Last Updated: February 26, 2008

Local Government Bonds
1.

The basics behind rating local government bonds
JCR evaluates local government bonds in Japan by assessing local governments in conjunction withcredit enhancement provided by the central government, not just by evaluating each local government asa single entity. The country provides solid credit enhancement to local government bonds, and thus, we
assume that these bonds carry a “tacit guarantee” from the government.

2.

Credit enhancement by the national government(1) Act on Assurance of Sound Financial Status of Local Governments
The series of reforms and events related to local finance has had a powerful impact on the market
since Heizo Takenaka took office as the Minister of Internal Affairs and Communications at the end of
October 2005. While Takenaka was in office, he had been in a series of privately held meetings (entitledthe 21st Century Vision for Decentralization or “Vision Meetings”) with related parties on developing alegal system for bankruptcy rehabilitation. At the same time, the city of Yubari was designated to beunder financial reconstruction. This caused concerns among market players, including financial
institutions, about the effectiveness of the “tacit government guarantee” given to local government
bonds.
A proposal to set up a legal system for bankruptcy rehabilitation within three years had been
proposed during the Vision Meetings. As such a study group was formed to examine a specificframework for new legislation on local government financial rehabilitation. A bill on Act on Assuranceof Sound Financial Status of Local Governments was drafted based on a report (dated December 8,2006) issued by this study group and passed in June 2007 and became effective in April 2009 with some
excluded provisions (hereinafter referred to as the “Financial Soundness Act”).
The previous system for local government financial reconstruction (hereinafter “reconstruction
system”) had a number of problems, some of which were addressed by the Financial Soundness Act.
The problems with the previous system were broadly divided into four areas: 1. inadequate financial
information disclosure; 2. incomplete standards for the application of the reconstruction system; 3.
Application of the reconstruction system was not compulsory; and 4. unclear responsibility of therelevant parties involved in the local government under financial reconstruction (see Table 1). As
measures against these problems, the following initiatives were introduced: 1. reinforced auditing
mechanism and thorough information disclosure; 2. new financial indicators; and 3. introduction of anearly correction scheme.
However, adoption of debt adjustment, which was the most watched aspect of this new system, wasstill up for discussion in the context of a drastic reform of the local administrative system. In order to1/13
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adopt debt adjustment, it became necessary to deny the validity of the government’s “tacit guarantee.”
And in order to deny this tacit guarantee, which was based on the current local administrative andfinancial systems, it was necessary to implement a drastic reform of the local systems.
(2) Key points in rating in relation to the Financial Soundness Act
Below are the three key points in rating local government bonds in relation to the Financial
Soundness Act.
(a) Improved transparency of financial conditions
Improved transparency of financial conditions of local governments helps attain detailed
financial data for analysis and standardize measures.
The Financial Soundness Act defines the consolidated real deficit ratio and the future burden
ratio in addition to the criteria included in the previous reconstruction system, namely, the real deficit
ratio, and real debt service ratio, which was already used under the consultation system for theissuance of local government’s bonds/loans (see Table 2). These four indicators (ratios) are regarded
as the “soundness” ratios, and a local government that shows any of these ratios above a certain levelis subject to financial rehabilitation. What is noteworthy is that areas outside of a local government’s
ordinary accounts in its financial statements are to be taken into consideration and that the futureburden ratio (considered a “stock” indicator) was added to the group.
We note that the range of areas in the financial statements that the four “soundness” ratios relate
to is slightly different from one another. That said, it is certain that adopting these financial indicators
and a thorough disclosure of financial information have facilitated the understanding of the overall
condition of local governments. Also, the document that describes the basis of the calculations ofthese indicators is referred to in the examination by the Audit and Inspection Commissioners. This
reasonably ensures the reliability of the indicators. The document is also placed at the office of every
local government, which makes it possible to utilize the financial indicators in different ways as
necessary.
(b) Ensuring financial discipline in advance
The Financial Soundness Act introduced a scheme of early achievement of financial soundness.
It also made it mandatory for a local government to conceive a fiscal rehabilitation plan if any one of
the indicators (“judgment ratios”) exceeds a certain level.
The previous financial reconstruction system did not include a scheme that enabled an early
achievement of financial soundness among local governments, and applying for national
government-led reconstruction was voluntary. As exemplified by Yubari City, therefore, there was arisk that bankruptcy would suddenly surface. There was often a delay in local governments shifting
to a financial reconstruction status, resulting in a protracted period of rehabilitation.
The Financial Soundness Act requires that a financial recovery plan be established when any of
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the soundness ratios is above the “early financial soundness standards”. And using three indicators
among the soundness ratios, excluding the future burden ratio, as the reconstruction judgment ratios,
if any of the three indicators exceeds the financial reconstruction standards, a financial
