Project Number: 37917 Investment Number: 7193 October 2012

Equity Investment LGU Guarantee Corporation (Philippines)

In accordance with ADB’s public communications policy (PCP, 2005), this abbreviated version of the XARR excludes confidential information and ADB’s assessment of project or transaction risk as well as other information referred to in paragraph 126 of the PCP.

Extended Annual Review Report

CURRENCY EQUIVALENTS

Currency Unit – peso (P)

At Appraisal At Project Review 7 November 2003 19 September 2012

P1.00 – $0.02 $0.02 $1.00 – P55.27 P41.73

ABBREVIATIONS

ADB – Asian Development Bank BAP – Bankers Association of the Philippines BSP – Bangko Sentral ng Pilipinas BVS – book value per share CAGR – compounded annual growth rate DBP – Development Bank of the Philippines DOF – Department of Finance EBIT – earnings before interest and taxes EBITDA – earnings before interest, taxes, and depreciation EPS – earnings per share EROIC – economic return on invested capital FIRR – financial internal rate of return GFI – government financial institution IRR – internal rate of return LGU local government unit LGUGC – LGU Guarantee Corporation MLE – medium-to-large enterprises NAV – net asset value ORM – Office of Risk Management PE – price–earnings PFI – private financial institution PSCM ROA

– Capital Markets and Financial Sectors Division return on assets

ROE – return on equity ROIC – return on invested capital USAID – United States Agency for International Development WACC – weighted average cost of capital

NOTE

(i) In this report, "$" refers to US dollars.

Vice-President L. Venkatachalam, Private Sector and Cofinancing Operations Director General P. Erquiaga, Private Sector Operations Department (PSOD) Director R. van Zwieten, Capital Markets and Financial Sectors Division, PSOD Team leader A. Taneja, Principal Investment Specialist, PSOD Team members C. Abuel, Project Analyst, PSOD

P. Flegler, Investment Specialist, PSOD

In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

CONTENTS

Page BASIC DATA i EXECUTIVE SUMMARY ii

I. THE PROJECT 1

A. Project Background 1 B. Key Project Features 1 C. Progress Highlights 1

II. EVALUATION 3

A. Project Rationale and Objectives 3 B. Development Impact 3 C. ADB Investment Profitability 7 D. ADB Work Quality 7 E. Overall Evaluation 8

III. ISSUES, LESSONS, AND RECOMMENDED FOLLOW-UP ACTIONS 8

A. Issues and Lessons 8 B. Recommended Follow-Up Actions 9

APPENDIXES 1. Project Background 10 2. Progress Made 1998 – 2011 11 3. Advocacy Activities: Key Regulatory and Policy-Related Changes 13 4. Business and Financial Performance 14 5. ADB Work Quality: Screening and Appraisal of the LGU Guarantee Corporation Investment 18

BASIC DATA Equity Investment: LGU Guarantee Corporation in the Republic of the Philippines

(7193 - PHI)

Key Project Data As per ADB Equity Investment Documents

($ million) Actual

($ million)

Total Project Cost ADB Investment:

Equity: Committed Disbursed

2.0

2.0 2.0

1.4

1.4 1.4

Key Dates Expected Actual

Board Approval Final Disbursement

2004 2005

19 Jan 2004 28 Feb 2005

Project Administration and Monitoring No. of Missions No. of Person-

Days

Concept Clearance Fact-Finding Appraisal Project Administration XARR Mission

1 1 1 1

2

Data not available -- -- --

5

ADB = Asian Development Bank, XARR = extended annual review report.

EXECUTIVE SUMMARY In January 2004, the Board of Directors of the Asian Development Bank (ADB) approved an equity investment of $2 million (up to 25% of the subscribed capital) to facilitate the expansion of the capital base of LGU Guarantee Corporation (LGUGC) in the Philippines. The investment aimed to support LGUGC and its credit enhancement facility, which was being tapped by creditworthy local government units (LGUs) as a private source of financing for municipal and urban infrastructure projects. The investment was also intended to foster the expansion of the subsovereign debt market in the Philippines and to broaden the investor base for bonds issued by LGUs. ADB invested in fresh capital issued by LGUGC. The expected holding period under the project was 7 years, ending in February 2012. LGUGC began operations in 1998 and initially guaranteed bond issues by LGUs. These were comparatively small, given its narrow capital base and a market that was relatively untested from the perspectives of both issuers and investors. In 2002, LGUGC shifted its guarantee operations from bonds to guarantees for loans extended by private financial institutions (PFIs) to LGUs. This was the result of competition from government financial institutions and changing dynamics in the LGU financing market, where bond transactions became intermittent and were handicapped by unfavorable economics. While this moved LGUGC away from one of the key objectives of ADB’s investment—the development of a subsovereign bond market in the Philippines—it remained entirely consistent with the project’s primary focus, which was to lead private capital toward viable capital investments in LGUs. LGUGC has made other realignments during ADB’s investment holding period by providing program management services and advocating for and playing a role in leading private capital to urban water projects. These initiatives have been driven primarily by LGUGC’s proactive management, efforts to diversify the scope of its operations, and pursuit of better earnings and profitability but also resulted to some extent from its capital constraints and the limited opportunities in its initial targeted area of LGU bond guarantees. This extended annual review report finds ADB’s investment in LGUGC to have been well conceived. It was aligned with ADB’s objectives of providing LGUs with greater access to private sector capital (primarily long-term debt), meeting the immediate capital requirements of LGUGC, and expanding the use of LGUGC’s guarantee program to other new sectors like electricity distribution, energy conservation and private entities. The project was also in harmony with ADB’s country partnership strategy, which identified the generation of greater investment and resource mobilization at the local government level and decentralized program development as key ways to reduce poverty in the Philippines. The overall private sector development impact of this investment, consisting of the direct impact on LGUGC and the wider beyond-company effect, is rated satisfactory. LGUGC was the first and is now the leading guarantee company in the financial sector in the Philippines and has been uniquely placed to enhance the credit of LGUs by extending guarantees for their borrowings. This has improved the access of LGUs to private sector capital and has widened their base of investors and lenders. The growing role of private sector financiers in LGU capital projects is partly attributable to an increased awareness by PFIs of this market and an improvement in their perception of the risk it involves. Both these changes illustrate LGUGC’s and the project’s contribution. LGUGC’s financial and business performance is rated satisfactory. LGUGC has capitalized on immediate opportunities and maintained the flexibility needed to alter its sector focus as prospects emerged. While this meant the company digressed from its initial objectives, it

