Havrda, Marek

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Local government borrowing in the Czech Republic 
 
Marek Havrda 
Europeum – European Policy Forum 
mhavrda@europeum.org 
 
 
In the Czech Republic, like in other countries in transition, decentralisation has 
provided new opportunities for local governments including the right to access credit markets 
through commercial loans and bond issues.  Borrowing at the local level is especially crucial 
for countries in transition because of its role in local development and financing strongly 
undercapitalised capital stock, as well as building more efficient and democratically 
accountable local governments. Issues of intergovernmental structure and the institutional and 
legal environment have often led to less-than-optimal borrowing practices and local 
indebtedness in many municipalities that prevents decentralisation from having maximum 
developmental impact.  Indebtedness in particular (Maastrich criteria) –but institutional / legal 
issues and structural problems as well- are of particular significance in the Czech Republic 
due to its intent to join the European Union in 2004.  Recent reforms have attempted to 
address these issues with mixed success. 
 
Territorial Administrative Structure 
To set the context for our analysis of local borrowing and financing in general it is 
necessary to look at the structure of local governance since 1989. The Constitution establishes 
the Czech Republic as a unitary state with two levels of territorial self government. Ideally 
this was supposed to be made up of larger regions and smaller municipalities.  Before 2001 
however, the regions had not existed and their functions were partially performed by 77 
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district offices (Okresní Úřady), which were primarily arms of the central state with no 
autonomy in the sense of self-governance. The municipalities are well over 6,000 legally 
classified bodies with autonomy over their assets and budgets, and with the legal entitlement 
to access public transfers and private capital markets.  Up to date only the Central 
Government and Municipalities have participated in credit markets. 
 This intergovernmental structure had significant consequences for the ability of local 
governments to gain access to credit markets. Primarily, the municipalities themselves often 
fail to achieve economies of scale in terms of administrative capacity and creditworthiness.   
Municipalities are extremely horizontally diverse in terms of size, tax-base, and degree to 
which they have been effected by transition reforms. In principle, all municipalities have free 
access to all forms of borrowing, but in practice access to borrowing by small municipalities 
is hindered by low credit worthiness. As a result of this intergovernmental structure the largest 
municipalities have had access to international markets including bond issues while the rest of 
municipalities have borrowed primarily from domestic banks. 
The Municipalities are often fragmented into entities of both efficient and inefficient 
sizes.  The new 2000 reform only partially addressed this problem by creating a more 
administratively competent group of 14 regions (Kraj, NUTSIII). The new regions are funded 
completely by the state budget between their creation in 2001 and December 2002, but 
according to the constitution they are allowed to engage in borrowing activities. This fact 
strengthens the need for clear regulatory framework – whole new level of local government 
will enter the credit markets.  
 A unique characteristic of the Czech system of intergovernmental fiscal relations is 
that there is no clear policy instrument that deals with “fiscal equalisation transfers”, which 
take into account regional differences in both tax capacity and expenditure needs.  In addition, 
with the inability of municipalities, especially smaller ones, to achieve any significant level of 
tax autonomy the most important method available for financing local fiscal imbalances and 
investment needs has been to borrow from non-commercial sources in the form of grants from 
various ministries and agencies, and to participate in commercial credit markets. 
 
