3.1 Nairobi City County current assets, March 2013

• National government entities claiming debts with accrued interest and penalties should be open to compromise and reduce demand by annulling penalties or reducing interest to ease the financial burden of the counties.

Alternatively, OAG or the National Treasury may set a one-time rule that the creditors in question must annul penalties on overdue statutory deductions. • ALSC may rule that cases that have not started or have not concluded within six months after the start of the resolution program should be transferred to

ALSC for assessment and a verdict without further negotiations between parties. • A policy guidance may state if (1) claims vis-à-vis private persons or entities could be part of this resolution framework or (2) counties should work out private claims via direct negotiation or civil court procedures; the second option seems more rational. • Each ministry and other entity involved in disputed assets or liabilities should establish an ALWC to analyze and negotiate the cases with the counties while following ALSC policy guidance, rules, and procedures.

The ALSC and the National Treasury may adopt another set of rules to guide full completion of asset and liability takeover in accordance with the Transition to Devolved Government Act 2012. The specific issues to regulate include but are not limited to the following:

• The ALSCs, the CWCs, and ALWCs of national government entities may continue working beyond the time frame of resolution of disputed inherited financial assets and liabilities to facilitate a pragmatic and quick transfer of assets from national government entities in accordance with the devolved functions, which may result in a new group of disputed assets and liabilities that need timely resolution under ALSC control. • OAG and/or the National Treasury may assess the inherited tax and fee arrears that are paramount. Uncollected taxes and fees could be several times larger than the annual budget revenues of some counties (see NCC in table 3.1), but these are nominal numbers with presumably much lower present value.

On the other hand, penalties and interest have been accumulating since devolution, which has increased the nominal value of inherited financial assets substantially. Including these inflated numbers in the municipal accounts (especially after adoption of accrual accounting standards) would make the

TABLE 3.1 Nairobi City County current assets, March 2013

Rates (property tax)

Business permits

Kenya Power Rents and others

Water company fee arrears Water company others Department of Defense land price

Water company shares Total

Source: NCC CALC 2017. Note: K Sh = Kenya shilling. K Sh (MILLIONS) % OF TOTAL

53,643 44.1

1,324 1.1

583 0.5

607 0.5

9,698

773 8.0

0.6

33,000

22,000 27.1

18.1

121,628 100.0

budgets unrealistic and unmanageable. Tax and fee arrears are hard to dispute, and thus could be taken over quickly, but policy guidance is required for rational and pragmatic treatment of these arrears. Also, programs are needed to build counties’ capacities to collect tax and fee arrears, which have been accumulating since transition above and beyond the inherited arrears. • The National Treasury might need to guide counties about how to address inherited bank debts, some of which are technically nonperforming, because counties have not served installments since devolution and predecessors stopped payments years before. Setting clear policy is vital, because the treasury is paying these debts on behalf of the counties without specific agreements on the counties’ liabilities. Counties (especially NCC), on the other hand, cannot resume debt service and especially cannot start repaying the treasury for the new debt accumulated by the installment payments over the past several years. Should the treasury make counties liable for these payments, NCC would become deeply insolvent immediately.

International experiences suggest that the best resolution of such situations could be an individualized debt restructuring program between the National Treasury and the respective counties focused on capitalizing accrued interest and issuing a new long-term loan to counties. In short, a close analysis of the inherited financial assets and liabilities is an urgent task. The treasury faces great challenges, because rolling over these enormous volumes of debts and inflated receivables is like a rolling snowball that may grow out of control.