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nonetheless made good use of its capital base, increased awareness of LGU financing among PFIs, and widened the applicability of its financial guarantee product. The financial parameters related to LGUGC’s business success and profitability, have met ADB’s expectations for extended annual reviews and qualify for a satisfactory rating overall. ADB's work quality is also rated satisfactory based on its (i) screening, appraisal, and structuring of the project; (ii) its ongoing monitoring and supervision; and (iii) ADB’s role and contribution. A noteworthy feature in the investment structure is a built-in exit arrangement, which has, in general, not often been a part of ADB direct equity investment structures. This feature establishes a clear time limit on ADB’s holding and sets a transparent exit path. ADB's role, contribution and additionality are rated satisfactory. ADB’s 2005 equity investment was critical for LGUGC, which had made full use of its initial capital and could not raise more from its original shareholders. ADB’s investment allowed the company to expand its portfolio of guarantees and its scope of operations to new sectors and applications. This rating is also supported by the benefits provided by ADB’s presence to the market’s perception of LGUGC and its operations and by more direct ADB contributions to governance, product pricing, and compliance with environmental, social, health, and safety standards. The review rates ADB’s investment in LGUGC satisfactory overall. This report recommends that ADB should now exit from its equity position in LGUGC in line with the procedure defined in the shareholder’s agreement.

I. THE PROJECT

A. Project Background

1. In January 2004, the Board of Directors of the Asian Development Bank (ADB) approved an equity investment in LGU Guarantee Corporation (LGUGC) of up to $2 million and no more than 25% of the company’s subscribed capital.1 LGUGC was established in 1998, with the Bankers’ Association of Philippines holding 51% of its equity, and the balance 49% being with the government-owned Development Bank of Philippines, and is a private sector entity engaged primarily in extending credit default guarantees on the borrowings (bonds and loans) of local government units (LGUs) in the Philippines. 2. The investment aimed to support LGUGC and its credit-enhancement facility, which was being tapped by creditworthy local government units (LGUs) as a private sector source of financing for municipal urban infrastructure projects. The investment was to expand LGUGC’s capital base, which would then be leveraged to help LGUs gain access to private capital and meet their growing investment needs. ADB also expected the investment to foster development of the municipal or sub-sovereign debt market, broaden the investor base for bonds issued by LGUs, and allow private finance to play a larger part in the then government-dominated sphere of LGU financing. Appendix 1 provides additional details on the project background.

B. Key Project Features

3. ADB invested in fresh capital issued by LGUGC. The expected holding period under the project was 7 years, ending in February 2012. At the time of the ADB investment, LGUGC had fully utilized its initial capital contributions through extending guarantees for LGU bond issues. ADB’s investment was expected to increase the company’s capital and play a catalytic role in LGUGC’s planned bid to raise capital from insurance companies. ADB retained the right to nominate one or more directors to the board of LGUGC, in proportion to its shareholding in the company. 4. ADB built an exit mechanism into the investment structure, which was incorporated in the share subscription agreement with LGUGC.2 This review considers such structuring as a positive aspect, because it set a definite time and laid out methods for ADB’s withdrawal from its equity investment in LGUGC. C. Progress Highlights

5. Even prior to ADB’s investment, LGUGC had made substantial progress in pursuing its mandate of leading private-sector capital for financing LGU projects. Its initial operations, in 1999-2003, were focused on enhancing the credit ratings of bonds issued by LGUs and undertaking extensive advocacy and urban-sector development work. This approach aligned well with the opportunities available at the time and the need for LGUGC to expand its

1 ADB. 2004. Report and Recommendation of the President to the Board of Directors: Proposed Equity Investment

in LGU Guarantee Corporation in the Republic of the Philippines. Manila. 2 ADB’s subscription agreement with LGUGC provided that at the end of the specified holding period, ADB would

first offer to sell its shares to existing shareholders. If within 60 days, none of the shareholders had agreed to purchase these shares, ADB would be able to offer the shares to at least two other counterparties at a price equivalent to the redemption price. If this offer remained unsuccessful, the equity investment would be converted into a loan to LGUGC, at a nominal amount of ADB’s share in LGUGC’s net asset value, payable in 14 semiannual payments at an interest rate based on Government of Philippines 91-day T-bill (at the time of conversion), plus a credit margin of 2.5% per annum.

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operations. The initial bond transactions LGUGC guaranteed (in 1999) were comparatively small (in the range of P50 million), due its narrow capital base and a market that, from the perspectives of both the issuers and the investors, was relatively new. With the success of the initial transactions and an enhancement of its risk-bearing ability through development partner support, LGUGC guaranteed two large-sized bond issues in 20013. This used a substantial part of its existing available capital. 6. In the period 2001-2004, with the impact of competing financing alternatives (i.e. loans extended by local banks) and a limited market for bonds issued by LGUs, LGUGC placed greater attention on guarantees for LGU loans extended by private financial institutions (PFIs). Its bond transactions remained intermittent and handicapped by unfavorable economics. While this was a significant change in LGUGC’s operating strategy and moved it away from ADB’s initial investment objective of developing the sub-sovereign bond market, it remained entirely consistent with the project’s primary focus of leading private capital to viable LGU-level capital investments. 7. The company has taken other significant strategic initiatives since ADB’s 2004 investment. In 2004, it began providing program management services and is currently managing the guarantee funds of the World Bank’s Global Environment Facility’s Electric Co-operative System Loss Reduction Project 4 being administered through the Department of Energy, Government of the Philippines. Since its inception, LGUGC has made extensive advocacy efforts in directing private capital to LGU water projects. This resulted in its membership in a steering committee created in 2005, to design the Philippine Water Revolving Fund,5 which opened avenues for LGUGC to guarantee the private financing components of water projects. These initiatives have been driven by a proactive management and the company’s desire to diversify the scope of its operations. They are also the result to some extent of its capital constraints, the limited opportunities for its initially targeted LGU bond guarantees, and the company’s effort to enhance earnings and profitability. 8. In addition to seeking new avenues for growth, LGUGC has enhanced its focus on (i) advocating a conducive policy and regulatory framework for LGU bonds, credit-guarantees, and the participation of PFIs in this financial sector; (ii) widening the applicability of its core guarantee product to new projects, sectors, and structures; (iii) continuously enhancing its internal organizational capabilities related to project analysis, risk assessment, monitoring, systems, and information technology; and (iv) strengthening its institutional linkages with several bilateral and multilateral organizations, such as the World Bank and the United States Agency for International Development (USAID), which brought capital, grant funding, new policy, and best practices into the urban infrastructure sector. 9. The progress made by LGUGC may be considered somewhat unexceptional, if measured only in terms of the monetary value of the financing it has guaranteed or facilitated. However, this review concluded that the larger impact of LGUGC’s activities in demonstrating

3 LGUGC entered into a co-guarantee arrangement with USAID in 2002, which allowed it to off-load 30% of its

exposure (or risk) for select borrowers, up to a specified guarantee limit. 4 A similar guarantee facility of the United Nations Development Programme is being administered by LGUGC.

