Promoting Subnational Financing for Cities
Urban 20 White Paper
A French Development Agency (AFD), International Finance Corporation (IFC),The United Nations Human Settlements Programme (UN–Habitat) andInter-American Development Bank (IDB) White Paper for the Urban 20 (U20)

Source: Prashanth Vishwanathan pour l’Agence Française de Développement

Authored by:About Urban 20•

Urban 20 (U20) is a new city diplomacy initiative developed under the leadership of, Horacio
Rodríguez Larreta, Mayor of the City of Buenos Aires, Anne Hidalgo, Mayor of Paris and Chair of
C40 Cities Climate Leadership Group (C40). Launched on December 12, 2017 at the One Planet
Summit in Paris, the initiative is chaired by the cities of Buenos Aires and Paris, and convened by
C40, in collaboration with United Cities and Local Governments (UCLG).
U20 seeks to highlight the expertise of cities in a range of global development challenges andto raise the profile of urban issues within the G20. U20 offers solutions and clear
recommendations for consideration by national leaders ahead of the 2018 G20 Summit. It will
culminate in the inaugural U20 Mayors Summit in Buenos Aires on October 29-30. This will be a
stepping stone towards ensuring a dialogue between cities and the G20.
In 2018, 26 cities have participated in Urban 20: Barcelona, Beijing, Berlin, City of Buenos Aires,
Chicago, Durban, Hamburg, Houston, Jakarta, Johannesburg, London, Los Angeles, Madrid,
Mexico City, Milan, Montreal, Moscow, New York, Paris, Rio de Janeiro, Rome, São Paulo, Seoul,
Sydney, Tokyo, and Tshwane.
For more information, please consult: www.urban20.org

About the White Papers
Urban 20 is proud to present a series of White Papers from our Strategic and Advisory Partners
that highlight the most relevant topics on the cities development agenda and the forthcoming
urban trends. These papers define the challenges that local governments are currently facing
and offer open recommendations supported by relevant, up-to-date research and data. The
intention of this work is to broaden the understanding and perspective of decision makers andstakeholders as to enhance their ability to tackle these most pressing issues. The White Papers
also represent the hard work and dedication of these agencies and organizations to keep the
public well informed about the ongoing efforts to address the present and future challenges weshare as humankind.

Image: Orbon Alija

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Promoting Subnational Financing for Cities is a
White Paper prepared by AFD, IFC, UN-Habitat and IDB
as a voluntary contribution to enrich the discussionsof the Urban 20 process.

About the Authors
Emilio Pineda, IDB
Between 2003 and 2008 he worked in the International Monetary
Fund (IMF) as an Economist in the Western Hemisphere
Department where he was responsible for conducting monetary,
fiscal and debt analysis for the Caribbean. Between May 2008 andJune 2012, Dr. Pineda worked at the Ministry of Finance in Mexico.
Since July 2012, he is a Principal Specialist of the Fiscal
Management Division of IADB, where he has led programs tostrengthen sub-national fiscal management in Brazil, Argentina and
Uruguay. He has also published in the areas of decentralization,
sub-national taxes, sub-national debt and public companies.
Marco Kamiya, UN Habitat
Head of UN Habitat urban economy and finance branch. Working
with cities he supports financing methodologies related withplanning, participatory approaches and infrastructure finance.
Previously he occupied senior positions at CAF, IADB, and at
PADECO Co., Ltd in Tokyo. Marco has published with Le-Yin Zhang“Finance for City Leaders” handbook, with Ni Pengfei the annual
Global Urban Competitiveness Report, and with Serge Salat“Economic Foundations of Urbanization”.
Kristtian Radda, IFC
Economist, he specialized in the Climate of Investment andSustainability Programs of the International Development Center ofHarvard University. As the current Leader for the Sustainable Cities
and Businesses Program for Latin America and the Caribbean of
the International Finance Corporation (IFC) of the World Bank,
Rada is promoting a broad portfolio of investment and advisory
services directed towards the Sustainable and competitive
development of the main cities of Latin America.

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Louis-Antoine Souchet (AFD)
Senior Program Manager and Lead specialist on local PFM anddecentralization, in the Local Authorities and Urban Development
department of the French Development Agency (AFD), he
manages and supervises programs for strengthening
decentralization in Asia, MENA and Africa, as well as direct
financing and TA programs for local governments in the different
countries of intervention of AFD and French overseas territories.
Before joining AFD in 2015, Louis-Antoine Souchet was working for
the City of Lyon, France’s third largest city, where he was CFO andthen Deputy Director General.

