Municipal sector review

The Treasury Guarantee Scheme (TGS)

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Iller Bank
Issues
Reforms

The Treasury Guarantee Scheme (TGS)

The TGS is the main vehicle for large municipalities to access foreign credits. The US$3.7 billion outstanding to Treasury (Table 5.1) represents municipalities’ debts to Treasury after guarantees were invoked and Treasury paid creditors, mainly IFIs, on municipalities’ behalf. Treasury paid an average of $445 million per year between 1992 and 2001 – equivalent to about 0.2 percent of GDP – and the scheme gradually became a de-facto transfer system (Table 5.3).

Table 5.3 Treasury Guarantee Scheme (US$ million equivalent)
	1996	1997	1998	1999	2000	2001
Paid to creditors	1,296^¹³	886	744	572	438	590
New Guarantees Issued	388	886	587	213	96	194
Total Outstanding Guarantees	2,141	2,290	2,418	2,250	2,093	1,669

Turkey’s larger municipalities started borrowing in foreign currency after the trade and financial liberalization in the 1980’s. Continued higher-than-abroad inflation caused deterioration in the exchange rate and municipalities found an increasing part of their TL nominated revenues being used to meet the expensive foreign currency debt service payments. The defaults started in early-mid 1990’s, and invoking the guarantees and leaving the payment responsibilities to Treasury soon became common practice. By 2001 when the financial crisis again devalued the Turkish lira, all municipalities with Treasury guarantees were in default.

5.7 The rules for issuing Treasury guarantees have now been made stringent under the Law on Regulating Public Finance and Debt Management that passed on March 28, 2002. This law is popularly referred to as the Debt Law that aims to control public borrowing in line with overall macroeconomic policies. This comprehensive law provides reformed procedures for all public borrowing and lending, including extensions of grants and debts, cash management, issuance of grants and monitoring of guarantees extended by the Treasury, financial relations between the Treasury and affected public institutions, associated budgeting and accounting rules. Supporting documents to the law include: circular on the “Policies and Procedures Relating to the Providing, Monitoring, Budgeting and Reporting of Treasury Guarantees” (April 11, 2002); circular governing borrowing without Treasury Guarantees; and regulation on the “Principles and Procedures of Coordination and Execution of Debt and Risk Management” published in the Official Gazette September 1, 2002. This regulation sets out measures to establish a “Middle Office” and a “High Committee”, involving Government officials to ensure effective debt and risk management and better overall monitoring and control of public borrowing.

5.8 Under the new legislation and associated regulations, to apply for a guarantee municipalities must clear any obligations outstanding to the TGS. Project applications must also have credible feasibility studies and financing plans, and provisions are made for Treasury to share the credit risk with the applying municipality. The ability to enforce the new law will be tested in the coming months as political pressure is building to obtain State support for municipal investments. This would be particularly challenging since mechanisms to impose stiff sanctions against municipalities are in place. Successful implementation of the Borrowing Law would be a benchmark to determine whether the municipal finance sector is reforming.

Iller Bank

5.9 Iller Bank is the main vehicle for most small and medium sized municipalities to fund and implement municipal investments. The bank is a government agency that was established in 1933^¹⁴ to provide municipalities with financial and technical support to develop their infrastructure. Its mandate was expanded in 1945 to include all local administrations^¹⁵, i.e. municipalities as well as SPAs, villages and other associated bodies. Its General Assembly includes representatives from the provincial and municipal councils and village boards across the country and representatives from the key ministries. The General Assembly meets in April every year to assess management performance.

5.10 Iller Bank’s board includes the Chairman (who is also the General Manager of the Bank) and four members, three of which are proposed by the Ministry of Works and one by the Ministry of Finance. The Iller Bank’s headquarters are in Ankara and there are regional offices in 18 provinces. The total number of staff at the end 2001 was 3,500 of which about 2,000 worked in the regional offices. About 1,300 were technical staff (mainly engineers), 1,800 administrative staff and 400 workers. Iller Bank carries out three types of activities (Table 5.4):

Transfers: The bank transfers central government resources to all municipalities and provincial administrations. It has the right to offset transfers against debt service payables to Iller Bank or other agencies of the central government. The intersection of transfers and debt service often makes it difficult to determine the actual level of debt service for investments which in turn makes it difficult to ascertain the costs of investments;

Investment finance: The bank provides both long term and short-term loans to municipalities and their utilities. The interests on the long-term loans are typically negative since rates do not keep pace with inflation. This interest rate subsidy has been a fundamental drawback of the system and makes Iller Bank operations non-viable without continuous transfer of funds from the local authorities, as shareholders, and the central government budget. Iller Bank’s interest rates are adjusted on a periodic basis but there is no standard policy for the rate adjustment which makes it difficult for the municipalities to estimate their dues to the bank.

