, France or UK, much less well appraised for suitability of purpose and directly financed by below-market rate" loans. Commercial banks are another source of foreign lending. However, loans from commercial banks are normally for relatively short periods, say a maximum of 5 - 7 years, even much less. Consequently, they are relatively unsuitable for financing large projects with long useful lives. Nonetheless, they have been used for this, particularly by public utilities. The openly commercial nature of the lending, coupled with the perceived and actual risk of doing business in developing countries, have led to interest rates which are high, relative to alternative sources. These, of course, are limited. Another disadvantage of commercial bank loans is that the banks attempt to make a significant proportion of their profits from transaction fees, often obscured in the small print, and receivable up-front, frequently high and often not validated by (nor verifiable against) their cost drivers. These charges serve to lower the amount of net cash actually received by borrowers. This has a similar affect upon effective100 interest rates as a discounted bill, described in paragraph 28 (above). Banks sometimes put together syndicated loan packages, even combining resources from different countries and in different currencies. Interest rates are usually variable, typically based on a "spread" above the London Interbank Offered Rate (LIBOR). This rate, derived from transactions among banks in so-called "Euro-currencies," has become a benchmark for the setting of international commercial lending rates101. Serious problems have occurred with borrowing from commercial banks. When interest rates are variable, even the relatively short nominal repayment periods are compressed, because the rates are changed frequently, perhaps every quarter. In effect, this creates a very short-term
100

An effective interest rate is rarely the one quoted, except for a simple loan. It is, instead, the total of the costs and losses, including (indeed, especially) the transaction costs, related to the net funds available for use, using discount factors to generate an annual equivalent. 101 Indeed, variable-rate long-term loans from the World Bank are currently (1999) linked to LIBOR rates.

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instrument, because if the borrower is not satisfied with an interest rate increase, it must repay the loan. Otherwise, as is usually the case, there is little option but to continue the loan on the new terms. When the nominal repayment term expires, at the end of (say) five years, the borrower is in an additional bind. This is because the lender has the option to recall the loan. Then, because of a lack of funds for repayment, it may have to be "rolled over" continued on new terms. The lenders, moreover, may significantly dictate these terms102. This concern may be compounded if the nation, through its central bank, cannot provide enough foreign currency to redeem or service the foreign debts. Sometimes, especially for specific components of projects, suppliers of goods and services may grant credit. This is known as "supplier" or "contractor" financing. It is, by definition, tied to specific imports from specific countries. Furthermore, its terms are sometime quoted as part of an overall contract for the supply of the goods and services, so that the "nominal" terms may be somewhat obscured by the pricing. This form of financing is usually provided by (or through) commercial banks, sometimes with the guarantee of special government agencies in the supplier's country. Thus, it normally suffers from the same disadvantages as direct commercial bank financing. Examples of national entities providing both finance and insurance are the Export-Import Bank (USA) and the Export Credit Guarantee Department (UK). These institutions, along with their counterparts in other countries, have sometimes engaged in "credit wars" to out-subsidize each other's products. For public sector entities, other than central governments, it is common for a central government to be their lender. This applies to public utilities, other state-owned enterprises and local governments. Typically, loans will be for specific projects, rigorously scrutinized by the central government. Repayment will typically be by installments, over a loan period often linked to project life. Interest rates may be subsidized or at market rates, depending on government policies and other political pressures. Of course, the central government must find the finance to make these loans, often by borrowing itself. Finally, for central governments, there is the option of borrowing from the central bank. This usually involves the creation of additional money so-called "printing money," largely a misnomer. Unlike (say) a bond issue, where resources are transferred from lender to borrower, "printing money" works by the government increasing the money supply, so that it appropriates the additional resources to itself. Unless this brings about matching increases in production, inflation will likely be triggered. A simplistic example will illustrate. Suppose the economy produces 1 million units of output, in terms of the physical quantity of goods and services. Call these units by a favorite term used by economists widgets. Assume, also, that there are 1 million units of currency in circulation say doables in cash and bank deposits, passing from party to party at the same velocity as the widgets. Under standard
102

Some loans in Russia, other countries of the Former Soviet Union and the Eastern bloc have suffered from this concern. Moreover, repayment of the debt has, almost always, been required in foreign currency.