AFD is an inclusive public financial institution and the main actor in
France’s development policy. It makes commitments to projects
that genuinely improve the everyday lives of people, in developing
and emerging countries and in the French overseas territories.
AFD works in many sectors fully in line with the Sustainable
Development Goals (SDGs)– energy, health, biodiversity, water,
digital technologies, training – and supports the transition to a safer,more equitable and more sustainable world: a world in common.
IFC, a member of the World Bank Group, is the largest global
development institution focused on the private sector in emerging
markets. Working with more than 2,000 businesses worldwide, we
use our capital, expertise, and influence to create markets andopportunities in the toughest areas of the world. In FY16, we delivereda record $19 billion in long-term financing for developing countries,
leveraging the power of the private sector to help end poverty andboost shared prosperity. For more information, visit www.ifc.org.
The United Nations Human Settlements Programme (UN–Habitat)is the United Nations agency working on normative and operational
areas of Urban Planning, Municipal Finance, Housing and Slum
recovery among other themes related with sustainableurban development.
UN-Habitat leads implementation of the New Urban Agenda andthe SGDs, in particular SDG11 on cities. Its global headquarters is in
Nairobi, Kenya and its Executive Director is Maimunah Mohd Sharif
since January, 2018.
IDB works to improve lives in Latin America and the Caribbean.
With a history dating back to 1959, IADB is the leading source ofdevelopment financing for Latin America and the Caribbean
through financial and technical support for countries working to
reduce poverty and inequality, with the aim to achieve
development in a sustainable, climate-friendly way. . The Bank’s
current focus areas include three development challenges –social inclusion and inequality, productivity and innovation, andeconomic integration – and three cross-cutting issues – genderequality and diversity, climate change and environmental
sustainability; and institutional capacity and the rule of law.

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Contents
Executive summary..................................................................................................................................... 6
Glossary......................................................................................................................................................... 7
Introduction...................................................................................................................................................8I.The necessary prerequisites for increased subnational financing: strong and effective
decentralization frameworks and robust cities capacities..................................................... 9
II. Bridging the financial gap implies broadening the range of financial instruments...... 15
Recommendations................................................................................................................................... 20
Bibliography............................................................................................................................................... 22

The views, opinions, positions and recommendations expressedin this White Paper are solely those of the individuals and theirorganisations. They do not necessarily reflect those of Urban 20
or any of its chairs, conveners, partners and participating cities.

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Executive summary
If cities are to play the major role they are assigned in the fields of development and struggle
against climate change, their funding capacities need to be rapidly and massively increased.
This crucial development depends heavily on the political will of the cities themselves, but alsoof the states, as well as the quality of the dialogue between these two levels.
States must indeed ensure that the institutional and fiscal framework for decentralization isstrengthened, and accepting the emergence of strong local governments, especially cities,
endowed with human and financial resources to enable them to fully assume theircompetences and enabling the states to rely on them as partners with which they can improve
the action of public authorities in favor of a balanced development of territories.
Cities must work on the strengthening of their capacities, in order to improve their credibility andthat of their projects vis-à-vis their potential funders.
DFIs and UN agencies have to intensify their support to this necessary and fruitful dialogue
between states and cities, and enhance the effectiveness of this support with more co-financed
programs or TA combination. They also have to continue developing new tools to contribute to
the increase and the diversification of funding sources for cities.

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Glossary
ADB

Asian Development Bank•

AFD

Agence Française de Développement

CICLIA

Initiative Villes et Changements Climatiques

COP

Conference of the PartiesDBSA

Development Bank of South Africa

DFI

Development Financial Institution

FEC

Fonds d’Equipement Communal

FINDETER

Financiera de Desarrollo Territorial

IFC

International Finance Corporation

IDB

Inter-American Development Bank

LED

Local Economic Development

LG

Local Government

NDC

Nationally Determined Contributions

PCG

Partial Credit Guarantee

PEFA

Public Expenditure and Financial Accountability

UPFI

Initiative pour le Financement de Projets Urbains

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Introduction
Local governments and especially cities are the most representative of the multidimensional
aspect of the needs of the population, constitute the relevant scale of intervention for balanced
urban development and are at the forefront of concrete responses to the impacts ofclimate change.
Their role in development and climate change issues was clearly recognized in 2015
(Conference of Addis Ababa on financing for development and COP 21 in Paris) and 2016
(adoption of the New Urban Agenda at the Habitat III conference), but the challenges they haveto face are huge. Urban population is growing fast: according to the United Nations (UN) 1, an
estimated 54.5% of the world’s population lived in urban areas in 2016 and will reach nearly 70%
by 2050 according to the World Bank’s forecasts. This trend requires rapid adaptability andcapacity for anticipation in public service delivery and urban planning to avoid uncontrollable
sprawling, with a growing part of the population living in slums or informal settlements with noaccess to basic services, and highly exposed to natural disasters and climate change risks,
especially in coastal areas.
And the paradox is that cities often remain weak actors, with insufficient resources to face thesechallenges. Despite the favorable conditions for long-term investments (low rates, abundantfunds), the gap between funding needs and observed financing of urban infrastructures
is growing.
The challenge is therefore to have cities:
With clearly defined competencies and responsibilities, in articulation with the State level,
Adequately endowed in terms of financial resources, as with proper project and financial
management capacities,
Able to deliver efficiently services to their population and in position to fund and manage
the operating of local infrastructure,
In capacity to anticipate the needs in terms of urban planning and natural risks management,
In a position to become catalysts for local economic development (LED).

