The Hindu Business Line : Municipal financing: Where are the issuers?

We are living in euphoric times with booming stock markets, bulging FII investments, a rippling wealth effect and an urban infrastructure that, by and large is getting moribund by the day. Belatedly there is growing recognition that lack of quality infrastructure reflected in traffic snarls (Bangalore, Mumbai etc.), bad drainage (Mumbai’s gloomy self-perception every monsoon), and bad public transport systems (almost every city) sooner than later will take a toll on growth itself.

The central problem lies not so much in poor quality itself as in planning and project size that lack a grand vision. All urban local bodies (ULBs) have to balance social objectives (providing services to poorer sections at minimal charges) and commercial considerations (quality infrastructure with user charges). Separating the ‘social equity’ function from the commercial aspects of services may help in inducing optimal solutions focused on accountability for responsive systems and speedy execution of deliverables.

Bond market and cities

At the outset, ULBs need to get away from an incremental approach to infrastructure and establish instead long-term viability with a large-step movement. Like plant and machinery in a factory, equipment in civic amenities should be depreciated with provision for continual funding for replacement of these assets. The drainage system in Mumbai is an apt example of a century-old system that was assumed would last forever till the disastrous monsoons of July 2005 showed just how vulnerable it had become.

Laudable as the Jawaharlal Nehru National Urban Renewal Mission (JNNURM) is, the proposed projects may solve immediate civic needs but are nowhere near the capacities needed from the perspective of future generations. Large projects with optimal scale of execution, though needing higher outlays, would serve civic needs better. Happily for us, the world is awash with funds seeking avenues for better risk-adjusted returns. This global liquidity in turn fuels domestic liquidity with similar ends in view. The problem for local bodies then is not funds per se but a matter of strategising the appropriate structures to attract that liquidity.

In the developed economies, the bond markets attract funds from institutional funding sources such as insurance companies, provident funds, banks etc. Bond markets need one simple assurance; the servicing of the promised cash flows would be timely and without any restructuring prospects. Over the years, fiscal discipline has reduced the volumes of state government guaranteed bonds; issuance by local bodies can fill this gap with better credit quality and clearly projected productive uses of funds.

Inadequate accounting systems

Funding structures for the municipal sector typically suffer from lack of commercial accounting systems. When commercial accounting policies are not followed and leakages in revenue collection cannot be plugged efficiently, then bonds on the full faith and credit of the local body may not evince much interest. So revenue bonds backed by the ring-fenced cash flows of a project would be a faster route to funding, as structuring such bonds is easier than rectifying the systemic issues at the local body level in the near future.

Establishing creditworthiness is the central issue for the funding structures. Various credit enhancement structures in the form of viability gap funding commitments, financial guarantees would work in the bond markets. In the initial phase, to provide strong impetus to this sector, a combined working of state guarantees and multilateral agency support could be worked out till the commercial aspects are established.

Since the maintenance of credit quality is important, credit substitution structures (financial guarantees) by State governments or banks would fit the bill. Alternatively, credit enhancement structures — escrows on tax revenues for instance would need to be robust enough to provide stability in the credit quality throughout the maturity of the bonds. Assuming downward variability in the cash flows and lower realisation in tariff revenues, some revenue-based structures could provide adequate safety outlets.

A tentative beginning

So far, about Rs 1,200 crore has been raised by 13-15 local bodies, among them Ahmedabad and Bangalore, through issuance of taxable and tax-free bonds.

The credit structures have primarily involved ring-fencing of the specific revenue flows. The Tamil Nadu Urban Development Fund has played a pioneering role in the pooled finance structure, by executing the first structure through credit enhancement by USAID for ULBs in that state. TNUDF’s role was to act as an intermediate specialised funding entity, a sort of Special Purpose Vehicle to channel funds to the municipal sector.

It has also developed various other issue structures — revenue bonds for Madurai, pool funding for water and sanitation pool funds, tax-free general obligation bonds. But it has not been emulated so far with consequences that are apparent in the urban decay so visible to the naked eye. Over the last 12 years, debt capital market funding has been around Rs 5,50,000 crore , out of which only Rs 1,200 crore has been raised by the local bodies. There is enough liquidity to fund the municipal sector to the tune of Rs 20000-30000 crore annually in five-10 years maturity buckets.

Tax deterrents

While tax-free bonds, as in American municipal financing systems have been designed to attract funding, the permissible amounts and taxation systems are a big deterrent; current income tax clauses hamper flow of funds to this sector. Section 14A of the Income Tax Act, 1961 does not provide tax benefits on a gross basis. Policymakers need to consider the possibility that clear tax concessions for municipal bonds would mitigate revenue losses through better public and social benefits through efficient and productive civic amenities.

Retail funds would be a better option in the long term. Tax benefits to the retail investors can make these funds attractive and achieve dis-intermediation and minimise costing. However, given the structural limitations — lack of product appreciation and secondary market liquidity etc. — institutional bond markets can provide a good alternative in the near future.

Funding from the insurance companies and provident funds would be long term in nature and could match the cash flows of the projects. With buy-and-hold nature of these investors, tradability of the bonds may not be a key requisite. Additionally, these investors provide long-term funds at fixed rates unlike banks where intermittent re-pricing is preferred. To attract funding from the banking sector, special dispensations in the form of assigning priority sector status, inclusion in the Held-Till-Maturity (HTM) category and lower risk weights could be planned.

The promise and challenge

There have been instances when some local bodies have not honoured commitments regarding security structures. Such instances compel investors to insist on structures that are strictly enforceable and actionable. An ideal example of a strong security mechanism would be to allow substitution of the local body with a third-party so that continuing commercial functioning could be ensured. However, such a scenario would require statutory and legal changes and could be challenging to execute.

Large municipal corporations can access the market on a standalone basis. For smaller municipalities and local councils, pooled finance system can work well as pooled finance structures provide a good option for credit enhancement through credit diversification facility. However these structures have their own implicit costs such as higher cash collateral and negative carry in collateral investments. Pooled structures also alleviate the single body-specific issues such as corporate governance etc. These structures can work better for the smaller local bodies that may find it difficult to establish the credit-worthiness on a single project basis due to adverse economies of scale.

Bond markets have sufficient depth and liquidity to meet the needs of the municipal issuers, provided structuring issues are tackled effectively. Immediate and prompt action can only determine whether we continue to live in urban chaos or create an urban bloom.

(The author is Head, Debt Capital Market, ICICI Securities Ltd.)

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