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principles of monetary formulas, in equilibrium, widgets might be priced at 1 each. If the government "prints" another 100,000, with no increase in production, there will be 1.1 million chasing 1 million widgets. At comparable velocities of circulation, prices of widgets would likely rise to 1.10 each. The government, previously "broke" why else would it borrow? now "owns" one-eleventh of the currency (100,000/1,100,000). So it can appropriate this proportion of the economic output to its own use. Its purchase of widgets, at 1.10 each, would provide it with 90,909 of them. In effect, the government would have taxed its public, without the need for tax assessments or internal revenue departments. The result would be the same as when historical monarchs "clipped the coinage" for seignorage. This is sometimes known as "monetizing" the debt. It is also likely to cause (or induce decisions about) devaluation of the national currency. As there will now be more doubles () chasing widgets, there will also be more chasing convertible foreign currencies. This will raise the price of the latter (e.g. Dollars, Yen, Pounds or Swiss Francs) and lower the price of (i.e. devalue) the . If the devaluation (or a further one, after the first) is expected by the markets, there will be greater than otherwise demand for the other foreign currencies, thus creating a self-fulfilling prophecy and making the devaluation (or the subsequent devaluations) even greater. This phenomenon is typically linked to capital flight, whereby holders of their own currencies sell them, and hold foreign currencies instead. Foreign Borrowing Some of the borrowing sources explained above would be foreign sources. This would be necessary, in any case, if the money were needed to finance the import of goods and services. Indeed, this is the principal purpose of lending by multi-lateral and bi-lateral entities, as well as by such sources as "suppliers credits." However, some foreign borrowing may be undertaken merely to raise loan funds simply not available from domestic sources. Sometimes, for example, especially for the poorer countries, the World Bank will include a component in a project loan to cover a proportion of local costs, as well as all the foreign costs. This provides a benefit for the national economy as well as to the entity financed. The World Bank will (actually or effectively) purchase local currency from the developing country's central bank, to lend to the project entity, which will then use the money to pay for local project inputs such as locally manufactured furniture for (say) a school. In practice, the World Bank would have acquired and established a local currency bank account in the borrowing country which it would then have transferred, by a monetary instrument, to the borrowing entity. In exchange, 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, with a value equal to

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the local currency purchased, at the ruling exchange rate. This foreign bank account would then become part of the nation's general foreign exchange reserves, to be used for other imports of goods and services. It might, of course, be used to repay outstanding foreign debt, for which the necessary foreign currency had not, hitherto, been available. Thus, the central bank would sell the foreign currency to a (public or private) local borrower for local currency, transferring the foreign bank account to it. The borrower would then pay this foreign currency to the foreign lender, thus disposing of the reserves held by the central bank.

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Financial Intermediaries Sometimes, governments establish financial intermediaries to receive loan proceeds on a "wholesale" basis and to "retail" these loans to individual borrowers. Examples would be "development finance corporations," "national housing banks," "municipal funds," "municipal banks," and "public works loans boards." These intermediaries might develop experience in dealing with national and international money markets, to raise funds in bulk. Concurrently, they might advise their client borrowers about the suitability of their projects and related operations. In practice, many of these institutions, in developing countries, have not lived up to their expectations. Deprived of independent market access and short of professional skills, they have typically relied upon meager central government funding and operated like government departments, often becoming moribund. However, competent intermediaries are often important, especially for international borrowing. For example, it would not be reasonable to expect the World Bank to enter into (say) twenty separate lending operations, in support of a multifaceted project for (say) urban development or industrial expansion, involving a large number of municipal governments or commercial enterprises. A financial intermediary will normally pool its funding to produce a weighted average of its costs of capital. It would then add an additional percentage say one or two percent as a "spread," to establish a lending rate to sub-borrowers. This would provide for the coverage of the operating and administrative expenses as well as a loan loss provision of the intermediary. Debt Management After raising debt, its management consists of dealing with the debt service. This involves raising the necessary funds and also allocating the costs for the appropriate purposes. The extent to which the latter can be done depends, to some extent, upon the accounting practices103. 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, including the capital costs. To the extent that the accounting is flawed or incomplete, recourse must be had to the general pool of public revenues. Where a particular loan such as a project loan can be specifically identified with the assets financed, this is sometimes known as "earmarking" the debt. The debt service expenditures can be charged against the specific public service for which the asset is employed and the revenues from that service, if any, will be affected by these costs. Even where there are no earmarked revenues, it is important to be aware of the capital recovery costs of public services, as well as the
103

For a detailed explanation of accounting practices relating to debt management, including the pooling of loans, refer to Chapters 14, 15 & 17-21 of Municipal Accounting for Developing Countries by David C. Jones.