Technical assistance: The bank assists municipalities to prepare investment projects and helps municipalities develop maps and urban develop plans. This technical assistance is financed from the bank’s own sources and the municipalities are not charged for this service.

Table 5.4 Iller Bank Activities – Overview
Activity	Source of Funds	Terms	Amount in 2001 (2002 constant prices)
Transfers	Central Government budget	Straight transfer, but Iller Bank can withhold funds to pay off debts due to the State	About $2.9 billion
Investment Finance	Long Term: From own funds and central government grants	35% p.a., 5-20 years; The interest rate has typically been negative in real terms given the high inflation	US$501 million expended - $444 million from own sources; $57 million from Central Government. Total long term commitment at year end US$ 4.5 billion
Investment Finance	Short Term: From money-market and own funds	Market interest rate for less than a year	US$16 million extended, US$36 million outstanding at year-end
Technical Assistance	Own funds	No charge to municipalities	Multiple projects

Key Financials
5.11 The financial statements – balance sheet, income statement, and cash flow statement – are available in Annex 1. The key financial figures (2001 year end) of Iller Bank are as follows: Total assets: US$1.3 billion of which US$770 million are loans and US$384 million are in money markets; Total liabilities of around US$997 million of which about US$353 million is due to contractors and debt is US$540 million. Equity is around US$273 million.
5.12 Iller Bank has committed itself to projects valued at around US$4.5 billion. Raising capital for this commitment has been difficult and as a result the Iller Bank projects have a long completion period. Although the total assets are small compared to the number of municipalities that Iller Bank can potentially serve, the bank’s operations clearly affect the municipal sector.
5.13 In recent years Iller Bank has moderated its expenditures to keep them below revenues, and the bank normally generates a profit (Table 5.5). The bank is exempt from property tax, but a profit tax is imposed with rates applicable to joint-stock companies in Turkey. Annual net profits are distributed as follows: 15% retained earnings, 30% retained in lieu of capital contribution from villages, and 55% allocated to villages to develop their infrastructure.

Table 5.5 Iller Bank Income^¹⁶ (US$ million)
Year	1994	1996	1998	2000	2001
Revenues	377	279	344	416	573
Expenditures	316	95	161	206	516
Gross Profit (pre-tax)	61	184	183	210	57

Capital Sources
5.14 Unlike a typical bank operation, Iller Bank does not use borrowings or deposits to invest in long-term assets to recover its capital costs. Instead, it relies on shareholders’ contributions and revenues from its commercial transactions to extend long-term loans on terms that are insufficient to replenish the capital used. Short-term loans with a maturity period of less than one year have a positive real interest rate and are a source of income for Iller Bank. However short term loans comprise a very small portion of the assets of the bank (in 2001, there were short term loans of US$ 16 million compared to total loans of US$ 770 million).
5.15 The main sources of capital are: annual capital contributions from local authorities (a de-facto tax), annual allocations from the central government budget, and income from banking and commercial operations ^¹⁷.

Annual capital contributions from the local authorities. The bank’s nominal share capital is increased from time to time, most recently in November 2001 when the Cabinet of Ministers increased it to TL900 trillion (about US$690 million). The share capital is collected from the shareholders over a period of time. The shareholders are municipalities, SPAs, villages and associated organizations. The municipalities and the SPAs pay 5% of their annual revenues as their shareholder contribution. Thirty percent of the bank’s annual net profits are withheld in lieu of shareholder contributions from the villages. The annual capital contribution payments reached their highest level in 2001 at US$175 million.

The central government’s payments to Iller Bank have fallen steadily since 1987. About US$253 million (in 2002 prices) was allocated in 1990, but only about US$50 million in 2002. The annual contribution from central government to Iller Bank is now made through the regular budget allocation process. Before 2002, it was made through the now abolished extra-budgetary Municipal Fund.

Interest income, commissions, transactions and banking service revenues and dividends. This remains the bank’s most important revenue source. The cash-flow statements for the last three years indicate a steady increase in the income from banking and commercial operations.

