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OUR DES

OMPTES

Management of local

public debt

July 2011

Disclaimer

Summary

of the

public thematic report

his summary

is designed to help the understanding and

use of the Cour des Comptes report.

Only the report is legally binding on the Cour des Comptes.

The responses of government departments, councils and

other organisations concerned are appended to the report.

Introduction

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

Particular characteristics of local debt

. . . . . . . . . .

More sophisticated, less controlled, debt manage-

ment

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The need for better risk management

. . . . . . . . .

Conclusion

. . . . . . . . . . . . . . . . . . . . . . . . . . . .

Recommendations

. . . . . . . . . . . . . . . . . . . . . .

Summary

of the Public Thematic Report by the

Cour des Comptes

Contents

he Cour des Comptes dedicated one chapter of its February 2009 annual

report to “risks taken by local governments and local public establishments in

borrowing”. On this occasion, it made a number of suggestions, based on which it

established an application report the following year indicating the number of its recom-

mendations that had not resulted in concrete action.

After this work, very focused on the risk involved in the development of so-called

structured products, and, in a context of growing public debt, reaching limits that are

difficult to go beyond, this report has established an overall assessment of the situation

of the local administrations and their public establishments in debt matters, their prac-

tices and the changes that seem necessary in this area.

This report is based on, in particular, the observations made during the examina-

tion of this subject launched in 2009 by the Court and the regional chambers of

accounts. It covered more than 150 local administrations and local public establish-

ments.

Summary

of the Public Thematic Report by the

Cour des Comptes

Introduction

Specific characteristics

of local debt

Increasing

debt

For several years, local debt has

once again been increasing sharply.

According to data published by the

French National Institute of Statistics

and Economic Studies (INSEE), the

gross debt of local public administra-

tions reached €160.6 B at the end of

2010. Taking as reference the out-

standing debt on the balance sheet of

local governments, since 2004 this

amount has increased by 41% with an

increase in 80% in regions, 63% in

departments, 18% in municipalities

and 69% in groups of municipalities

with powers of taxation.

The increase of debt in local gov-

ernments is linked to an important

investment cycle, for all of the local

governments, until 2009.

Despite this change, the share of

local public debt in overall public debt

has remained relatively stable over the

past years. In 2010, the debt of local

public administrations amounted to,

according to INSEE, 10% of French

public debt, compared to 10.3% in

2004.

The trend is the same if local gov-

ernment debt is compared with

national wealth, representing 8.3% of

GDP in 2010—1.6 point more than in

2004 but 1.1 point less than in 1994,

the year in which it reached a high of

9.4% of the GDP.

Local governments mostly self

finance their capital expenditures.

Moreover, the total internal financing

amount generated by local govern-

ments in 2010 was one of the highest

observed since 2000, amounting to

€30.2 B. The share of borrowing to

finance local investment is small

(between 9 and 15%) and local gov-

ernments have a good debt reim-

bursement capability (3.9 years).

This rather favourable situation,

coupled with the near absence of

claims with creditors, explains the

confidence shown on the part of the

banks, which are relatively few in

number to participate in this market

and which provide nearly 97% of

debt products for local governments.

These products amount to €10 B to

€20

B, depending on the year.

Budget

management

Unlike those of the state, the debt

flows (new borrowing and reimburse-

ment) of the local administrations

must be budgeted.

Rules governing budgets, article

L.1612-4 of the general code for local

governments (CGCT) in particular,

placing the “golden rule” first, by

Cour des Comptes

Summary

of the Public Thematic Report by the

Cour des Comptes

Specific characteristics of local debt

Summary

of the Public Thematic Report by the

Cour des Comptes

which borrowing is reserved for

financing

investment

only.

Furthermore, the reimbursement of

the principal must be ensured every

year by appropriated resources, main-

ly gross savings. Borrowing cannot

thus be used to reimburse existing

debt.

These budget rules are sometimes

bypassed or generate perverse effects.