reconstruction plan must be established. The early financial soundness standards and financial
reconstruction standards were established by a Cabinet ordinance issued on December 28, 2007, aspresented in Table 3.
We can expect these systematic indicators to ensure fiscal discipline among local governments
and prevent a sudden emergence of fiscal breakdown as in the case of Yubari City. Even if a local
government were to be designated as being under financial reconstruction, the new system would be
able to curb a further worsening of the financial condition compared with the previous system.
(c) Strengthening the central government’s credit enhancement
The reconstruction scheme in the Financial Soundness Act enables strong involvement by thecentral government and incorporates a systematic financial support of the central government.
The central government’s involvement in the reconstruction scheme is clear when comparing
the early financial soundness scheme and reconstruction scheme in the Financial Soundness Act (seeTable 4): More specifically, the Minister of Internal Affairs and Communications, not the local
governors, is the one that receives reports on plans and its progress and is responsible for providing
advice to the heads of local governments facing difficulties in achieving their plans. Local
governments may consult their reconstruction plans with the Minister of Internal Affairs andCommunications to seek his/her consent, but without consent, the issuance of local government
bonds will be limited, except in the event of disaster recovery or other emergencies. In addition, thereconstruction scheme specifies the relationship between a local government’s budget and its
reconstruction plan, suggesting the influence of the central government’s strong involvement on
budgeting during financial reconstruction.
Further, if a local government has obtained the consent of the Minister of Internal Affairs andCommunications, it can issue “rebuilding transfer special bonds” within the range of its balance
shortfall. In principle, the central government is to provide appropriate funds for the special bonds as
far as the central government’s fiscal situation permit it to do so. As such, this type of funding
support from the central government is also a major positive factor for rating assessment. Caution
must be used, however, that when private sector funds are involved when these special bonds arerefinanced, there is a possibility of issues including an interest rate reduction or exemption and adeferred redemption.
(3) Key points going forward
Some of the national credit enhancement programs -- such as the approval system of local
government’s bonds/loans, local government’s finance program, local allocation tax system, and3/13
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financial reconstruction system -- that have conventionally supported the credit capacity of local
government bonds have been successively revised since 2006. These include the repeal of the approvalsystem of local government’s bonds/loans and shift to a consultation system; the introduction of a new
local grant tax; the adoption of a new financial reconstruction system; and the repeal of the system ofnegotiations under uniform conditions for public offering local government bonds. These, however, arehardly considered drastic institutional reforms, and the framework of credit enhancement provided by
the central government basically remains unchanged.
Rating local government bonds requires attention to reform-related trends not only of the local
government bond system and local financial system, but also of the local administrative system. The
rating assessment is affected by the state of the administrative system due to the close and inseparable
relationship between the local financial and administrative systems. In other words, administrative
system reforms changes the local financial system and in turn changes the concept behind rating local
government bonds.
Table 5 summarizes the actual and projected institutional changes as a result of the shift from theconventional centralized administrative and financial systems to decentralized systems, which areclosely related to rating local government bonds. The systems that already been changed are limited,suggesting that drastic institutional reforms have yet to take place.
We are interested in the direction of future discussions regarding this topic because ratingassessments will inevitably focus on the fiscal condition and management of individual local
governments once the institutional changes are complete.
(4) Direction of ratings in relation to national credit enhancement
The series of institutional reforms based on the Financial Soundness Act and other regulations have
solved the problems surrounding the local financial reconstruction system. Though temporary, this has
increased the involvement of the central government in local public finance. The institutional reforms of
local government bonds since 2006 are likely aimed at a conversion into a local government bondsystem that is based on market mechanics, and we can see the present as a transitional phase. These
institutional reforms are not considered drastic as they have been made on the assumption of a tacit
guarantee from the government, delaying the adoption of debt adjustment, which became the issue to beaddressed in the future, with the function of the local grant tax remaining unchanged.
In light of the central government’s credit enhancement, local government bond ratings willconceivably be at an extremely high level and their direction should generally be upward. The ratings of
all local governments are expected to range, in most cases, for AA and above except for certain
organizations like those undergoing financial reconstruction as per the Financial Soundness Act. JCR
revised its outlook for Japan from negative to stable in August 2006, which made the upper limit oflocal government bond ratings at the same level as that of Japan (AAA/outlook: stable for both the yen
and foreign-currency based assessments).
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The idea of credit enhancement provided to local government bonds by the central government will
be reviewed as appropriate after identifying the specifics of future decentralization reforms.
3.