1

The World’s Cities Report, UN-Habitat, 2016.

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Source: Jorge Cardoso pour l’Agence Française de Développement

I. The necessary prerequisites for increased subnational
financing: strong and effective decentralization frameworks
and robust cities capacities
1. How DFIs and UN Agencies can contribute to the strengthening ofdecentralization processes

i. Why support decentralization?
Decentralization is both a modality of institutional organization and a process of reform, thatdefines the distribution of powers between national and local levels.

“The two main objectives generally assigned todecentralization are the following:
Improving the delivery of services to citizens withproximity and a better understanding of the needs,
Fostering democratic endorsement andconsent to reduce political radicalism, due to moretrust of citizens in local governments considered as
more responsive, and the fact that accountability ofpolicy-makers at the local level is easier”.

It is a complex and sensitive issue, with a strong political dimension. It therefore has a specificmeaning in each country, with institutional systems arising from national history, and sometimes
more specific complementary objectives in certain countries like fight against poverty andterritorial disparities, promotion of social stability in conflict or post-conflict environments(« asymmetrical decentralization» in Mozambique or in reflection in Colombia), preservation ofhistorical, linguistic, ethnic or cultural specificities like in Ethiopia.
Globally, the level of decentralization is rather weak in developing countries, mainly because of
the reluctance of central governments to transfer power and resources to local governments,

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which explains why cities lack clear empowerment and responsibilities, as well as sufficientfinancial resources and human skills.

ii. The keys to effective and fiscally responsible decentralization
The key aspects are the following:
Clarity in the division of responsibilities between the different levels of government
The clarity in the responsibilities of the different levels of government is specific to each country,
but as a general rule it is to be expected that the vaguer the definition of responsibilities in thelegal framework, the greater the need for intergovernmental cooperation arrangements that canresolve the needs for clarification.
Correspondence between responsibilities and resources to finance them
There must be a correspondence between the spending responsibilities of the local
governments and the resources they have to finance them. There are many examples of local orregional governments that are assigned responsibilities and spending mandates that exceed
their assigned revenues, where they consider that there is an implicit commitment on the part ofthe central government to finance these income deficits. If on the other hand, the revenues of
local governments exceed their spending needs, then unnecessary pressures can begenerated on the central government deficit, as well as generating incentives for inefficient
spending at the subnational level.

AFD: Main instruments and projects inthe field
AFD has a long experience in supporting and financing local governments andespecially cities, in French overseas as well as in foreign countries. Its objective isto provide the widest range of tools to improve cities’ access to financing. The threemain instruments are the following:
Policy based loans in support of decentralization processes, to increasefiscal transfers from governments to cities as well as increase of own-source
revenues.
AFD has granted such loans to the Republic of the Philippines since 2009, in
co-financing with the Asian Development Bank (ADB), to the Kingdom of Jordan
since 2016, and to Ethiopia and Senegal in co-financing with the World Bank in 2018.
Credit lines to financial institutions specialized in LGs, to reach second tiercities that can hardly benefit from direct loans, and giving them access to loans inlocal currency tailored to their needs (long-maturity loans).
AFD has financed and provided technical assistance to many of these FIs, like
FINDETER in Colombia, DBSA in South Africa, CPSCL in Tunisia, or FEC in Morocco.
Direct loans to LGs, mainly cities (or their urban operators) for projects,
investment programs or policy loans, according to their capacity in terms of project

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management and their financial position, accompanied by programs of
capacity building.
(e.g. AFD loans to Dakar, Greater Amman, Joburg, Medellin, Guayaquil).
Project preparation facilities to finance pre-feasibility or feasibility studies,and help cities transform their ideas into real investment projects, with climate
co-benefits.
(e.g. CICLIA for Africa, UPFI for the Mediterranean).

