MUNICIPAL BONDS AS A SOURCE OF FINANCE FOR URBAN INFRASTRUCTURE DEVELOPMENT IN INDIA
Ramakrishna Nallathiga
Associate Professor, School of Projects, Real estate and Infrastructure Management, National Institute of Construction Management and Research, 25/1, NIA P.O., Baner, Pune
e-mail:
talking about the huge increase in the population and the growing demand of road infrastructure, and food.
Also talking about the report of rbi on municipal finance and work on the aspect of resource requirements of urban infrastructure based on the pre-set norms of service provision including backlogs. The report emphasized on undertaking a series of reform measures at ULB level to improve the situation.
Talking about the the recently appointed High Powered Expert Committee report ,
Reform required in the municipal bodies as they will not be able to cope up with the situation which we have seen in the past The municipal bodies required some major overhaul in order to meet with the rising challenges of urbanisation in India. Focusing on how the municipal body has totally realised on National Urban Renewal Mission (NURM) as the only as a source of funds for the urban infrastructure projects.
Given this situation of little scope for improvement, borrowing from market came to fore in mid -1990s as source of funds required for urban infrastructure projects and continued to play the role until mid 2000s. Thereafter, the UPA government by setting aside Rs 50,000 crores as support for the urban local bodies towards urban infrastructure creation, which was designed with mandates to ULBs to (a) reform their finances and systems (b) reform planning, engineering and procurement processes (c) preparing city development plans and identifying investment requirements based on the same. The municipal bodies have stopped thinking anything else other than NURM
The sustainability of funding from Central government is under question now with the end of NURM, which is a time-bound programme that would actually have ended by 2012. Certainly, grant based support from the Central and State governments cannot be expected as they are themselves under pressure to cut down fiscal deficit while performing well on economic growth. Debt financing is once again coming up as an option for the ULBs in India. Bonds are better instruments for raising finance rather than private or institutional debt, which come with the risks of high cost and withdrawal any time by the issuers. Therefore, municipal bonds and bond markets have a greater role to play in the current circumstances. In fact, municipalbonds are touted as the best instrument for financing projects with long gestation period like urban infrastructure projects in theory (Bahl and Linn 1995). Even in practice, several noteworthy experts e.g., Rakeshmohan (1996), Ravindra (2004), Vaidya (2008), and Sheikh and Asher (2012), have advocated tapping bond markets for raising financial resources required for executing urban infrastructure projects in India.
In the next section, we will discuss the feature of municipal bonds as a source of finance for urban local bodies. We will then discuss the experience of municipal bonds during the period of 1997-2007 as well as recent experiences of other types of bonds that came into vogue. Based on the learnings from it and assessment of current resource requirements, the broad agenda for revival of municipal bonds will be finally set, especially on the requirements on the part of various stakeholders of the municipal bonds. We conclude with some optimism sensing an opportunity in the wake of developing smart cities, which would require them to be sourcing funds for investing on development and maintenance of infrastructure services required for the development of smart cities.
2. INTRODUCTION
Bonds are apopular financial instrument to raise financial resources with the view of deploying them into long term projects or investing into companies that are engaged in businesses that holds promise. Bonds therefore can be for either financing development or for investment. Bonds are a convenient instrument for retail, business and institutional investors as they promise assured return over the period of bond (also, called as tenure). Apart from the income yield from bond, it is the ‘yield-to-maturity (YTM)’ which holds more importance while assessing a bond’s total returns on investment. Only those firms that are already doing business and have a good history of financial management are allowed to float bonds and mobilise money from domestic investors so that it remains in safe hands.
Bond floating requires regulatory approvals such as that from Reserve Bank of India (RBI) and Securities Exchange Board of India (SEBI). An important aspect of bond subscription is the financial strength of the floating firm to do business and pay promised interest as well as repay the borrowed capital, which is assessed by the rating of a bond using the financial performance track record of the company as well as other factors. Independent agencies rate the bonds based on the set criteria that help the investors in deciding upon whether to subscribe the bonds or not. Bonds can also serve as useful instruments for raising financial resources for development activities such as infrastructure development. Sovereign governments (including India) encourage floatation of infrastructure bonds by authorized financial institutions towards meeting the financial requirement of economic infrastructure.
