Municipal bond mkt in need of support in India

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There have been 14 issues of municipal bonds by 12 cities and towns and two states infrastructure and financial entities for Rs 1,550 crore. Advocates for municipal bond say, this is a market that needs support. They cite the example of United States where this is an instrument of choice for urban asset creation. But the market in India is quite dead; the municipalities that participated in earlier bond issues are rather indifferent and tax free bonds have no takers.

Ahmedabad Municipal Bond was the first municipal bond that was issued in India. At the beginning of this year it observed its tenth anniversary. Ahmedabad Municipal Corporation issued the bonds in January 1998 for Rs 100 crore to part finance, it's nearly Rs 5 crore water and sanitation programme. A quarter of the bonds were offered to the public who oversubscribed even though there was no explicit state government guarantee on repayments.

Utpal Padia, Deputy Commissioner, Ahmedabad was involved in that issue. He said, “Our bond was escort with certain income so we require income from that particular amount and fiscal discipline has to be observed.”

Ahmedabad Municipal Corporation has accumulated Rs 35 crore in cash losses by 1993-94. There is nothing like debt and debt to focus the mind they say. What is true of individuals is true also of Municipal Corporation. So during the next three years, Ahmedabad Municipal Corporation went about repairing its finances in preparation for bond issue with technical assistance from USA. It improved property tax and octroi collections, introduced computerised double-entry accounting, recruited MBAs to upgrade financial management, developed a five year infrastructure programme and got its credit worthiness rated by Crisil.

By March 1999, the corporation had a cash surplus of Rs 21 crore. Nabaroon Bhattacharjee who was than with USA, financing infrastructure with bonds into play a different setup attitude than paying for it with grants from Central or State government or own money.

Nabaroon Bhattacharjee, Water & Sanitation Programme, World Bank said, “There are number of projects prepared which are on the traditional way of typical looking at CPW, the schedule of rates, doing a technical estimation and preparing a budget and that’s what goes into a project proposal. But when you have to access the market project, it has to be structured which is financially viable, which also looks at the risk profile and also looks at debt servicing.”

The taxable seven year bond with an interest rate of 14% was listed on Ahmedabad and National Stock Exchange to reassure lenders a charge that was created on a bank account in which collections from ten octroi post were deposited. Since then the corporation has raised Rs 458 crore through four bond issues and repaid a little more than half the amount raised. Fifth issue for Rs 150 crore is on hold now because of difficult market conditions. But Ahmedabad Municipal Commissioner also has a word of caution. Tapping the market also has its downside, he says with the borrowed money it is not investments in projects that pay for themselves.

IP Gautam, Municipal Commissioner, Ahmedabad said, “If you are going to the market then all fund raised from the market as a debt is shown as a payment due and due to that particular phenomena. When rating agency will come they will try to downgrade.”

Alandur is a municipality 20 sq. m in size close to Chennai airport. At the beginning of this decade, it was home to 1.5 lakh people. Its proximity to Chennai had brought in a lot of migrants but they did not have the amenities of a modern city. Sai Bharati’s four times Chairman recalls the difficulty he had in installing this Rs 34 crore sewage treatment plant and the underground system to drain waste water from houses. It was tough going initially getting each household to contribute. Sai Bharati remembers holding a number of roadside meetings and advertising that has contributed as an example for the others who are holding out. In all he was able to get 11,000 household to 5000 each to part finance the project, Rs 5000 was a lot of money in the year 2000.

R Sai Bharati, Chairman, Alandur Municipal Council said, “They are ready to pay if you do something to the people. They want the transparency to be maintained and should have confidence in the institution that is the municipality. The previous municipality gave them the initiative to take part in this scheme and we didn’t have any difficulty in collecting Rs 5 crore from the public within a span of three months.”

Two years later in 2002, Alandur participated in another financial innovation. The country’s fist Pooled Bond to augment water supply; Alandur was not alone 11 other municipalities are joining Chennai associated with it, Madurai also joined in to raise money for its underground drainage project. Krishnaswamy Rajivan was the Managing Director of Tamil Nadu Urban Development Fund at that time. He recalls the excitement of playing midwife to the issue.

Krishnaswamy Rajivan, Former Managing Director, TN Urban Development Fund said, “Once the bond issue was subscribed to the huge sense of small and medium municipality sense of ownership.”

