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## **Box 4: Risks of Land as Loan Collateral**

Baron Haussmann’s reconstruction of **_Paris,_** France in the 19<sup>th</sup> century was one of the largest urban redevelopment programs ever undertaken. Two-thirds of the costs were borne by the municipal government, via budgetary contributions, land sales, and borrowing. Haussmann acquired huge swathes of land through condemnation and expropriation at current-use value or less. After construction of grand boulevards and installation of infrastructure lines, excess abutting land was sold to private promoters at prices greatly enhanced by the public works. Land sales by the municipality were used to repay the borrowing used to finance construction.

For more than 15 years, this process worked successfully to finance massive urban investment. In the end, however, it revealed two types of risks that undermined the scheme. First, the courts eventually ruled that the municipality could not capture all of the land-price gain resulting from public improvements. Much of this gain had to be shared with the original landowners. This impaired the municipality’s ability to finance investment from public land profits. Second, most of the investment activity and borrowing was conducted off-budget, unknown to the municipal council and without public oversight. When the rules regarding landowner compensation were changed, the city had to default on many of its debt obligations, precipitating a crisis throughout the entire French financial sector.

In urban **_China_** during the 1990s and early 2000s, one of the most used forms of financing for major infrastructure projects was to borrow against the future anticipated value of land after infrastructure was installed. For example, the city of Changsha (Hunan Province) contributed undeveloped land on both sides of a proposed ring road to the municipal-owned Ring Road Corporation. In its existing condition, without infrastructure or road access, the market value of most of this land was very limited. However, the Corporation was able to borrow US$350 million from China Development Bank and commercial banks for highway construction, based on the projected value that the land would have after completion of the ring road. Borrowing that is based on the _future_ appreciation of land values is particularly risky, given the history of land market fluctuations in China and elsewhere, as well as the risk of project completion. One of the first steps that the government of China took in limiting the risk of subnational debt (in 2003) was to require that banks making loans to municipalities appraise land collateral at its current market value rather than at its projected value after the completion of infrastructure investment. Sources: Peterson (2009); Peterson (2006) Land and infrastructure often are the ultimate collateral supporting debt to finance publicly sponsored development projects. Experience has demonstrated that the risks in this arrangement require special regulations. When the State of California (United States) adopted Proposition 13, it essentially froze local property tax assessments and property tax rates, limiting local governments’ borrowing power. Other laws directly restricted local debt issuance. As a result, public authorities looked for ways to shift to private developers (and ultimately homebuyers) the costs of infrastructure investment for new residential subdivisions. One instrument was MelloRoos bonds, which allowed private developers to borrow against land values and the anticipated revenue stream that would materialize when the subdivision was sold out. Private developers were allowed to add the amounts necessary for debt repayment as a separate item in the public property tax bill. In recognition of the potential fiscal risk, from both declining land values and the failure to complete or sell out development projects, special regulations were put in place limiting the amount of infrastructure debt developers could issue to one-third the appraised value of land. Even so, Mello-Roos bonds have had much higher default rates than local government bonds issued to finance the same types of infrastructure, and have been flagged as risky instruments by the credit rating agencies.

# **_Diversion of Land-Sale Proceeds to the Operating Budget_**

One of the greatest potential risks to subnational finances is that the proceeds from the sale of land or other assets owned by subnational governments will be used to finance recurring operating expenditures. This practice can build an unsustainable level of current spending, and place the subnational government unit at risk when it has to cope with a budget shortfall once asset sales are exhausted. It also depletes wealth that should benefit more than the current generation.