To have a large expenditure on

capital, the local administrations

might have wished to reduce the

annual amount of reimbursed princi-

pal. They thus operated through

adjustments, aiming to decrease the

corresponding expenditures of the

fiscal year and those of the near

future, by increasing the term of

reimbursement.

Practices focused on an approach

to debt problems that was too exclu-

sively budgetary in nature also led to

the use of unsuitable financial ratios

for analysis of the debt.

Rules for

accounting

and management

The local administrations and

their public establishments have great

freedom when it comes to the sub-

scription of borrowing contracts or

derivative contracts. The deliberative

assemblies can delegate to their exec-

utives the power to execute borrowing

and financial operations useful for the

management of borrowing, including

operations for covering interest-rate

and foreign-currency risks. The rules

governing public contracts are not

applicable to these contracts.

The freedom to borrow given to

local governments is often presented

as a result of the principle of free

administration of local governments..

It is not prohibited for this liberty to

be controlled by law, however, if jus-

tified by public interest.

The legal framework applicable to

borrowing by local governments has

made control difficult, whether they

address legality or public accounting.

On the other hand, it has permit-

ted local governments to make use of

a large variety of financing products,

which has progressively expanded to

increasingly risky loans, some of

which have the characteristic of tem-

porarily lowering interest rates on

loans and rendering lender margins

more opaque.

The emergence of the financial

crisis during 2008 and the discovery

of the magnitude of risk taken on by

certain local administrations in terms

of debt management, led the minis-

ters involved to call together in the

end of 2008 the main groups of elect-

ed officials and main credit establish-

ments participating in the sector of

local government finance.

This approach led to the signature

on 7 December 2009 of a code of

conduct between the major lenders

and the groups of local elected offi-

cials. In addition, an interministerial

circular issued on 25 June 2010 reiter-

Summary

of the Public Thematic Report by the

Cour des Comptes

Specific characteristics of local debt

ated the rules and principles applica-

ble to borrowing and the coverage

products taken out by the local

administrations.

These reference documents have a

limited prescriptive value and do not

change the legal and accounting

framework applicable to the manage-

ment of local government debt.

The special case of public health care

Public health care sector debt, which has more than doubled since 2004 to

reach €24 M in 2010, is not included in local public debt.

All the same, examination of the management of hospital debt led the region-

al chambers of accounts to draw conclusions very comparable to those pertaining

the debt of local administrations. Thus, the Cour des Comptes believes hospitals’

supervisory boards should be more involved the definition of debt strategy and in

the monitoring of debt management.

Summary

of the Public Thematic Report by the

Cour des Comptes

More sophisticated, less

controlled, debt manage-

ment

Lack of strategy

In a context of increasing debt

since 2003 and rapid increase in inter-

est rates until the end of 2008, debt

management has become more and

more important. Local actors have,

however,

not

always

sufficiently

recognised this.

The clear definition of a debt

strategy by the executive authority

and its formalisation in a reference

document remain rare occurrences.

This lack is coupled, in several

local administrations, with insufficient

development of multi-year financial

monitoring tools, such as multi-year

investment plans. The definition of a

debt strategy, even if it can be period-

ically revised, requires setting expecta-

tions that cannot be limited to the

short term.

The deliberative assemblies are

not always in a position to be able to

comprehend the nature of the debt

management operations that they

authorise, to check whether they are

carried out in the interest of the com-

munity and to ensure, as needed, that

they are coherent with the overall

defined strategy.

The audit also found that a signif-

icant number of local administrations,

especially but not limited to small-size

municipalities,

had

implemented

active debt management and had per-

formed complex and risky operations,

the subscription to structured loans

or adjustments, based on the advice of

only their banks.

The accountants of the public

Treasury are seldom consulted before

decisions

concerning

debt.

Furthermore, they are not always in a

capacity to offer advice satisfying the

needs of those overseeing the local

management in this area.

The terms of

debt are more and

more complex

Cash management

The local administrations must

place all their cash at hand with the

State Treasury. It is in their interest to

limit their non-interest-bearing cash

as much as possible, when it is supple-

mented by borrowing. This is the first

mean available for significantly limit-

ing financial costs.