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operating costs. Indeed, capital recovery costs are often a dominating feature of public sector operations. If these remain unidentified and unallocated, as they frequently are, decisions made by reference to the resulting financial reports will, inevitably, be flawed. Accounting for earmarked debt is greatly facilitated if the loans are repayable by installments. Otherwise, annual debt service expenditures will include only interest, with no provision for principal repayment. Instead, this will be due in a single payment, on maturity, as in the case of a bond. This situation is often overcome by the use of sinking funds. Where used, money is periodically set aside and separately invested, at the same time as the periodic interest payments are made. The sums set aside are calculated by the use of compound interest formulas, similar to those used for annuity loans. Thus, when investment interest is added into the sinking fund, it will have accumulated, at the end of its term, sufficient funds to repay the loan. The sinking fund contributions would be charged against the service using the assets, as a surrogate for the amortization payments. Municipal governments commonly use sinking funds. Sometimes, they are used by state-owned enterprises, as a means of "earmarking" cash flow, from internally generated funds, so that debt can be retired, perhaps in favor of greater equity. Central governments use sinking funds much less commonly. Instead, as explained below, they tend to rely on their sovereign right to borrow and to tax. They can also rely on what is known as the law of inertia of large numbers. This means that their cash flows are usually so huge that any single transaction, such as a loan or an item of debt service, is in the totality of transactions, a relatively insignificant item. The administration of sinking funds can, however, become complex. First, 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. Then, if loans are raised for shorter terms, they will need to be repaid partly out of by then, inadequate sinking funds and partly out of re-borrowing. Where there are many projects and loans, the potential for administrative overwhelm is considerable. Thus, municipal accounting practice includes the concept of "pooling,104" through the establishment of "loans pools," "consolidated loans funds" or "capital funds." These act, in effect, like an internalized financial intermediary. Depending on the extent and detailed design of the pooling system, all loans (or sometimes only those of a specified character or for a specified purpose) will be pooled. Sometimes other capital financing, including central government grants, might be included in a pooling system. It would then become a capital development fund system. On the external borrowing side, loans will be raised (in the market place and from other sources) on whatever best terms are available.
104

The "pooling" concept, is explained in "Municipal Accounting for Developing Countries" (Jones). Indeed, its final chapter is a virtual handbook for accounting by financial intermediaries.

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These funds will then be made available to finance capital development projects as "internal loans." These will carry strict repayment schedules, related to asset working lives. Interest and other debt management expenses will be apportioned to the "borrowing accounts" in relation to their outstanding balances "owed" to the pool. Typically, central governments, because of the crudity of their cash-accounting systems, do not indeed cannot use earmarking or pooling systems. Instead, they borrow continuously to cover potential cash deficits. These potential cash deficits are increased whenever expected expenditures, on operations and development, together with interest on existing debt, exceed expected revenues, from taxes, fees and charges. Cash deficits are also created by the need to repay existing debt, as it matures. As already indicated, central government borrowing may be by a mixture of local bonds, bills and money creation, enhanced by various foreign sources. In theory, at least for domestic borrowing, a central government can go on borrowing forever and never repay105. In practice, at a minimum, governments should pay at least a part of their interest payments. More prudently, 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. Simply stated, 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; and, temporary borrowing only pending the imminent receipt of funds from other sources. Macro-economic concerns, however, are inter-mingled with central government borrowing. These are beyond the scope of this paper. Debt Service Funding Funds for debt service expenditures will normally come from taxes, fees and charges. Where earmarking is used, specific revenues can sometimes be raised from the activities enhanced or sustained by the related usage of the community plant or other assets. Examples might include toll roads and bridges, water and electricity supplies or even property tax surcharges in special development areas. 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." This is an acknowledgement of a government's general power to tax its public for the necessary funds. In the USA, loans with this kind of security would include "general obligation bonds." The likely private sector alternative, mortgages against real property, would mostly be inappropriate. This is because many assets held by governments would: often have no value to the private sector, if sold (e.g. sea or river defense works); fulfill a purpose usually reserved
105

In fact, there are some British central government debt instruments, called Consols, that pay interest but have no redemption date, albeit that they are a historical anachronism

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exclusively to government (e.g. a public road); have strategic security importance (e.g. military bases or equipment) or, not be usable for their original purpose (e.g. public schools). Furthermore, the political fall-out, not to say public outrage, from selling certain public assets to the private sector, might be considerable. Consequently, the mortgaging of property for security of local government loans might well be deemed as contrary to public policy. Sometimes, the issue of a specific debt instrument will be specifically securitized against the revenues resulting from the use of the related assets. This is particularly appropriate for state-owned enterprises. 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. Examples might include loans raised for public housing construction, public transport or water supply.

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As an alternative to revenue bonds, institutions like the World Bank, when lending to a revenue-earning enterprise, will include specific provisions in the loan agreement requiring a minimum standard of financial performance. This is often measured by a rate of return on assets or by a minimum coverage of debt service from internally generated funds. These financial performance conditions will be backed by requirements for the competent operation and maintenance of plant, capable general management and sound financial administration. In the absence of earmarking, debt service will be funded in a somewhat haphazard and random fashion from general revenue sources or from further borrowing. This process, as illustrated by the earlier and still ongoing "budget deficit" deliberations in the US Federal Government, leads to indiscipline, confusion and misunderstanding106. It also engenders political opportunism! The only assessments that can be made, in these circumstances, 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. Although highly appropriate to subject central government borrowing to such an economic overview, it is questionable whether to dispense with the financial disciplines, which could flow from more rigorous accounting practices. Accounting practices are, admittedly, flawed. However, macro-economic data are obtained from statistical measurements. These are becoming significantly less reliable even than accounting information. Indeed, 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. More's the pity. Official statistics steal headlines, wipe billions off shares and defeat governments, yet all too often the numbers are ropey. Britain's national accounts for example, are so riddled with holes and revisions that the true state of its economy is anybody's guess. Macroeconomic policy is, at best, like driving a car with a blackened windscreen and only the speedometer and the rear-view mirror as guides, and becomes scarier if the dials are wonky and the mirror cracked. 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....
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A most serious misunderstanding, in earlier years, 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, all of the (imagined) surplus and much more besides effectively belonged to the Social Security Trust Fund. This is set up as a separate account into which earmarked social security taxes are deposited, to pay for prescribed benefits. It was only the borrowing, by the general fund of the Federal Government, from the Social Security Trust Fund, that created the illusion that there was a budgetary surplus. In fact, even when pooled with social security money, there was a net budget surplus only in one single year. In recent years, moreover, the US Federal Government appears to have abandoned even a pretence at fiscal discipline, relying upon a common theme of some economists that deficits dont matter! This in not a position acceded to by many others, including the Federal Reserve. However, without successfully distinguishing economics from politics, it is impossible to sensibly comment.

