Country Study: Czech Republic

DEBT MANAGEMENT OF CZECH LOCAL GOVERNMENTS: PROBLEMS AND SOLUTIONS

Robert Jahoda[1]

Abstract

Financing by means of debts is one of the important sources for local budgets in the CzechRepublic. Before 1993, local self-governing units were not allowed to enter the capital market, however, after the division of Czechoslovakia and founding of the CzechRepublic, the situation has changed. Moreover, the CzechRepublic signed the European Charter of Local Self-Government that explicitly permits financing of local budgets from returnable resources. In the last 13 years, most of municipalities have used this possibility, and the indebtedness of all municipalities in the CzechRepublic grows both nominally and really. In relation to GDP, however, it does not pose a serious problem, since the indebtedness of all municipalities does not exceed 3 %of GDP, and therefore it does not substantially affect fulfillment of Maastricht Convergence Criteria in the area of fiscal balance. The situation of particular municipalities, though, may be different: some have serious problems with paying off their loans.

In the CzechRepublic, higher self-governing units (regions)werefounded at the end ofthe year 2000. Until last year, their expenses were financed mainly by subsidy programs, and regions were therefore careful in using debt instruments. It is also the reason why they have managed balanced budgets so far.

The aims of this study are the following:

• brief description of the development of territorial public administration in the CzechRepublic and means of its financing;
• short analysis of the development of municipal indebtedness, and brief characteristics of the development of state regulation regarding the indebtedness of municipal budgets;
• detailed analysis of causes leading to municipalities having problems with paying off returnable financial sources.

The study will focus especially on the analysis of municipal indebtedness. If necessary, the analyzed parts will be related to the development at central level.

Chapter 1: Local Government Finance: An Overview

The CzechRepublic is the Unitarian state. The Constitution specifies three levels of government of the CzechRepublic with separate budgets. The top level is represented by Central Government, fourteen higher self-administrating units are called Regional Governments and the lowest level is represented by approximately six and half thousands Municipal Governments. Regions andmunicipalities are responsible for expenses within “own” and “delegated” responsibility.

The following Table No. 1describes the share of local finance (municipalities and regions) in GDP. The share of expenses in GDP has been stabilised around 12 % recently.Comparability of statistical data of local finances is partly biased by interpretation of district office budgets as part of the state line of public administration of the Czech Republic. Before 2000 these budgets were not part of the state budget and were included in local finance together with municipal budgets. In 2001 until closing of the district councils their budgets were part of the state budget.

Table No. 1: Distribution of Expenditures Between the Levels of Government

Source: State Final Account for 1997-2004, State Budget 2006, MFCR (2006)

For revenues and expenditures of municipalities see the below Table No. 2. The table shows that the share of expenditures in GDP has been relatively stable, with the volume of revenues corresponding to the volume of expenditures. Economies of municipalities are in deficit, but the balances are relatively low. For more details of the deficit and the indebtedness see the following sections.

Table No. 2: Consolidated balance LG’s budgets [in % GDP]

2.1Revenues

2.2Expenditures

Source: State Final Account for 1999-2004, State Budget 2006

The volume of tax revenues has been relatively stable since 1993, with certain increases from the year 2002. While tax revenues show a slightly growing trend, the non-tax revenues keep moderately decreasing. This does not encourage the trend of responsibility transfer onto municipalities. These two incomes together, however, represent a relatively stable source. Capital income is expected to drop in the following years.More than a fifth of all municipal sources in the Czech Republic come from the state budgetsubsidies, from state funds, and from other programmes, such as EU financing programmes (via the National Fund).

Chapter 2: Regulation of the Local Government Borrowing

2.1Scope of the Local Government Borrowing

Self-administrative units of the CzechRepublic for funding communal public investments usually use refundable resources. Small municipalities with small budgets may get into difficult financial situation in the beginning of the year, having no reserves from previous periods and forced to use borrowings, often for provisional financing of operational costs.

Local governments may make use of:

• Refundable financial assistance and loans, for example from the state budget or from state funds, or from the budget of another municipality, or from the regional budget, either interest-free or in the form of low interest bearing loans,
• Short-term credit loans, refundable in one year time, or by the end of the respective budget year,
• Medium-term credit loans, refundable in four years, or sometimes in five year time, and
• Long-term credit loans, refundable in ten years, or sometimes in fifteen year time,
• Or, under certain terms, the municipality may issue securities for financial source acquisition (this variant involves additional costs of the bond issuing – issue procurement etc., reducing the net revenue from the issue).

Credit loans, and therefore indebtedness, must be approved by the municipal authority. Loans are provided on the basis of loan agreements concluded with a bank and approved payment schedules – refunding of the body of the loan and the interests from the municipal budget. The banks provide loans to municipalities against collateral (capital, future income, securities).

