Public Finance Committee
Co-Sponsors “Sub-Sovereign Finance in the New Europe”

An unprecedented group of diverse public officials and expert practitioners gathered in Prague in April 2002 to present a “first of its kind” conference on “Sub-Sovereign Finance in the New Europe.

The conference was sponsored by the American Bar Association and The Bond Market Association. Its organizers included Stephen J. Weinstein, then of the Office of Municipal Securities of the Securities and Exchange Commission and now the chief finance officer of the California Consumer Power and Conservation Financing Authority; Lynnette K. Hotchkiss, associate general counsel of The Bond Market Association; and Roy J. Koegen, then chair of the Section’s Public Finance Committee. Other U.S. public finance experts who participated in the conference included Roger Davis of Orrick, Herrington & Sutcliffe; James Spiotto of Chapman and Cutler; Dean Pope of Hunton & Williams; and Jeff Brown of Goldman & Sachs. European speakers included Igor Kostikov, chair, Russian Securities Commission, and Peter Szegvari, office of the Prime Minister, Republic of Hungary.

Sub-Sovereign Finance in the New Europe

The municipal securities market in the United States is mature, liquid, efficient, stable, and safe. Specialized areas of practice in this market have developed within the American bar. Similar specialties abound in the finance community. Two principal borrowing models have taken shape over the past century (“general obligation” and “revenue” bonding), with numerous variations to take account of specific situations.

In contrast, it is a time of evolution in the formation and financing of local government functions around much of the globe. This evolution is most pronounced in Europe. Ongoing changes in the structure and function of government below the national, or “sovereign,” level have a variety of origins relating to the nature of local, or “sub-sovereign,” government and its relation to the sovereign state. Reexamination and reorganization of sources of revenues generally, and, in particular, access to capital for new infrastructure investment, are very current topics in Europe and worldwide. Indeed, the regional and municipal governments of several Central and Eastern European nations have made initial forays into debt issuance to provide needed capital.

Europe is also driven by the dramatic expansion of the European Union (EU) (formerly the “European Community” and before that the “Common Market”), both geographically and politically. Provisions of the current EU governing treaty restrict reliance of sub-sovereign units of government on their respective sovereign treasuries for budgetary and borrowing purposes. Further, certain categories of sub-sovereign government borrowing are excluded from calculating the sovereign debt ceiling while others are included. The phasing in of all these provisions, coupled with new EU limitations on sovereign debt, may well accelerate the trend already underway to attract capital investment by means of marketing sub-sovereign debt instruments. The types of instruments may vary widely.

The United Kingdom’s “Private Finance Initiative” has, over the last decade, offered a somewhat different model for accessing the capital markets to fund revenue-generating infrastructure projects by using the private sector to deliver public services, similar to a “public private partnership” in the United States. Another borrowing model that has been emerging in both Europe and the United States is “structured finance,” in which existing assets in the form of revenue streams are “securitised” into “synthetic securities” that are marketed to investors.

The Need for Change in Europe

Effective sub-sovereign government needs adequate financing sources. This is true both for day-to-day operations of public services, like education, policing, and sanitation, and for long-term public capital investments, ranging from water supply and sewage disposal to seaports and airports. Countries within Central Europe are devising sources of sub-sovereign revenue along with powers of sub-sovereign government to meet these needs, coming from local taxes and charges, and from varying categories and mechanisms of cash flow from their respective national budgets. The needs outpace financial resources in many places, however.

It is possible for strong and well-managed sub-sovereign governments to borrow from the capital markets of Europe and the world. They could do so by issuing medium- to long-term debt instruments to investors within their own borders and beyond. The sub-sovereign government could then spend the money generated by such debt instruments on long-term capital investments to benefit their local citizens. Some sub-sovereign governments in Central Europe have already begun to test these markets.

This is a marked departure from most past or present mechanisms for financing capital projects in Central Europe. Accordingly, a great deal of painstaking work goes into preparing the way, and effective results may not come for some years. This work will require carefully constructed and comprehensive legal and financial mechanisms, originating in the legislative and administrative processes of central governments. Once cities and provinces within Central Europe establish track-records of sound fiscal management and strong creditworthiness, sub-sovereign debt could become an effective tool for meeting capital investment needs.

Each nation must sort out its own priorities and powers. However, every nation must work toward some commonly accepted credit measures and mechanics. Each nation must also look to what has worked elsewhere, whether it be in other countries in Europe, across the Channel in Great Britain, or across the sea in the United States.

Financing public projects through sub-sovereign securities is a proven approach. It is just as, or even more, real than requesting grants from the national budgets or for shares of money raised through sales of sovereign securities by the national governments. Sovereign and sub-sovereign securities markets can co-exist side-by-side as independent sources of financing for the central state and for its local governments. As a result, control over local programs by local officials and local citizens will be enhanced. Separation of sovereign and sub-sovereign credits may be difficult at the outset but both levels of government will be stronger for it. Many of the world’s multilateral lending agencies support separation of credits, making interim loans to the developing nations of the region ultimately easier to obtain. Also, as virtually every nation in Central Europe is or will be applying for membership in the EU, conformity with its limitations and controls on sovereign borrowing offer additional motivation.

Primarily, however, sub-sovereign finance can become a significant enabling tool for sub-sovereign governance. Sub-sovereign finance benefits local citizenry, the central treasury, and the national economy all at the same time. With a system of sub-sovereign finance in place, citizens will command their own destinies and how they are paid for, while nations can concentrate on financing national programs and the capital of each country’s banks is fully available for investment in private sector endeavors.