Views regarding financial conditions of individual local governments
Assessing the financial position of individual local governments is both quantitative and qualitative.

(1) Quantitative assessment(a) Basic concept
A quantitative assessment is based primarily on finalized up-to-date financial results using threecriteria: 1. tax-bearing capacity of each local government; 2, the fiscal condition of ordinary account;and 3. the state of local public corporations, third-sector enterprises, etc. (see Table 6).
JCR’s basic policy in selecting fiscal and economic indicators regarded as important in theassessment is to keep it “simple and clear.” We employ basic indicators that are used by the generalpublic as much as possible. JCR does not create or modify indicators on its own except for the “stock”
indicators that had not been used by the general public in the past.
We will apply to our ratings assessment the soundness ratios that have been introduced by the
Financial Soundness Act after verifying the validity of their calculation methods as described later. In
particular, the disclosure of the future burden ratio is thought to contribute substantially to our ratings
assessment. The ratings, however, are our comprehensive evaluation that includes the central
government’s credit enhancement, and the ratings are not directly affected by any change in thestatus of a local government to one designated for early fiscal recovery or financial reconstruction.
(b) Understanding the tax-bearing capacity, and ordinary accounts
The indicators that we focus on for assessing the tax-bearing capacity of a local government
include the fiscal power index and gross prefectural (municipal) domestic product. We also focus onproperty tax valuation by carefully examining local governments that are structured to receive a largepart of its tax revenue in the form of property tax revenue.
In terms of ordinary accounts, our assessment is based on dividing them between income andexpenditures and debt.
When assessing income and expenditures, we look at factors including the ordinary balance
ratio, status of revenue shortfalls and funding initiatives, and the balance of available reserves forfinancial activities. As for the ordinary balance ratio, when the sinking fund reserves to pay off bullet
bonds are insufficient, the reserve method is modified if it is significantly different from that of otherorganizations. At the prefectural level, the ordinary balance ratio tends to fluctuate markedly every
fiscal year due to trends in corporate and related taxes. Therefore, we think it is appropriate to use
methods like moving averages to eliminate such fluctuations. We would deem a local government’s
income and expenditures being in a relatively difficult state if revenue shortfalls and funding
initiatives need to be covered by various borrowings, such as from funds and other accounts, or
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through the issuance of administrative reform promotion bonds or other special bonds.
As for debt conditions, we look at the future burden ratio and the basis of the calculation of thisratio as much as possible.
(c) Understanding local public corporations, the third-sector enterprises, etc.
For extra-departmental organizations such as local public corporations and the third-sector
enterprises, we must consider the level of burden on ordinary accounts caused by transferred funds
and additional investments and loans. The disclosure of the future burden ratio by local governments
contributes substantially to ratings. In this context, the method used to calculate the amount ofburden on the ordinary accounts is the most contentious.
Based on our policy of using as often as possible the indicators that are generally used by the
public, we plan to apply the method of calculating the future burden ratio to our assessment as longas the method can be verified to be appropriate. We individually analyze the management andfinancial conditions of local public corporations and major third-sector enterprises, and we will
individually verify the validity of the calculation of the amount of burden on ordinary accounts ofsuch organizations.
(2) Qualitative assessment
The important points in qualitative assessment are future financial prospects and the stance of thelocal governments regarding fiscal management that forms the basis of the prospects. Even inqualitative assessment, JCR strives to obtain as much quantitative information as possible that could