Municipal bonds are one such option available to the Municipal corporations of the large cities in India in order to raise funds towardsthe development of urban infrastructure. Technically, ‘a municipal bond is an evidence of the obligation of a ULB to repay a specified principal amount on a certain maturity date along with the interest at a stated or formula-based rate (Dirie 2005: 273). Financing infrastructure development using borrowings from capital markets has advantage of bringing in discipline on the issuers of bond as they are bound to perform in order to pay the interest to investors (Mehta and Satyanarayana 1999). Municipal bonds, like other bonds, have the advantage of borrowing on long term basis (about 10-20 years) while paying for short term infrastructure project requirements that give rise to revenue. The tax advantages of municipal bonds i.e., non-taxing of interest income, in particular, make them popular with investors.Countries like the USA have had a long experience of using municipal bonds to financethe development of cities and their infrastructure (Fahim 2010).
3. OPERATIONALISATION OF MUNICICPAL BONDS
The operationalisation of municipal bonds follows certain processes and structures that are described in the subsections below.
a. Floatation/ issuance of bonds
Municipal bonds can be floated/issued by the municipal bodies with a high revenue base i.e., large municipal corporations, which also need to obtain the permission of respective State governments in order to be able to float municipal bond. The bond has to be floated with some specific objectives or projects that improve urban infrastructure. The proposal for floatation of bond has to be approved by the executive body i.e., commissioner, as well as legislative body i.e., municipal council. It is expected that the ULB has done some preliminary feasibility of the project to be undertaken using the proceedings from bond and will be able to take up the project clearances from concerned authorities. A detailed reference document has to be prepared on the municipal bond with the details of objective/ purpose, size, unit value, interest rate, tenure, issuers, rating and past financial record.
b. Design of bonds
Municipal bonds in general are of two types:
(i) General Obligation (GO) Bonds, wherein borrowing is made while using the overall financial strength of ULB so as to make use of the money by municipal body. Interest and principal payments are made from the general revenue account of the municipal body.
(ii) Structured Obligation (SO) bonds, wherein borrowing is made while emphasizing on the urban infrastructure project for which it is done while pledging the repayment of interest and capital through a structured payment mechanism.However, no such distinction is made of municipal bonds in India, which follow structured debt obligation mechanism for making payments and enhancing the same.
c. Securitisation of payments
Securitisation of bond payment obligations is achieved through funds flow arrangements and other mechanisms. Figure 1 shows one such securitisation mechanism. An escrow account is established and contributions to it are made by the ULB from (i) its own and grant resources, (ii) the revenue arising from infrastructure project. Debt Service Reserve Fund is established to make contributions in the event of shortfall between payments and receipts and therefore serves as a credit enhancement mechanism. Interest and capital payments are made through escrow accounts to the bond investors.
Source: based on Pradhan (2003)
Figure 1 Flow of Funds under Municipal Bonds
d. Rating of bonds
One important aspect of the municipal or any other bond is attractiveness to customer. Investors not only compare the returns across various investment vehicles to make decision but also would like to understand the risk associated with bond investment. However, they cannot assess the same themselves as they cannot perform an analysis of finances and other conditions of the issuing ULB. Ratings come handy to assess risk and express it in understandable terms to investors such that they can make decisions with regard to subscription. Rating of bonds is a specialised job done by consultants based on the financial and other data of the floating urban local body.
e. Additionalities e.g., tax position, guarantees
Some of the municipal bonds come with advantages of no tax implications and guarantees. Tax concession when applied to municipal bond gives rise to interest income going tax free and non-deductible at the source, which increases the bond yield and YTM thereby make it attractive. Guarantees by the State governments or any other government agency also improve the credibility of instrument, as in the event of default on payment of interest and capital the guarantor will make payment of the same. Guarantees and tax concession also strengthen the case of bond as investors perceive it to be more secure instrument.