Robust own-source revenues
The decentralization literature recognizes the benefits of local governments at least in themargin being financed with their own resources. These benefits include the following : (i) fiscal
responsibility because the financing of local governments spending with own revenues allows
local and regional governments to internalize the cost of their spending decisions; (ii) politicalresponsibility because when local governments spending is financed by taxes collected by
local or regional governments themselves, it encourages and facilitates citizens to monitor theauthorities in the exercise of this expense; and (iii) compliance with local preferences because
subnational taxation facilitates alignment between the tax structure and differences in local
preferences. For example, this allows a region that has a preference for a higher level of public
services or goods to finance this preference with a higher local tax pressure.
Appropriate design of intergovernmental transfers
A very important share of local governments’ expenditure will have to be financed with transfersfrom the central government. Therefore, how these transfers are made is of the utmost
importance to maintain subnational fiscal sustainability. These transfers have to be predictable,
and the formula of calculation based on simple and transparent criteria (e.g: population, incomeof the population).
To minimize the risks of subnational fiscal indiscipline, the good design of the transfers between
levels of government must safeguard the objective of not generating perverse incentives.
International experience shows that the best way to incorporate these conditions in the transfer
mechanism is through formulas based on indicators of need for spending and capacity togenerate own revenues. Ideally, the formula should use a set of indicators of expenditure needs
and fiscal capacity at the level of each jurisdiction. In general, jurisdictions with higher spendingneeds and / or lower relative fiscal capacity will receive a higher level of transfers per capita. In
this regard, a design condition of the greatest importance is that the indicators of the need for
expenditure and / or fiscal capacity used are "exogenous" to the jurisdiction receiving thetransfer. This means that local governments cannot manipulate the value of such indicators
through autonomous decisions, with a view to skewing the allocation mechanism in their favor.
The same applies to indicators of fiscal capacity indicators, where it is better to use structuralvariables that estimate their potential income.
Fiscal Responsibility Framework
The financial market has been generally ineffective in regulating subnational debt with the
exception of countries with a long and proven history of hard budget constraints such as the
US. This is because the market normally expects that local governments cannot go bankrupt
and that in the event of financial difficulties they will be rescued by central governments andtherefore willing to provide credit beyond the local governments’ repayment capabilities. This
explains the growing emergence of sub-national fiscal rules. The most appropriate combination

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of controls on sub-national indebtedness depends on the specific circumstances of eachcountry, although in most cases it has to involve: a combination of well-designed and strongly
applied fiscal rules in a uniform manner; and institutional reforms that make it possible toincrease the effectiveness of market discipline over local governments (in particular, measures
to improve the quality and transparency of sub-national fiscal accounts, elimination of privileged
access channels for local governments to credit, and use of independent risk rating systems).

UN-Habitat: Case Studies on Subnational
Finance
UN-Habitat has broad experience integrating operational and normative projects
on municipal and subnational finance at a global scale. The agency works on urban
planning and design, municipal finance, legal; framework, land and regulations,basic services and integrates local revenues with planning.
UN-Habitat aims to achieve sustainable and productive urbanization, with municipal
finance s key part, but there won’t be results if municipal finance is not strongly
linked to legislation, and to urban planning 2 . One practical example: our project inKiambu County in Kenya; starting with revenue enhancement, basic ICT network,and basic financial management. But to support land registration, an
understanding of planning and logistics in the city is needed, to properly establish
public space, rules and regulations are required. To design small private
investment in local services, a specific set of by-laws need to be provided. To retrofit
urban planning and expand the city with planned city infills, a feasibility analysis,
financial business cases with costs, and cost-benefit analysis are necessary. In allcases the integration of local finance, laws, and planning is essential. With small
resources, however, and patient work, Kiambu county was able to show results byincreasing revenues by more than 50% in two years. Those additional revenues are
now reinvested in basic services, and currently the county requires support to set
up a municipal corporation and design local infrastructure funds.
Several partner cities that have adopted programmes and strategies for improved
urban and municipal finance in coordination with UN-Habitat. The Kiambu County
Government in Kenya could increase its revenue generation by 50 percent between
2014-17 period as a result of technical assistance provided by the agency. In Somalia,
an automated municipal finance system established in 15 districts has improved
transparency, accountability, and financial procedures of local governments withsome districts increasing revenues by over 300 percent between 2008 and 2015.
In Afghanistan, improved methods of land surveying, land registration, tax invoicing
and collection have resulted in a 15% revenue increase, on average. The Urban
Economy Branch, in addition, is and has provided support to cities as diverse as
Kampala, Dar-Es-Salam, Accra (Ghana), Al-Alamein (Egypt), Port Au Prince, Buenos
Aires and Mendoza, Havana (Cuba), and has countrywide support to cities in Saudi
Arabia, Egypt, Uganda, Tanzania, Mexico, Myanmar, and several cities in China,
notably Beijing, Shenzhen and Guangzhou.