Table 5.6 Iller Bank Capital Sources and Investments (US$ million)
Capital/Investments	1994	1996	1998	2000	2001

Capital
Paid in capital^¹⁸	61	64	98	167	175
Central Government Budget^¹⁹	159	153	104	269^²⁰	67
Banking and commercial activities^²¹	260	99	154	138	193
Total Capital	480	316	356	574	435

Total Investments (long & short term)^²²	340	320	456	602	501
of which short term loans^²³	148	135	82	18	16

Types of Investments
5.16 Iller Bank funding for municipal infrastructure has increased during the last decade in real terms. Activities related to the Marmara earthquake pushed annual expenditures to an all-time-high of US$602 million in 2000. Investment expenditures amounted to US$501 million in 2001 (Table 5.6).
5.17 The number of projects grew from 1,672 in 1995 to 2,664 by end-2001, and the size of the portfolio (in 2002 prices) grew from US$3.7 billion to US$4.5 billion during the same period. Water and wastewater projects continue to be the dominant line of business and make up about 88% of the portfolio. Buildings amount to 8%, and the remaining 4% are projects to develop maps and development plans (Annex 2). The average investment cost per project has halved from US$16 million to slightly more than US$8 million since 1995 as the bank has focused increasingly on the smaller (less than 100,000 population) municipalities. The average completion time per project has gone down from 15.5 years in 1995 to 7.9 years in 2001.
Long-Term Lending
5.18 The selection of projects for Iller Bank financing is subject to political influence since objective criteria are not used. A municipality seeking Iller Bank’s assistance to realize an infrastructure investment starts the process by making a project request. The bank compiles the requests, certifies that there is a public need for the services the investment would produce, and forwards them to the State Planning Organization. Here the applications join the many other proposals from ministries and a vast number of agencies seeking to get their proposals included in the annually prepared Public Investment Program (PIP). A description of the PIP is attached (Box 5). After the SPO/PIP review process, approved requests go back to Iller Bank where they are developed into projects, prepared and executed by private contractors that the bank hires on behalf of the municipality.

Box 5: Public Investment Program (PIP)
The management of the Public Investment Program, of which the Iller Bank projects form a part, remains problematic, although some recent progress has been achieved. The planned average completion time for a project in the PIP was reduced from 12.5 years in 2001 to 8.5 years in 2002. Total cost of the projects was reduced by TL 36.9 quadrillion. This was achieved by modifying or eliminating 1,459 projects from the portfolio.
A Public Investment Review was conducted by the State Planning Organization (SPO) in October 2001 and the conclusions were: unclear criteria and processing rules have resulted in too many new projects being included into the PIP, the stock of approved but unfinished projects grew to more than 5,000 during the latter half of the 1990’s, and the average completion time increased to about 10 years. Many projects received “trace” allocations, i.e. nominal amounts of budget funds nowhere near enough to implement the project, but assigned to keep it in the PIP. Similarly, many projects had stayed in the program, and remained unfinished, for 30 years or longer.
Actions to sustain the PIP will include effective monitoring to ensure that discontinued projects are not “re-imported” into the program, establishing strict criteria for accepting new projects into the PIP, providing institutional strengthening to agencies to ensure that projects are prepared and implemented in an economic manner.

5.19 Disbursements for each project are turned into a loan to the respective municipality at the end of each year. Central Government funds used are passed on as a grant while the bank’s own funds carry a 35% interest rate^²⁴and have a repayment period varying from 5 to 20 years. The real interest rates^²⁵ on these loans have been negative every year since 1995 except in 2000. Debt service is often debited at source from the municipality’s share of transfers from the central government if the municipality is unable to service its debt in the previous installments.

5.20 The final cost, and annual debt service, to the municipality depends on a number of factors. Cost overruns are common (occurring in 85% of the projects according to a 1986 assessment) and are borne by the municipality. The size of the debt service payments depends on the blend of disbursements from the two funding sources (Government grant or Iller Bank own resources) described above. The funding mix for any given project may change from year to year depending on the availability of “cheap” central government funding and a number of other factors. The criteria used to determine the funding mix are not clear, but one aspect is to keep the share of each municipality’s transfers from central government that is claimed for debt service down to reasonable levels. This is in the bank’s interest since it will not in practice be able to withhold a large share of any single municipality’s central transfers to recover debt service payments.
Short-term Lending
5.21 Iller Bank provides short-term loans (less than one year) to municipalities for: (i) co-financing Iller Bank funded investments; (ii) incremental investment costs over and above projected cost estimates, (iii) other, i.e. non-Iller Bank funded, investments, and (iv) working capital requirements. New short term lending has gone down in recent years as the real interest rates have gone up, and municipalities have paid off their short-term loans (Table 5.7). Short-term lending is funded from income from banking and commercial operations, and from funds raised at commercial terms on the money market and from commercial banks.