Institutional and Legal Issues 
The institutional framework that would allow the financial sector to co-operate with 
local governments efficiently is still being developed. Municipalities face high uncertainty 
about future revenue from state sources. Accounting practices are problematic, and the audit 
process, although compulsory for municipalities and regions, is more of a formal procedure.  
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There is no official monitoring or supervisory mechanism acting on local governments to 
prevent their financial crises and there is no procedure to impose central government 
management on municipalities in case they were led by their councils close or into 
insolvency. However, these are not the only factors impeding local governments from 
efficient access to the credit finance. 
 Municipal revenue is only partially derived from its share of taxes (which are shared 
with the central government) whereas the other part is received in the form of grants from the 
state level. However, there exist no clear rules for the distribution of these grants. Considering 
that only 55% of municipal budget is based on tax revenue and uncertainty of grants from the 
central government, the ability of municipalities to predict their revenue in medium run is 
severely limited. This obviously makes any sensible analysis of municipality’s ability to take 
on a loan virtually impossible. 
 To date, there has been no implementation of a standard accounting system. Although 
general rules do exist, there is a lack of uniformity because of diverse interpretation and 
coverage of budget items. (e.g. operational expense as investment) by different municipalities. 
The explanatory power of accounting reports is further limited by off-balance sheet 
operations. Among these operations the most common was the use of the municipal assets as 
collateral for commercial loans to private firms. This led to serious financial problems of 
several municipalities when a private firm was not able to fulfil its financial obligations. The 
positive step forward was made when such a practice was made in the framework of recent 
reforms.  
Vast majority of audits of municipalities has been carried out by district offices for 
free. Municipalities can opt for audit to be performed by a private auditing firm, but in this 
case they would have to pay for it from its own budget. The high costs of independent audits 
are particularly prohibitive for small municipalities. Thus the use of independent auditors is 
close to none and the administrative capacity of district offices to perform audits is obviously 
limited. Therefore even audited results of municipal accounting do not provide credible 
information. The situation will be analogous with new 14 regions where the free of charge 
audits will be performed by the Finance Ministry.  
The balance sheets themselves (which we explained above are of limited use) are the 
only subject of audits.  Although the central government does formally monitor the 
management of its own grants and subsidies, it does not monitor with on-sight checks how the 
municipalities actually spend these funds. The use of municipal tax revenue and funds coming 
from their own for profit activities are not the subject of monitoring at all. In other words, 
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oversight of the actual use of these resources accounted for on the books is never performed 
and there is therefore little to prevent the misuse of state grants for private gain or to 
improperly finance the municipalities operating budget.  
Since no on-sight performance audit is executed and local government reports do not 
include explanations for any deviations from approved budgetary targets, both budget 
execution and formulation is still a locally top-down process (only municipal council oversees 
budget formulation although approval does come from the assembly). In addition, achieving a 
higher degree of direct regulation is complicated by the Czech constitution that allows local 
government autonomy over their assets and budgets. 
The standard operating procedure of the Ministry of Finance has been, that the debt of 
local governments may not exceed 15% of the previous year’s revenue, otherwise they will 
not be considered for any subsidies from the central government. The 15 % threshold needs to 
be a subject of further analysis to which the LGI sponsored study should contribute. For some 
municipalities the limit may be set to low thus hindering their development for other it may be 
too much in order to prevent their financial difficulties.  
Nonetheless, moral hazard on local level seems to be the most serious issue. Current 
monitoring and supervisory mechanisms of local financing are insufficient to prevent 
irresponsible and destabilising behaviour of local governments. A good example, how far this 
can go, is the perverse use of municipal assets as collateral for private loans. Thus, moral 
hazard takes mainly two forms – local populism and corruption. Buying political support with 
credit finance services had not been an exception. There has been a lack of regulation to stop 
conflicts of interest on the local government level. 
In addition, the Bankruptcy and Composition Act does not include municipalities as a 
subject, but instead concentrates solely on private firms. Thus there does not exist any 
mechanism to cope with over-indebted municipalities or regions. A kind of bankruptcy 
procedure is needed. The potentiality of bankruptcy would also reduce moral hazard on the 
part of Commercial banks which were eager to provide credits to municipalities led by the 
Česká Spořitelna which itself provided over 30 % of total municipal commercial credit. 
Although the potential role of the central government as a lender of last resort to local 
governments should be clearly defined. There is no transparent legal regulation on who and 
when should be bailed out. There have been precedents when non-interest loans provided to 
municipalities by the central government were turned into grants or subsidies in case the 
municipality was in financial trouble. 
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There are more hindering legal regulations vis-à-vis access to credit finance. 
According to the Czech Commercial Code future revenues (even tax revenues) are not 
permitted to be used as collateral for commercial loans.  This considerably hampers the ability 
of especially poorer municipalities to qualify for commercial fund, because only physical 
assets can be used outside of cash-in-hand as collateral.  However, market control of local 
borrowing is of crucial importance. USAID contributed to the launch of municipal ratings 
performed by Czech Credit Agency, but only about 30 out of over 6000 municipalities receive 
actual rating so the impact of market discipline is only marginal. Other municipalities receive 
external feedback only from commercial banks – usually based on the low-value accounting 
reports. 
To sum up, low quality and non-unified accounting accompanied by poor auditing 
cannot serve as a decision basis on credit manageability for financial institutions but most 
importantly for municipalities themselves. In the context of poor monitoring mechanisms 
from the side of the central government market discipline is insufficient to control and 
guarantee responsible and sustainable access and use of credit finance by municipalities. 
 
Current State of Indebtedness 
 Low administrative capacity of local governments is a major result of a dearth of 
expertise in financial management. Municipalities have been unable to successfully predict 
revenues, pursue sound risk analysis, and to calculate costs of credit.  It is fair to conclude that 
municipal credit management is still in a stage of early development in the Czech Republic 
despite efforts by development organisations.  
Roughly 65% of all municipalities are carrying some form of debt. The pace in which 
the indebtedness of local governments increased is considerable. Local indebtedness increased 
in nominative terms by a factor of 15 between 1993 and 2001. Whereas the steepest growths 
occurred till 1997, i.e. during the restrictive fiscal policy executed by the central government. 
This illustrates the possibility of local governments to exercise fiscal policies contrary to those 
of the central government. However, once considerable (the central public debt was 
converging to zero) local debt was put into shadow by increasing public debt on the national 
level due to the course of social democratic government since 1998. 
Many small and middle-size municipalities are already facing serious financial problems. 
About 10 municipalities are in a state of insolvency and there has been one case of forced 
auction in the small municipality Rokytnice nad Jizerou, where municipal assets were sold. 
Often the cause of the serious situation is that municipalities owe the state for non-interest and 
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subsidised interest loans from different various state government development sources 
(Environmental Improvement Fund, Ministry of Finance, Ministry of Regional Development 
etc.) When they are not able to finance the state loan they use commercial credits, which 
exacerbates the situation.  Or sometimes the reverse is true, and municipalities use all of their 
state grants only to pay the interest on their commercial loans.  
 The credit finance for local governments will be even of higher importance. Currently 
municipalities are running out of assets to privatise. Most of these assets were the shares in 
the distribution companies which municipalities were granted in the transformation process. 
Since there was no regulation on the use of privatisation revenue, not all of the acquired 
privatisation funds were used for capital investments. Without available privatisation funds to 
subsidise the operating budget, previous budget items will be put under more pressure. The 
needs and incentives to borrow will thus increase because of a lack of privatisation revenue.  
 In the framework of the Czech accession to the European Union there are available 
pre-accession funds both for municipalities and regions. The funds could be used to co-
finance various development projects, mostly capital investments. However, the transparent 
and efficient management of local finance is crucial in order to qualify for the pre-accession 
aid, which is even more needed due to the recent floods that hit the Czech Republic.  
 
 


Local government borrowing in the Czech Republic

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