2

See UN-Habitat: Salat, Kamiya, Bourdic (2017) ‘Economic Foundations for Sustainable
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iii. The role of DFIs and UN agencies regarding decentralization
DFIs and UN agencies can contribute to the strengthening of decentralization processes. The
relevance of their intervention implies a pragmatic approach to this issue. This means that they
have to be fully aware of the assets but also of the potential risks of decentralization, and take
into account the fact that each country has distinctive characteristics in their decentralization
legal and institutional frameworks, based on a case by case analysis.
In order to be efficient, the support to decentralization processes requires in-depth andlong-term political dialogue with national and local authorities. To implement this dialogue themain instruments used by DFIs are policy-based loans, accompanied by technical assistance.
These loans focus on the different key aspects of decentralization:
Support to streamline fiscal transfers from governments to local authorities (adequate
and sufficient, stable and predictable, based on transparent and objective criteria, etc.)
Strengthen the legal and regulatory framework concerning local authorities’ ownrevenue (tax rates, revenue collection procedures, etc.)
Strengthen local authorities’ financial management processes, systems and capacities(designing and rolling out of financial information systems, infrastructure and GIS databases,
training plans, etc.)
Improve transparency and accountability on local finance (communication strategy andtemplates, participatory budgeting, etc.)

IFC-World Bank: Projects in the field
IFC, a member of the World Bank Group, provided a $50 million loan to the City of
Buenos Aires aimed to support the development of reliable, safe, andenvironmentally friendly urban transportation, including the building of new efficient
bus lines, introduction of new bicycle lanes and bike-sharing stations that will cut
commuter times and reduce carbon emissions in the Argentine capital. In addition
to the loan financing, IFC is providing advisory services to Buenos Aires spanningtransformational priorities for the city, including transport, energy efficiency in publicbuildings and assistance in the promotion of green buildings standards with a
special focus on Villa 31, a low-income urban settlement in the heart of
Buenos Aires.

2. The support to improve cities capacities
Cities have different sizes and capacities as UN-Habitat Global Municipal Database shows(Figure 1). For example, for cities in East Asia and Pacific, where the most dynamic cities of Asia
are located, the average budget per capita is over USD 2500, and the allocation of budget tofinance capital expenditure is USD 937.

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Figure 1. Budget and Capital Expenditure (by Region)

Average budget
per capita (USD)

Average capital
expenditures per
capita (USD)

East Asia and Pacific$2.521$937

Europe and Central Asia

$1.718$254

Latin America and the Caribbean$1.003$159

Middle East and North Africa

$489

$385

North America$3.382$572

South Asia

$80

$30

Sub-Saharan Africa

$138

$26

All

$1.610$406

RegionSource: UN-Habitat, Global Municipal Database 2018.

In smaller cities, in Africa, low-income countries in Latin America, and South Asia, revenues are
extremely low, around USD 138 annual per capita in Sub Saharan Africa. More than 70% of cities
in the world just don’t have the capacity to finance capital expenditure. Most of the revenues areused to cover current expenditures, salaries and maintenance.
These figures clearly underline that despite the recent recognition of their crucial role indevelopment, cities often lack financial resources and human skills to be able to carry out the
public policies for which they are responsible for.
In order to address this issue, DFIs and UN Agencies can provide training and capacity building
workshops for the staff of these cities, and technical assistance programs for example throughcity to city technical cooperation, focusing especially on financial management and means toincrease revenues:
Training on accounting and budgeting procedures, debt management and financial
information systems
Basic financial management is the starting point. In many cities, accounting and budgeting
procedures are weak. Many small municipalities across the world just don’t apply double entry
accounting systems, with revenues and expenditures in two columns. It is thus impossible forthem to have a basic record. Training in this area is inexpensive but extremely useful. Even incities in middle-income countries sometimes basic accounting method is not in place. As forbudgeting, few cities have real multi-year budgeting procedures, which are essential forinvestment planning. It is also crucial for cities to modernize their financial management tools
and use proper information systems, with staff properly trained. Basic capacities in terms ofdebt management of municipal financial staff also have to be strengthened.
Expanding endogenous sources of revenues
The main source of revenues for cities is local assets, which comprise land, properties, local
firms forest, etc., that can be used to generate income. But one major issue in many cities is the

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lack of records, especially land registers or cadasters, that indicate land or properties
ownership. These instruments are necessary and have to be created or made more reliable, inorder to raise taxes like property taxes and implement land value capture policies, which canincrease significantly cities revenues. Cities also have to explore potential areas of revenue
generation related to local wealth like betterment levies or local fees.
The modalities of tax and revenue collection can also be improved, for example throughone-stop shops or online payment.