5 The Philippine Water Revolving Fund is a multilateral effort of USAID; the Japan Bank for International

Cooperation; and Philippine partners, including the Department of Finance, the National Economic Development Authority, and the Bankers Association of the Philippines. The fund aimed to establish sustainable financing to achieve the Philippines’ Millennium Development Goals targets in water supply and sanitation, and to bring existing services in the Philippines up to par with international benchmarks. Source: Development Alternatives Inc.: Fund - Design and Implementation Framework (Final Report). Philippines (July 2006).

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the viability of private-sector financing at the LGU level for urban infrastructure investments, and bringing in improved project planning, assessment, and monitoring practices is noteworthy, particularly given some of the structural and policy constraints it has faced.

II. EVALUATION A. Project Rationale and Objectives 10. ADB’s investment in LGUGC was conceived well and aligned with ADB’s objectives of providing LGUs with greater access to private capital (primarily long-term debt), meeting the more immediate capital requirements of LGUGC, and expanding the use of LGUGC’s guarantee program to other components of urban infrastructure sector. It was also in harmony with ADB’s country partnership strategy for the Philippines, which identified decentralized program development, greater investment, and resource mobilization at the LGU level as key steps toward reducing poverty.6 11. ADB’s initial expectations7 were that LGUGC’s guarantees would be used primarily to enhance the credit ratings of LGU bonds. ADB’s investment rationale also included rather expansive objectives related to capital market development and a widening of the investor base for LGU bonds. These broad-based objectives now appear to have been overambitious and to have overestimated the potential impact of ADB’s investment, given its small size and structure, as well as the impact of LGUGC activities, given (i) the LGUGC’s modest capital base (ii) the lack of any specific procedural or cost advantage for LGUs to issue bonds rather than to borrow directly from government financial institutions (GFIs) or PFIs, and (iii) the competition from the GFIs and local banks.8 The negative effects of these factors were later magnified by (a) the operating arrangements between GFIs and LGUs, wherein GFIs had preferential access and control over the funds transferred from the federal government to the LGUs and (b) delays in adoption of regulatory measures needed to strengthen the capital market development linkages. 12. The investment was also expected to segment the market for LGU borrowers, with LGUGC focusing on the more creditworthy borrowers and channeling their investment requirements towards PFIs, while smaller and weaker LGU borrowers that had only a limited ability to attract commercial finance sought funding from GFIs. An underlying objective of shifting towards project-based lending and encouraging best practices among LGUs was also expected to be served by this arrangement. Even though the number of guarantees issued by LGUGC is not particularly large (48 guarantees over the period 1998 to 2011), a trend toward the adoption by LGUs of project-based lending, involving detailed assessment of financial viability and thorough risk assessment ,is now evident. B. Development Impact 13. The development impact of the investment is rated satisfactory based on the parameters of (i) private sector development; (ii) business success; (iii) economic sustainability; and (iv) environment, social, health, and safety aspects.

6 ADB. 2002. Country Strategy and Program Update: Philippines, 2003−2005. Manila.

7 At the time of ADB’s investment, LGUGC’s guarantee portfolio consisted almost entirely of bonds issued by LGUs,

and PFI loans, which were not prevalent, were not being guaranteed by LGUGC. 8 Some of the competing GFIs and local banks were also prominent shareholders in LGUGC. As bonds issued by

LGUs under the guarantee of LGUGC directly compete with LGU loans sanctioned by these GFI banks, this had a limiting impact on LGUGC’s growth prospects.

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1. Private Sector Development

a. Overall Assessment of Private Sector Development 14. The overall private sector development impact of the investment in LGUGC is rated satisfactory. LGUGC was the first and is now the leading guarantee company in the financial sector in the Philippines and has been at the forefront of enhancing the credit of LGUs, by extending guarantees for their borrowings. This has improved access by LGUs to private sector capital and widened their base of investors and lenders. LGUGC has contributed to the growing participation by private sector financiers in LGU capital projects, which is partially attributable to increased awareness on the part of lenders and borrowers of the opportunities in this market due to LGUGC activities and to an improvement in perception of the degree of risk involved. Although the development impact has been subdued due to LGUGC’s limited capital base and a relatively small number of guarantee transactions (48 transactions, covering a cumulative amount of Php5.6 billion), LGUGC’s expansion of guarantees to the urban water supply, electricity distribution, renewable energy and small and medium enterprise sectors and the dissemination of new lending and project monitoring practices through LGUGC’s advisory services justify this rating.

b. Beyond Company Impact 15. The beyond company impact of LGUGC is rated satisfactory. Appendix 3 provides details on this impact. 16. At the appraisal stage, ADB expected that its investment in LGUGC would trigger the development of a municipal bond market in the Philippines through which more creditworthy LGUs, equipped with better project-development and implementation capabilities, would tap long-term funding from such nonconventional investors such as pension and insurance funds under the credit protection of the LGUGC guarantee. However, LGUGC and ADB’s investment made only a modest impact on this objective due to a limited LGU bond pipeline and the fact that the underlying economics favored direct borrowing over the issuing of bonds.9 17. Nonetheless, LGUGC has made a sustainable impact far beyond its immediate sphere of operations. It has (i) encouraged competition through its activities, which has substantially improved the terms and conditions of loans obtained by LGUs from individual PFIs and GFIs;10 (ii) opened up more ways for LGUs to finance public infrastructure projects; (ii) enhanced the project structuring, appraisal, and monitoring systems of some LGUs, (iii) advocated with the MoF and the BSP, for the creation of a level playing field between GFIs and PFIs in the context of LGU financing, (iv) advocated for regulatory changes that would support the development of a municipal bond market and make LGU bonds more acceptable to investors; and (v) attracted other private sector guarantors into this line of business.

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Some of the competing GFIs and local banks were also prominent shareholders in LGUGC. As bonds issued by LGUs under the guarantee of LGUGC directly compete with LGU loans sanctioned by these GFI banks, this had a limiting impact on LGUGC’s growth prospects and requirements of the underlying project eliminates the carrying costs of raising funds ahead of the deployment plan through bond issues.

10 This competitive behavior hurt the growth and profitability of LGUGC but certainly benefitted the LGUs, which in this respect have been the main beneficiaries of ADB’s intervention. Prior to LGUGC’s presence, GFI loans for LGUs typically had a 3-year tenor and carried the maximum permissible interest rates. This did not match the long-term nature of the LGU projects and overestimated the underlying risks. LGUGC’s involvement increased competition, which in turn led to an extension of loan tenors to 7 years and reduced credit margins (by nearly 2%, according to LGUGC estimates). This has benefitted borrowing LGUs and the population they serve.

