Perspective

The bond less explored

A new framework for debt securities issuances is welcome but there is a need for a vibrant secondary market

Illustration by Kishore Das

Delivery of public utilities is generally a case of natural monopoly. These services involve large fixed costs for creating and maintaining the goods and services and relatively small marginal cost to provide extra units of goods and services. Hence, natural monopolies are generally operated by governments. In India, urban local bodies (ULBs) are entrusted to provide a number of public utility services.

The 74th constitutional amendment Act, 1992, was a significant step towards strengthening the role of ULBs. This amendment gave constitutional recognition to ULBs, along with the constitutional right to exist, and the Twelfth Schedule of the constitution provided a recommended list of local functions for the ULBs. Through the constitutional amendment, state governments were required to amend municipal laws and empower ULBs with such powers and authority as may be necessary to enable them to function as institutions of self-governance.

The constitutional amendment was an imperative, given that urban areas are catalysts to economic growth as a major part of industrial and service sector activities are concentrated in and around them thanks to better infra and proximity to consumers with higher purchasing power. It has been observed that the contribution of urban areas to GDP increased to 52% in FY05 from 38% in FY71 and is projected to have increased further to 63% in FY10. Both organic growth in population and migration of rural populations to urban areas have led to urban population growth reaching 32% in the last decade in relation to overall population growth of 18%.

However, the size of the municipal sector in India is small — it constitutes 2-3% of the combined central and state government revenue, compared with 20-35% for developed countries. In relation to the services supposed to be offered by ULBs, their revenue size is small. Consequently, the quality of urban civic services in Indian cities is much below the desired levels. According to Census 2011, only 32% of India’s population receives treated water, while 19% of urban households do not have any access to any sanitation facilities at home.

In this context of demand-supply mismatch in urban civic services, the Union cabinet has rightfully approved the plan for building 100 smart cities and the Atal mission for rejuvenation and urban transformation of 500 cities. Their implementation would entail substantial expenditure for the creation of urban infra.

Indian cities are a classical example of under-investment. As the income-generating capacity of municipalities in India is abysmally low and their financing requirement huge, they often find implementing existing projects under Jawaharlal Nehru National Urban Renewal Mission (JNNURM) a tough task. Of the ₹637.9 billion worth infrastructure being created under its schemes, 37% of the required funds are being arranged by ULBs, 47% is being provided by the Centre as grants and the remaining by states. According to the latest update of the ministry of finance, the Centre has released 73% of its approved commitments but ULBs still need to mobilise around ₹66 billion, based on India Ratings and Research’s estimates. While 83% of the funds’ appetite lies with investment-grade ULBs, 31% of the funds are needed by BBB category cities alone.

Hitherto, urban infra in Indian cities was generally funded by grants from the central and state governments and borrowings from financial institutions such as LIC, Housing and Urban Development Corporation (Hudco) and commercial banks. The National Capital Region Planning Board (NCRPB) in the national capital region and MMRDA in Mumbai are two organisations financing urban infra projects. Even the World Bank report on municipal borrowing pegs the funding requirements of ULBs in India to be huge; however, actual levels of ULB borrowing are quite low.

Municipal bonds have been in existence in India since the late ’90s; however, they have failed to excite investors and bonds (tax-free, taxable and pooled finance) worth only ₹14 billion have been issued till now. Sebi has proposed a new regulatory framework for issuing of debt securities by municipalities, which is a welcome step. The requirement of funds to improve urban infrastructure are enormous, as estimated by the 12th plan. According to India Ratings, the Indian municipal bond market has the potential to reach ₹450 billion in the near future. There is a pressing need for a few benchmark issuances, to be followed by a series of issuances. However, certain impediments need to be addressed before India can witness a deep municipal bond market.

The major issue with municipal debt issuances is information disclosure by ULBs meeting capital market requirements. In the process of issuing municipal bonds by ULBs, regular disclosure of financial and non-financial information is a major requirement. As per the World Bank report, Sebi should publish disclosure guidelines for the public issue of municipal bonds in line with the ministry of finance tax-free standards and incorporate current international practices. The report also recommended following electronic municipal market access) in the US, where the securities and exchange commission has no specific disclosure requirements and relies instead on the voluntary industry standard, though after suitably adapting to the Indian context.

Sebi has placed the onus on respective states to address violations and non-compliance by ULBs. However, bankruptcy laws and security enforcement laws applicable against ULBs vary from state to state. Hence, a predictable debt recovery and bankruptcy regime applicable on a pan-India basis is a necessary condition for gaining investor confidence on municipal bonds.

 Regulatory regime

The draft regulations on municipal bonds contains certain regulations on defaults, buy-back of security, security for secured debentures, debt redemption reserves and listing conditions, which may be relooked or fine-tuned. Some conditions — if applied in the present form — may be detrimental for the creation of a stable municipal bond market in India. Sebi is of the opinion that a corporate municipal entity (CME) is a company acting as a non-banking financial company (NBFC) under the debenture redemption reserve requirement according to companies Act, 2013. If the RBI treats it as an NBFC, regulatory regime for CMEs will change. 