Promoting accountability at the municipal level
Accurate fiscal data is also critical in order to strengthen transparency and accountability ofmayors and their teams and develop participatory budgeting techniques.

Inter-American
Developmentbank:experience on Subnational governments’revenue-generating capacity
IADB experience reflects the need to continue working to increase subnational
revenue generation to cover growing expenditure obligations. Economic policy andcountry context are important variables that can explain the low mobilization of
own-source funds by subnational governments, which often lack the necessary
incentives to increase revenues and thus depend to a greater extent onintergovernmental transfers from the central government. There are also
weaknesses in local tax administrations’ abilities in the areas of tax profiling,assessment, collections, and debt recovery. Actions taken in IADB´s operations
that may be considered in other interventions to support the strengthening of
subnational revenues include the modernization of registries; the creation of
inventories of property tax arrears, as well as improvements in tax systems;
integrated financial management, procurement, and human resources systems at
the subnational level; and the development of methodologies to measure the fiscal
cost of tax benefits granted for municipal taxes accounting for the largest share ofsubnational governments’ ownsource revenues, with a view to building theiradministration capacities.

II. Bridging the financial gap implies broadening the rangeof financial instruments
1. Financing facilities for project preparation
In the project financing cycle, the main barrier is between the prioritization of investments andthe investments themselves: for many developing cities, the project preparation phase is a
blocking factor. Indeed, they lack the technical and financial expertise that is necessary to carryout preliminary studies (vulnerability studies, feasibility studies…). Completing this phase isessential to attract investors with bankable urban infrastructure projects, especially when it
comes to projects with climate co-benefits.
DFIs can bridge this gap and fund project preparation through dedicated facilities for cities,

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generally segmented by geographical region, which will include technical assistance, capacity
building, pre-feasibility and feasibility studies. These facilities will target first and foremost
low-carbon and resilient urban infrastructure projects.

2. Diversification of funding sources is crucial to increase cities’ access tofinancing for their infrastructure needs

i. The role of DFIs to foster diversification of funding sources
Cities may have access to different debt financing types depending on the nature of theirfunding needs to be determined by the profile of their capital investments and debt
management strategies. It can take the form of on-balance corporate financing raised on the
Cities’ balance sheet to cover funding gaps on operating balances to finance capital
expenditures from multiple investment projects with various sizes including smaller projects that
their annual operating revenues are not sufficient to cover. Corporate finance differs fromproject finance mainly on the entity raising the debt financing and the extent of recourse to the
Cities’ balance sheet for debt repayment. Under corporate finance, the Cities operating balanceis the source of debt repayment, whereas under project finance, which is raised as off-balance
sheet by special purpose vehicles established for the development of specific projects, debt
repayment relies on the specific project’s cash flows which are pledged to the lenders withlimited or non-recourse to the Cities’ balance sheet.

“Cities can tap corporate financing from different
sources with various maturities, ranging from medium
to long-term loans, raised from commercial and DFIs
and bonds issued in the capital markets, toshort-term credit lines raised from local banks tofinance funding gaps arising from capital
expenditures and/or refinance existing debt toextend tenors and/or obtain better conditions”.

DFIs can support Cities and municipally-owned entities in addressing their funding gaps:
Directly, granting loans, with or without a sovereign guarantee, or mobilizing multiple
sources of lenders through syndication and/or parallel loans. Direct lending without a sovereignguarantee from a DFI sends a positive signal of credibility towards the banking sector andfinancial markets and generates an incentive effect for risk-taking by private actors.
Indirectly through credit lines or Partial Credit Guarantees (PCGs) as credit enhancements
whether to Local financial institutions and Municipal development funds - generally public owned- that constitute in many countries essential intermediaries and relays between governments andlocal authorities and are useful to reach smaller cities on long maturities, or to commercial banks.
These latter generally view cities and local governments with reluctance, because of their needs
in terms of financing, especially the maturity of the loans, which are different from their usual
clients, and of the political dimension of that can also often be a source of mistrust or excessive
caution. PCGs and TA are therefore very useful in order to encourage the structuring of a local
borrowing market, with higher loan amounts, longer maturities and reduced borrowing rates, andthus broaden and diversify the financing sources for cities. PCGs can also be used for theissuance of bonds by cities in the capital markets, targeting green bonds in priority, to reduce therisk for investors and encourage them to take an interest in cities.

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ii. The requirements that cities need to comply with to have access to financing“Cities need to demonstrate a commitment totransparency, prudent financial policies, and financial
management capacity to meet operating and capital
expenditures required for the adequate provision ofmunicipal public services, while maintaining
sustainable debt service profiles. This includes
adequate financial management policies andpractices, financial performance, timely execution ofbudgets and planned investments, ability to increase
revenues with timely collection of receivables, andinvestments to expand operating balance to support
capital expenditures and debt service”.