Municipal self-administrative authority should loan refundable financial means up to the amount corresponding to annual debt service equal to the lowest positive current budget excess assumption (i.e. the difference between regular income and regular expenses) for the period of the loan refunding. The need for realistic planning of the amount is more than obvious. This could represent a problem, especially for smaller municipalities.

Basic information about the encumbrance development in the self – governmental regions is stated in Table No. 3. This table also compares encumbrance of municipalities with total encumbrance of whole public sector and also with GDP growth.

Table No. 3: Development of regional and municipalities encumbrance in comparison with encumbrance of the whole public sector

Source: State Final Account for 1997-2005, MFCR (2006)

From this table could be seen that major part of public debts is formed by the state debt (central government) and also dynamics of debt is the highest at the central government level. Regions’ encumbrance at the present is quite marginal and does not posses any problem for the public budgets. Municipal debt is slightly raising in last few years, but if we compare it to GDP we could state that its high is quite negligent and stays on the same level in last three years.

The positive aspects of local borrowing include the fact that as a rule municipalities used borrowings with refunding deadline exceeding one year for financing of capital costs of investment, mostly into local public sector. The reasons included mainly the poor technical infrastructure in towns and villages.

Significantincrease of municipal debt during 2003 was due to big flood in summer 2002 and huge reparation works on municipal property in the next years. The image of municipal indebtedness is somewhat distorted by the debts of big cities – Prague, Brno, Ostrava and Plzeň. Encumbrance proportion of these four corporate towns reached in 2005 total level of 61, 3 % of total municipal debt with consideration that this debt is slightly raising (more in Table No. 4). When we exclude encumbrance of these four towns we could say that debt of all other municipal subjects in the Czech Republic is in the long term around the level of 1 % GDP.

Table No. 4: Balance sheet formed to the 31st of December in billions CZK

Source: ARIS

From macro economical point of view the municipal encumbrance in total high of 2,7 % GDP does not posses any problem. But if we zoom in a little bit we find out that some municipalities have high debts and they could face some problems while servicing the debts. Special attention is paid also to the capital city Prague, because of significant growth of foreign sources in the last couple of years.

2.2Origins of Local Government Borrowing regulation

Not all municipalities were always able to realistically assess the purpose of the investment covered with a refundable financial source (loan), especially in the cases of financing of the so called profit investments from credit loans, when very often the planned profit to be used for the loan refunding did not reach the levels assumed in the beginning – this was particularly the case of certain small municipalities – such as Rokytnice nad Jizerou (see the case). Municipalities often underestimated business risks of their enterprises.

Case study: How the state solved problem with insolvency of Rokytnice nad Jizerou (3.254 inhabitants)

The town of Rokytnice nad Jizerou is a model warning example of failure to manage debt management. In addition to a loan for the municipal wastewater treatment plant (CZK 70 M), issue of communal bonds (CZK 120 M) the town provided collateral for construction of a funicular (CZK 145 M). The investment into the funicular was not as profitable as expected; the debt of the town increased and Rokytnice nad Jizerou became unable to refund the debt. The Consolidation Agency, taking over the debt in the meantime, ordered the first “forced" auction of municipal property (2002). The auction was to serve as a warning for other municipalities that the state would not perform the role of the “last instance guarantor”.

In May 2004 the Czech Republic’s government adopts principles for solving the municipal debts that was composed by the Ministry of Finance. In daily praxis it means interruption of pursuits between municipality on one side and the State Environmental Fund and Czech Consolidation Agency on the other side. Within the frame of fiscal relations rectification the city agreed with sale of “redundant” property in total high of 43 M CZK and also with subsequent pay off (till the year 2008) of loan’s part in total amount of 25 M CZK. Other loans’ debt (in total amount of 230 M CZK) were forgiven. All above mentioned operations are documented in the city’s balance sheet in Table No. 5.

There are more municipalities, however, reported in the press to be approaching this state of affairs. Representatives of all municipalities should take a lesson from this case.

Table No. 5: Balance sheet of the Rokytnice nad Jizerou city valid to 31st of December in millions CZK

Source: ARIS

Another negative impact on municipal debts was represented by local business credit loans with the business risks taken over by the municipalities without appropriate weighing of the risks. When a businessman failed to refund the loan the municipality as the guarantor had to take over the responsibility for the loan refunding.

Following the applicable legislation the Czech state takes no responsibility for liabilities of local governments. In the past ten years the state either did not regulate use of refundable resources and indebtedness of municipalities at all or paid insufficient attention to the regulation. Indirect regulation of municipal indebtedness by the state was represented by the 15 % indicator of maximum debt service share in regular municipal income in the case of applications for non-eligible subsidies from the state budget. We can speak about state regulation in the case of communal bond issues. The regulation was first exercised through granting (or refusing) the obligatory approval of the Ministry of Finance with the issues. In late 1990s the regulation took the form of approval by the Securities Commission.

