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Funding and governance are the largest areas of reform

Funding and governance are the largest areas of reform
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First Published: Fri, Apr 23 2010. 01 15 AM IST

Updated: Fri, Apr 23 2010. 09 59 AM IST
New Delhi: As many as 590 million people in India—roughly 40% of the country’s population—will be living in urban areas by 2030, according to McKinsey and Co. Even as they are expected to take up more than two-thirds of the new jobs generated by then, urban service levels will continue to lag, Shirish Sankhe, director at McKinsey and one of the co-authors of the report, said in an interview. Edited excerpts:
Also See | Population explosion, Income growth, Urban services and more (Graphic)
You recently released a similar report on China. How different were the issues faced by cities there?
In China, we looked at what should be the shape of their urbanization going forward—should it be concentrated or should it be distributed. Those were the type of issues. In India, the issues were a lot more basic because the basic nuts and bolts elements of our urbanization still need to come together. So that’s why we looked a lot more at funding, governance, planning, housing in a more fundamental manner in India compared to China.
That country is already urbanized. How did they drive the growth in their cities, in terms of funding?
Habitation problems: McKinsey and Co. director Shirish Sankhe says India has not yet figured out housing solutions for the bottom two income groups, making slums the only solution for those classes. Ashesh Shah/Mint
You know, it is a very well-established system. In fact, what we noticed is that what’s happening in China is not just unique to China. It’s happening in almost all best-practice cities and countries around the world, where they have a systematic, formula-based funding mechanism directly to the city. It’s not ad hoc like it is in India. Let’s take government funds. China allows 25% of its VAT (value-added tax) to be retained directly by the city. There is inbuilt incentive for attracting investments and creating the type of city that will attract citizens and investors.
China also has done a very good job on two other areas. One is monetization of land—all expanding, developing cities have used monetization of land very effectively; China has done that as well. They have also used the debt portion of it quite well through creating special purpose vehicles. So if you take debt, land monetization and direct government funding, all these are very important sources of revenue in Chinese cities and it’s all done in a very methodical manner.
What is the single biggest reform which needs to happen for Indian cities to make that leap forward?
The two largest areas of reform are funding and governance. If I have to pick one, I will say city governance. It’s like a jigsaw puzzle. The whole thing has to come together in governance. The biggest one probably is to create empowered city administrations both at the metropolitan level as well as the city level, with directly elected political leaders at the metropolitan level. That probably will be the biggest one.
In that respect, what do you think of the Finance Commission’s recommendations this year?
What the 13th Finance Commission has recommended is a good step in the right direction. Our medium-term recommendation on this is to share 20% of the GST (goods and services tax) directly with the cities, which constitutionally is not possible. But I think that change can be made. But this by itself will be a very fundamental source of revenue for the city in addition to the four which I’ve already mentioned.
What sort of money are we looking at—the 20% of GST alone?
You know, the number in the next five years is somewhere between $10-15 billion (Rs44,500-66,750 crore) a year for our cities. So whether you take 18-20% of GST or whether you give it as a direct grant through the Jawaharlal Nehru National Urban Renewal Mission, in the short term does not matter. Even in the medium term, a methodical formula based approach like the GST share is probably the right way to go. For the short term, you can do that as a direct grant to the establishment.
Any counter-intuitive findings?
When you think urban, tier I and tier II cities immediately come to mind. But what was quite pleasantly surprising is the amount of economic contribution that the tier III, tier IV cities are making to India. Their GDP (gross domestic product) growth rates were 7%-plus. And the amount of funding (for capital investments) we are putting in is less that $1 per capita per year, when the benchmark should be $100... We’ve recommended $20 per capita per year as the type of support that the government needs to give in addition to all the other ones related to planning and governance and so on...
Housing is one of the biggest problems that India faces currently. How do you see this playing out?
See, India basically has not figured out how to house the bottom two income groups—below Rs90,000 of annual income and below Rs200,000 of annual income. There the affordability comes into play because there is a maximum amount that these households can pay. And everywhere in the world, almost at any stage of development, the government had to step in and devise solutions to bridge the gap between affordability and market price. So that is the basket of incentives, subsidies and various mechanisms, tax regimes that the government has to pull together. In India we haven’t really thought it through on an end-to-end basis. So the only solution for that income class is a slum solution. And there is no other solution. There is no rental solution. Nothing is available at Rs1-2 lakh. Or nothing is available at Rs2,000 per month rent. So those are the solutions you have to devise and the subsidy has to be borne either by cross subsidization of the market or by the government.
But in the past where subsidies have been given—there is an ongoing interest subsidy scheme by the government—they haven’t really been successful.
It is a complex problem. One, you have to bridge the whole affordability gap. For example, the interest subsidy, out of the Rs5 lakh overall cost of a house in tier I, tier II cities, the interest subsidy only takes care of Rs40,000. First of all, you have to bridge the rest of the affordability gap. If you give the interest subsidy by itself, you cannot create too much affordable housing.
And then, of course, banks find it very tough to lend to these income groups because they don’t have formal sources of income. You need to do two things on that. One is you have to realize that ownership, in that group of people of the lowest income, may not be the best solution. Bring a substantial rental solution.
The second thing is, if it has to be ownership, we have made a whole series of recommendations, but one of the big ones is a mortgage guarantee fund, the way it has worked in some of the other countries. It reduces the risk of lending to any such income groups substantially.
Urban Upsurge
By 2030, India’s cities will likely account for 70% of the nation’s gross domestic product, generate 70% of net new jobs created, drive an almost fourfold increase in the nation’s per capita income and contribute 85% of total tax revenue, according to new research by McKinsey Global Institute (MGI).
“Turning around its cities and unleashing their dynamism will be critical to India’s future economic growth,” says the economics and business research arm of McKinsey and Co. in a report titled ‘India’s Urban Awakening: Building Inclusive Cities, Sustaining Economic Growth’.
Graphic: Ahmed Raza Khan / Mint and Illustration: Jayachandran / Mint
It won’t be an easy task. According to the report—the result of 21 months of research—India will need as much a $1.2 trillion in capital investment by 2030 to cater to an estimated 590 million people who will be living in urban areas.
Surging growth and employment in cities are driving the pace of urbanization—it took India nearly 40 years till 2008 for the urban population to rise by nearly 230 million, but will take half that time to add the next 250 million. Indian policymakers are yet to come to grips with the magnitude of the phenomenon.
The report suggests allowing cities to monetize land reserves. It calls for sharing of Central taxes with city administrations and devolution of powers to local governments, allowing for elected mayors and increasing private participation in urban projects. It recommends that the government provide interest and tax subsidies and set up a national mortgage guarantee fund to spur lending to low-income families to buy homes.
“The cost of not paying attention to India’s cities is enormous,” warns MGI. “Today’s policy vacuum risks worsening urban decay and gridlock, a declining quality of life for citizens, and reluctance among investors to commit resources to India’s urban centres.”
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First Published: Fri, Apr 23 2010. 01 15 AM IST