MANAGING FINANCIAL ASSETS AND LIABILITIES: SHORT ASSESSMENT OF NCC COMPARED WITH A WELL-MANAGED AUSTRALIAN LOCAL GOVERNMENT

Managing financial assets and liabilities is a natural part of strategic asset and liability management (ALM). The National Treasury via the National Assets and Liabilities Management Department has taken the lead in guiding counties toward enhancing practices and moving toward professional ALM. Financial and nonfinancial assets are transient forms of each other, so both are vital for healthy management of cities, but there are specific characteristics and challenges in financial ALM. At the strategic level, cities should establish two critical balances on financial assets and liabilities, regardless of the adopted accounting standards:

1. Net debt, the difference between the sum of all financial assets and the sum of all debts and other direct financial liabilities 2. Net liabilities, the difference between the sum of all financial assets and debts and other direct and contingent liabilities (Net liabilities often appear greater than net debt [ACT 2018] because they include contingent liabilities about uncertain outcomes.)

Assessing the quality of management of financial assets and liabilities in Kenyan counties is a difficult task, because counties apply only fragments of an adequate management framework and often lack staff and reliable data. NCC is far ahead of the other 46 counties, because it has a reasonable financial management system, qualified staff, an appointed debt and liquidity management team, and reasonable data. These offer a bold opportunity for comparison of Australian Capital Territory (ACT) and NCC—both are local governments with comparable

characteristics (for example, population and economic position in the country). The major difference is that ACT is a historically well-run entity, despite that it also inherited a problematic portfolio when the pension funding system changed in Australia (as will be discussed). In contrast, NCC is still in transition because of issues discussed in this chapters and faces transitional challenges. We use the standard indicators of financial assets and liabilities to compare the two entities and draw lessons on managing financial assets and liabilities.

Liquidity management. Financial ALM also includes and plays a pivotal role in liquidity management, because the financial assets are more liquid than the fixed assets and thus can and should be used in liquidity management. Finance departments often include a team assigned to liquidity management that also includes risk management as part of ALM. NCC appointed such a team a few years ago. Cities may deposit surplus cash daily, not only because they cannot legally keep large sums of cash in vaults, but also to maximize overnight interest revenues. Likewise, financial assets are used to bridge gaps between revenue inflows and outflows to ensure stable liquidity and timely payments of due liabilities. Timely payment is not a well-obeyed principle in developing countries where ALM and liquidity management are poor and liquid financial assets (cash and financial investments) are miniscule, so invoices often land in drawers of mayors or chief financial officers to wait until cash inflow enables the city to pay the due liabilities. This might change when Kenya adopts accrual accounting for all public entities, but it will only help improve accounting and transparency without providing solutions for liquidity or solvency issues.

Financial assets. Financial assets broadly include investments in public entities, cash deposits, advances paid, financial investments and loans, and receivables (for example, uncollected fees and taxes). These values are found in cities’ financial reports in both the developing and developed world, although cities in the developing world may keep and publish poor or no reports on financial assets. Books show great differences across these two groups of cities in composition and real present value of the financial assets, which impacts the quality of the ALM. Below we compare the composition of financial assets and liabilities of the ACT and NCC and show major differences in managing financial assets and liabilities.

Large differences in composition of financial assets. The situations of ACT and NCC are quite different. ACT financial assets are well recorded in books and are well performing (ACT 2018 report shows multiple evidence of good performance). In contrast, NCC has inherited its financial assets from the defunct local government as part of a devolution program, and the values of those assets have not been updated, which means they can be larger or smaller than the historical book value. For instance, a substantial volume of uncollected taxes and fees has accumulated since devolution, but this value is not yet reflected in NCC reports.

Figure 3.3 shows important differences in the composition of financial assets in NCC and ACT. ACT is heavy in financial and fixed investments, while NCC is heavy in tax and fee receivables. Other receivables are very substantial in NCC, while they are zero in ACT. Other receivables represent 20 percent of NCC revenues, including disputed revenues from various transactions between NCC and national government entities. Such disputes are common in developing countries, where national government entities are reluctant to pay fair compensation for assets they have taken over from cities.

Tax and fee receivables. Figure 3.3 shows that ACT has a healthy negligible volume of receivables in taxes and fees, while 60 percent of NCC’s inherited financial assets are uncollected taxes and fees legally accounted as receivables,