4. EXPERIENCE OF MUNICIPAL BONDS IN INDIA
Indian cities have also taken the route of raising financial resources by tapping bond markets in the past (beginning in 1997, the last being in 2010), especially few large cities have taken active interest in it. Good ratings of financial conditions of some municipal corporations also helped some of the cities to become interested in municipal bonds. The municipal corporations in India floated taxable as well as tax free bonds to the tune of about Rs 1, 095 crores during the period of 1997-2007, which is relatively small when compared to the market potential for bonds in India.
4.1 Taxable Municipal Bonds in India
Eight municipal corporations in India had mobilised an amount of Rs 445 crores through the floatation of taxable municipal bonds during the period of 1997-2004. The size of these bonds varied a lot between Rs 10 – 125 crores (average size of Rs 55.6 crores) and so also the interest rate offered on them which varied from 7.75-14.75%. Further, most of the bondswere privately placed with only a few of them making use of State government guarantee. The objective/purpose of bond was either water supply and sanitation or roads. Escrow account was well designed in most of the bonds.
It may be noted the National Democratic Alliance (NDA) Government was ruling the nation during most of the period of bonds floatation.It was the NDA Government that emphasized upon private sector participation in public infrastructure development, especially through PPPs in road development. Table 1 shows the municipal corporations of the cities that tapped bond markets along with details/ characteristics of each such bond.
Table 1: Taxable Municipal Bonds in India
City / Amount (in Rs. Crores) / Placement / Guarantee / AnnualInterest / Escrow / Purpose / RatingBangalore (1997) / 125 / Private / State Govt. / 13% / State Govt grants and property tax / City roads/street drains / A- (SO)
Ahmedabad(1998) / 100 / Public & Private / No / 14% / Octroi from 10 collection points / Water &Sewerage / AA- (SO)
Ludhiana (1999) / 10 / Private / No / 13.5% to 14% / Water & Sewerage taxes and charges / Water &Sewerage / LAA- (SO)
Nagpur (2001) / 50 / Private / No / 13% / Property tax and water charges / Water Supply / LAA- (SO)
Nashik (1999) / 100 / Private / No / 14.75% / Octroi from four collection points / Water &Sewerage / AA- (SO)
Indore (2000) / 10 / Private / State Govt / 13.0% / Grants/property tax / Improvement of city roads / A (SO)
Madurai (2001) / 30 / Private / No / 12.25% / Toll tax collection / City roads / LA+(SO)
Visakhapatnam (2004) / 20 / Private / No / 7.75% / Property tax / Water supply / AA-(SO)
Source: Based on Vaidya and Vaidya (2008)
The interest in taxablemunicipal bonds went on decline after 2005 for a variety of reasons. First, with the high levels of taxation and existence of competitive fixed and small scale depositsin market, municipal bonds were not attractive to investors. As macro economic scenario had improved after 2004, the newly elected United Progressive Alliance (UPA) government laid down a different approach towardscountry’s fiscal management. By taking advantage of the buoyant tax revenue due to rise in GDP, the UPA government came out with an urban renewal mission (known as JNNURM) to aid the municipal bodies with finance. A sizeable amount of funds were made available to urban local bodies (ULBs) of mission cities through grants and loans under the JNNURM. The ULBs also found that accessing funds from JNNURM more attractive when compared to hard work required in the case of municipal bonds.
4.2Non-Taxable Municipal Bonds in India
The Government of India took the decision to give tax-free status to municipal bonds in the year 2000 by making amendments to Income Tax Act 1961, which made the interest income from them not taxable. This act has led to a spate of non-taxable municipal bonds. As a result,-eleven municipal corporations in India mobilised an amount of Rs 650 crores by issuing non-taxable municipal bonds during the period of 2002-2007. The size of these bonds was higher than that of taxable bonds (comparing the average bond size of Rs59.4 crores vs Rs 54.5 crores of taxable bonds)and it varied between Rs 21.2 – 100 crores per bond. Further, most of these bonds were placed with multiple objectives/purposes than one objective/purpose.