Cities also need to prioritize investments through an efficient investment decision-making
process by using a strategic long-term vision and the definition of medium-term goals to
optimize available resources and identify funding gaps to be filled by private service providers.
Global Rating Agencies (i.e. Standard and Poor’s, Moody’s and Fitch Ratings) have rating
methodologies used for local and regional governments which define key rating drivers thatstart with assessing the Cities’ institutional framework followed by the analysis of key rating
factors that determine the Cities’ credit profile. They take into consideration legal and statutory
regulations, control and oversight by upper tiers of government, operational and financial
autonomy, rigidity of expenditures, demand for capital investment, and access to third-party
funding in addition to central government transfers. They also consider the adherence to soundinstitutional processes and policies, transparency and prudential regulations in data adequacyand disclosure.

Source: Zaid Ali Taher Assaf pour l’Agence Française de Développement

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For example, S&P starts assessing the Cities’ institutional framework and regulatory environment
where Cities operate, focusing on the predictability, revenue and expenditure balance, andtransparency and accountability. It then assesses seven key rating factors: (i) economy,
measuring factors that affect revenue generation capacity, spending needs, and debt service
ability; (ii) financial management, measuring aspects that affect the willingness and ability toservice debt (political and managerial strength, long-term capital and financial planning,
revenue and expenditure management, debt and liquidity management, and impact of related
entities); (iii) budgetary flexibility, measuring the willingness and ability to raise revenues, politicalaspects and economic limits that could curb the use of the flexibility and revenues from asset
sales, and to cut expenditures (expenditure flexibility) as needed to maintain debt service ability;(iv) budgetary performance, measuring the level and volatility of cash flows from operations andinvestment activities available to service debt and the efficiency of financial policy (operatingbalance and balance after capital accounts ratios); (v) liquidity, measuring how internal sourcesof liquidity, (cash reserves and cash flow generation), and external sources (bank lines andmarket access) may affect debt service capacity; (vi) debt burden, measuring how the level,
structure, and size of debt may affect debt service capacity, including access to liquidity,
revenue and expenditure predictability, and budgetary flexibility; and (vii) contingent liabilities,
measuring the extent the risk of occurrence and relative size may impair debt service capacity
net of contingency reserves.

iii. The means to improve cities’ creditworthiness“Cities have various options to enhance their
creditworthiness and become bankable that range
from technical advisory support through Municipal
Financial Management Assessment (FMA) andcreditworthiness evaluation, issuance of independent
credit rating, institutional capacity, PEFA subnational
evaluations, and action plans to improve debt
profiles to reduce the risk of default”.

Cities have various options to enhance their creditworthiness and become bankable that range
from technical advisory support through Municipal Financial Management Assessment (FMA) andcreditworthiness evaluation, issuance of independent credit rating, institutional capacity, PEFA
subnational evaluations, and action plans to improve debt profiles to reduce the risk of default.

FMA and creditworthiness assessment (diagnostic stage): Advisory support can start with an FMA
to analyze a City’s financial management practices, its strengths and weaknesses in relation topeers and international good practices and include obtaining an international credit rating to havean independent view on its creditworthiness, how it stands relative to the central government
rating and what constrains it. An FMA includes reviewing financial projections to assess the City’s
financial capacity to meet its obligations from on-going investments and debt service payments
though (i) an evaluation of existing financial statements and other relevant information to enable
prospective sources of financing to evaluate the City’s financial standing; (ii) a financial model thatallows for the modeling of new commercial and development financing required by existing andforeseen capital expenditures; (iii) evaluation of the City’s financial condition to determine its
capacity to finance foreseen investments given its current and projected financial condition andfiscal implications; and (iv) recommendations of actions to strengthen the City’s financial conditionand debt capacity. It may also include a funding sources assessment to explore areas to generatehigher revenues from current and foreseen provision of public services and new taxes.

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Based on the initial FMA and credit rating assessment, a financial sustainability road-map canbe designed with actions to address identified weaknesses and strengthen a City’s financial
management practices, financial performance, revenue generation and debt management,
including areas for revenue generation from current and foreseen provision of public services,sustainable management of its operating expenditures, and debt reduction scenarios toimprove the City’s capacity to meet its infrastructure investments requirements and maintain
prudent financial policies and sustainable debt profiles. Actions may also include theprioritization of high-impact infrastructure initiatives to optimize the use of available resources
and identifying funding gaps that can be met by private service providers by supporting
investment decision-making by using a strategic long-term vision and the definition of
medium-term goals. The credit rating can be helpful for potential bond issuance, to diversify theCity’s funding sources.
Public Expenditure and Financial Accountability (PEFA) assessment methodology of the Public
Finance Management (PFM) systems can be used for Cities. Supplementary guidance forsubnational governments was released in December 2016.
Since the update of the methodology in 2016, PEFA identifies seven pillars of performance for
PFM systems that are essential to achieving these objectives. The pillars are as follows:

