Using municipal bonds to bolster city finances
The ambitious plans for urban renewal in India are currently built on the quicksand of weak city finances. The news that Pune is getting ready to launch the biggest Indian municipal bond issue thus needs to be welcomed—but with caution.
This newspaper has always stuck to the Ambedkarite argument that cities rather than villages are the future. They will drive economic growth, innovation, social mobility and individual freedom. But it is no secret that our cities are becoming increasingly unlivable.
The committee on urban infrastructure headed by Isher Judge Ahluwalia had estimated in its 2011 report that Indian cities would collectively need to invest around Rs40 trillion at constant prices in the two decades to 2031. Some 600 million Indians will be living in cities by then. The inability of cities to meet their growing needs will not only throw the economy off the rails but also create social tensions.
Indian cities do not have the financial capability to build this infrastructure. Two points are worth pondering over. City revenue is less than 1% of gross domestic product. And the share of own revenue in city budgets has been declining consistently. The net result is that cities do not have adequate financial autonomy—a flaw that can be traced back to the landmark 74th constitutional amendment that empowered local governments. Cities depend heavily on money passed to them from either the national or the state governments.
A robust municipal bond market could be part of the answer. It has been dormant even though some 25 cities have raised money since the first municipal bond issue by Ahmedabad in 1998. Pune now seems to be getting ready to raise more money in a single issue—Rs2,300 crore—than all the other cities cumulatively collected over the past two decades. Many other cities are also waiting on the sidelines. There are also prospects for pooled financing, where several small cities jointly raise money, as has been done in Tamil Nadu and Karnataka in recent years.
Municipal bonds are thus welcome, but there is also good reason for caution. First, bonds are merely a way to collect money today based on revenue to be generated tomorrow. They are not a substitute for city revenue. So cities will still have to deal with hard policy issues such as collecting local taxes, user charges, stamp duties, etc. Bond investors are unlikely to put money into cities unless they are convinced about their fiscal strength.
Second, India has had a dark history of sub-national governments raising money from bond investors for specific projects but then diverting the money for other uses. This was especially serious in the 1990s. Many bond investors were burnt in that episode. Cities should thus make credible commitments that the money raised from bond investors will be used only for the specified projects. It is to be seen how investor money is ring-fenced.
These are early days. The new municipal bond regulations released by the Securities and Exchange Board of India (Sebi) in 2016 do deal with many of the problems that we have discussed. However, it is likely that India may need to create an agency that is ready to take some of the risk out of municipal bonds—through market making, credit enhancement and underwriting. This can create the usual problems of adverse selection and moral hazard, but the point is that just giving tax-free status to municipal bonds may not be enough. Some policy innovations may be needed till a proper market for bond insurance is in place.
There are several international models to benchmark against. The Development Bank of South Africa uses its balance sheet to support municipal bond issues. Denmark has an agency that takes some of the risk out of pooled finance by creating a mechanism to protect bond-holders in case one city in the pool defaults. The Japan Finance Corp. for Municipal Finance has a sovereign guarantee.
Municipal bonds should thus be seen as only one part of a larger package to strengthen city finances. Cities need to generate more revenue as well as get more untied funds from the money collected through the new goods and services tax. And to pull this all together will require city administrations that are empowered. Having directly elected mayors is an idea whose time has arrived.
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