Municipal Bonds in India

With 30% of its population residing in its 5161 towns and cities and growing fast, it is estimated that our cities would require investments of over $200 bn in urban infrastrucutre over the Eleventh Five Year Plan period (2007-2012). The World Bank estimates that atleast $37 bn is needed over the next decade, just to provide safe drinking water and sanitation to city residents. Property taxes and assigned revenues (stamp duty, entertainment tax, motor vehicle tax), apart from state grants, form the overwhelmingly major share of municipal finances. These revenues while adequate for financing smaller works, are nowhere large enough to finance capital intensive infrastructure projects. It is therefore imperative that our Urban Local Bodies (ULBs) look at raising reources externally to fund its huge requirements.

The Government of India have recently thrown open the doors for atracting urban infrastructure investments through the pooled financing mechanism. A Pooled Finance Development Fund (PFDF) of Rs 400 Cr ($100 mn) for the 10th Five Year Plan period, has been set up to help ULBs finance their investment needs. This PFDF will provide ratings enhancement facility through a Credit Rating Enhancement Fund (CREF) and raise the credit worthiness of all bond offerings to investment grade. This additional credit protection to the ULBs and the lenders/investors is expected to reduce the costs of capital and encourage ULBs to shed their apprehensions and enter the Municipal debt market to finance their investment needs.

The ULBs will have to access the market through a State Pooled Finance Entity (SPFE). Further, it is also proposed to purchase guarantees from financial institutions willing to underwrite the risk of a cash-flow shortfall. All this additional layers of credit protection, over and above the Project cash flows, is meant to mitigate the risks, lower the cost of capital and thereby encourage the growth of Municipal debt market in India. While credit enhancement facility may be a good short term intervention to facilitate the emergence of an active Municipal Bond market, there is no substitute for the ULBs getting their financial houses in order.

Under the pooled financing mechanism, a number of infrastructure projects will be pooled together and debt finance raised. The cash flows from them will be escrowed into a special bank account from which the bond investors will be repaid. This arrangement has many advantages
1. Helps risk diversification. Even if one project is doing badly, the others can make up the loss due to that
2. Less economically viable, but socially useful projects, can bandwagon on the more bankable projects.
3. By pooling together a number of projects, it can help finance more projects.

While most smaller municipalities are surely constrained by their dismal balance sheets, this should not prevent them from financing major investments in civic infrastructure by the pooled financing option. The project mix, refinancing pattern and schedule may be appropriately structured, so as to give the financiers enough confidence in mitigating their risks.

In the US it is common for the various State governments to fund major infrastructure projects by issuing municipal bonds (or munis) by leveraging the federal, state and local body finances. The US Municipal Bond market is $2.2 trillion strong and forms nearly 10% of the total debt market. With more than $300 bn worth such bonds issued in 2005-06, given its tax deductible nature, it is one of the highest yielding debt instruments.

In contrast, a mere Rs 850 Cr ($210 mn) has been raised through Municipal Bonds in India since the first Municipal Bond issue by Bangalore in 1997. Municipal Bonds form nearly 10% of the debt market in the US. Tamil Nadu and Karnataka are the only tow states to have raised resources from the market through the pooled finance route. Further, all the Municipal Bonds issued by Indian ULBs have been more in the nature of general obligation bonds, financed by escrowing property tax or other internal ULB revenues. Again in contrast, the US Municipal Bonds are mainly revenue bonds, financed by the revenue streams associated with specific projects.

The Indian debt market suffers from the crowding out phenomenon, both from the short term markets and Government debt. Short term investments in banks lock up over 40% of the household savings in India. Long term investment is distributed between Government debt securities, 17.7%, insurance, 14.9%, and pension funds, 13%, and more or less all of this ends up financing Government fiscal deficits. The high interest rate offered by investments in Government instruments, has also prevented the development of greater depth and breadth in the Indian debt market.

There is an element of the lemon problem facing municipal bond market in India. A recent study of the 63 JNNURM cities by the Waer and Sanitation Program (WSP) found that the major demand for debt is coming from those ULBs that are strapped for finances and have weak balance sheets. In contrast, the stronger and richer ULBs are trying to fund their investments from internal revenues, reluctant as they are to venture into the debt market. The potential adverse selection problem is getting reflected in the municipal bond market in the higher interest premiums demanded. This risk can be mitigated by moving away from financing the ULB to financing specific projects.

One of the biggest concerns for investors in ULBs arise from political related risks. It is therefore necessary to put in place all possible measures to insulate Project financing structures from political interference or decisions based on political and other external considerations. More than any credit guarantees, investors will value guranteeing such Projects from politically populist interventions. Tarrifs and other revenue streams from such projects need to be fully insulated from the vagaries of all politics. Given the weak institutional capacity of ULBs to monitor the implementation of such arrangements, it is also imperative that release of funds is followed by capacity building to monitor its implementation.

The Government is also considering utilizing atleast a part of its burgeoning foreign exchange reserves to fund infrastructure requirements. These reserves can be used for non-inflationary spending by financing imports of capital equipment and technology for bigger infrastructure projects.