City Finances: So Many Ratings, So Few Bonds

When 94 smart cities in India received credit ratings in May 2017, it generated a buzz around the bond markets. As of March 2018, 363 cities had received credit ratings awarded under the Atal Mission for Rejuvenation and Urban Transformation (AMRUT) programme. Never mind that the present urban agenda was only taking a leaf out of the erstwhile Jawaharlal Nehru National Urban Renewal Mission (JNNURM), which mandated credit ratings for the 65 cities that it covered. While none of the cities covered by the JNNURM accessed the bond markets, the smart cities and AMRUT programmes have pushed a little harder in that direction.

Since 2017, two smart cities have raised municipal bonds: Pune and Hyderabad. We are told that there are a few more in the pipeline, like New Delhi, Indore, Vizag, Jaipur, Lucknow, and Ahmedabad.

If cities are slow to warm up to bonds, it is because of credit quality and governance issues. Other reasons are the availability of institutional funding and growing number of public-private partnerships (PPP) in rendering civic services.

Credit quality and governance in urban local bodies remain a challenge

Of the 363 cities that received ratings, 144 cities have investment grade ratings of ‘BBB-’ and above. Of these, 29 cities have ‘A-’ or above credit rating and have the potential to issue bonds. So the ratings that could make it to the market are just 8 per cent of the total ratings assigned. The weak credit quality is reflective of the quality of governance and the fiscal health of the urban local bodies.

The municipal, which is the third tier of the government, came into its own in 1992 with the Seventy-Fourth Amendment to the Constitution of India. Certain funds, functions, and functionaries were devolved to the local bodies as per this amendment. The local bodies are yet to attain the capacity for governance that state governments have. While certain key leadership positions in the local bodies are held by Indian Administrative Service officers, major critical expertise like urban planning, transport, information technology, finance, and accounts are unavailable for urban development. Some of the states like Tamil Nadu, Maharashtra, and Karnataka have dedicated municipal cadre and these are the states that lead in urban governance. Many other states are still developing capacity for urban governance.

The weak fiscal health of the urban local bodies stems from a mismatch between their limited sources of revenue and their extensive service commitments.

While cities themselves contribute a significant portion of the gross domestic product in India, the taxes on their economic output, such as the goods and services tax, do not accrue to the city governments. Their primary revenue comes from property taxes. Fee-based income such as fee from building permits, advertising, rent from municipal markets, parking, and user charges for water supply and sanitation have the potential to generate revenue for these urban local bodies. So far, the income from these secondary sources has been limited.

The level of expenditure depends on the civic services the cities are expected to perform. The broad range of services that city governments render is maintaining infrastructure such as roads, water supply, and sanitation, parks and stadium, public health programmes, schools for elementary education, street lighting, and public transport. In larger cities, water supply and sanitation are often handled by a separate water supply and sewerage board.

Overall, cities across India are not strictly comparable as the levels of civic services rendered vary greatly. However, the nature of their revenue and expenditure are similar and almost all urban local bodies suffer from a mismatch of revenues with service commitment. The urban local bodies are therefore dependant on their state governments to bridge this gap.

Public-private partnerships are emerging as a preferred funding option

As per the Ministry of Urban Development Annual Report 2018, a total investment of Rs 203,979 crore has been proposed by the 99 cities under their smart city plans. Twenty-one per cent of this investment is expected to be funded by private investment. Smart city proposals have factored PPPs in projects relating to car parking, solar lighting, water front development, water supply, waste collection, and cycle sharing. These projects show a great diversity in private sector involvement.

The own resources of the urban local bodies constitute only 1 per cent of the total funding requirements. The ‘others’ component of Rs 15,930 crore could be raised by way of bonds.

Municipal bonds need credit insurance and larger pool of investors

As per the estimate of credit rating agencies, annual municipal bond issuance is likely to be at the level of Rs 3,000 crore for the next three years. Many state governments are looking at pooling of weak municipalities to issue bonds as they will not be able to raise funds independently. Therefore, while some of the 30 urban local bodies with ‘A-’ and above ratings could access the market independently, the others are likely to appear as pooled funds.

Municipal corporations would look at bond issuance only if the interest rates are competitive. The well-performing munis have recourse to institutions like the Housing and Urban Development Corporation, which have traditionally funded the urban local body programmes. The bond coupon rates are a product of credit ratings. Pune and Hyderabad raised bonds at the rate of 7.59 per cent and 8.9 per cent respectively. These bonds were rated ‘AA+’ and ‘AA’. The Government of India has offered to provide 2 per cent on the total size of the bond issue as an interest subsidy in lieu of a tax-free status for the bonds. Even this subsidy will not make the lower investment grade ratings (BBB) attractive to the markets.

Internationally, credit risk on municipal bonds is mitigated with the mechanism of bond insurance, wherein a ‘AAA’-rated insurer guarantees the return of principal and interest on the bond. In the United States, large municipal bond insurance companies such as MBIA, AMBAC, and FGIC helped to grow the bond markets. In India, the government had announced the setting up of a credit guarantee fund in its 2016 Union budget. It is expected that the India Infrastructure Finance Company Limited will be the lead promoter of the fund with a corpus of Rs 1,000-1,500 crore. Such a guarantee fund can give the urban local bodies with BBB ratings a push towards bond issuance.

Complex credit structures such as pooled funds and bond insurance make rating products difficult to sell to retail investors. So far, municipal bonds have been raised for roads, water supply, and sanitation. The Smart Cities Mission (SCM) has included visible and impactful projects such as riverfront development, lake conservation, and redesign of public spaces and parks. These projects that transform the public domain have an emotional connect with citizens and they can be persuaded to invest in bonds that finance this development. This will enlarge the available pool of bond investors.

The SCM hopes to achieve the professionalism, and citizens connect through the setting up of special purpose vehicles (SPVs) to manage the development projects. Internationally, SPVs have provided the local governments with a corporatised structure to borrow from the market and quickly implement infrastructure projects. The Urban Development Investment Corporations (UDIC) in China is an example. The 360 UDICs reportedly have enabled the rapid growth of urban infrastructure in China, where infrastructure investment has been maintained at approximately 9-10 per cent of the GDP.

However, the municipal bonds of Hyderabad and Pune were issued by the corporations themselves, not by SPVs. The government’s policies are in the right direction, but the markets are still waiting for the action on the ground. While the municipal road map is still unfolding, one thing is clear: the process of issuing municipal bonds is likely to bring in a much-desired reporting discipline. Urban local bodies will get their accounts audited and budgets published, and make timely repayment of debt! This spin-off alone is worth the effort invested in municipal bonds!