As India experiences rapid urbanisation, the need for vastly increased levels of investment in urban infrastructure and amenities require urgent attention of the policymakers.
Recent estimates by the McKinsey Global Institute (2010) suggest that the urban population in India increased from 290 million in 2001 to 340 million (about one third of the total population) in 2008; and, is projected to be 590 million by 2030.
Over the next 20 years, urban India will create 70% of all new jobs. The new urban jobs will be more productive, and could help increase India’s per capita income substantially.
The Institute estimates that total capital investment of $1,200 billion will be required to safeguard India’s urban future.
For financing in such a scale, fiscal transfers to the urban local bodies (ULBs) from higher levels of government, though critical, will not be sufficient.
The ULBs have been experimenting, to a limited extent, with unconventional methods of financing such as public-private-partnerships; utilising urban assets more productively; accessing carbon credits; and obtaining better outputs in creating and maintaining urban amenities financed by public expenditure.
This column, however, focuses on the potential for developing municipal bond market as a financing source.
At Rs1,400 crore ($0.3 billion), the total value of municipal bonds currently outstanding is negligible in relation to capital requirements. Even this is distributed among only a few ULBs, with a quarter raised by the Ahmedabad Municipal Corporation, around one-sixth each by Nashik Municipal Corporation and ULBs around Bangalore.
Credit ratings for the municipal corporations/municipal councils of the 63 Jawaharlal Nehru National Urban Renewal Mission (JNNURM) cities are being released regularly; and nearly 40% of them have been rated as investment grade.
Reversing the above dismal performance requires understanding the supply and demand constraints that limit the market for municipal bonds. Major constraints faced by the ULBs in issuing municipal bonds, which may be termed supply constraints, include the following:
A majority of ULBs remain in a state of perpetual operational deficit; this is despite the measures which have been undertaken by the JNNURM to improve their financial and fiscal practices.
Absence of a buoyant and recognized source of revenue for ULBs increases the reluctance to borrow. In the past, most of the ULBs which accessed the bond market established escrow accounts comprising octroi collections for servicing debt; however, octroi has now been abolished in all states except Maharashtra.
Restricted autonomy of ULBs to decide on their own revenues. This remains the case as state governments play a key role in determining user charges, property tax rates and coverage. The lack of willingness of the states to let ULBs play a more prominent independent role remains a major barrier.
JNNURM grants, which are virtually free, have crowded out the funds which could have been borrowed from the market. The JNNURM was supposed to reduce grant support to creditworthy cities and increase their borrowing from the market. But, it has instead acted as an impediment. This is substantiated by the fact that borrowings in the municipal bond market peaked during 2002-2005. But in 2007-08, two years after the introduction of the JNNURM, ULBs had incurred capital expenditures to the tune of `180 billion, of which only 3% was in the form of borrowing.
The skills deficit in ULBs, especially with respect to skills required to understand the commercial borrowing market and structuring debt obligations; and plan and implement infrastructure projects to improve the capital absorption capacity.
Demand constraints which create hurdles in the participation of institutional and individual investors include the following:
Existence of bipolarity in the borrowing market, as long term funds such as pension funds, Life Insurance Corporation funds and provident funds of the Employees State Insurance Corporation, are directed towards the central government and short-term funds are deposited in banks. The long-term funds may choose municipal bonds as a viable investment option. However, the government offers them a higher interest rate as it needs these funds to finance its deficit, hence restricting the diversification of the portfolio of these funds.
Absence of a secondary market for municipal bonds forces investors to hold these bonds until maturity. This reduces the appetite for these bonds among banks as well.
Division between priority and non-priority sectors for the purpose of investment continues and urban infrastructure is not included within priority sectors.
Municipal bonds are considered risky investments due to mainly two reasons: (i) lack of a public disclosure culture across ULBs and hence their credit information is not considered sufficiently reliable and (ii) absence of an insolvency or bankruptcy law which can be applied to local government bodies.
For a more robust municipal bond market, the following measures merit urgent consideration:
Capacity building of ULBs in public financial management, including in accounting and budgeting systems, should be given priority.
Capital grants to ULBs, in the investment grade, ought to be structured in a way that only a limited proportion of project costs are funded by grants and require them to access the bond market for the remaining financing, where the credit rating is expected to act as a disciplining agent. The possibility of designating a fraction of the JNNURM grants to escrow accounts for repayments of money borrowed through bonds could be explored.
Municipal bonds could be given the status of “public securities” so that they become admissible for statutory liquidity ratio investment by commercial banks.
Since municipal bonds are relatively cheaper as compared to the alternatives, they could be used as a secondary financing option instead of being used only for primary financing.
The existing regulatory framework needs to be improved. Steps to be taken could include: allowing institutional investors to invest in long gestation projects such as urban infrastructure projects; developing public disclosure guidelines for ULBs by an established and experienced institution such as Sebi; reducing state government guarantees; and establishing borrowing limits for ULBs and enforcing them.
Introduction of a bankruptcy law applicable to urban entities and support to develop a secondary market for municipal bonds.
The above policy measures are particularly relevant in the present context as the JNNURM’s first phase undergoes assessment and its second phase begins within a year’s time. The significant learning from the ULBs which have accessed the bond market already is that, in addition to complementing the other existing sources of financing, municipal bonds have the crucial non-financing benefits of increasing transparency and improving fiscal practices which could improve overall urban governance.
Mukul Asher (email@example.com) is a professor of public policy at the National University of Singapore and Shahana Sheikh (firstname.lastname@example.org) a research associate, Indian Institute of Management, Bangalore. This column is based on the research undertaken by Sheikh while writing her dissertation submitted at the London School of Economics and Political Science, in part completion of her Master in Public Administration, in May this year.