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Capital markets gain traction as power shifts to local hands

20 May 2008

That Europe needs to invest heavily to bridge its infrastructure gap is beyond debate. Latest estimates put the amount required in the trillions of euros. What is in question is who is best placed to oversee the spending. A clear trend in recent years has been the growing financial autonomy of regional and municipal authorities, as public and project finance spending power decentralises. This has in turn led to the growing use of capital markets products in this sector.

Italy’s recently re-elected prime minister, Silvio Berlusconi, may have promised to spend at least three days a week in Naples until it has sorted out its problems. But no tourist in his or her right mind would choose to stay in the city longer than is absolutely necessary these days.

The city’s dustmen stopped collecting rubbish in December, leaving the Italian army to bulldoze thousands of tonnes of putrid waste from the streets of Naples.

A number of Naples’ best hotels and restaurants have been forced to close or drastically reduce their prices, and unions estimate that the transformation of the city into a giant rubbish heap will cost up to Eu500m in lost tourism receipts. "See Naples and die? I do not know that one would necessarily die after merely seeing it, but to attempt to live there might turn out a little differently," wrote Mark Twain in 1869, and little seems to have changed since then.

Naples’ desperate infrastructural shortcomings are, thankfully, unusual even by Italian standards. The waste collection crisis, which dates back some 15 years, reflects the fact that the service is controlled by organised crime. But the chaos in Naples is an extreme example of what is known as an "infrastructure gap" that appears to be widening throughout Europe. "Its impact on economic growth, job creation and social cohesion is felt across every country in the region," notes PriceWaterhouseCoopers in a report published in November 2005.

The link between infrastructural deficiencies and economic growth is not purely anecdotal. In a report entitled Closing the Infrastructure Gap, published in 2006, Deloitte points out that the Federal Reserve Bank of Chicago has estimated that "more than half of the decline in labour productivity growth areas in the United States during the 1970s and early 1980s resulted from infrastructural neglect".

Estimates on the total financing required to plug the infrastructure gap across the EU vary wildly, but the Deloitte report puts it at "trillions of dollars", with the energy sector alone requiring $1.2tr of investment over the coming 20 years.

While some of that funding will be the responsibility of central governments, a clear trend in recent years has been the growing financial autonomy of regional and municipal authorities.

The degree of local self-governance still varies from country to country, with some EU member states remaining far less decentralised than others. According to analysis published in December 2007 by Dexia, subnational investment as a share of GDP ranges from 0.2% in Malta to 2.8% in Ireland.

"The role of subnational investment as a driving force of public investment also varies tremendously within the EU," the analysis reports, "ranging from 21% in Cyprus to 96.8% in Belgium... This weight is particularly heavy in the three federal countries and the strongly decentralised ones (Italy, Denmark, Spain, Finland, the Netherlands), where subnational authorities are in charge of the lion’s share of public infrastructure needs in the areas of education, healthcare and transport."

The Dexia analysis adds that investment levels also tend to be higher in the so-called Objective One countries of the EU (where GDP per capita is below 75% of the EU average) and in cohesion regions that benefit from European Commission co-financing — notably Ireland, Spain, Poland, Portugal and Italy. "In countries with a federal structure," adds Dexia, "the local public sector is the principal subnational investor. It handles 60% of the subnational investment in Austria and Belgium and... 75% in Germany."


Sharp recent growth

Throughout Europe, in recent years sub-sovereign investment has been rising faster than GDP growth, expanding at an annual average of 2.8% between 2000 and 2006, according to Dexia, compared with average GDP growth over the same period of 2% a year. But it was in 2006 that subnational investment exploded, rising by 6.6%, or more than double the GDP growth rate for the year of 3%.

Much of that surge in the EU average was driven by investment in the new member states of the EU (the so-called EU12), where subnational investment rocketed by an average of almost 29%, compared with a more gentle 5.1% rise in the 15 countries that were members before the Union’s enlargement in May 2004. "In the EU12, but also in Ireland and Greece, the high growth rates can be linked to sizeable infrastructure needs and the acceleration of the implementation of local projects co-financed by structural funds," notes Dexia.