help estimate the extent of an improvement or a decline in the fiscal indicators, rather than simply try to
determine the direction alone.
Our key points for assessment include: 1. review of annual expenditures and debt management andother efforts aimed at financial soundness; 2. prospects of initiatives aimed at fiscal balance and funding
for the local government’s ordinary accounts; and 3. fiscal outlook and efforts to strengthen the
management base of local public corporations and third-sector enterprises.
We also take into account efforts and the strength of the will of the local governments in achieving
fiscal health, in addition to details of administrative and financial reform plans as well as their financial
recovery plan. This is because reforms could fail even with an outstanding plan depending on views of
the local assembly or local residents. If we can confirm the strength of the will of the entire local
government while taking into account the trends in the local assembly, we would be able to incorporate
into our ratings the effort made toward fiscal health at least during the existing administration. In such acase, we acquire as much quantitative information as possible on the prospects of improvement inindicators such as the ordinary balance ratio and outstanding loans and incorporate our findings in theratings.
As for debt management, numerical targets for the balance and amount issued should be set as
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clearly as possible based on the future prospects of local government bond balance.
For the prospects of financial balance and revenue shortfalls in ordinary accounts, we examine thedetails of the local government’s initiatives to find revenue sources for expected revenue shortfalls. Any
reliance on borrowings from funds or issuance of special bonds due to failure in reducing annual
expenditures will leave the burden for the future. Thus, this is not desirable. Because the prospects varysignificantly depending on the assumption of annual revenues and expenditures, we must verify whether
the assumptions are appropriate. A local government might have been slightly increasing its annual
expenditures in reports to the local assembly, for example, but in many cases the increase might havebeen intentional so that the local government could stress its “financial tightness” to the assembly. Suchprospects, however, are not useful for market players. These local governments must present morefeasible prospects to market players by, for instance, presenting different scenarios.
We are particularly interested in future cash flows and the outlook for debt repayment funds inassessing efforts to strengthen the management base and financial prospects of local public corporationsor third-sector enterprises. Because the amount of burden on ordinary accounts from outstanding loansof these organizations is basically derived from the latest financial results, our quantitative assessment
does not include the effect of improvement in future management. An increase in cash flow fromoperating activities associated with improved management of these local public corporations andthird-sector enterprises is expected to reduce the amount of burden related to their debt redemption on
ordinary accounts.

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Table 1: The local financial reconstruction system: Issues, problems and initiatives

1

2

3

Issues in the local financial
reconstruction system (national
government-led reconstruction)
Financial information disclosed is notcomprehensive. Cannot fully
guarantee the objectivity and accuracyof the financial indicators and themethods used for calculation.

Problems caused by issues
stated on the left

Description of proposals in “reports”

Understanding the overall
financial condition of local
governments is extremely
difficult for residents,
financial institutions,market players, etc.

The deficit ratio based on real income
and expenditures in ordinary accounts
is the only indicator used to determine
whether a financial reconstruction
system is needed.

The real income andexpenditures balance does
not necessarily indicate theexact fiscal condition of a
local government. This ispartly because local
governments are
institutionally allowed tocover their deficit in cash
flows through measures
such as issuing local
government bonds andborrowings from otheraccounts.