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Britain is not alone in this predicament. America, too, has become prone to revision after revision of its official numbers. There are two common causes. First, the changing structure of economies makes them more difficult to track. Statisticians' machinery is still geared up to measure steel and coal rather than financial services and consultancy; yet the service sector now accounts for 60% or more of most modern economies. Things you can drop on your toe are easier to find and count. In America just three car companies account for $150 billion worth of sales in the car industry; to arrive at the same output for the restaurant and drinks sector would require a survey of 189,000 firms. The second blight has been deregulation, which has blocked off sources of data. The scrapping of foreign exchange controls, for example, makes it harder to monitor inflows and outflows, so balance-of-payments figures have become murkier. It may be no coincidence that America and Britain, two of the speediest de-regulators, have the loudest complaints about numbers. To confuse matters even more, 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. They are, more correctly, "national" economic statistics. Accounts result from a rigorous identifying and recording however imperfect the methods and analysis of each and every financial transaction. Statistics are derived from samples only107. Capitalized Interest Sometimes, borrowing takes place to cover all or part of the interest costs on earlier borrowing. This might occur where a development project, financed by debt to be serviced from operating revenues, takes a long time to construct. An obvious example would be the construction of a hydroelectric power station, incorporating a dam. The additional electric power, which would be sold to obtain revenues, might not be available for at least as long as (say) five years. In the meantime, half-yearly interest payments would be due, gradually increasing as additional loan moneys were drawn for construction and working capital. Additional borrowing, either from the original lenders or from others would cover these interest payments. At the completion of the
107

These concerns about statistics might serve as a warning not to rely upon them too much, for budgetary or accounting purposes. For example, following principles espoused by the former Soviet Union, the Russian Republic now uses complex economic statistics to calculate Minimum Social Standards to support claims against public funds for certain social expenditures. Moreover, the UK Government uses a somewhat similar, albeit simpler, process to determine Standard Spending Assessments. These are used in the allocation of the Revenue Support Grant Britains main general local government grant. They are also used to cap or limit total budgeted expenditures by individual local government units. Neither the Russian nor the British system produces initially objective data. Instead, they are used by politicians and public officials from different levels of central, regional or local government to serve as a basis for negotiation of inter-governmental financial transfers or spending limits.

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construction, the full outstanding loan to be serviced would be the borrowings for the construction itself, plus all interest charges, added in and periodically compounded.

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Much more crudely, capitalized interest can arise where a government merely borrows more money to pay all or part of its interest costs. Naturally, future interest costs will include the interest on the new borrowing, in other words, interest on the interest. That, exactly, is what compound interest is! Debt Drawdown Debt funding can be made available to public sector entities in a variety of ways. The easiest and most obvious will be by a straight deposit of the loan proceeds into the bank account of the borrowing entity. This might occur with an issue of bonds, notes or bills. It is highly appropriate if (say) central government debt is being rolled over, perhaps incorporating a net increase in indebtedness. A typical report in the Wall Street Journal, for example, might state: "WASHINGTON - The Treasury plans to raise $1.45 billion in new cash Thursday by selling a record $10.5 billion in 52week bills and redeeming $9.06 billion in maturing bills." Where debt is being raised for specific purposes, such as project financing, it is inappropriate to draw down the entire loan proceeds at once. Taking the hydroelectric power station example, it is clear that all of the funding would not be required up-front, as work begins. Thus, it might be better to draw down the loan funds as the work proceeds. Otherwise, there will be idle cash to administer, with a potential loss of interest, together with administrative expenses. It will still be necessary, of course, for financing to be secured (contracted for) before construction begins. Otherwise, cash-flow problems will occur during the construction period. Sometimes, banks will make a commitment charge, usually as a small percentage on the undisbursed balance of a commitment, to compensate it for the administrative costs of providing the money in tranches and also against the potential losses from temporary cash-management. International lending entities will usually disburse loan moneys against specific project procurement of goods and services. In addition, where the World Bank or the IMF, for example, make loans for "structural adjustment" they will disburse the funds in "tranches," perhaps covering the importation of specific goods. Between each disbursement, the borrowing country would be expected to have fulfilled some pre-determined promises related to structural reform. These might include exchange-rate adjustments, cutting public payrolls or changing interest rates. Risk