Figure 2. The Seven Pillars of PFM Performance

Source: https://pefa.org/content/pefa-framework

Within these pillars, PEFA defines 31 specific indicators disaggregated into 94 dimensions that
focus on key measurable aspects of the PFM system.
Since 2006, some 240 PEFA assessments reports have been prepared at the subnational level,
which has assessed 203 different local governments in 41 different countries.
This instrument is both essential in the analysis and assessment of fiduciary risk, and very useful
to foster the dialogue with national and / or local authorities in the articulation of decentralization
support programs. Its framework of analysis is complementary to that of the rating agencies
and the own financial analysis of the DFIs Ensures on the robustness or fragility of budget andfinancial processes.
The strengths and weaknesses highlighted in the PEFA studies help identify the in-depth workneeded to improve the situation and develop a reform action plan with the provision oftechnical assistance.

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RECOMMENDATIONSThe Way Ahead: Strengthening Subnational Finance

Responding effectively to the challenge of improving subnational funding requires
both a proactive and a pragmatic approach.

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The need for financing urban infrastructure requires strong action to quickly release large
amounts of financing. It is therefore imperative to strengthen and diversify funding channels :increase and improve the predictability of fiscal transfers from central governments ; strengthen
the autonomy of creation, modulation and recovery of own-source revenues, especially local
taxes; facilitate direct financing by DFIs and intermediated financing via public or commercial
banks; give access to disintermediated financing through the issuance of bonds. In thisperspective, DFIs must innovate and widen the range of tools that they can propose, making
sure to adapt to the legal and institutional realities of each country.
But the success of this strengthening of subnational finance in the long term implies a morein-depth dialogue and increased mutual trust between national and local governments. This isindeed fundamental to enable LGs to benefit from an institutional and financial framework thatfully empowers them on clear competences, and allows them to take effective action with
sufficient resources, and give them access to the possibility of borrowing, so as not to put theburden of investments only on current users and taxpayers. This dialogue and mutual trust will
also enable national governments to rely on LGs with strong management capacities, that areable to finance, build and operate public infrastructure expected by the populations, and which
can play a role of growth drivers and catalysts of local economic and social development. A
good illustration of this crucial need for increased cooperation between national and local
governments is the capacity to hold the Nationally Determined Contributions (NDC)
commitments taken under the Paris agreements. Only joint action of national and local
governments will make these commitments reachable. DFIs and UN Agencies must become
more effective actors in the support they can bring to this decentralization dialogue in many
countries, increasing their mutual cooperation with more co-financed programs or technicalassistance combination that will impact the leverage effect and the coherence of their joint
actions in favor of the strengthening of local governments’ role and capacities.

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Bibliography
Fretes Cibils, Vicente, et al. Decentralizing Revenue in Latin America: Why and How.
Inter-American Development Bank, 2015.
Muñoz Miranda, Andrés, Emilio Pineda, and Axel Radics. "Descentralización fiscal ydisparidades regionales en América Latina: El potencial de las transferencias de igualación."
Monografía del BID (Sector de Instituciones para el Desarrollo. División de Gestión Fiscal);
IDB-MG-568 (2017).
Pineda, Emilio, et al. "Estrategia integral para una descentralización efectiva y fiscalmente
responsable: evidencia de Chile." (2018).
“Finance for City Leaders”, UN-Habitat 2017: http://financeforcityleaders.unhabitat.org/
UN-Habitat Global Municipal Database http://globalmunicipaldatabase.unhabitat.org/“PEFA and Subnational Governments: Lessons Learned by AFD” PEFA Working Paper No. 124
https://pefa.org/content/pefa-methodology-and-subnational-governments-lessons-learnedafd“El financiamiento de las ciudades latinoamericanas, herramientas para el desarrollo urbano
sostenible”. Savoirs communs n°16 Agence Française de Développement, IPEA & Fundación,
Ciudad Humana.

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Conctacts for this report
Emilio Pineda (IADB)
emiliopi@iadb.org

Kristtian Radda (IFC)
krada@ifc.org

Marco Kamiya(UN Habitat)
marco.kamiya@un.org

Louis-Antoine Souchet(AFD)
souchetla@afd.fr

The views, opinions, positions and recommendations expressedin this White Paper are solely those of the individuals and theirorganisations. They do not necessarily reflect those of Urban 20
or any of its chairs, conveners, partners and participating cities.

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www.urban20.org