Consider strengthening the audit mechanismof local governments such as by including the
calculation of financial indicators in auditing.
Ensure complete information disclosure suchas by placing documents that explain thecalculation method for financial indicators at
offices. Consider necessary measures such as
using a third-party institution to ensure theobjectivity and accuracy of the indicators.
Create new “flow” indicators in addition toreal deficit ratio and consolidated real debt
service ratios. Create a new “stock” indicator
to compare real debt and redemption capacity,
including the scale of public finance. Consider
local public corporations and third-sector
enterprises that are likely to experience aburden on ordinary accounts as de facto
liabilities.

Applying for national government-led
reconstruction is completely
voluntary.

In terms of a method that sets levels offinancial indicators for early correction andreconstruction, consider one that takes into
account the authority, scale of finance, etc. ofeach local government. Values that span overmultiple years may be used as criteria.
Introduce an early correction scheme. Make ita requirement to include a financial recovery
and reconstruction plan in both the earlycorrection and reconstruction schemes.

As exemplified clearly by
Yubari City, the application
to become designated as anentity subject toreconstruction is often
delayed. This may cause a
protracted reconstruction
period.
4
Once designated to undergo a
Financial discipline may not Organize the reconstruction scheme into two
government-led reconstruction plan,
be exercised in providing
categories: 1. reconstruction is carried out
not clear who the responsible party iscredit to local governments
within the basic framework of the current(governor / mayor, local assembly,
because the lender is not
local administrative and financial systems;
residents, central government, or theheld liable. In combinationand 2. reconstruction is carried out throughlending financial institution for thewith issue 2, a local
drastic reform of the local administrative andreconstruction plan) during the life of
government may not
financial systems. Debt adjustment is
the plan.
declare bankruptcy until its
assessed as an option for Case 2.
debt has grown very large.
Source: Prepared by JCR based on a report of a study group for a new system of local government financial reconstruction(Dec. 28, 2006), etc.

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Table 2: Targets of the Ratio for Determining Soundness
Previous
Reconstruction
Law

Act on Assurance ofSound Financial Status of
Local Governments

Generalaccount

Real
deficit
ratio

Local
government

Bad debt*Calculated
for eachpublicenterpriseaccount

Generalaccount,
etc.

Real
deficitratio

Consolidated
real deficit
ratio

Specialaccounts

Publicenterpriseaccounts

Real
debt
serviceratio

Publicenterpriseaccounts

Futureburdenratio
Financial
shortfallratio*Calculated
for eachpublicenterpriseaccount

Partial administrative associations,wide-area local public bodies

Local public corporations,third-sector enterprises, etc.

Source: Ministry of Internal Affairs and Communications “White Paper on Local Public Finance, 2011”9/13
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Table 3: Early financial soundness standards and financial reconstruction standards
Real deficit ratio
Early financial soundness standards
Financial reconstruction standards
Consolidated real deficit ratio
Early financial soundness standards
Financial reconstruction standards
Real debt service ratio
Early financial soundness standards
Financial reconstruction standards
Future burden ratio
Early financial soundness standards

Prefecture

Municipality

3.75%
5%

11.25—15%
20%

8.75%
15%

16.25—20%
30%

25%
35%

25%
35%

400%
350%
(Ordinance-designated cities = 400% of prefectures )Source: Financial Management Division, Local Public Finance Bureau, Ministry of Internal Affairs andCommunications “Early financial soundness standards, etc. under the Act on the Assurance ofSound Financial Status of Local Governments” (Dec. 7, 2007)10/13
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Table 4: Early financial soundness scheme and reconstruction scheme
PointsPlan
FormulationPlanannouncement

Central andprefectural
government
involvement

Early financial soundness scheme
Financial recovery through independent
improvement efforts
Require formulation of a financial
soundness plan. Formulation is subject
to an assembly approval.
Announce the plan and report to the
Minister of Internal Affairs andCommunications / the prefectural
governor.
Announce the progress of the plan
every year and report to the Minister ofInternal Affairs and Communications /the prefectural governor.
The Minister of Internal Affairs andCommunications / the prefectural
governor will make necessary
recommendations to the head of local
government if early financial recovery
is extremely difficult in cases such as
when the progress of the plan issubstantially behind target.

