Changes in the credit risk profile of polish local governments. An assessment of unsystematic risk

Abstract

The paper presents research devoted to changes in the local government credit risk profile in Poland. Firstly, the risk assessment is conducted based on the free operating cash flow and net debt approach as a preferred alternative to the statutory debt limits. Then, using the Data Envelopment Analysis method, an analysis is conducted of changes of unsystematic risk of local government subcategories during the period of economic slowdown. The study finds that the general risk profile of local governments strongly deteriorated compared to the precrisis year of 2008. Since 2011 it has slightly improved. However, this partial improvement was mainly due to a drop in market interest rates in 2013. Adjusting data for this factor reveals that the financial standing would not have changed in a positive way. Two local government subcategories have relatively inferior risk profiles. The first one is the towns with county rights, which represent more than one third of the population and revenues of the local government sector. They have the highest debt levels compared to their debt service capacities, and some of them accumulated high unsystematic risk. Approximately 20% of them have debt service indicators below safe levels. The second category is the counties. Despite relatively low debt levels, there is high systematic risk in this group. Without system reform of the counties, approximately 25% of them may have problems with performing their statutory tasks or servicing their debt in the medium term. The rural boroughs are the safest local government category in Poland.

An appraisal of financial indicators for local government: a structured literature review

“…Furthermore, debt management in the public sector is different from private entities, due to the possibility of many LGs to raise revenue through taxes, receive additional funding from central governments when in distress, and the redistributive role they play in managing the economy (Caruana et al , 2019). The representation of liabilities in the balance sheet of a LG may be misleading (Kluza, 2017a). In fact, a negative asset balance does not necessarily deter potential investors from investing in a public entity's debt (Caruana et al , 2019).…”

“…Over time, scholars started talking interchangeably about financial condition, financial health and financial sustainability, even though they are neither understood nor operationalized in the same way and suffer from various conceptualizations. Most authors understand financial health as the absence of distress, meaning an imbalance between revenue capacity and expenditure needs, which though for some is related solely to risk and debt management (Kluza, 2017a, b; Pridgen and Wilder, 2013; Yi, 2009), while others pinpoint to short-term considerations, namely a LG's ability to meet its payroll on time (Manes Rossi et al , 2012), while for others it corresponds to service delivery and adhering to minimum quality standards (Winarna et al , 2017), and for yet others it refers to a combinations of these issues (Murray and Dollery, 2005; Padovani et al , 2018; Trussel and Patrick, 2018). Other scholars include in a healthy financial condition also the ability of LGs to deal with events that are unexpected in the impending future, such as natural or social disasters (Ritonga, 2014).…”

“…This greatly limits the meaning of comparing financial indicators across LGs that do not adopt the same standards within and across countries. Moreover, risk assessment with respect to both internal and external factors requires a more detailed analysis than debt analysis which treats debt simply as something bad and undesirable (Kluza, 2017a). Future research could look further into LG's credit rating and consider, for example, that debt may be spent on investments which create cash inflows, efficiencies or public value.…”

Risk assessment of the local government sector based on the ratio analysis and the DEA method. Evidence from Poland

“…Based on them and the format of statutory reports of LGs, as well as over 10 years of professional experience of the author in the LG sector financing, the following indicators are proposed. Detailed definitions and the rationale of the indicators described below are presented in Kluza (2014). All the ratios can be calculated with annual or quarterly frequency, which enables more precise risk monitoring.…”