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The principal risk attached to a borrowing operation is that the terms of the loan agreement will not be fulfilled. This will affect the lender's investment return and the borrower's credit rating. Thus, a shortfall in tax revenues or service charges would inhibit full and prompt service of debt. Similarly, an increase in interest rates - on variable rates or loan renewal - would add to debt servicing costs. For public utilities or local governments, this could lead to default. For central governments, as already indicated, potential default can always be covered by new borrowing, albeit by "printing money." These risks can only be contained and managed, however, when all borrowing is within the country, in local currency. Indeed, some economists argue that for the country as a whole, the public debt is just money owed by one set of residents to another set, canceling itself out. When foreign borrowing is involved, however, the situation is different. It introduces two further risks, which can have very serious consequences. The first is the risk of adverse changes in the exchange rate. For example, if the government of an imaginary country, Masonia, borrowed US$1 million, at a rate of exchange of (say) 1.5 masons to the US$, its local currency debt equivalent would be M1.5 million. If the rate of exchange later worsened to (say) 2 masons to the US$, there would be a one-third increase in Masonia's debt (measured in its own currency) to M2 million. Consequently, debt service would also increase, in the same proportion. This is because more masons would be required to purchase the foreign currency for the debt service. If Masonia's currency is further under pressure, the government has a dilemma. To the extent that it has any option, it must choose whether to "peg" the rate of exchange, to avoid worsening its debt service obligations still further. This, however, would affect the terms of trade for its exports, including its tourism industry, perhaps causing a net disadvantage for its overall earnings of foreign currency. The second risk, closely related to the first, is that there will be a shortage of foreign currency. In this respect, 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 sector may, of course, have certain access to foreign currency not available to the private sector. This will include official foreign aid and the foreign earnings of nationalized industries such as airlines, ports and oil companies. There are two additional problems, which are political, as well as economic. First, if priority is to be given to the service of foreign debt, 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. Even worse, nations may need to export foodstuffs to earn foreign currency, instead of having its residents eat the food themselves, thus going hungry or even risking starvation. With poverty all-pervasive in many developing countries, this can create increased personal suffering and a risk of governmental instability.

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Secondly, residents may perceive the government to be mismanaging the economy, especially with respect to monetary management. Some will attempt, therefore possibly in contravention of exchange controls to hold foreign currency (privately) outside of the country, in the form of monetary instruments, instead of making it available to the local economy for development, import of foreign goods and services or enhanced consumption. Indeed, it could well be that the public sector is borrowing, from foreign commercial banks, foreign exchange deposited as so-called "flight capital" by the country's own residents! These matters, relating to foreign borrowing, have been principal causes of the international debt crises. They have sometimes created the need for debt relief.

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Debt Relief Developing countries have been seeking debt relief for a number of years, albeit with only limited overall success. Some countries are now, technically, insolvent unable to service their foreign debts. However, there is no way in which they may be (officially and legally) declared "bankrupt" given a new start, including the write-off of debt. Consequently debt relief has proceeded in an ad hoc and haphazard manner. In the 1980s the so-called "Baker Plan" called for new lending by the commercial banks, to stimulate economic growth by developing countries. This was intended to lead to increased foreign exchange earnings and consequent service of foreign debt. This plan largely foundered, because of the unwillingness of the foreign commercial banks to go along with it. This, 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, so far, only moderately successful in resolving the problem. One obvious solution is that of forgiveness. Indeed, individual governments have in fact, forgiven some bilateral debt. However, it is easier for this to be done by governments than by private sector entities, including commercial banks. Furthermore, 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. Unlike governments, they have no "full faith and credit," based on a sovereign right to tax. Moreover, one now hears more and more often about the phenomenon of moral hazard. This is derived from the insurance industry, 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. This is particularly true in the health and car insurance industries. The concept has now been appropriated by the international lending community. It takes the position that if current loans are too readily forgiven, potential future borrowers will develop some assumptions that the forgiveness has become endemic. They will, thus, be less prudent than if they are to be fully held to account. The economics of this position seem unassailable. However, it does not do much to help the countries whose people must continue to endure more than their fair share of suffering108. Incidentally, much has been heard, in recent years, of commercial banks, especially in the U.S. and the U.K. "taking a hit" on their balance sheets, with respect to foreign debt. This, however, does not mean forgiveness. It is simply an accounting distinction, following standard practices, to recognize the probability of non-collection of a proportion of the outstanding debt. Thus, it merely removes some value from the stated loan in the balance sheet, establishes a reserve and charges the resultant loss, currently, against book profits. This is done as a preference to recording the loss when the debtor actually defaults. It might, indeed, be required as a condition of an unqualified (i.e. clean)
108

It used to be argued, by those sneering at foreign aid, that it took money from poor people in rich countries and gave it to rich people in poor countries. 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. Thus, there is certainly hazard but, like most of economics, there are no morals.