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c. Direct Company Impact 18. The direct impact of ADB’s investment in LGUGC is rated satisfactory overall. 19. LGUGC was able to expand its guarantee portfolio and simultaneously maintain its credit standing after ADB’s capital injection. Without the investment, the company’s operations might have stalled. Prior to ADB’s investment in 2005, LGUGC’s P215 million capital base was leveraged about nine times, with a guarantee portfolio of about P1,850 million, and it had exhausted its capacity to issue guarantees. The member banks of the Bankers Association of the Philippines (BAP), which was LGUGC’s only private sector shareholder at that time, turned down its request for additional capital, evidently because they felt they needed to focus more on their own core operations. 11 This paved the way for ADB’s contribution. 12 This immediate redress of LGUGC’s capital requirements, at a time when its business prospects appeared promising, but its ability to raise additional capital from existing shareholders was uncertain, constitutes the most significant direct company impact of ADB’s intervention. 20. Other direct company benefits of ADB’s investment included (i) LGUGC’s enhanced awareness and acceptability with other multilateral and bilateral institutions, which facilitated access to grant funding for technical support, diversification into newsegments, and reinsurance options; (ii) the expectation that with ADB’s investment, LGUGC would have to adopt better governance and risk management practices, and (iii) LGUGC’s adoption and regular compliance with environment, social, health and safety standards in its business processes and transactions, which also made it more acceptable to other institutions. In addition, although this report draws no direct link, ADB’s presence as a shareholder was possibly a factor in the strengthening LGUGC’s governance and disclosure practices and internal procedures, which supported the PRS Aa+ rating assigned to it by Philippine Ratings Services Corporation in 2010.13

2. Business Success 21. LGUGC’s business success is rated satisfactory. Appendix 4 provides financial highlights during 2006–2011. LGUGC has capitalized on immediate opportunities and maintained the flexibility needed to alter its sector focus as prospects emerged. While this meant the company veered away from its initial objectives, it nonetheless made good use of its capital base, increased awareness of LGU financing among PFIs, and widened the applicability of its financial guarantee product. This dynamic shift in business focus as certain opportunities, such as LGU bond issuances, dried up and new ones (like water district financing) emerged, resulted from strategic management initiatives and the fact that funding arrangements between GFIs and LGUs allowed GFIs to retain a firm hold on the LGU financing business. 22. Such shifts are not unusual in the financial guarantee business because its economic life in dealing with a particular set of borrowers is often limited. As guarantee-seeking lenders or investors become more familiar with the underlying risk profile in a segment, their propensity to continue seeking such credit protection—and sharing a part of the earnings—declines. This means that either a steady flow of debt requiring credit protection must exist (e.g., in the

11

LGUGC could not seek capital from the Development Bank of Philippines because this would affect its private sector status, as it would then convert into a majority government-owned entity.

12 In 1999, ADB provided a grant to the Government of Philippines for capacity building in LGU financing (Technical Assistance to the republic of Philippines for Capacity Building in LGU Financing. Manila. TA 3349). The completion

report for this technical assistance recommended additional capital infusion in LGUGC. 13

The PRS Aa+ is the second-highest rating on the scale adopted by Philippine Ratings Services Corporation.

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municipal bond market in the United States) or companies providing guarantees must constantly diversify into new segments, as LGUGC has done. 23. As a financial guarantee company, LGUGC was expected to have a relatively stable financial performance based on a steady income from the fees levied on its guarantee portfolio and the interest income from its capital, which has been deployed in financial assets and securities. Despite this, its cash flow profile has been somewhat erratic due to (i) large prepayments14 made on some of the LGU bonds initially guaranteed by the company, and (ii) a steady reduction in interest earnings due to falling interest rates in Philippines. Table A4.1 in Appendix 4 shows the key financial variables for LGUGC during 2006−2011. 24. Despite this variability, LGUGC’s financial performance has been sound. This has been principally due to (i) the absence of claims on guarantees issued so far; (ii) steady operating expenses, which are partially supported by grants received for upgrading organizational and technical abilities; and (iii) the growing diversity in its sources of revenues. The accretion to capital was relatively modest during 2006–2011, at less than 5% per annum. This was a reflection in part of the low-margin guarantee business and lower interest earnings from treasury operations.

3. Economic Sustainability

25. Economic return on invested capital. From 2005-2011, LGUGC generated a total of P448.4 million in gross revenues from guarantee fees and related income, and recorded net profit of P229.7 million. Growth in gross revenues posted a CAGR of 8.3% to P81.3 million while net profit grew each year by a CAGR of 10.6% to P40.6 from 2005-2011. Taxes paid totaled P38.5 billion during the same period.

4. Environmental, Social, Health, and Safety Performance 26. The project’s environmental, social, health, and safety performance is rated satisfactory. ADB’s investment was classified category FI (financial intermediary) under its Environment Policy (2002). As a part of its due diligence, ADB conducted an environmental impact assessment and reviewed LGUGC’s operations, and concluded that the organization was not required to adopt a separate environmental management system. 27. Compliance with all laws of the Philippines was included in ADB’s subscription agreement with LGUGC to underpin the project’s commitment to environment, social, health, and safety standards.15 LGUGC has consistently ensured that the projects undertaken through its guarantees comply with the Department of Environment and Natural Resources’ environment and social safeguards and safety standards by requiring a borrower to submit an environmental compliance certificate for its project.16

14

In most cases, bond issuers that choose to prepay a bond are required by their terms to compensate the investors and the guarantee company for lost or foregone income (based on contracted and prevailing interest rates). This is a substantial disincentive and incidents of prepayments are not frequent. Evidently, these terms were not incorporated in these LGU bonds, which was a deficiency in their structuring.

15 ADB. 2003. Subscription Agreement with LGU Guarantee Corporation. Manila (21 January).

16 The company reports that in a few instances guarantee proposals have been declined by the LGUGC management or its board due to environmental concerns and considerations.

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C. ADB Investment Profitability

28. ADB’s investment profitability is rated satisfactory given the strategic importance of ADB’s equity contribution during the expansion period of LGUGC in 2005. From 2005-2011, LGUGC paid a total of P51 million on dividends to shareholders. ADB held a 25% equity stake in LGUGC amounting to P74.13 million and has held the investment since then. D. ADB Work Quality 29. ADB's work quality is rated satisfactory based on its (i) screening, appraisal, and structuring of the project, (ii) monitoring and supervision, and (iii) role and contribution.

