It is a perceived wisdom that external financing has been one of the main sources for supporting the Ukrainian economy at all times, including in times of hardship, as we have now. At the same time, all foreign funds, by and large, were coming to the state and private sector, while municipal borrowers have been lagging behind. According to the data of the Ministry of Finance of Ukraine, there were seven loan agreements executed by Ukrainian city councils in 2013 with foreign lenders and only one in 2012. Based on the publicly available information, the number of external local borrowings in 2014 would hardly reach the level of 2013.

Given that urban development is quite important for overall Ukrainian economic growth and its needs are not currently satisfied in full, we believe that the government should give more attention to the issue of local financing in order to create positive dynamics in the regions.

At the moment, the number of tools for raising foreign funding by municipalities is very limited. Historically, Ukrainian cities were raising money abroad only through direct loans. Even in cases where financing was raised in international capital markets (such as Eurobond issues of the city of Kiev), it was still structured as a loan to the city council. In most of the cases, such loans are provided by international financial organisations, which maintain programmes aimed at improving urban infrastructure or energy efficiency in the municipal sector and can offer, as a result, better commercial terms than private banks or financial institutions.

Given that direct issues by our cities of any securities outside of Ukraine are still not feasible, we would concentrate in this article on the procedure applicable to loan agreements with the municipalities.

Necessary authorizations

Despite the low activity of cities in borrowing funds abroad, Ukraine already has in place basic legislation regulating this sphere, which has been tested by now.

The Ministry of Finance plays a key role in the process of raising funds by municipalities. Under the law the Ministry of Finance is the only body vested with powers to give a green light for external borrowings of the municipalities. In particular, the Ministry of Finance must approve the amount and all other essential terms of the loan to be borrowed before the loan agreement can be executed. While the law does not set any specific requirements for the scope of the Ministry of Finance approval, as a practical matter, such approval would normally cover the currency, amount, term, interest rate, repayment schedule and the purpose of the loan.

In order to obtain from the Ministry of Finance an approval of the loan the respective city council would need to provide the Ministry of Finance with the documents package containing data on the local budget and its performance, other borrowings for the last 5 years, population statistics, status of current liabilities, etc., as well as a draft internal resolution approving the borrowing. The Ministry of Finance has twenty working days for reviewing the documents received from the city council and taking its decision. It is important to stress that although a positive decision of the Ministry of Finance is required to proceed with a particular borrowing, the issuance of such approval does not constitute any guarantee by the Ministry of Finance in respect of that local borrowing.

Further, the approval process for the borrowing would require the city council's own resolution be adopted. Such resolution may not conflict with the terms approved by the Ministry of Finance and a copy of it shall be sent to the Ministry of Finance within 10 days upon execution. With all approvals in place, execution of the loan agreement may follow. In this respect an important thing to note is that the right to make local borrowings is vested with the territorial community of the city represented by the head of the local financial authority. At the same time, there are instances when such local financial authority has not been established and its functions are performed by the mayor, which would usually require extra diligence of the lawyers working on the transaction.

It is also worth mentioning that Ukrainian legislation imposes an obligation on the city council to provide the Ministry of Finance with a copy of the signed loan agreement (within 10 days after it was signed) and information on making any payments under such agreement (within 10 days of the date of the payment).

Budget law considerations

Foreign borrowings by municipalities are even more complicated as they have to comply with the rules established by the Budget Code of Ukraine of 8 July 2010 (Budget Code). In particular, the anticipated amount of the borrowing under the loan agreement of the local council shall not exceed the ceiling for local debt set by the decision of the local council approving the budget for the year when such loan agreement is signed.

Although the Budget Code provides that payments to fulfil obligations under the local debt must be made in accordance with the relevant loan agreements irrespective of whether the required funds have been specifically allocated for such payment purposes pursuant to the local budget decision for the relevant year, in practice, such payments can be made by the treasury only if the funds for the repayment and servicing of the loan agreement were allocated in the local budget for the respective year. Accordingly, if the payments due under the local debt exceed the budgeted amount, the local council will have to amend the local budget accordingly by adopting the respective resolution.

It is important to ensure that no default takes place under foreign borrowing of the municipality, as in such an unfortunate case the city would become prevented by operation of the law from making any foreign borrowings for the next five years.

Currency control regulations

Ukrainian law provides for a rule pursuant to which practically all loan agreements (as well as most of the amendments thereto) with foreign lenders have to be registered with the National Bank of Ukraine (NBU). Given that NBU registration, subject to certain exceptions, is a condition for effectiveness of the loan agreement, no funds can be disbursed to the borrower in the absence of such registration.

In order to be registered with the NBU the interest rate under the loan agreement with a foreign lender shall comply with the maximum permitted interest rates established by the NBU. Currently, loan agreements may provide for USD 3 month LIBOR plus 750 bps in case of floating interest rate loans, and from 9.8% to 11.0% per annum (depending on the loan term) in case of fixed interest rate loans. According to the applicable NBU regulation, such maximum interest rates include any fees, default interest, penalties and other charges and payments provided under the respective loan agreement. In practice, the NBU would refuse registration of the loan agreement if it does not comply with the interest rate limitation or fail to contain any other mandatory provisions set forth by the NBU for loan agreements with foreign lenders.

However, in light of the fact that municipalities often borrow funds from international financial organisations, they can benefit from the more relaxed requirements applicable to the IFOs, which do not provide, inter alia, for the effectiveness of the loan agreement upon its registration or compliance with the maximum interest rate rule.

Government initiatives regarding budget decentralisation

Currently, municipalities in Ukraine are very much dependent on the central government and all their finances are tied to the funds transferred from the state budget. The current system does not create incentives for local councils to increase revenues of local budgets, as they do not have any guarantee that such excess revenues would get back to them in the new budget year. At the same time, we believe that local councils can be much more effective if they have more flexibility in managing their revenues and expenditures as they deem fit.

The Draft Act On Budget Decentralisation (New Act) was presented by the Cabinet of Ministers of Ukraine this summer. Budget decentralisation implies transferring financial authority (functions, powers and responsibilities) from central to local authorities. The New Act calls for introduction of local autonomy and financial independence of local councils. Such reforms, in our view, should facilitate cross-border capital inflow, since the proposed changes provide for simpler foreign borrowing procedure by municipalities and more flexible process for managing local budget funds.

In particular, the approval procedure is proposed to be brought in line with other deregulation initiatives in the government, providing for the principle of "tacit consent" (i.e. the terms of the foreign borrowing are deemed to be approved by the Ministry of Finance if no comments are received from it within one month after the documents were submitted). Flexibility in managing local funds derives from the option to keep them not only in the accounts of the State Treasury of Ukraine (as provided now), but also, in certain circumstances, in the accounts opened by the local councils with Ukrainian banks. Such an additional option could mitigate the risk of blocking the funds by the State Treasury of Ukraine and allow local councils to allocate necessary payments in due time.

However, in order to implement the decentralisation reform holistically the respective legal framework (not limited to the New Act) must be established. A number of existing laws and regulations would need to be amended using the experience of other countries, which had similar problems and managed to resolve them through such decentralisation efforts.

Obviously, such steps may raise numerous practical issues in Ukraine, as well as certain reluctance of the central government to give away its powers. Nevertheless, based on the experience of the developed states, Ukraine must ensure fresh inflow of funds to its cities and give them a possibility to get closer involved in determining their future, which should also have a positive effect on the overall economic situation in our country.

Originally published by The Ukrainian Journal of Business Law.

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