Table 5.7 Iller Bank – Short-term Lending^²⁶
Year	New loans (US$ million)	Loans Outstanding (US$ million)	Real interest rate (Percentage)	Interest income (US$ million)
1990	75.6	73.1	3.7%	31.1
1994	148.4	199.7	-6.4%	260.9
1996	135.3	180.4	-1.9%	99.4
1998	81.6	222.9	23.7%	154.6
1999	86.4	305.6	18.6%	208.2
2000	17.5	290.6	17.6%	138.5
2001	15.5	35.6	43.1%	192.5^²⁷

Issues

5.22 There are two sets of issues related to municipal borrowing; (i) municipalities’ poor credit records; (ii) weaknesses and distortions in the current system of credit allocation through Iller Bank.

Poor creditworthiness of municipalities: Municipalities’ poor credit record and associated poor creditworthiness remains the most fundamental issue. Key performance problems include (a) larger cities invoking Treasury guarantees, (b) smaller municipalities falling behind on their repayments to Iller Bank, and (c) big cities and small towns alike falling behind on tax and social security payments. Together, these factors raise fears that any loans to municipalities will not be repaid. Given the poor collective credit history of the municipalities, private lending for municipal operations is limited. The lack of interest from the private sector to invest in municipal operations is also due to conditions in the financial sector where long term lending is not common even in sectors that yield higher rates of return compared to the municipal sector.

The municipalities have almost always depended on public funds and guarantees and this has also not worked well since the sanctions for not servicing debt are limited and often not invoked. Following the passage of the new Debt Law, the requirements for obtaining a guarantee through the Treasury Guarantee System have been made more stringent. However, the new Debt Law should be implemented in an objective manner and sanctions against municipalities and their enterprises must be called as needed. Since the law has been recently adopted, its implementation effectiveness has not yet been fully tested. Another issue that is emerging with the new law is that the municipalities do not have the capacity to prepare the required documentation and make the necessary preparatory work to successfully obtain a guarantee.

Distorted system of credit allocation: The current responsibilities and the operations of the Iller Bank distort the municipal finance sector. Two major issues are:

Conflicting responsibilities of Iller Bank: The hybrid nature of Iller Bank as an agency that transfers Central Government resources, provides technical assistance and engineering services, and finances investments makes it difficult to effectively function as a development institution.

The adjustments made on the transfers against debt service of the municipalities blur the real cost of investments. Further, the financial impact on the municipalities for investments is not clear over the loan maturity period since the Iller Bank interest rates are constantly adjusted based on its available capital which is a blend of central government grant funds, contributions from shareholders, and income of the bank.

The institutional arrangements where the Iller Bank is both financing and implementing the projects weaken the link between project design and local affordability and priorities and increase the risk of over-design. Municipalities frequently state that investments are over-designed, poorly phased and costly to run. However, these municipalities do not have viable alternatives and as a result are dependent on Iller Bank. The bank also does not have much competition for its technical services that are not directly charged to the municipality but are factored in as overall cost of operations for the Bank. This lack of competition is a disincentive for Iller Bank to improve its operations and become more responsive to financing priority investment in municipalities.

The bank’s role both as a financier and implementer blurs responsibilities and the technical assistance costs of the Bank are not directly recovered. To a municipality, the costs of Iller Bank’s technical assistance for a particular project are not known since it is aggregated in the entire operations of the bank. The true cost of the technical assistance service and the willingness of the municipalities to pay for such services will be known only if the financing and technical assistance services are separated.

(ii) Sustainability of Iller Bank: The sustainability of the bank remains an issue since the reliance on annual contributions from central and local governments severely limits the growth prospects for Iller Bank and restricts the role the bank can play as financier of investments in the sector as the demand for urban services continues to grow. Even the current level of operations would quickly be unsustainable if the inflow of public funds were suspended.

Iller Bank uses the central government budget contributions and the capital payments from local authorities to finance subsidized lending to all the municipalities. The de-facto cost to municipalities is even lower than the market lending terms as the default rate is high since sanctions are limited. The only recourse the bank has is to withhold transfers in lieu of debt service payments which creates other complications affecting the quality of service provided by the municipalities and not being able to cost the investments properly.
(iii) Poor criteria for investment selection: Not surprisingly, Iller Bank has an excess demand for its loans due to its favorable lending terms, often with a negative real interest rate, and lack of competition. This, in turn, makes it necessary to administratively ration the available funds – through the PIP process – and this causes several problems:

The rationing process does not use economic viability as a test to select the most justifiable projects. The feasibility studies required for funding consideration by Iller Bank often do not include credible economic analysis. As a result, funding decisions are not taken in a transparent manner, using objective criteria.

Given the limited availability of capital and the vast needs of 3,200 municipalities, the outcome of the PIP process is uncertain and it does not allow a municipality to plan for an investment. Even after a project is selected, it is often delayed and sometimes not completed due to lack of funds.

