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Daily Editorial – Municipal Bonds in India



Municipal Bonds in India


Click here to Download Daily Editorial PDF (16 Feb. 2017)

Context

The City of Pune is getting ready to launch the biggest Indian municipal bond issueto raise Rs. 2300 crore which is more than all the other cities cumulatively collected over the past two decades.

In this context let us get a 360 degree perspective about the Municipal Bonds, before we go on to discuss a few questions that may appear in the exam?

What are Municipal Bonds?

Suppose the city you live in wants to set up a new Metro or a Bus Rapid System. The City Corporation can issue municipal bonds to fund the project. Institutional investors as well as the public can buy these bonds. Revenues from the Metro will then be used to repay the interest and principal on these bonds.

In Municipal bonds the funds raised are earmarked for one project, are called revenue bonds.

When did the Municipal Bonds start?

Starting with Ahmadabad in 1998, several cities likeBengaluru, Nashik and Madurai (some 25 cities in total) have issued them but mostly privately placed with institutions, and not tradable.

As a result, the municipal bond issues only touched Rs. 1,353 crores and there have been no new issues since 2010.

These have now been permitted for public offering by SEBI.

Why is it important to have Municipal Bonds?

  • 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 Rs. 40 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.
  • Solving urban infrastructure problems requires a lot of money. The Smart City programme introduced by the Centre has envisaged infrastructure spending to the tune of Rs. 7 lakh crore over the next 20 years (i.e. Rs. 35,000 Cr. each year)
  • Indian cities do not have the financial capability to build this infrastructure.
  • Cities depend heavily on money passed to them from either the national or the state governments.
  • Moreover the importance of raising money through municipal bonds is more and more increasing in the face of GST. For example, the BrihanMumbai Municipal Corporation – the richest municipal body of India – earned 33 per cent of its revenue in 2015-16 from octroi, which would go away once Goods and Services Tax kicks in.

These bond issues could help corporations directly raise funds without looking to State grants or agencies such as World Bank.

Large institutional investors such as pension funds and insurance companies are always on the lookout for look for less risky avenues to invest. Municipal bonds could tap these sources of fund and help get many projects off the ground.

Challenges with the Municipal Bonds

  • 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.
    • o Take the case of China where there are now fears of default by local governments that have raked in debt totalling $2.9 trillion. S&P believes that nearly half of the issuers ‘only deserve junk rating’
  • 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. In the 1990s many bond investors lost money invested.
  • Other challenges such as lack of incentives for municipal bodies to tap debt market, lack of prevalence of institutional finance and absence of any particular requisites to issue bondsserve as major impediments.

 

What can be done to incentivize the Municipal Bonds?

Incentivizing Municipal Corporations for bonds issuance

  • Incentive by way of Additional Grants: Given that all municipal bodies who issue a bond would be assigned a credit rating, it would give a fair sense of the credit worthiness of the municipal body. Hence, a clause can be introduced to the effect that municipals which raise debt by way of bond issuances are beneficiary to additional grants from the Centre and State governments that go beyond the allocations as specified by the Finance Commission. This will be a certain and definite incentive to municipals to issue bonds.
  • The borrowings of the Municipal Corporations from Financial Institutions such as HUDCO etc. can be linked to the bond market. For instance, HUDCO can be mandated to lend to municipal bodies close to 80-90% of the financing requirement provided the municipal body raises the balance 10-20% through the debt market.

Incentivizing investors to invest in Municipal Bonds

  • At the retail level.
    • o The minimum tenure of the bond should be increased to 5 years from the current recommendation of the CoBoSAC of 3years.
    • o All bonds issued by Municipals should be made taxfree.
    • o The ceiling of 8% on interest rate should be withdrawn for such bonds
    • o The interest rate can be marked at 50 basis points higher than the 5yr Government security paper. Such a step would enable municipal bonds to become a second alternative to the safe government bonds and thereby induce investments.
  • At the wholesale level.
    • o Banks should be mandated to lending to ULBs as a part of the ‘priority sector’.
    • o Alternatively, Bank holdings of Municipal Bonds should also be given space in the SLR requirements provided they are of certain specified category.

Safeguard principles

  • o Organizations  such  as  HUDCO  etc.,  can further  provide  guarantee  to  the  bonds  issued  by Municipal Corporations, i.e. after lending x%  to the municipal, they  could provide guarantee for the residual amount raised by way of bonds by the Municipal Corporation.
  • o Additionally,  an  ESCROW  mechanism  can  be  created wherein  the  first  charge of  pre-specified  revenue should  be  kept  aside  for  paying  the  interest  and  principle  amount  to  the  guarantee provider.  The guarantee provider would in turn invest in the safe government bonds and pay the interest to Municipals.

The formation of an organization called the State Municipal Development Corporation (SMDC) which is a state level organization

This entity can perform the same function of being a conduit i.e. it would borrow from the market by issuing bonds for onward lending to the ULB (Municipal Corporation). However, along with this, it would also ensure that operations in the ULB remain glitch free. In an implicit manner, it would serve as a supervisor for the ULBs juxtaposed with being a link to the market. Hence, an SMDC would not only satisfy all the functions outlined by SEBI in its recommendations, but it would also go a step ahead in over viewing the operations and financial health of ULBs.

International Models

  • 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.

Conclusion

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.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.


 TEST YOURSELF


PRELIMS Qs:


  1. Which city was the first to issue Municipal Bonds in India?
  2. Who regulates the Municipal Bond Market in India?

Mains:


  1. Indian Citiesdo not have adequate financial autonomy—is it the failure of the landmark 74th constitutional amendment?
  2. ULBs in India are dependent on octroi taxes and grants from Centre and State governments. How can ULBs raise more resources in the post GST era given the pressing need for urban infrastructure?


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  • Manoj

    Thank you for a detailed analysis