Barring a few ULBs, budgeting and accounting systems for most lack transparency. In the past, some municipalities, including Ahmedabad and Nashik, could not use the mobilised bond funds effectively due to poor project evaluation and lack of specialised project management support. Therefore, the bonds floated by a CME with a separate escrow account for the servicing of municipal bonds with earmarked revenue as well as for usage in defined projects or a set of projects would protect investor interest. Appointment of a monitoring agency such as public finance institutions or nationalised banks to monitor funds in escrow accounts in case of ULBs and a debenture trustee for corporate municipal entities will increase the confidence of investors in these bonds.

Conditions of either a guarantee from the government or a structured payment mechanism for listing of unsecured bonds will help deepen the bond market. Additional conditions such as the financial viability certificates for projects and a separate project implementation cell are also likely to bring in transparency.

Status of reforms

JNNURM was envisaged for the reform-driven planned development of cities. However, the implementation of key reforms has not been encouraging. Only a few states have transferred all functions as per the 74th constitutional amendment Act to the ULBs. Many ULBs are yet to adopt the National Municipal Accounts Manual (NMAM) and migrate to accrual-based double-entry accounting systems from cash-based single-entry accounting systems. Many have failed to meet the 85% coverage of property tax along with 100% recovery of operations and maintenance charges by way of user charge collections. The ULBs to be eligible for public issuance of debt securities shall have to adopt the NMAM for at least last three preceding financial years. The municipalities shall not have negative net worth in the last three preceding financial years.

The proposal of issuance of revenue bonds is a better way of tapping project revenue for debt servicing. In this case, the levying of user charges and property tax, frequency of revisions and sufficiency of revision are important. The recovery of user charges for ULBs or on any public or social goods provided by the government is very low. A number of national committees had recommended that user charges from the public or social goods offered by various governments should at least cover operations and maintenance expenditure of the asset, which doesn’t happen. According to the high-powered expert committee report, user charges cover less than 50% of the operations and maintenance cost of basic infra services in India. The major reason is a widespread leakage and infrequent and insufficient revisions in user charges. 

Property tax is one of the most important source of tax revenue. However, its collection is generally poor, along with low revenue buoyancy. In many cities, it has been found that the number of properties subject to property tax is much lower than the properties identified in the geographical information system. Besides, lack of clear titles of properties also leads to their underestimation. Municipal bonds can take off if issues related to user charges and property tax are adequately assessed and revised at regular intervals and in the right amounts.

The absence of secondary markets to trade municipal bonds is one of the significant factors for their tepid growth so far. The lender does not have the flexibility of trading municipal bonds prior to maturity in the secondary market. Liquidity in the secondary market is a necessary condition for the primary municipal bond market. Retail investors’ preference for bank deposits, postal savings schemes and national saving certificates over bonds due to the liquidity risk and small institutional investor base are hurdles towards the development of secondary debt market for municipal bonds. 

The government at different times has issued guidelines for municipal bonds to improve urban infrastructure and give a fillip to the municipal bond market. According to the guidelines of the ministry of urban development in February 2011, tax-free municipal bonds should carry a maximum per annum interest rate of 8%. These bonds compete with systematic investment plans and other products offered by the mutual fund industry. During the time of low inflation and a low-interest rate regime, tax-free bonds are attractive investment options; however, during a high-interest rate regime, these are not a very attractive investment options leading to a lower investor appetite.

Though Sebi’s proposals on debt securities will certainly impact the municipal bond market, we still need to improve the demand for municipal bonds. An innovative way of making municipal bonds attractive to investors could be government-citizen partnership bonds, where citizens invest to improve infra in their own city. By subscribing to bonds floated by their own city’s ULB, citizens will be a part of the city’s improvement process.

Also, the government should increase its focus on pooled finance. While bigger and better ULBs could go to the bond market to raise finances, smaller ones can take the pooled finance route and raise funding at a lower rate. Tamil Nadu has already done three bond issuances under this scheme and the rest of the states could benefit from the state’s experience. In case of a financial crisis at ULB, pooled finance entities generally have the power to tap state finance commission devolutions to ULBs (those that have taken loans from pooled finance entities) and thus avoid defaulting on their commitment to bond holders.

Compared with an individual ULB, specialised entities such as NCRPB, MMRDA and pooled finance entities are managed by professionals and are in a better position to satisfy the demands of capital markets in terms of governance, transparency and information disclosures. Floating of a number of such specialised entities at the state level — pooled finance entities for small ULBs and NCRPB or the MMRDA kind of structure for large ULBs — can help change investor perception and appetite for municipal bonds.