The good news, to date, is that local and regional governments’ rising infrastructure investment requirements have not exerted much downward pressure on their credit quality. In its outlook for the sector in 2008, published in January, rating agency Fitch reports that "despite the first default by a western European local government rated by Fitch (that of the City of Taranto, Italy, in January 2007), the general creditworthiness of local governments in Europe remains strong.

"Of the 155 Fitch LRG ratings at end-2007, 90% had a stable outlook and 6.5% had a positive outlook." Of the 44 rating actions taken by Fitch in the sector in 2007, 24 were upgrades and 10 were upward outlook revisions; only three were downgrades, with seven downward outlook revisions.

Fellow rating agency Standard & Poor’s, which released its 2007 Default and Transition Study for International Local and Regional Governments in early February this year, was similarly upbeat about the stability of credit ratings in the sector in 2007. "Of the LRGs that began the year in the ‘AAA’ and ‘AA’ categories, 94% finished the year with the same rating," S&P observed. It added that "the number of LRG upgrades has never been higher than in 2007, and upgrades exceeded downgrades, matching the overall trend since 1995. We raised 17.9% of our LRG ratings in 2007 while lowering only 4%."

"The US economic slowdown and turmoil in the financial markets since summer 2007 triggered no changes in ratings on international LRGs," S&P added. "Economies outside the US had yet to feel the impact of deteriorating market conditions, and few LRGs encountered refinancing problems or barriers to accessing the markets."


Liquid Länder

In the bond market, that has allowed a number of the local government issuers to benefit from the flight to quality that has been a by-product of the recent global crisis in the financial system. That has been especially true of the German states (Länder), which are the most liquid of the local government borrowers in the capital market.

"The Länder have definitely enjoyed safe haven status and their spreads have been relatively stable," says Arnold Fohler, managing director and head of fixed income origination and syndication at DZ Bank in Frankfurt. "In part, the spread tightening reflects the overall lower funding needs of the German Länder, given the fact that tax income in Germany has been much higher than had been anticipated."

It also reflects the relatively low volatility of sub-sovereign bonds. According to a Dexia presentation made last year, triple-A rated local authority bonds have a volatility level 24% below agency issues and between 50% and 60% lower than the 10 year iTraxx index.

The less auspicious news, as far as Europe’s local governments are concerned, is that the jury is out on how long this robust creditworthiness can last. As Fitch advises: "European LRGs will face important challenges in 2008, those of coping with a potential slowdown in fiscal revenue and increasing demand for services. Although Fitch expects subnationals to continue to post budgetary surpluses at the operating level on average, operating margins are likely to be under pressure and in some cases decline."

The same report also points to the vulnerability of some LRGs to a slowdown in house prices. "Most European local governments have a tax based on the rateable value of... property which has some links to market value," says Fitch. "As this market value declines, and if such a decline is prolonged, the rateable value will be negatively affected and the tax base will potentially decline. The expected decline in consumer confidence and spending is also likely to lead to a reduction in VAT receipts."

It is, however, precisely these budgetary challenges that make the market for local government financing so appealing to many market participants. "What we have in Europe at the moment is competing forces," says Anthony Fine, a partner in the energy, infrastructure, project and asset finance group at law firm White & Case in London. "On the one hand there is a very real requirement to replace infrastructure in the widest sense, and on the other there is a clear inability among most governments to afford to finance it."

The catalyst for that imbalance has been the Maastricht Treaty and the strict limits it imposed on government indebtedness in the EU. "Since Maastricht there has been a progressive move from the central to the local level in terms of debt control and management," says Fabrice Henry, managing director and head of origination, syndication and principal finance at Dexia Capital Markets. "That has spurred the growth of an entirely new generation of products for local and regional governments, ranging from plain vanilla bonds through to a variety of structured products."
20 May 2008