Several local administrations are

striving to reduce the amount of their

cash, through revolving loans in par-

ticular. To the contrary, the regional

chambers of accounts are often led to

recommend to certain administrations

More sophisticated,

less controlled management

Summary

of the Public Thematic Report by the

Cour des Comptes

that they implement better cash man-

agement.

Use of bond financing

The largest local administrations,

benefiting from the provisions of the

law on new economic regulations of 15

May 2001 have, furthermore, developed

disintermediated financing, through the

issue of treasury notes directly on the

market, in particular. Due to their size,

few local administrations in France are

able to participate in the bond market.

In order to be large enough to issue, cer-

tain communities have organised to

pool their financing needs in the form

of grouped bond issues.

Insufficient progress in

bidding

The loan market for local govern-

ments was characterised by a diversifica-

tion of bank services before the finan-

cial crisis. The participation of new

lenders, however, has contributed more

to favouring the distribution of increas-

ingly risky products than allowing bor-

rowers to better compare offers. It has

thus not truly provided for more com-

petition.

Audits led by the regional chambers

of accounts have still too frequently

found situations in which local govern-

ments do not sufficiently make use of

competitive bidding before taking a loan

or adjustment or, when they do, they

limit themselves to their usual creditors.

The local governments are also con-

fronted with the difficulty of making

choices between bank offers that are

even more complex to evaluate now that

the calls for bids from banks are not sys-

tematically based on specifications.

Development of the

range of structured loans

The significant development of

structured loans is part of this context.

These loans very often have the charac-

teristic of offering to the borrower a

reduced interest rate for a first amortisa-

tion period, in exchange for acceptance

of increased risk, for a later reimburse-

ment phase.

The use of underlying indexes that

are more and more volatile (currency

markets, bond markets outside of the

euro zone), and less and less negotiable

(indexes that are specific to certain

banks) have certainly provided for this

“improved”

interest

rate,

but

exchange for acceptance of greater and

greater risks that are less and less man-

ageable. The leveraged or cumulative

effects have resulted in an amplification

of risk, justifying the “toxic” label that is

sometimes applied to some of these

products.

Numerous structured loans have

been taken out as part of debt renegoti-

ations that can be described as leading

to the acceptance of riskier and riskier

positions. Most often, the financial

analysis provided to the deliberative

assemblies of the local administrations

More sophisticated,

less controlled management

Summary

of the Public Thematic Report by the

Cour des Comptes

only mentioned part of the true flows

generated by these contracts. Thus, the

amount of the balancing payment to

pay for the renegotiated position was

generally not identified.

Without this information, the delib-

erative assemblies could only carry out a

limited audit, facilitating the distribution

of structured loans and confirming the

need to reinforce the role of these bod-

ies in the future.

Certain local governments have,

moreover, subscribed this type of loan

or derivative without being sure that

they have the sufficient internal capacity

to understand the contents and possible

consequences of these contracts in par-

ticular. If calling on a council may prove

useful, it will nonetheless require that

the local gouvernment have the ability

to analyse the suggestions made by this

council.

Summary

of the Public Thematic Report by the

Cour des Comptes

Control needed for

structured loans

The audit led by the regional

chambers of accounts found a very

wide distribution of structured prod-

ucts, in all categories of communities,

regardless of their size.

It is thus regrettable that the find-

ings of the Cour des Comptes in the

annual public report of February

2009, concerning the lack of public

statistical data on the structure of

local public debt, are still relevant

today.

Outstanding local public debt

from structured loans amounts to

€30–35 M, presenting a potentially

high risk.

The risk of significant deteriora-

tion in the finances of the communi-

ties involved has not yet truly materi-

alised, however. This is not surprising

considering the characteristics of

these loans, which generally begin

with a lower interest rate period.

Furthermore, in the case of greatly

deteriorated rates, the additional

charge may have been compensated

by the simultaneous decrease of rates

paid on the variable-interest loans,

linked to the collapse in money mar-

ket rates since Autumn 2008. Risks

remain high, however, due to the

structure of these products, longer

than traditional products with fixed-

and variable-interest rates, and the

highly volatile indexes on which they

rely, especially when exchange rates

or exchange rates spreads.

