Thursday, March 6, 2008

Credit Rating ULBs in India

This post is in continuation to a previous post on credit rating of cities in the US. The situation is no different here in India. The head of corporate and infrastructure ratings at a leading credit rating agency says, “Several of the urban local bodies (ULBs) are not in robust financial health and may find it hard get good ratings. In such cases, they may have to commit to higher coupon rates or carry out some financial reforms and go back for fresh ratings. But the market’s appetite for these bonds may be low.” This remark is both self full-filling and reveals a surprising lack of clarity about the context. Here is why.

Credit Rating of an ULB is a signal to a potential lender or investor or partner about the strength, potential and prospects of the Municipal Corporation. In the present circumstances, it is an important determinant in arriving at the cost of borrowing of the ULB. In fact, one could argue that the most important utility of a credit rating is in accessing the debt market. Given that ULBs need to minimize their cost of borrowing, it is therefore imperative that they have a good credit rating.

It has always surprised me as to why ULBs, as a single entity, should be rated by credit rating agencies. To the extent that credit rating is a well established signalling mechanism aimed at bridging the information asymmetry in the financial markets, any credit rating of ULB as an organization would be the equivalent to adding more noise to an already confusing milieu. In an age of Special Purpose Vehicles (SPVs) and Project Finance (PF), rating an entire ULB is tantamount to mixing apples and oranges and then talking about its combined taste!

The activities of any ULB spans multiple functions and sectors - roads and transport, water supply, streetlighting, sewerage, sanitation, Urban Community Development (UCD) etc. Some of these activities are financially self-sustainable while some others are more welfare oriented and cannot be financially viable. In fact, even within the same sector, the legacy processes and systems are generally inefficient and cannot achieve cost recovery, whereas the newer investments use modern technology and are much more efficient. But fortunately, given the situation of scarce resources and spiralling needs, most ULBs across the country have been adopting various systemic reforms and optimizing revenue collections, so as to eliminate pilferage and improve efficiency. Further, some ULBs have tried to dovetail private resources to fund their huge capital expenditure requirements in major infrastructure projects.

In the circumstances, any rating of a ULB, which naturally has a disproportionately high weightage for the legacy processes and systems, will not be reflective of the trend. Given this, beyond giving a very broad assessment (too broad to draw any meaningful conclusion) of the ULB, any ULB level rating has limited utility. The only conceivable utility of a general ULB rating is for the purpose of a General Obligation Bond to be repaid from out of the Property Tax revenues of the ULB.

Many water, sewerage, and solid waste projects have very strong cash flows, from connection charges and tariffs, which can recover the project cost over a time period. Since these revenue streams already fixed, free from any uncertainty (in fact, these cash flows can only go up), and in many cases bundled into Property Tax and other established revenue streams, there is very little financial risk associated with them. The basic civic service nature of such projects will ensure that operational risks are minimized, as Governments have an interest in completing them in time and certainly in ensuring that they are run for their full operational lives. An appropriately structured project finance arrangement will by itself go a long way in bringing in financial discipline in the ULB finances and thereby mitigating other risks. Such Projects ought to be rated on a stand alone basis, without being influenced by the legacy systems.

Any general rating of the ULB is certain to influence the rating of even the most ideally structured and financially strong project executed in the ULB. Even Projects with its own independent cash flows, distinct project execution and management teams, are bound to be influenced by legacy systems. A not so favorable ULB rating is bound to adversely affect the cost of capital for even a very good Project.

It is a widely held view, and rightly so, that our ULBs are typical examples of bureaucratic inertia and corruption. It is generally perceived that ULB executed projects are not conceived in an integrated manner, do not get completed in time, experience cost over-runs, do not employ the latest technologies, and are not well operated and maintained. Fortunately, due to a number of reasons, both internal (scarce resources and therefore need to improve efficiency, reduce wastage, increase revenues etc) and external (declining grants from Government, URIF agenda, projects like JNNURM and their reform requirements, demands imposed by process reforms like outsourcing operation and maintenance, need to access private capital etc), things are changing. In the circumstances, it is important that these big infrastructure projects be judged and rated based on their inherent merits than on any widely held perception or misconception of the reality. We need to facilitate mechanisms that can signal the credit markets about the changing reality, not feed the existing misgivings.

A recent study of the 63 JNNURM cities by the Water and Sanitation Program (WSP) found that the stronger ULBs are not keen on approaching the debt markets, and the ones looking for external funding are those with weak balance sheets. This is despite the fact that even the strongest ULBs will require external funding to fullfill all their infrastructure requirements. The financially stronger ULBs are wary of approaching the debt market due to the complicated and time consuming procedures involved in accessing it, and the perceived higher cost of debt, arising partially due to the miserliness with credit rating. These weak ULBs are invariably going to be rated as below investment grade. Given the limited depth and breadth of our Municipal debt markets, they will therefore face very high borrowing cost for even financially good projects.

So the immediate objective should be to get Credit Rating agencies to rate specific projects, taking into account the cash flows of the project and the mechanisms put in place to mitigate construction, credit and operational risks associated with the project. This has to take into account the strength of institutional arrangements available within the ULB to expedite such projects. In case of ULBs aggressively implementing reforms, their reform commitment and track record should be used to discount for legacy costs and ineffciencies.

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