The rationing is subject to many pressures and lobbying from various groups trying to influence a decision about including a project in the PIP. This has led to too many new projects being accepted without matching financing resources, leaving less funding for completion of works already in progress.

Reforms

5.23 Proposals are currently under discussion in the country that would promote prudent borrowings. Municipalities would be allowed to borrow (i) only for investments approved in the budget; (ii) with Treasury approval for foreign loans; and when the loan draw down period exceeds the term of office of the municipal administration seeking a domestic loan, (iii) only if the total debt service does not exceed 1/3 of annual revenues (1/2 for metropolitan municipalities). Any exceptions to these rules would have to be authorized by the Cabinet of Ministers. The Minister of Economy (i.e. the Treasury’s Minister) can order extra deductions from transfers to defaulting municipalities to recover debt service from loans guaranteed or issued by Treasury. Future actions should focus on increasing the creditworthiness of municipalities and creating a viable local government borrowing system that would meet the increasing demand of infrastructure services in urban Turkey.

Increasing creditworthiness: The following measures would contribute towards increasing the creditworthiness of municipalities:

Increased Automatic Sanctions: The draft bill should consider stiffer sanctions against municipalities that do not service their debt. The sanctions should also be automatic and should include offsetting the entire amount of unserviced debt against the transfers. Currently, there are no legal and regulatory obstacles for Treasury and Iller Bank to hold back transfer funds in full, but in practice this is not done, which has contributed to the problem of low creditworthiness of municipalities. By making the sanctions automatic and not discretionary, greater incentives would be created for the municipalities to honor their debt obligations.

Performance Benchmarking: The performance monitoring system that is being developed through the Bank’s IDF grant will be the basis for assessing the performance of municipalities. The system will monitor both financial aspects and quality of service provided by the municipality and its enterprises. The results would be publicly available and it is expected that such a benchmarking system would create incentives for the local authorities to be fiscally more responsible. Further, proposed reforms that would allow municipalities to raise and control local revenues would promote accountability and increase the focus on financial management at the local level.

Institutional Capacity Building: The recently mandated reforms on audits, public procurement, financial accountability and budget classification are being implemented centrally, but will have to be extended to the local authorities as well. This requires a major training and extension effort. Also, the recent reforms of the TGS under the Debt Law are a good start for strengthening the current system for municipal borrowing. To obtain a guarantee, a municipality must submit a credible feasibility study and financing plan, and the issued guarantees will often only cover part of the loan. However, to use the new scheme, many municipalities will need assistance to comply with the new requirements. Technical assistance would also need to be provided to municipalities on investment planning and asset management, financial management, and project appraisal and implementation techniques.

Clear Overdue Payments: Actions should be taken to make the municipalities pay off their overdue debts and to put incentives in place to discourage non-payment of loans and other financial obligations to central government. A detailed payment plan should be made for the municipalities to pay off the debts outstanding to the three main credit sources, i.e. Treasury, Iller Bank and the tax/social security offices. This would include reviewing and firming up rules for Treasury and Iller Bank to withhold transfers in lieu of debt service payments. Incentives could include monitoring and making public the financial performance of each municipality, for example in the MoI initiated municipal performance program. Mechanisms in place in Hungary and Latvia to handle municipal non-payments may be of interest to Turkey.

Transparent and Targeted Subsidies: Any use of subsidies should be clearly identified and budgeted. Subsidies should be targeted towards the poorer municipalities, based on objective criteria. With reforms related to generating their own revenue base, larger and richer municipalities should not be dependent on the State. The use of below-market interest rates for all municipalities should be discontinued and replaced by an up-front subsidy policy for the poorer municipalities. One alternative may be for a financial intermediary to create two types of lending windows: a) based on market terms and a positive real interest rate; and b) a grant facility through which the subsidy would be channeled.

Reforming the system for municipal borrowing: There is an immediate need to reform and strengthen the current system for municipal borrowing. The three core elements of this would be (i) Iller Bank reform, (ii) monitoring and possible changes in the TGS as it starts to operate under the new Debt Law, and (iii) strengthening of the financial behavior and capacity locally as outlined in the earlier chapters of this report. Given the many weaknesses in the current system, and in particular the growing arrears and poor local credit performance, it is premature to discuss measures that would link Turkey’s municipalities to the private and commercial sources of credit. There is little preparedness to extend funding for municipal investments by the markets, and the ability to handle such credits locally is not in place. The reform focus should thus be on Iller Bank, which would continue to be a major institution implementing the transfers and providing funds – although increasingly limited – to municipalities for investments.

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