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audit. It has also been used, as a part of window-dressing strategy, by firms wishing to get rid of bad news in one fell swoop, leaving the opportunity for subsequent financial statements to show enhanced profits.

150

Other standard forms of debt relief have occurred, either voluntarily or involuntarily. These include, of course, re-lending, whereby as the loans mature and cannot be repaid they are rolled over, with new interest rates. Frequently, all or part of the accumulated unpaid interest will be rolled into the new loan. The lender often has no choice. However, as an accounting artifact, it is sometimes easier to offer a new loan than to write off the interest. It gives a better appearance, in the lenders balance-sheet109. A similar method is that of debt rescheduling. In this case, the borrower declares an inability or difficulty with repayment and requests a new and hopefully more favorable contract. If market interest rates are to be maintained, the only option is to spread out the repayment period. Unfortunately, depending on the existing interest rate and period, much of the current debt service schedule may already be in the form if interest. Thus, the opportunity for reducing the amortization, from an already thin level, is bleak. A further reduction in cash flows could then only be achieved through "negative amortization," virtually the same as capitalization of interest. This measure can only be a temporary palliative, for it results in a net increase in the debt principal. If re-lending or re-scheduling runs up against the above concern, then interest rate reduction or an interest subsidy is about the only remaining option. Indeed, some borrowers claim that the high public sector borrowing requirement of the USA, resulting from its accumulated budget deficit, 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, which prices them at discounts from their original face value. 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. This process helps the lenders, but by itself does nothing to assist the borrowers. In effect, it is just a market reflection of the (actual or hypothetical) accounting adjustments in the books of the lenders. The purchase of discounted debt instruments has sometimes led to a procedure called a debt/equity swap. In this case, 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. This would be redeemed for its face value - but in local currency. The local currency, in turn, would then be available to the foreign investor to purchase local assets or an equity interest in a local company. Effectively, this is a repatriation of flight capital. It does, therefore, provide debt relief, for both the borrower and the borrowing country's economy. Finally, an increasing amount of lending by international entities has been directed at "structural adjustment." As already indicated, this provides loan funding for what are, in effect, current foreign purchases, rather than those for capital
109

In accounting jargon, this is just another example of window-dressing!

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development. The purpose is to provide some temporary relief, whilst the developing country undergoes structural adjustment, in cooperation with the international aid community. The implementation of the structural changes is made a condition of the borrowing.

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ANNEX 1 CAPITAL DEVELOPMENT PROGRAMS FINANCIAL IMPLICATIONS ------------Options for Funding of Capital Expenditure and Coverage of Annual Expenses for Operation, Maintenance and Debt Service110
TYPE OF INFRASTRUCTURE EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. Water Supply: On-site 1.Owner/Developer. 2.Land sale profit (public land) & development fees111 (public & private land). OPERATION & MAINTENANCE. 1.Owner/developer. 2.Plot charge (before vesting). 3.User charge &/or public subsidy (after vesting). Full cost recovery is possible and desirable by using economic pricing. Public subsidy may provide more or may provide less social equity. It may be economically inefficient, in that more water will be used at lower prices. COMMENTS

Water Supply: Immediate Access

1.Land sale profit (public land) & development fees (public & private land). 2.Public funds112 (central/local). 3.Foreign aid grants. 4.Loans (local & foreign). 1.Public funds (central/local) 2.Foreign aid grants. 3.Loans (local & foreign).

1.Plot charge (before vesting). 2.User charge &/or public subsidy (after vesting).

Water Supply: Trunk/Treatment

110 111

1.User charge &/or public subsidy.

The options shown in the tables are not mutually exclusive. Several methods may be combined, to cover the cost for each type of activity. Development fees may be imposed by legal authority or might result from agreement between owners/residents and the planning authority. They can include other types of payments, such as "proffers," "exactions," or "betterment levies." In addition, "work in kind" might be provided, instead of cash payments. 112 "Public funds" connote general revenues from either local or national resources. Local revenues are often derived from national government budgets and some taxes may be shared revenues. Thus, it is sometimes rather meaningless to presume a clear distinction between "local" and "national" revenues.

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TYPE OF INFRASTRUCTURE

EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. OPERATION & MAINTENANCE.

COMMENTS

Sewerage: On-site

1.Owner/Developer. 2.Land sale profit (public land) & development fees (public & private land).

1.Owner/developer. 2.Plot charge (before vesting). 3.User charge &/or public funds (after vesting).

"User charge" could be a surcharge on water supply or a property-based charge. Sewerage, (unlike water supply) is not clearly a "market good." Users may have less expensive options which create higher public costs (e.g. septic tanks). Thus, it may be appropriate to compel use of a public system. This can be done by making charges whenever the public system is accessible or by covering costs from public funds. A surcharge on water is, in principle, a sales tax - even if levied by a private entity.