Certain local governments already

find themselves bound by loans and

derivatives that they can only pay off

by accepting to pay an interest rate or

balancing payment that is prohibitive

compared to their financing means.

These situations remain very concen-

trated. A few hundred local govern-

ments find themselves sustainably

exposed to risk in a small portion of

their outstanding debt, with probably

less than one hundred highly vulnera-

ble to risk.

The risks induced by structured

loans remain high and liable to signif-

icantly deteriorate the financial situa-

tion of the local governments that are

the most exposed to them.

It is therefore important to draw

thorough conclusions on this situa-

tion, something that neither the code

of conduct or the interministerial cir-

cular of 25 June 2010 sufficiently do.

The Cour des Comptes recommends

that a report be drawn up on the

application of this code and to review

its provisions for avoiding products

based on deviations of indexes out-

The need for better risk

management

The need for better risk management

Summary

of the Public Thematic Report by the

Cour des Comptes

side of the euro zone or including

leveraged

effects.

Similarly,

the

acceptance of a period of interest

reduction for part of the term of the

contract creates imbalance in the con-

ditions of its performance and dimin-

ishes the interest costs in the short

term to carry them over to future fis-

cal years. This practice should be pro-

hibited or offset in accounting.

Other measures should be taken

to increase control over risks. It

would also be fitting to:

- implement statistical monitoring

of the structure of local public debt

- make it mandatory, in debt rene-

gotiation, to post all the balancing

payments and prepayment penalties,

without compensation

- translate, on the chart of

accounts, the consequences for the

existence of high-risk products by

implementing a system of mandatory

provisioning of these risks which

should, as a minimum, aim to offset

the temporary gain made by the exis-

tence of a “reduced” rate

- reinforce the role of the deliber-

ative assemblies in imposing the year-

ly presentation of a report on debt

management, which would serve as a

basis for an annual debate on this sub-

ject, along with the vote on the

budget

- improve the collective address of

the most difficult cases, but without

creating in a defeasance structure.

Anticipation of

changes in the

financing model

Beyond the risks generated by the

distribution of structured products

and that should thus be addressed, it

appears that the financing model of

the local governments is liable to

undergo profound change, the conse-

quences of which it would be helpful

to try to anticipate.

The access of the local adminis-

trations to credit with favourable con-

ditions may be called into question,

considering the reduction of competi-

tion and increase of bank margins

since the financial crisis, as well as the

difficulties that the main bank estab-

lishment participating in this market

is currently experiencing. Finally, this

announced change of prudential

norms within the framework of the

discussions referred to as the Basel III

Accords is likely to have, over time, an

important effect on the volume and

cost of credit for local governments.

In this context, diversification of

financing sources for local govern-

ment should be pursued.

Bond financing constitutes a pos-

sible direction of diversification for

the largest local administrations, but

will probably remain limited with

respect to the needs to be satisfied.

The creation of a local govern-

ment financing agency could provide

The need for better risk management

Summary

of the Public Thematic Report by the

Cour des Comptes

an additional solution for the diversi-

fication of the financing options for

local governments, provided that the

conditions required for it to function

properly are met. They pertain to its

field of activity, the group guarantee

mechanism of the communities on

the behalf of the agency, the level of

capital and cash reserves, the method

of governing and more fundamentally

its ability to comply with the pruden-

tial rules imposed by the Basel III

Accords.

Conclusion

Summary

of the Public Thematic Report by the

Cour des Comptes

he audit carried out by the Cour des Comptes and the regional chambers of

accounts on local public debt has led to a mixed result. Progress has been made

by the local governments in the improvement of the quality of debt management, but

this progress remains insufficient.

The banks are partly responsible for the current situation, having designed the

range of structured loans and encouraged their distribution without always ensuring the

provision of sufficient information on the associated risks.

