Alternative Financing Instruments in Times of low Interest Rates and a booming Economy

– Are German municipalities ready to tap the capital market?

This “Blickpunkt” issue was published as an article in the 1 August 2017 issue of “Immobilien & Finanzierung” magazine, which was dedicated to “The future of municipal finance”

Cologne, 20 September 2017 Between autumn 2014 and spring 2015, IR.on AG and IKB Deutsche Industriebank AG carried out a survey among decision-makers in municipalities, banks and financial intermediaries to shed light on new forms of municipal finance. The purpose of the survey was to understand the motivation and requirements of both local authorities and investors. Based on qualitative telephone interviews, we asked municipal treasurers about alternative financing options, their financial communication and the ability of their municipality to tap the capital market. At the same time, typical investors in, and lenders to, municipal institutions expressed their opinions about alternative forms of municipal finance. Today, the question is if and to what extent the general framework and the market for alternative finance have changed since our first survey.  

Municipal finance in Germany – moderate easing but no sustainable improvement

The financial situation of German municipalities has improved somewhat in the past two years. In 2016, local authority budgets posted a clear surplus for the second consecutive year, according to preliminary computations by the Federal Statistical Office. And according to the latest tax estimate, tax revenues of the federal, federal state and local governments will continue to grow. Moreover, the federal government and the governments of the federal states seem to have become aware of the critical situation at the municipal level – as is reflected in a number of relief measures recently adopted.  

Even in the present comfortable macroeconomic situation the gap between poor and rich municipalities and regions continues to widen.

But upon closer inspection, most of these measures turn out to be of a short-term nature and no sustainable improvement has been achieved to date. This can be seen from the fact that even in the present comfortable macroeconomic situation of low interest rates and economic stability, the gap between poor and rich municipalities and regions continues to widen. Highly indebted municipalities, in particular, have been unable to reduce their short-term borrowing significantly in the current advantageous situation. With regard to the short-term borrowing burden, the authors of the latest “KfW-Kommunalpanel” therefore speak of a “phase of stabilisation at a high level”. The latter is primarily attributable to the continued increase in social spending in structurally weak municipalities – a situation which has been aggravated by the influx of refugees in 2015/16.

The backlog in municipal capital spending is also being eliminated only slowly. While the latest “KfW-Kommunalpanel” shows that the investment backlog declined from EUR 136 billion in 2015 to EUR 126 billion in 2016, the Federal Finance Ministry explains in its monthly report of January 2017 that this reduction is due to the fact that “the generally good trend in municipal capital spending [...] was driven by the financially strong municipalities” and that “many financially weak municipalities were unable to fund the necessary investments.”

This has led to a great regional divide.  Between 2012 and 2015, Bavarian municipalities invested an average of EUR 473 per inhabitant in tangible investments, whereas North Rhine-Westphalia invested only EUR 163 per inhabitant. These regional disparities have since become engrained and are bound to aggravate the financial situation of many municipalities in a deteriorating macroeconomic environment.

Especially those municipalities that have not yet completed the structural change or are facing a massive population loss will continue to need assistance in order to keep up with the nationwide increase of prosperity.

In their latest forecast of the municipal financial situation, Germany’s municipal umbrella associations (Deutscher Städtetag, Deutscher Landkreistag and Deutscher Städte- und Gemeindebund) therefore criticise that "in the coming years [...] too many cities, districts and communities will hardly be able to pursue a policy that actively changes something instead of merely managing the current state of hardship. Especially those municipalities that have not yet completed the structural change or are facing a massive population loss will continue to need assistance in order to keep up with the nationwide increase of prosperity.”

Apart from the scarcity of locally generated funds, not only financially weak municipalities often lack the human resources that are required to apply for funding and to adequately prepare and implement construction measures. Moreover, the pronounced cyclicality of public sector commissioning poses a challenge for construction companies; capacity utilisation in parts of this sector is set to remain high into the year 2019, anyway. What is more, municipalities’ growing tax revenues contrast with sharply rising construction costs.

To support an improvement in the financial situation, it will be important that municipalities are enabled to set aside reserves for difficult times  while at the same time being able to raise sufficient funds for necessary investments.

To support a sustainable improvement in municipalities’ financial situation, it will be important in the coming years that the federal government and the federal states enable the municipalities to “set aside reserves for difficult times and, most importantly, for sudden and unexpected challenges“ (Bundesvereinigung der kommunalen Spitzenverbände, Federal Association of Municipal Umbrella Organizations) while at the same time being able to raise sufficient funds for necessary investments. Moreover, it is the responsibility of the municipalities to ensure, based on forward-looking financial planning, that no additional structural debt is built up during an economic downturn and that the investment backlog is eliminated at a steady pace.

Municipal loans are always the first choice – but importance of “beauty contests” is set to rise

Many financially weak municipalities will continue to rely on large amounts of external funding. Besides government grants and development funds, the focus remains on the traditional municipal loan. This was also the “first choice” for most of the respondents in the 2014/15 study, as this is a functioning, established market with smoothly running processes. But there is also some movement in the lending market. Loanboox, a Swiss start-up, revolutionised the Swiss market for municipal loans within only a few months and reported a funding volume of SFR 3 billion already in mid-June 2017. The firm will shortly start operations in Germany, where it – alongside competitors such as Commnex or Firstwire it – will work to convince municipalities of the benefits of using a financing platform.

A comparison of our survey and the results of the latest KfW panel shows that lending terms have eased somewhat. It remains to be seen, however, what effect the stricter Basle III regulations and the withdrawal of some providers will have if the economy slows down, the interest rate environment changes and/or municipalities’ funding requirements increase. In our opinion, it is quite a realistic scenario that more municipalities will have to undergo “beauty contests” for the best terms and conditions and that the market for alternative finance will continue to grow. Alternative forms of municipal finance include note loans, shared or individual municipal bonds but also citizens funding and other crowdfunding instruments.