1. Screening, Appraisal, and Structuring of the Project

30. ADB's work in screening and appraisal and structuring the transaction is rated satisfactory. The investment was aligned with ADB’s prevailing country strategy and program, which called for the promotion of more resource raising and investment planning at the LGU level, with a greater contribution from the private sector and capital market funding.17 The policy measures adopted by the government were also conducive and supported this intervention. The timing and implementation of the investment were also well managed. Appendix 8 has details related to structuring and appraisal. 31. The exit arrangement built into ADB’s equity position in LGUGC, something not often seen in its direct equity investments, was a noteworthy feature of the investment’s structure. It provides a time limit on ADB’s equity holding (footnote 2) and triggers a pre-defined divestment process. ADB also made critical contributions to strengthening LGUGC’s governance code and guarantee pricing, which have added value to the company. On the other hand, ADB failed to recognize that that the GFIs and members of BAP that were LGUGC shareholders and also direct competitors of LGUGC, might not forego their own business interests to set aside opportunities for the company. This turned out to be the case. Another shortcoming was ADB’s expectation that LGU bond investors, such as insurance companies, would take an equity holding in the company and thus alleviate these inherent conflicts, something that did not materialize.18 While these setbacks cannot be attributed exclusively to the quality of ADB’s work, they have hurt LGUGC’s performance and growth prospects.

2. Monitoring and Supervision

32. ADB's monitoring and supervision is rated satisfactory. The project administration unit of ADB’s Capital Markets and Financial Sectors Division has periodically monitored the business and financial performance of LGUGC through the company’s operational and financial reports. The Office of Risk Management has supported the monitoring process through its independent reviews of the monitoring reports and valuation for the transaction. ADB’s representative has participated regularly in the company’s board meetings and has provided the expected level of inputs in these discussions.

17

Footnote 6, p. 3. 18

ADB. 2004. Report and Recommendation of the President to the Board of Directors: Proposed Equity Investment in LGU Guarantee Corporation in the Republic of the Philippines. Manila

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3. ADB's Role, Contribution, and Additionality 33. ADB's role, contribution, and additionality are rated satisfactory. The ADB’s equity investment in LGUGC was critical at a time when the company’s existing shareholders were unable to supplement its capital base. The increased capital enhanced the company’s ability to expand its portfolio and scope of operations. The greater market confidence in LGUGC generated by ADB’s involvement as well as ADB’s more direct contribution to better governance, product pricing, and environment, social, health and safety compliance, also support this rating. Because LGUGC’s management did commendable work to strengthen linkages with other development institutions and seek financial assistance for upgrading their organizational setup and processes, ADB made no contribution in this regard. E. Overall Evaluation 34. ADB’s investment in LGUGC is rated satisfactory overall (Table 1).

Table 1: Evaluation of ADB's Equity Investment in LGU Guarantee Corporation

Item Unsatisfactory Less than

Satisfactory Satisfactory Excellent

A. Development Impact

1. Private sector development √ 2. Business success √ 3. Contribution to economic development √

4. Environment, social, health, and safety √ B. ADB's Investment Profitability √ C. ADB's Work Quality

1. Screening, appraisal, and structuring √ 2. Monitoring and supervision √ 3. ADB's role and contribution √ D. ADB's Additionality √

Overall Rating Satisfactory

ADB = Asian Development Bank. Source: ADB.

III. ISSUES, LESSONS, AND RECOMMENDED FOLLOW-UP ACTIONS

A. Issues and Lessons 35. ADB has supported several credit enhancement activities in its developing member countries, to promote domestic capital markets and local currency bond issuances by private and sub-sovereign entities. As was the case with the LGUGC investment, ADB has often expected local banks and financial institutions partnering in these interventions, to support local bond market development even when this would clearly undermine their conventional direct lending businesses. ADB’s investment in LGUGC also highlights the need to seek equity participation and focus more on investors such as insurance companies and pension funds, whose interests as potential holders of local currency bonds, are more aligned with the purpose of such interventions. In addition, ADB’s objectives of stimulating capital markets and making a significant impact on bond issuances must line up realistically with the capital and resources of the investee company. These objectives, as stated in the report and recommendation of the President for this project, were not rational or proportionate to LGUGC’s capital base of less than $10 million. This has resulted in an appearance of underperformance.

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36. ADB’s investment in LGUGC had a built-in exit arrangement that is not often incorporated in ADB’s direct equity structures. The absence of such an arrangement makes ADB’s eventual exit an open-ended issue and creates uncertainty about the evolving capital structure of the investee entity. The LGUGC investment underscores the benefit of applying such arrangements universally. B. Recommended Follow-Up Actions 37. Given that ADB has substantially fulfilled its role in helping LGUGC expand its scope of operations and the organization has attained commercially sustainable status and significant presence in LGU financing in the Philippines, ADB should now pursue its exit under the terms incorporated in the subscription agreement.

10 Appendix 1

PROJECT BACKGROUND 1. The enactment of the Local Government Code in 1991 paved the way for the establishment of a governance framework and a system of decentralization for local government units (LGUs) in the Philippines. The passage of this law was an important step toward fiscal autonomy for LGUs and spawned a significant demand for financing for infrastructure projects. These projects are traditionally financed through borrowings, internal revenue allotment, and revenues derived from local taxes and fees. 2. The subsovereign debt market in the Philippines has been dominated by national government agencies and government financial institutions (GFIs). Private financial institutions (PFIs) have been reluctant to lend to LGUs, mainly due to skepticism about LGU creditworthiness and the fact that the political aspects of financing a project in the public sector are perceived negatively. Because the GFIs are the authorized depository institutions for internal revenue allotments, they are uniquely positioned to secure debt on a cash-collateralized basis. However, the GFI dominance in the subsovereign debt market raised several issues, including (i) conflict with stated policy guidelines of the Bangko Sentral ng Pilipinas and Government of the Philippines, to act as wholesale lenders to PFIs rather than retail lenders to LGUs, (ii) their potential access to below-market-rate donor funds, which are on-lent to creditworthy LGUs at subsidized rates, and (iii) perpetuation of cash-collateral credit, which may impede the implementation of international best practice in credit risk analysis and unnecessarily restrict LGU funds. Other issues in the subsovereign debt market also needed to be addressed, including short debt maturities and the lack of policies that would facilitate increased LGU access to debt markets. 3. The LGU Guarantee Corporation (LGUGC), established in 1998, is a private credit guarantee institution that provides a credit enhancement facility for the subsovereign debt market. Prior to ADB’s equity investment in LGUGC in February 2005, 51% of company’s equity was jointly owned by the Bankers’ Association of the Philippines, with the remaining 49% held by state-owned Development Bank of the Philippines. LGUGC’s total guarantee transactions reached P1.5 billion in 2003 and had consumed much of its reserve capital, leaving the company unable to provide new guarantees for projects in the pipeline that were expected to conclude within the next 12−18 months. 4. ADB supported a national government objective to wean creditworthy LGUs from dependence on traditional sources of financing. Its equity investment in LGUGC supported the subsovereign debt market and was consistent with the development of the capital markets in the private sector. By helping to bridge the financing gap between creditworthy LGUs and private investors, ADB’s support for LGUGC was expected to make more public funds available for less creditworthy LGUs to finance infrastructure, including social and environmental development projects.

