Indiana University SPEA Edward J. Bloustein School of Planning and Public Policy University of Pennsylvania AIR American University

Poster Paper: Does Financial Slack Reduce Municipal Short-Term Borrowing?

Friday, November 13, 2015
Riverfront South/Central (Hyatt Regency Miami)

*Names in bold indicate Presenter

Min Su and W. Hildreth, Georgia State University
Many municipal governments face the challenge of mismatch between the day-to-day cash flow-ins and flow-outs: their major revenues are scheduled and come in once or twice in a fiscal year or at quarterly intervals whereas operating expenditures are roughly constant throughout the year. As a result of this mismatch, there are often temporary cash shortfalls in their daily operations. To smooth the temporary deficit, municipal governments can use either internal resources such as financial slack or external resources such as short-term borrowing if their state governments do not prohibit local debt financing. If a municipal government has the option to use either tool, which one will it prefer? The pecking order theory in corporate finance literature states that due to information asymmetry between owners/managers and investors, firms have a preference ranking over financial sources: internal funds first, followed by debt, and then equity (Myers and Majluf 1984). This paper applies pecking order theory to municipal finance and examines whether municipal governments also have a pecking order preference when choosing between internal financing (using financial slack) and external financing (using short-term debt). The primary research question is: does financial slack reduce municipal short-term borrowing? We test two hypotheses: (1) financial slack reduces a municipal government’s probability to issue short-term debt; and (2) municipal governments with more financial slack tend to issue less short-term debt.

 We use a sample of municipal governments in California, because California is among the states where local governments actively issue short-term debt for cash management purpose. We collect data from multiple sources, including the California Debt and Investment Advisory Commission’s Debt Issuance Database, the Government Financial Officers Association’s Financial Indicator Database, and the Census Bureau’s Local Government Finance Database. The time span of this study is between fiscal years 2003 and 2012. We use a dichotomous variable which is coded 1 if a municipal government issues any cash management notes in a fiscal year and 0 otherwise as the dependent variable to test the first hypothesis. We use the ratio of total cash management notes to total current expenditures as the dependent variables to test the second hypothesis. We use the unreserved undesignated general fund balance lagged by one year as the independent variable. Our model also incorporates a group of control variables that are hypothesized to affect a municipal government’s cash flow management choice.

Our study extends the application of pecking order theory to municipal finance. It contributes to the increasing literature on municipal financial slack and municipal short-term debt financing. It sheds light on municipal cash management as well. We expect findings from this study to provide insights into municipal financial management, in particular municipal governments’ decisions to choose between internal financial resources and external financial resources.


Myers, Stewart C., and Nicholas S. Majluf. "Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have." Journal of Financial Economics 13, no. 2 (1984): 187-221.