For its part, the State did not sufficiently consider the risks created by structured

loans, distributed on a large scale and excessively in the case of certain local govern-

ments. The code of conduct, concluded in December 2009, responds in certain points

to the recommendations formulated by the Cour des Comptes in its annual public report

of February 2009. Nonetheless, it seems not to be restrictive enough to efficiently

resolve the current difficulties or prevent their reoccurrence. A change in accounting reg-

ulations should be foreseen to require that the risk inherent in these loans be included

in provisions.

The financing conditions for local governments after the financial crisis and the

withdrawal of several lenders will probably change. The entry into force of bank stan-

dards from the Basel III Accords should change the options of the local governments

for access to bank financing. The methods of diversifying sources of financing for the

local sector should therefore be studied starting now.

Recommendations

Summary

of the Public Thematic Report by the

Cour des Comptes

To improve information on

debt risks

favour the use of solvency

ratios such as ability to pay off debt,

which measures the reimbursement

of debt principal in years of gross

saving, as well as information based

on the financial valuation of the

loan or coverage instrument;

inversely, take care when

using ratios and indicators devel-

oped based on debt payments (pay-

ments on real current revenue, aver-

age rate of debt, net internal financ-

ing ability) that favour reduction in

the short term of debt repayment,

without taking into account future

risks, lengthening the term of

amortisation and increasing the

financial risk in general;

introduce an obligation to

make a depreciation for debt risk of

the same amount as, as a minimum,

for contracts initially foreseeing a

rate lower than the market rate, the

artificial budget gain created as a

result, into the accounting of local

administrations, their public estab-

lishments and public social housing

establishments;

require that any balancing

payments paid or received during

debt renegotiation or upon the early

termination of coverage instru-

ments appear in the accounts of the

local governments and their public

establishments;

implement global statistical

monitoring of the debt structure (in

terms of maturity and exposure to

rate risks in particular) of the local

administrations and their public

establishments, leading to the publi-

cation of a national annual report.

To favour the diversification

of loan bids:

make the bidding process of

the banking establishments system-

atic during each financing or debt

renegociation,

obtaining

broad

counsel and relying on precise spec-

ifications;

seek a balanced distribution

of bank creditors so as to avoid a

situation of dependence on one sin-

gle establishment;

study and judge the feasibility

of the creation of an agency for the

financing of local government, and

make sure that its operating princi-

ples and rules will make it possible

to offer local administrations a new

source of financing within the con-

ditions of competition and perma-

nent financial security.

Recommendations

Summary

of the Public Thematic Report by the

Cour des Comptes

To reinforce the internal and

external controls:

for the largest communities

(for example, those with a population

greater than 5,000), supplement the

primary budget project with a report

on debt presenting, on the one hand,

the results of the debt and cash man-

agement strategy from the last com-

pleted fiscal year as well as the future

strategy, and on the other hand, the

characteristics of each loan and cover-

age contract subscribed;

introduce each year, based on

the aforementioned report, a policy

debate on the debt before the deliber-

ative assembly, which will determine

the debt management strategy and, if

applicable, define at this time the del-

egation of power accorded to the

executive to subscribe loans and

derivative products;

eliminate incoherency between

the texts governing the legality control

in the loan contracts, so that these

contracts are clearly subject to a

requirement

for

verification

legality.

To help local administrations

that are in difficulty:

implement, for the smaller

communities wishing to pool the

management of their structured

loans, a monitoring cell to help them

identify and realise, working with the

banks, exit solutions;

however, do not pursue the

project for the creation of a defea-

sance structure in charge of higher-

risk loans without holding the com-

munities that subscribed the loans

responsible for the exit cost.

To improve the best practices

for loans:

in compliance with the prohibi-

tion of deficits established by Article

26 of the by-law on finance laws,

encourage “zero” cash management

in the local administrations, reinforc-

ing

the

exchanges

with

public

accountants, in particular by the signa-

ture of partner conventions;

perform the assessment of the

code of conduct that was to be per-

formed after one year of application

and, in any case, avoid products based

on index deviations outside of the

euro zone, or including leveraging.

Modify the 25 June 2010 interministe-

rial circular as necessary.