Krakow's Debts: The Twilight Zone

Most practical budgeting may take place in a twilight zone between politics and efficiency.' Aaron Wildavsky (1961)

Across the world excessive debts at an individual, corporate and state level have brought the global economy to its knees. Years of easily available credit fuelled by financial engineering techniques such as 'securitisation', led many to rack up debts that somehow they thought would never have to be repaid. Now that the hangover has settled in and it's time to tighten belts and reduce indebtedness, local and national budget deficits (There aren't too many surpluses) are the topic de jour. What better time to have a closer look at the state of Krakow's financial health.

A budget is a financial plan on how a set of objectives for a given year will be achieved, allocating estimated resources against estimated requirements,but more importantly budgets are the life-blood of government. Whereas politicians often view a budget as a political tool for gaining political advantage, economists view it as a matter of allocating resources based on an 'opportunity cost' of not allocating it elsewhere. The role of the accountant is to sit above the political arena and report on the actual performance of budget programs versus their forecasts as well as balance sheet items such as accumulated debts. Transparency of information through these reports, allow the public to judge whether public officials are good stewards of public funds.

Where deficits (When incomes for the year are less than expenses on the budget plan) are created and accumulated over several years, debt (Shown on the balance sheet) is used to fill the hole. The interest cost associated with these debts drain resources away from socially productive budget programs and eventually the debts must be repaid and that cash must come from somewhere or the city risk default and a credit downgrade as the US just experienced. Debt levels therefore become an important indicator of the financial and social health of a city.

The Budget by the Numbers

Krakow's budget plan for 2011 and the projected deficit of 20 million zloty are presented above.

Some of the largest revenue centers such as tax (Guaranteed by statute) are marked in blue and a few large cost centers such as Education are marked in orange. Interest costs or public debt servicing are 107 million zloty which is around 3% of revenues. These are generated by Krakow's declared debtof around 2 billion zloty.This debt stands at around 57% of total expenses, which is approaching the statutory permissible maximum of 60%. Despite thisthe credit rating agency Standard & Poor's conclude that Krakow conducts generally stable financial policies and grants it a long-term credit rating of A-, which in turn affords the city lower interest rates.

Transparent as Mud
Dig deeper and it becomes apparent that Krakow owns shares in a number of municipal and non-municipal subsidiaries, whose financial status is not reported in the budget or balance sheet. The Kosciuszko Institute, an economic think tank, published an analysisof these city subsidiaries across Poland and concluded that in Krakow alone, if you were to include the losses of its subsidiaries, Krakow's budget deficit for 2011 would be 13 times greater, at around 260 million zloty.Krakow's debt level would increase to 2.8 billion zloty, around 80% of declared expenses and well beyond the limit set by law. Overall in Poland the Institute found that Poland's largest cities have official debts of 19.7 billion zloty, rising to 27.4 billion zloty when the debts of subsidiaries are factored in.Bear in mind that even theseestimates may be significantly understated, as the Kosciuszko Institute could only find financial information for approximately half of the known subsidiaries owned by local governments.

Who are the Subsidiaries?
A list of Krakow's subsidiaries can be found on the city's public information website: www.bip.krakow.pl. The city has minority shareholdings in a number of external companies such as Concorde Investissement S.A. (0.2%) and KRAK-SYSTEM S.A. (17%), both of which are involved in real estate development. Its only majority shareholding is in the football club Cracovia (51%), who recently finished a new football stadium. However none of these would explain the additional 800 million zloty of debt pointed out by the Kosciuszko Institute. The majority of debts lies in Krakow's 100% owned holding company KHK S.A. which in turn holds the main utility providing subsidiaries. These include, the heating company (MPEC S.A.), transport (MPK S.A.) and water and sewage (MPWiK S.A.). On KHK's website for 2009we found consolidated financial numbers (which include the subsidiaries) showing that short term debts stand at around 400 million zloty, long term debts are 285 million zloty and accrued liabilities of 470 million zloty (this may include amounts owed to suppliers). So the majority of debt is concentrated in these municipal subsidiaries, but at this point the trail goes cold. There is no separate financial reporting for the subsidiaries of KHK and potentially the subsidiaries of these subsidiaries. As city entities ultimately backed by public funds, one has to ask why are these reports in a financial twilight zone?

Some Fancy Financial Stuff
In some cases Krakow may be using a fairly common financing structure that allows it to borrow and invest in projects without breaking statutory debt limits imposed on the city by law. This typically involves the creation of special purpose vehicles (SPVs), or subsidiary companies, where capital from different sources, debt, public and private funds, can be structured 'off balance sheet', that is to say the financial statements of the subsidiary SPVs do not have to be combined or 'consolidated' with the parent (ie Krakow) of the subsidiary. These vehicles can be structured in such a way as to piggy-back off the parent's creditworthiness and therefore allow them to borrow significant amounts and be fairly highly 'leveraged' in banker speak. The projects themselves must still be productive and be assured of producing an income stream that can pay interest and ultimately repay the loan. These structures are typically designed by a combination of Treasury Department officials advised by consultants and bankers who are motivated by the potential fees involved.

Below is a simple example of how such a structure can work in the case of a transport company.It should be noted that the municipality must still provide some form of guarantee against the loan granted to the SPV and provide the SPV with a public service contract securing the SPV revenue stream. In this way the creditworthiness of the new entity is established.

The mixing of public and private funds in investment projects is referred to as a Public Private Partnership or PPP. Across Europe and the world there has been a rapid growth in the number of such partnerships, particularly in areas such as infrastructure expansion and renewal. They offer the advantages of increasing sources of capital for projects beyond public funds, spreading the risks (and also the rewards) of the project and working with private sector contractors or operators whose use of capital is typically more efficient than public bodies. The city lists a number of the PPP's it is involved in on its public information site, but this may not include the PPP's of its subsidiaries.

However the argument can also be made that if these structures take project debts off the public balance sheet and project costs away from the publicly reported budget plan, they are adding a sort of 'stealth'indebtedness to a city and adding opacity to government reporting. Ultimately the city must still provide guarantees against bank loans and as a result is exposed to any potential default on the debts of the subsidiaries. With no reporting on the debts of these vehicles, they have the potential of becoming a ticking time bomb that only become publicly known when there is default or bankruptcy situation, at which point public services must be cut back in order to repay loans. Such structures can also become overly complicated when multiple layers of SPVs (Subsidiaries of subsidiaries) are employed and complex interrelationships between the actors in the arrangement arise. This further serves to reduce the transparency of the exposure to the public and runs the risk that Krakow's treasury department may have difficulties in managing these indirect debts.

Some in the media have suggested that the city have sought to conceal debts in these subsidiaries calling this 'creative accounting'. I view this rather as fairly common structured finance and would hope that Krakow has used this financial engineering to attract private investment and responsible levels of leverage into infrastructure projects, thereby boosting Krakow's growth prospects. However as I mentioned at the start of this article, similar financial products like securitisation,created large levels of incorrectly rated stealth debt that ultimately brought the world economy to its knees.

Whichever set of intentions you believe, it is clear that transparent financial reporting regarding these activities would go a long way to alleviate concerns about the state of Krakow's financial health. At the end of the day, debt is debt and the people have a right to know.