Appendix 2 11

PROGRESS MADE, 1998–2011 1. Considered a pioneering institution, the LGU Guarantee Corporation (LGUGC) was the first company to introduce a guarantee mechanism for local government unit (LGU) borrowings in the Philippines and the first private corporation to go into the guarantee business in the country.1 The company’s vision is to provide a viable alternative to local government financing. Its operations were in line with a provision for fiscal autonomy specified in the Local Government Code of 1991, which expanded the fiscal authority of local governments by allowing them to borrow from private financial institutions (PFIs) and float debt instruments without prior approval from the Department of Finance (DOF). 2. The first mandate of LGUGC was to help initiate the involvement of private banks in direct lending to LGUs but because some LGUs planned to issue bond in 1999, LGUGC shifted its strategy from slowly opening up participating financial institutions to the LGU debt market through direct loans to providing guarantees for LGU bond issues. In 1999, LGUGC extended guarantees to the City of Urdaneta and the Province of Aklan for bond issues of P25 million and P40 million, respectively. The company also worked to advocate policy changes and regulatory reforms for LGU financing, in discussions with multilateral agencies; Bangko Sentral ng Pilipinas (BSP), which is the country’s central bank; and national government agencies such as the DOF and the Department of Interior and Local Government. These efforts paved the way for the development of a municipal bond market, in line with LGUGC’s vision of an active capital market for LGU debt. 3. LGUGC has continued to call for and seek an open national government support for the development of the LGU bond market in the country. Its effort to liberalize the trusteeship of LGU bonds, then limited only to GFIs, finally paid off with BSP approval in 2008 of a proposal to allow PFIs to serve as trustee agents of any mortgage or bond issued by an LGU. 4. These steps fell short of creating a policy environment in which LGU bond issues could flourish, however. The GFIs adopted a competitive lending stance after LGUGC made its presence felt, which made bond flotation an unfavorable option for LGUs due to the higher costs and more complicated processes involved. The GFIs also adjusted their loan terms and conditions for LGUs, offering them prime market rather than off-market rates. After the P50 million Baliuag Star Bond issue in June 2006, there was a 3.5-year lull until the next LGU bond issues guaranteed by LGUGC took place. LGUGC guaranteed 18 bonds issues amounting to P3.15 billion during 1998–2011. 5. An opportunity to expand the LGUGC’s services to segments other than urban infrastructure, arose with the signing of an agreement between the company and the United States Agency for International Development, the Japan Bank for International Cooperation, and the Development Bank of the Philippines in 2001, to pilot a financing scheme for water projects. Referred to as the Municipal Water Loan Financing Initiative, the scheme aim to blend official development assistance with private bank financing to make the latter more affordable to water service providers that could not otherwise meet private sector credit finance terms. The initiative was the precursor of the Philippine Water Revolving Fund, established by the Japan Bank for International Cooperation, the United States Agency for International Development, the Development Bank of the Philippines, the government’s Municipal Development Fund Office, and LGUGC. The fund was designed to help the Philippine government achieve its Millennium Development Goal targets for water and sanitation and leverages public resources with private

1 This appendix is based on text extracted from a corporate profile prepared by LGUGC in June 2011.

Appendix 2

12

sector financing at terms and conditions that are affordable to local utilities. As of the end 2010, LGUGC had guaranteed 12 water districts loans totaling P1.53 billion. 6. LGUGC credit enhancement enabled the flow of P5.59 billion in private sector funds during the period 1998 to 2011, to critical LGU development projects and local water districts. No defaults have occurred. Total loan volume guaranteed as of December 2011 was 17 times LGUGC’s paid-up capital of P288 million. 7. In January 2010, LGUGC launched a guarantee facility for medium and large enterprises, pursuant to a directive by its board to expand the company’s guarantee service to sectors other than its existing market. This facility has terms and conditions that will encourage PFIs to utilize the LGUGC guarantee when funding medium- and large-enterprises projects that have risk factors beyond PFI internally acceptable limits. The facility focuses on the middle market engaged in basic infrastructure projects.

8. LGUGC obtained a second-highest rating of PRS Aa+ (Corp.) from the Philippine Rating Services Corporation on 8 November 2010. As a result of the rating, LGUGC received confirmation from the BSP that all LGUGC-guaranteed loans and bonds shall have a risk weight of only 20%, pursuant to BSP circular 538.

Appendix 3 13

ADVOCACY ACTIVITIES: KEY REGULATORY AND POLICY-RELATED CHANGES 1. LGU Guarantee Corporation (LGUGC) pursued several regulatory and policy-related initiatives that have facilitated private-sector investment, primarily in the form of debt, in the local government unit (LGU) projects in the Philippines. LGUGC participated regularly in both government and private-sector led forums to support policy reforms in the guarantee business. 2. Based on the advocacy work done by LGUGC, the Bangko Sentral ng Pilipinas (BSP) issued circular 310 in November 2001, which prescribed the reduction of risk weighting on all LGU bonds guaranteed by LGUGC from 100% to 50%. The regulations were aimed at encouraging local banks to invest in LGUGC guaranteed bonds, by reducing the impact of such investments on the bank’s capitalization and liquidity levels. In July 2007, BSP circular 538 amended circular 310. The new circular reduced the risk weighting further to 20% for all credit exposure to LGUs that were guaranteed by LGUGC, on the condition that LGUGC maintained a minimum risk rating of AA−. This provided capital relief to banks that invest in LGUGC-guaranteed bonds issued by LGUs. 3. In an effort to broaden the investor base for LGUGC–guaranteed bonds and make these bonds a more attractive investment option, the Philippine Insurance Commission in 2003 approved the automatic qualification of LGUGC-guaranteed bonds as reserve instruments for insurance companies. This measure had been supported through extensive canvassing by LGUGC. In 2004, BSP liberalized the regulations on trusteeship of mortgage or LGU bond proceeds to allow private banks to serve as trustee agents. This had previously been limited to government banks.

4. LGUGC continues to be a committed participant in and signatory to many partnerships with government and government-funded initiatives, including the Local Water Utilities Administration, Task Force on Financing and Infrastructure Development, Private Finance Advisory Network, and the National Electrification Administration. This collaboration allows LGUGC to (i) promote private–public partnership in developing water supply projects in the country, (ii) provide viable and long-term financing for capital expenditures, and (iii) promote domestic clean energy investments.