Sewerage: Immediate Access

1.Land sale profit (public land) & development fees (public & private land). 2.Public funds (central/local). 3.Foreign aid grants. 4.Loans (local & foreign). 1.Public funds (central/local). 2.Foreign aid grants. 3.Loans (local & foreign)

1.Plot charge (before vesting). 2.User charge &/or public funds (after vesting).

Sewerage: Trunk/Treatment

1.User charge &/or public funds.

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TYPE OF INFRASTRUCTURE

EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. OPERATION & MAINTENANCE. 1.Owner/developer. 2.Plot charge (before vesting). 3.Public funds (after vesting).

COMMENTS

Roads & Drainage: On-site

1.Owner/Developer. 2.Land sale profit (public land) & development fees (public & private land).

User charges are usually neither possible nor appropriate. There is often no opportunity for tolls in congested urban systems, although road pricing is now becoming more likely. Full economic pricing of motor fuel can reduce the use of private vehicles. Also fuel taxes are good proxies for pollution charges. One concern to be avoided is too readily to concede that fuel taxes are only user

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TYPE OF INFRASTRUCTURE

EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. OPERATION & MAINTENANCE.

COMMENTS

charges for roads, to be earmarked for construction and operation. They may also contribute to general public revenues, in support of other public costs. Roads & Drainage: Immediate Access 1.Land sale profit (public land) & development fees (public & private land). 2.Public funds (central/local) 3.Foreign aid grants. 4.Loans (local & foreign). 1.Public funds (central/local). 2.Foreign aid grants. 3.Loans (local & foreign). 1.Plot charge (before vesting). 2.Public funds (after vesting).

Roads & Drainage: Main/Trunk

1.Public funds.

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TYPE OF INFRASTRUCTURE

EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. OPERATION & MAINTENANCE. 1.Owner/developer. 2.Plot charge (before vesting). 3.User charge &/or public funds (after vesting).

COMMENTS

Solid Wastes: Neighborhood

1.Owner/Developer. 2.Land sale profit (public land) & development fees (public & private land). [Only minor expenditure - like communal bins or hand-carts].

Charge can be: 1.Contract for commercial wastes, with institutions which have no less costly collection or disposal. 2.Simple plot or house fees for households that have no less costly systems and/or are motivated to safe/full disposal. 3.Public funds. [Waste disposal is not clearly a "market good." Users may have less expensive options, which create public costs (e.g. illegal or unsanitary dumping). It may be better to compel use of the public system, by making charges whenever the public system is accessible or by covering costs from public funds. Clean public spaces creates a public good.

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TYPE OF INFRASTRUCTURE

EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. OPERATION & MAINTENANCE. Collection from Specific Premises 1.Plot charge (before vesting). 2.User charge &/or public funds (after vesting). Cleaning of Streets and Public Open Space 1.Public Funds.

COMMENTS

Solid Wastes: Collection

1.Public funds (central/local). 2.Foreign aid grants. 3.Loans (local or foreign). 4.Privatization or contractingout - implicit rent of equipment from contractor. 5.Equipment lease.

Solid Wastes: Disposal

1.Public funds (central/local). 2.Foreign aid grants [likely only for imported equipment or full disposal systems]. 3.Loans (local) for landfill. 4.Loans (foreign) [likely only for imported equipment or full systems]. 4.Private ownership of disposal sites or systems. 1.Owner/Developer. 2.Land sale profit (public land) & development fees (public & private land).

1.User charge &/or public funds. 2.Fee to private parties or contractors for use of private disposal facility. 3.Recycling profit from selected types of wastes.

Electricity: On-site

1.Owner/Developer (Bulk fee to electricity utility - before vesting). 2.User charge &/or public subsidy (after vesting).

Full cost recovery is possible and desirable on the basis of economic efficiency pricing. Public subsidy may provide more or less social equity. It is also economically inefficient, in that more

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electricity will be used at the lower (subsidized) price. Electricity: Immediate Access 1.Land sale profit (public land) & development fees (public & private land). 2.Public funds (central/local). 3.Foreign aid grants. 4.Loans (local & foreign). 1.Public funds (central/local) 2.Foreign aid grants. 3.Loans (local & foreign). 1.User charge &/or public subsidy (after vesting).

Electricity: Main/Generation

1.User charge &/or public subsidy.

TYPE OF INFRASTRUCTURE

EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. OPERATION & MAINTENANCE. 1.Plot charge (before vesting). 2.User charges (passenger fares) &/or public funds (after vesting).

COMMENTS

Urban Transport On-site

1.Owner/Developer 2.Land sale profit (public land) & development fees (public & private land). [Only minor expenditure - like bus

Full cost recovery may be possible on the basis of economic pricing. However, it is common for urban transport to be

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TYPE OF INFRASTRUCTURE

EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. shelters and (possibly) turning circles]. OPERATION & MAINTENANCE.

COMMENTS

subsidized, to reflect actual or claimed public benefits from reduction of pollution, congestion and hazard. The poor state of many urban roads suggests that a public subsidy which reduces car use might be in the public interest, as well as adding environmental benefits. 1.User charge (bus fares) &/or public subsidy.