In 2002 the Parliament passed an act regulating municipal indebtedness – however, counter-proposals raised in the Parliament caused ambiguity of the selected indicator and resulted in subsequent cancellation of the regulation by amendment to the act.

The Czech Republic’s government adopted in spring 2004 decree about Regulation about municipal and regional debts through indexes of debt service (more on Ministry of Finance). This task – to monitor debt of municipalities – was assigned to the Ministry of Finance that sends the report about municipalities debts’ to the government.

"Debt service index" compares the amount of the “debt service” to the volume of “debt base” for last fiscal year. Content of the debt service is defined as: paid interests of settled payments of emitted of bearer bonds, repayment of principals and leasing refinancing. Debt base is formed from:real achieved tax and non tax incomes plus precisely defined type of grants from state budget.

This "debt service index" has been calculated to every municipality and to every region by the Ministry of Finance. To those municipalities and regions which cross the given level of the debt service indicator in the high of 30 % are noted by the mail from the Ministry of Finance with recommendation to adopt enough regulation not to cross this level of debt service in the next period. At the same time the Ministry of Finance will ask these municipalities and regions to report within the three months period which arrangements will be adopted. Also Minister of Finance will ask for submission of the Report about economic results for relevant fiscal year and opinions of vestry to this Report and to the budget perspective. Ministry of Finance evaluates all required materials; makes consideration about all facts that led to cross of stated level. In doing so are considered all the facts:

• Total encumbrance of municipality or region;
• Total encumbrance of municipality or region conversed on one inhabitant;
• Total taxes yield conversed on one inhabitant of municipality or region;
• Encumbrance trend in last years;
• Size of municipality or region;
• Total financial situation of municipality or region.

In case that municipality or region will cross the given level of debt service in next year, then the Ministry of Finance could hand out the list of these municipalities and regions to relevant subjects responsible for resources from state budget and state funds so they could have a look to this list whenever they are dealing with requests from these municipalities and regions concerning grants or loans.

2.3Regulation of the Local Government Borrowing in 2004

According to the approved schedule, the Ministry of Finance calculated the debt service index for the periods of 12/2003 and 12/2004. The calculations utilized data from the territorial database of the Automated BudgetInformation System of the Ministry of Finance (ARIS).

In 2003, as many as 3,004 municipalities out of the total number of 6,244 municipalities had a debt service, while the debt service of only 211 of the indebted municipalities exceeded the set-up limit. These municipalities that exceeded the limit set up to 30 % were addressed in June 2004 by a personal letter from the minister of finance and asked to state the reasons for their indebtedness and to submit proposals for measures improving their debt situation. The replies showed that, based on minister’s appeal, the municipal authorities in many cases re-assessed their budget priorities for the following period with the aim to reduce their debts.

The last published debt service indicator calculation was carried out the end of 2004. This calculation revealed that 3,107 out of the total 6,244 municipalities had a debt service in the period in question, and 192 of these municipalities exceeded the limit of 30 %. Further corrections eliminated 21 municipalities that—though they exceeded the limit of 30 %—had zero indebtedness, i.e. paid off all their liabilities. This means that at the end of 2004, the debt service of 171 municipalities exceeded the set-up limit, including 104 new municipalities. The minister of finance sent a letter to these municipalities that exceeded the limit for the first time asking them to give reasons for their debt service indicator excess and to inform about measures they aim to take, in a three month’s time.

Case study: Jindřichovice pod Smrkem (624 inh.)

Jindřichovice pod Smrkem is probably a municipality that argued most against monitoring of debt through the debt service index. In media were seen during the year 2005 open mail war between municipality mayor and minister of finance (respectively representatives of Ministry of Finance). How this war was launched?

This municipality during the nineties of the last century decided to follow the principle of sustainable development. Part of this decision was building of ecological boiler plant and construction of two wind power plants that threw municipality into debt. In the year 2003 the municipality started operation of two wind power plants in total amount of 62 M CZK.Biggest portion of this investment was financed by State environmental fund (85%) from which 45% was irreclaimable grant and 40% was a loan with 12 year due date. The rest of this investment was covered by the municipality itself. And above mentioned grant became an apple of discord between municipality and Ministry of Finance (the course of balance sheet is in Table No. 6). After calculation of debt service index for the year 2004 the municipality reached result of 31,1 % (influenced especially by repayment of a principal). Ministry asked for explanation and for list of further steps to prevent such a status in the future.