It may be noted again that the National Democratic Alliance (NDA) Government was ruling the nation during most of the period of bonds floatation. Only three bonds were floated when the UPA government was ruling, which would have been cleared by the NDA government itself. Table 2 shows the municipal corporations of the cities that tapped bond markets along with details/ characteristics of each such bond.
Table 2: Non-Taxable Municipal Bonds in India
City / Objective/ Purpose / Amount of Tax-free Municipal Bond (Rs. Crores)Ahmedabad (2002) / Water supply and sewerage / 100
Hyderabad (2003) / Road construction and widening / 82.5
Nashik (2002) / Underground sewerage scheme and stormwater drainage system / 50
Visakhapatnam (2004) / Water supply system / 50
Hyderabad* (2003) / Drinking water supply / 50
Ahmedabad (2004) / Water supply, stormwater drainage, roads, bridges and flyovers / 58
Chennai* (2003) / Chennai water supply augmentation / 42
Chennai* (2005) / Chennai water supply project / 50
Chennai (2005) / Roads / 45.8
Ahmedabad (2005) / Roads and water supply / 100
Nagpur (2007) / Nagpur water supply and sewerage / 21.2
Source: Based on Vaidy and Vaidya (2008) [* floated by City Water and Sewerage Bodies]
NB: Excludes the latest bond of Rs 30 crores floated by Vizag Municipal Corporation in 2010
The interest in non-taxable municipal bonds also went on decline after 2007 for a variety of reasons. First, with the bonds in general were losing sheen with the rise of equity markets municipal bonds were not attractive to investors as they were illiquid. The UPA government had come out with JNNURM to aid all the eligible municipal bodies in India with finance rather than leaving each city to look after itself. As sizeable amount of funds were made available to the ULBs through grants and loans under JNNURM,the ULBs found that accessing funds from JNNURM was more attractive option when compared to hard work required in the case of issuing and servicing municipal bonds.
4.3 transition Path of Municipal Bodies in India
It can be observed from the experience of the municipal bonds in India during the decade of 1998-2007 that they played an important role in terms of financing urban infrastructure projects in large cities only that too not in a big way. Further, the higher interest rate offered on these bonds would have had a drag effect on the finances of these ULBs. The past experience of municipal bonds in India also shows that accessing funds through municipal bonds is not possible in the case of small and medium sized ULBs, which lack institutional capacity to issue bonds and utilise the proceedings for the purpose of urban infrastructure development. The bonds had also come out due to general monetary tight conditions and dry up of funds with government. There was also some kind of reluctance on the part of ULBs to go hard in accessing funds; this is evident from the failure of Urban Reforms Incentive Fund (URIF)window of the NDA Government, which was accessed by a few ULBs.
With the JNNURM coming to end, there are lots of questions on how the large amount funds would flow into the ULBs in India. As mentioned earlier, several ULBs have been dependent upon grants from Central and State governments for a long time. During the last two decades, the State governments stopped giving any major grants to ULBs unless they are required for running the State government schemes implemented at the hands of ULBs. That leaves Central government as a major provider of grants through direct devolution. The quantum of devolutions is determined by Finance Commission, whereas most of the devolutions were made by the Planning Commission through plan and non-plan grants.
With the abolition of Planning Commission and formulaic method of allocation and transfer of funds, it is not as how much and when the funds will be allocated. Certainly, the fund allocation will follow political bargain principle in a federal structure of government. This leaves some cities as the benefactors (those that are ruled by NDA) and others may end up as losers. Therefore, a case emerges for the municipal bonds now viewed as a potential source of finance for municipal corporations in Indiain order to raise funds. However, greater preparedness is required now on part of the ULBs to brace up the challenges in floating the municipal bonds and continue to perform so that they can be serviced as well.