Reconstruction scheme
Solid reconstruction measures with government involvement
Require formulation of a financial reconstruction plan. The planis subject to an assembly approval. Include plans for tax hikes
and expenditure reduction that are more specific than thefinancial soundness plan.
Announce the plan and report to the Minister of Internal Affairs
and Communications.
The head of the local government adjusts the budget based on thereconstruction plan.
Announce the progress of the plan every year and report to the
Minister of Internal Affairs and Communications.

The Minister of Internal Affairs and Communications may
investigate the progress or seek reports on the reconstruction planas necessary.
The Minister of Internal Affairs and Communications may advise
the head to take necessary measures such as changing the budget
or the reconstruction plan if financial management of the local
government is deemed not to conform with the reconstruction
plan, etc.
The head must report to the Minister of Internal Affairs andCommunications the measures that were implemented based on
the advice received from the minister.

The head may consult with the Minister of Internal Affairs andCommunications about the reconstruction plan to seek his/her
consent.
FinancingIssuance of local government bonds is subject to the approval of
the Minister of Internal Affairs and Communications. Without the
Minister’s consent, the issuance of local government bonds will
be limited except in the event of disaster recovery or otheremergencies.
Only when the consent of the Minister has been obtained about
the reconstruction plan, rebuilding transfer special bonds may be
issued within the range of the balance shortfall. The rebuilding
transfer special bonds must be redeemed during the period of thereconstruction plan. The central government is to provide
appropriate funds for the rebuilding transfer special bonds within
the scope allowed by its own fiscal situation.
Source: Prepared by JCR based on the Act on Assurance of Sound Financial Status of Local Governments, etc.

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Table 5: Administrative and financial systems, and the national credit enhancement system for local
government bonds

Relationship between central
and local governments
Status of local jurisdiction
administrative work

Local tax
Function of local grant tax

Financial reconstruction system
Disclosure of financial
information
Local government bonds
Bond issuance regulation

Conditions for issuance
Underwriting funds
Local allocation tax grants
Rating assessment of local
government bonds

Centralized administrative and financial
systems
Master and servant relationship (vertical)

Decentralized administrative and financial
systems
Equal and cooperative relationship

Involvement and requirement of the central
government in local administration; relianceof local governments on the central
government; unclear relationship ofauthority and revenue sources
Impose statutory tariffs at the standard tax
rate
Revenue source guarantee and revenue
source adjustment

Clear range of authority and responsibilitiesof the central and local governments
Clear relationship between authority andrevenue sources

Tacit guarantee of the central government
Inadequate

The approval system of local government’s
bonds/loans, limited purpose for bondissuance (bond-issue standards), specified
bond issuance rate
System of negotiations under uniform
conditions
Government funds
Fixed rate inclusion
Assessment focuses on credit enhancement
provided by the central government

Source: JCR
Note: Shaded sections are areas that we think are already reformed.

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Exercise autonomy
Maintain functions of revenue source
adjustment
Function of revenue source guarantee may
be modified
Debt adjustment is also an option
Thorough

Liberalization and diversification of local
government bonds

Decisions based on individual conditions
Private-sector funds
Reduced rate of inclusion
Assessment focuses on fiscal condition,
financial management, etc. of individual
local government

Table 6: Assessment process of a local government’s own Credit Strength

Local economic fundamentals

Fiscal condition of ordinary account•Gross prefectural (municipal) domestic productper capita•Growth in gross prefectural (municipal) domestic
product•Fiscal power index•Property tax valuation per capita → municipality•Growth in property tax valuation → municipality•Status of income and expenditure•Status of debts

Local public corporations,Third-sector enterprises

Weighted
average
Estimated amount scale of burden
on ordinary accounts

Reflected in
Future Burden
Ratio

Deviation measurement→ quantitative assessment+

Qualitative assessment

Assessment of a local government’s
own Credit Strength

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