14 Appendix 4

BUSINESS AND FINANCIAL PERFORMANCE

Table A4.1: LGU Guarantee Corporation—Financial Performance, 2006–2011

Item 2006 2007 2008 2009 2010 2011

Change over Prior Year

Portfolio of outstanding guarantees (%)

(20.9) (1.9) 21.8 47.9 7.4 14.5

Total capital 9.7 2.3 0.6 4.3 7.9 8.6 Gross revenues 63.8 (32.8) (1.9) 6.8 14.7 22.1

Guarantee fee (16.4) (23.7) 51.4 26.0 43.1 13.1 Interest income 100.1 (41.4) (21.6) 3.9 3.8 11.4

Operating expenses (9.4) (10.3) 4.8 1.1 10.1 8.3 Net income 156.5 (56.8) (1.7) 15.7 18.3 22.8 Key Ratios PAT—net income/revenues (%) 69.1 44.4 44.5 48.2 49.7 50.0 ROE 12.9 5.5 5.3 5.9 6.5 7.3 Operating expenses/ guarantee fee

202.3 238.1 164.8 132.2 101.7 97.3

Guarantees/paid-up capital 4.0x 3.9x 4.7x 7.0x 7.5x 8.6x

() = negative, PAT = profit after tax, ROE = return on equity, x = times. Source: LGU Guarantee Corporation audited financial statements.

1. Guarantee portfolio: During 2006–2011, growth in the guarantee portfolio of LGU Guarantee Corporation (LGUGC) was inconsistent and generally subdued due to (i) weak macroeconomic conditions, (ii) predatory pricing from competitors, and (iii) political interference. Prior to the equity investment by the Asian Development Bank (ADB) in 2005, LGUGC guarantees had gone exclusively to bonds issued by local government units (LGU). Due to the prevailing lower interest rate in the Philippines,1 the first 10 LGU bond issues covered by LGUGC guarantees and amounting to P1.4 billion were redeemed by LGUs before their maturity dates (prepayment). These bonds were refinanced by government financial institutions, which had a competitive advantage over private financial institutions (PFIs) because they could provide loans at concessionary lending rates.2 As of the end of 2011, guarantees for bond issues constituted only 13% of the LGUGC portfolio (P433 million), compared with 87.0% made up by guarantees for PFI loans. During the review period, the exposure of PFIs to LGU financing has diminished their need for a guarantee (Figure A4.1). In addition, insurance companies such as Prudential Guarantee and Assurance and Malayan Insurance Company were issuing guarantees for bond issues that had evidently been rejected by LGUGC.3

1 Average nominal lending interest rates decreased from 9.2% in 2006 to 6.7% in 2011. However, the interest rate

reduction was more significant in real terms (net of inflation), declining from from 4.9% in 2007 to −0.8% in 2008. 2 For instance, according to the LGUGC’s 2007 Strategy Review, loans guaranteed by LGUGC amounting to P328

million to the water district projects of Silang, Calamba, and Laguna were refinanced by government owned agencies.

3 PhilRatings. 2012. LGU Guarantee Corporation (LGUGC) Keeps Strong Credit Rating. 6 January. Manila.

Appendix 4 15

2. Trends in income. During 2006–2011, growth in guarantee-fee related income was moderate. Guarantee fees grew by a compounded annual growth rate (CAGR) of 13.3% during 2006–2009, although it accelerated to 27.3% during 2010–2011. The growth in fee earnings was primarily volume-driven, since LGUGC retained stable pricing arrangements. LGUGC provided guarantees for working capital and fixed-asset funding requirements of medium-to-large enterprises (MLEs). The diversification of LGUGC’s business outside the LGU finance market provided an alternative for expansion at the time when water districts were unable to secure approvals to apply for an LGUGC guarantee from the local water regulatory boards. The P270 million in guarantees for funding to MLEs accounted for 23% of all guarantees approved in 2010 during the year but these guarantees declined to just P13 million in 2011. Guarantees for MLEs have higher risk than those for an LGU because MLEs, unlike LGU utilities, are in cyclical businesses security cover is limited.4 As of the end of 2011, LGUGC maintained a zero-default record on repayments of debt it had guaranteed. 3. Interest income on investments accounts for 60% of LGUGC revenues and has remained significant, given the large amount of liquid assets maintained by the company. While the available-for-sale securities kept by LGUGC have remained stable and have increased gradually in line with the internal accruals, interest earnings declined rapidly from P67 million in 2006 to P37 million in 2011 due to falling interest rates. 4. Trends in expenses. LGUGC’s operating expenses remained relatively unchanged during 2006−2011, averaging P26 million annually. Employee costs and professional fees made up about 55% of operating expenses. LGUGC spent about 15% of total operating expenses on consultants’ fees. The average cost–income ratio during 2006–2011 was 39%, which reflects a high and consistent level of operating efficiency.

4 Back-to-office report of ADB extended annual review report mission, dated 15 March 2012, based on account of a

senior LGUGC official.

Figure A4.1: LGU Guarantee Corporation Annual Guarantees, 2006–2011 (in P million)

Source: LGU Guarantee Corporation management reports.

Appendix 4

16

5. After a more than 50% decline in net income in 2007, the year-on-year net income growth increased by a nominal average of 18.9% during 2009–2011. The return on assets ratios and the return on equity ratios remained stable during 2006–2011, although the ratios were not comparable to the profitability ratios of local banks (Table A4.2). This is ascribed to the higher capitalization requirement of LGUGC, its narrower business focus, and limitations in profitability. LGUGC’s average dividend payout ratio during 2006–2011 was 28.2% of net income, or 3% of paid-up capital, in line with the stated dividend policy of the company.

Table A4.2: Profit Ratios of LGU Guarantee Corporation and Selected Philippine Financial Institutions

Item LGUGC Top 8 PFIs a

2006–2011 Average 2011 2011

ROA (%) 6.9 6.9 1.6 13.3 ROE (%) 7.3 7.3

LGUGC = LGU Guarantee Corporation, PFIs = private financial institutions, ROA = return on assets, ROE = return on equity. a Includes Banco de Oro, Bank of Philippine Islands, Chinabank, Metrobank, Philtrust Bank,

Philippine National Bank, Rizal Commercial Banking Corporation, and Unionbank Sources: LGUGC’s 2011 audited financial statements, Bloomberg.