Urban Transport Mains & Depots

1.Public funds (central/local) 2.Foreign aid grants. 3.Loans (local & foreign). 4.Privatization or contracting out - implicit rent of equipment from contractor.

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TYPE OF INFRASTRUCTURE

EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. OPERATION & MAINTENANCE.

COMMENTS

TYPE OF INFRASTRUCTURE

EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. OPERATION & MAINTENANCE. 1.User charge &/or public funds.

COMMENTS

Social Services (Education, Health, Welfare, Parks, Fire, Ambulances, Cemeteries, Street Lights etc.)

1.Owner/Developer. 2.Land sale profit (public land) & development fees (public & private land). [Only minor expenditure - like local parks, clinics and street lights]. 3.Joint community contributions. 4.Public funds (central/local) 5.Foreign aid grants. 6.Loans (local & foreign). 7.Privatization or contracting out - implicit rent of equipment from contractor.

User charges likely to be minimal and not aimed at cost recovery. Most social services are "merit goods," by definition to be met from taxes. A well motivated community may provide cash or work contributions for some facilities.

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TYPE OF INFRASTRUCTURE

EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. OPERATION & MAINTENANCE.

COMMENTS

TYPE OF INFRASTRUCTURE

EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. OPERATION & MAINTENANCE. 1.Owner/developer.

COMMENTS

Low-Income Housing:

1.Owner/Developer.

Contributions by owners or developers can come

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TYPE OF INFRASTRUCTURE

EXPENDITURE FUNDING OR COST COVERAGE CAPITAL EXPENDITURE. OPERATION & MAINTENANCE. 2.User rent &/or public subsidy.

COMMENTS

On-site

2.Land sale profit (public land) & development fees (public & private land). 3.Public funds (central/local). 4.Foreign aid. grants & NGO funds. 5.Loans (local & foreign).

out of monopoly rents from use of a specific site. This will need to be imposed by a "linkage" agreement. Otherwise the owner will maximize revenue from the site, by the sale of all plots for their highest and best use. 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, rather than reduce profit further or take a loss. Annual O & M may need to be subsidized. [Low-cost housing is a complex and vexatious issue].

Low-Income Housing: Off-site

1.Owner/Developer of another site (as an outcome of a "linkage" agreement. 2.Land sale profit (public land) & development fees (public & private land) from another site, appropriated for this purpose. 3.Public funds (central/local). 4.Foreign aid grants & NGO funds. 5.Loans (local & foreign).

1.Owner/developer. 2.User rent &/or public subsidy.

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Upgrading: Immediate Access

1.Development fees (public & private land). 2.Community participation. 3.Plot charges. 4.Public funds (central/local). 5.Foreign aid grants. 6.Loans (local & foreign). 1.Public funds (central/local). 2.Foreign aid grants. 3.Loans (local & foreign).

1.Plot charge 2.User charge &/or public subsidy - depending on nature of service.

Upgrading: Trunk Infrastructure

1.User charge &/or public subsidy - depending on nature of service.

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ANNEX 2 CONTRACTING OUT OF PUBLIC SERVICES Conditions Likely to Facilitate Economic, Efficient and Effective Implementation 1. 2. Credible and comprehensive accounting systems, which ensure that comparison of alternative in-house costs (including administrative overheads) with contracting-out (including regulatory costs) is meaningful, reliable and useful. Economic overview, mitigating potential for private contractor financial savings to become additional public costs (e.g. welfare payments to compensate for meager employee benefits or economic externalities or inequities resulting from less effective or efficient service standards). Bidding and contract evaluation which ensures that selection based on price is also consistent with acceptable quality. Fees paid by the government to cover all business costs of the contractor, including return on capital and reasonable profit. Service not a natural, actual or near monopoly and therefore subject to meaningful competition and a potential for exit. Service not potentially prone to crisis conditions, in the event of contractor or supervisory shortcomings, causing: a. b. c. d. 7. 8. 9. breakdown of security, safety, law, order and government; conspicuous and immediate public dissatisfaction; disruption or distortion of public policy goals; and potential political threats to declared mandates of key elected officials.

3. 4. 5. 6.

Relatively swift, easy and inexpensive recovery in the event of contractor failure to deliver, including withdrawal from contracts and reinstatement of alternative delivery systems. Relatively easy and inexpensive execution, administration and supervision of contracts, including cost accounting for this. Willingness (or requirement) of private contractors to follow employment practices which are decent, fair and dignified.

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10. 11. 12.

Inability of contractor to conceal or obscure long-term costs, including those of depreciation and maintenance, which may not be obvious from accounting or management information systems nor from reasonable and customary physical observation. Avoidance of fragmentation in the overall strategic delivery and management of public services, creating administrative or economic costs exceeding those saved by contracting out. Resulting overall economic and social outcomes which are compatible with the prevailing political discourse.

166