Alternative financing instruments: Note loans and bonds are used more frequently  

For most of the treasurers, the municipal note loan is the most interesting alternative financing instrument. At the time of the survey in late 2014, the favourable terms currently offered, in conjunction with longer maturities, and the broader investor base were the most important advantages of the note loan, according to the respondents. 90% of the investors participating in the survey had previously already subscribed municipal notes or could imagine doing so.

The note loan is increasingly being regarded as a genuine alternative to conventional loans.

A large number of municipal note loans have been issued in the meantime. While the note loan has still not established itself as a mainstream instrument of municipal finance, municipalities, banks and investors have certainly become more professional and the note loan is increasingly being regarded as a genuine alternative to conventional loans.

For many years, German municipalities have been using Public Private Partnerships (PPP) to finance their projects. Our survey showed that – notwithstanding some negative experiences – most of the respondents consider PPP to be recommendable in individual cases, provided that they are used properly. It is not so much the cost advantages in financing, planning, construction and operation which count for them but the time and efficiency gains.

It is not so much the cost advantages but the time and efficiency gains that are crucial for PPP projects.

Notwithstanding the above, less and less use is being made of this instrument. The discussion about the foundation of the state-owned motorway management company revealed that public perception of PPP projects is heavily driven by ideology, which is making it more difficult to use them. At the same time, it became apparent again that private and public large investors (insurance companies, pension funds, etc.) are very interested in infrastructure investments in Germany. It remains to be seen to what extent this interest will materialise at the municipal level, given that local projects tend to involve relatively low investment amounts. The conversion of ÖPP Deutschland GmbH into a public-sector consulting company for PPP organisation and investment projects could also provide a fresh boost for this financing instrument.

Citizens funding is also a potentially suitable route for the financing of projects. Most of the treasurers surveyed in 2014 considered this form of crowdfunding to make political sense with a view to involving citizens in municipal projects. It is therefore not surprising that this form of finance is frequently mentioned in political discourse; at the same time, however, two thirds of the respondents consider citizens funding to be unattractive from an economic point of view. Consequently, after closer analysis of the cost-efficiency aspects, this form of finance is used only very rarely and will therefore remain somewhat exotic and be used only in isolated cases in the future.

Municipal bonds: Treasurers dislike the efforts involved – but there have been repeated lighthouse issues

Already back in 2015, half of the treasurers could imagine participating in a shared municipal bond issue or had already done so. According to the treasurers, sharing issues with other municipalities offers the advantage of more easily achieving a marketable volume. By contrast, large municipalities prefer individual bonds. The great effort required to issue municipal bonds is generally regarded as a drawback. While investors from the savings bank sector tend to dislike this instrument, the large investors surveyed were open to investments in municipal bonds. The more familiar municipalities become with handling the instrument and the investors, the smaller the effort becomes, however. This may be one of the reasons why several issuers have repeatedly tapped the capital market, whereas other large cities with high funding requirements remain hesitant. April 2017 already saw the fifth NRW city bond issue. Having participated in the first NRW city bond issue as well as in several successful note loan transactions, the City of Dortmund issued its first individual bond in 2016 and issued its next bond already in spring 2017.

Bonds are playing an increasingly important role in the municipal finance mix.

This shows that bonds are playing an increasingly important role in the municipal finance mix. Large cities, in particular, regard them as a good opportunity to restructure their debt towards more favourable interest rates and longer maturities and, ideally, to free their budgets for new investments.

Investors primarily attach importance to aspects such as the issue amount and the order volume, the maturity and the yield of the municipal investment. The actual financial situation of a given German municipality is not seen as a knock-out criterion by most of the investors, as municipalities are still regarded as being part of the federal liability chain. Due to the limited availability of other investment options, municipal issuers have so far found it easy to raise any amounts needed. But if and when conditions change, municipalities will increasingly be challenged to cater to investors’ information requirements and take measures to make it easier for investors to assess their creditworthiness – from more comprehensive financial reporting to the unpopular commissioning of external rating agencies.

The market for alternative finance will continue to grow – but municipalities are challenged to demonstrate their ability to tap the capital market

Alternative finance gives municipalities much greater room for manoeuvre; moreover, municipalities find a large number of investors with great interest in secure long-term investments in this market.

We therefore assume that the market for alternative finance will not only continue to grow but that it will even grow faster as the macroeconomic conditions change and instruments such as note loans will establish themselves as complementary components in the finance mix. As the number of issuers and issues rises, however, the beauty contest for the best terms will intensify and investors’ ability to assess a municipality’s capital market prospects will play an increasingly important role. Greater transparency is therefore required on the part of issuers/borrowers to allow investors to optimise their ongoing analysis and creditworthiness assessments in accordance with applicable regulations.

The market for alternative finance will not only continue to grow but it will even grow faster as the macroeconomic conditions change 

Moreover, the federal government, the federal states and local authorities should establish a clearly defined policy for alternative municipal financing instruments and promote the inter-municipal know-transfer across all instruments in order to avoid undesirable developments that would adversely impact the overall perception and the market development of alternative instruments.

Our 2014/15 survey showed that German municipalities see themselves well positioned to tap new financing channels via the capital market. Almost three quarters of the treasurers surveyed considered their municipality to be well equipped. Only about one third of the investors surveyed believed that German municipalities are ready for the capital market. At this stage, it is impossible to say if and to what extent this impression has changed in the meantime. It is for certain, however, it is now up to the existing and new municipal issuers to improve this perception through effective and pro-active financial management and professional financial communication with their investors.

Florian Kirchmann, IR.on AG | Jakob Fichtner, IKB Deutsche Industriebank AG