6. Balance sheet related trends: Total assets of LGUGC grew by a CAGR of 5.1% during 2006–2011. About 95% of LGUGC’s total assets represent its securities and investments (liquid assets), which is typical for any guarantee company. LGUGC established a guarantee fund for these investments, which is being managed by Development Bank of the Philippines. The high level of liquidity serves as an assurance to lenders in the event of a call on the guarantee. LGUGC’s total equity grew moderately by a CAGR of 4.7% during 2006–2011, given its modest profitability and the slow accretion to reserves. This was composed mainly of the original capital contribution of P287.6 million from shareholders and accumulated retained earnings during 2006–2011. With growth in the aggregate value of the guarantee portfolio, the leverage ratio of contingent liabilities to paid-up capital increased from about 4 times in 2006 to nearly 9 times in 2011, or approaching LGUGC’s prudential gearing cap of 10 times (Table A4.4).5

Table A4.3: LGU Guarantee Corporation—Selected Financial Data (P million)

Item 2006 2007 2008 2009 2010 2011 Balance Sheets Available-for-sale securities 426 438 438 456 507 552 Total assets 460 468 473 489 534 590 Total equity 440 450 453 472 509 553 Contingent liabilities

a 1,146 1,124 1,369 2,025 2,175 2,491

Income Statements Investment income 67 39 31 32 33 37 Guarantee fee income 13 10 15 18 26 30 Gross revenues 82 55 54 58 67 81 Operating expenses 26 23 24 24 27 29 Net income 56 25 24 28 33 41 a Off-balance sheet account.

Source: LGU Guarantee Corporation annual reports, 2006–2011.

5 LGUGC has a prudential gearing ratio of 10:1, which is equal to or lower than comparable financial institutions.

Appendix 4 17

Table A4.4: LGU Guarantee Corporation—Selected Financial Ratios

Item 2006 2007 2008 2009 2010 2011 Return on average equity (%) 12.9 5.5 5.4 6.0 6.7 7.6 Return on average assets (%) 12.4 5.3 5.1 5.8 6.5 7.2 Cost to income (%) 30.9 41.3 44.1 41.7 40.1 35.5 Liquid assets to total assets (%) 94.1 95.2 94.6 94.6 96.3 95.7 Leverage ratio (times) 2.6 2.5 3.1 4.3 4.3 4.5 Total assets growth (%) 7.5 1.9 0.9 3.4 9.2 10.6 Dividend payout ratio (%) 25.0 24.6 41.6 24.9 24.8 … … = data not available. Source: LGU Guarantee Corporation’s audited financial statements, 2006–2011.

Appendix 5

18

ADB WORK QUALITY: SCREENING AND APPRAISAL OF THE

LGU GUARANTEE CORPORATION INVESTMENT 1. Prior to its investment in the LGU Guarantee Corporation (LGUGC), the Asian Development Bank (ADB) had dealt with the company through a study on the development of municipal bond markets of select developing member countries.1 This study estimated that the financing needs of for local government units (LGUs) financing Philippines were P4.5 billion–P25.0 billion per annum. 2 On the other hand, total LGU borrowings had been gradually increasing from just less than 2% (about P448 million) of total local government receipts in 1991 to about 4.2% (P5.6 billion) in 2001. 3 In the context of this vast gap between financing requirements and actual inflows, ADB’s identification of the need for an institution like LGUGC to facilitate LGU borrowings and capital investments was well-substantiated. 2. In 2002, ADB’s Private Sector Operations Department and LGUGC met and discussed the latter’s broad business plan and LGUGC asked ADB to consider taking a minority shareholding in the company to bolster its capital base over the next 12 to 18 months.4 An equity investment by ADB offered an opportunity to LGUGC to meet the increasing demand of guarantees from LGU bond issuers, given that the management’s efforts to raise capital from existing shareholders had been unsuccessful. ADB’s equity investment provided a platform to further develop the subsovereign debt market, an important policy objective for the region.5 3. ADB conducted a due diligence review of LGUGC in September 2003 with the assistance of a Philippine law firm. During the review process, it was established that, as prerequisites for ADB’s proposed investment, LGUGC would need to adopt a formal corporate governance code and revise its guarantee fee structure.6 The project was structured as an equity investment, rather than debt, to address (i) the need for capital and give LGUGC an option to multiply and leverage over this incremental funding and (ii) the risk of a potential mismatch between LGUGC’s uneven cash inflows and the need to meet regular debt service payments.

4. ADB’s equity investment in LGUGC has helped catalyze the entry of private sector capital into the local government financing market, although the share of government financial institutions in this market remains dominant. 7 LGUGC’s strong institutional linkages with

1 The current president and chief executive officer of LGUGC, Lydia Orial, was the author of the recommendations

for the Philippine municipal bond market in connection with this ADB regional technical assistance. ADB. 1998. REG-5809: Study on the Development of Government Bond Markets in Selected Developing Member Countries. Manila.

2 Saldana, Cesar G. 1997. Study for the Design of a Viable Private LGU Debt Guarantee Institution. Quoted in

United States Agency for International Development. 2009. DCA Philippines LGUGC Evaluation Report. Manila. p.

6. 3 R. G. Manansan et al. 2010. Fiscal Decentralization in the Philippines: Issues, Findings and New Directions.

Manila: Department of the Interior and Local Government. 4 ADB. 2003. PHI: Equity Investment in LGU Guarantee Corporation – Concept Clearance Paper. 4 September.

Manila. 5 Footnote 4, p. 20.

6 The revised Code of Corporate Governance and Operating Policy Statement were subsequently approved by

LGUGC’s board on 8 February 2007. 7 The two government financial institutions—the Land Development Bank and the Development Bank of

Philippines—and the Municipal Development Fund Office continue to be the dominant sources of local government financing, accounting for 84.7% of total local government borrowing as of March 2008. About 13.8% comprised loans to LGUs financed by the Philippines National Bank and Philippines Veterans Bank while the balance of 1.4% represents bonds held by other private banks. ADB. 2008. Philippines: Sources of Local Government Unit Financing. Manila.

Appendix 5 19

international organizations such as ADB have contributed to LGUGC’s high credit rating of PRS Aa+.8 The rating has provided an incentive for private financial institutions to seek LGUGC guarantees because this will reduce the risk weighting for all such bonds and loans from 50% to 20%.9 Despite the current small share of private financial institution lending in the overall LGU debt market, accessing private capital remains remain vital for local governments to finance their infrastructure projects.

8 PhilRatings. 2012. LGU Guarantee Corporation (LGUGC) Keeps Strong Credit Rating. 6 January. Manila.

9 On 15 November 2001, the Bangko Sentral ng Pilipinas issued circular 310, which provided a 50% risk weighting

on all LGU bonds guaranteed by LGUGC. This regulation was amended by BSP circular 538 issued on 1 July 2007. It lowered the risk weighting for all LGU bonds and loan exposures guaranteed by LGUGC to 20%.