The traditional has a visual appeal that the modern does not have and that can be said of Pooled Finance Bond that TNUDF issued in the year 2002. By this time the technology had caught on and the bond were issued in digital and demat form which is why you cannot see them on your screens. They were of Rs 50 crore and of 15 years duration, they offered a taxable interest rate of 9.2% and use to retire debt contracted by the municipalities at 12%. Banks in India do no invest long-tem. Vikram Kapur currently Members Secretary of Chennai Metropolitan Development Authority explains why TNUDF had to step in to bridge the duration gap.

Vikram Kapur, Members Secretary, Chennai Metropolitan Development Authority said, “Most investors are averse to long-term paper unless they are pension funds or insurance agencies which are looking at long-term returns. But for short-term investors like banks or high net worth individuals this issue will always remain. It is for this reason there is a necessity to have an intermediary like Tamil Nadu Urban Development Fund which can in a way counter guarantee such kind of loans and guarantee that repayments will take place while at the same time they are willing to take the construction risk of such projects.”

To improve the market, bonds investors were allowed to redeem them five years before expiry. They were reassured with a charge on property and another tax collection of participating municipality and these were deposited in a bank account. Another comfort was provided by state government grant of nearly Rs 7 crore that was invested in low risk securities. USAID (United States Agency for International Development) guaranteed repayment of half the principal amount while the Tamil Nadu government undertook to makeup any default in the repayment of interest and the remaining principal from municipal grants

Rajivan said, “First, fiscal reforms, second, administrative reforms so that the Mayor could actually settle a contract don’t have to roam in Mumbai, Delhi, Chennai to get a contract in place and third, raise user charges for the people. So, these 74th type of reforms empower somebody so that the power and responsibility are in the same place and there is some accountability to the citizens without that none of this is possible.”

Urban infrastructure cannot be financed only with public money; the government has tried to attract private funds. It has offered what is called viability gap funding to improve profitability of projects or public goods that don’t pay for themselves. Municipal bonds also have got the Finance Ministry’s support.

Finance Minister P Chidambaram said, “In order to facilitate the creation of urban infrastructure, I propose to allow the issue of tax free bonds through state tooled finance entities formed for raising funds for a group of urban local bodies.”

Advocates of municipal bonds like Nabaroon Bhattacharjee see this as an acknowledgement that the municipal bond market has come of age while admitting that at less than 1% of the corporate bond market, they have a long way to go. Compared to the US where they have been in existence for the past 120 years and are a prime source of urban infrastructure finance.

Bhattacharjee said, “What has been proved is that it is these 14 bond issues that have happened and it is conceptually sound there. It is operationally successful, which has been demonstrated. What it needs is a strategy for scaling it up.”

Curiously, the enthusiasm is not shared by municipal leaders like R Sai Bharati who should have proposed more projects to be financed by municipal bonds after the success of the first issue. But they would rather borrow from banks or raise money from the public. Municipal bonds are a matter between an issuing agency like TNUDF (Tamil Nadu Urban Development Fund) and a project implementing entity like Metro Water.

Sai Bharati said, “This was done entirely by TNUDF. Since there were 13 local bodies involved, there should be a common organisation to take care of it. That was done by TNUDF.”

It is not just the smaller municipality even investors have turned distinctly cold to municipal bonds. Earlier this year after a gap of six years, TNUDF made a second issue of pooled bonds worth Rs 45 crore on behalf of six municipalities to finance water supply and underground sewerage projects.These were tax-free bonds carrying an interest of 7.25% repayable in five instalments after five years. But only bonds worth Rs 6 crore were subscribed. Curiously, tax is stated the very element that should have been made attractive has gone against them.

Kapur said, “One thing we have to realise is that from the investor’s point of view, at the moment, there is very little interest in municipal bonds. There is lack of awareness, first and foremost is that awareness has to be carried out.

Then there are certain structural issues. One prime issue relates to the lack of attractiveness for tax free bonds among a large sector of investors. There are certain sectors like mutual funds where the funds themselves are tax exempt entities. When it comes to banks though they are not tax exempt, but then there are certain issues related to the IT Act, which come in the way. Banks are not excited because the only difference between income earned from bonds and the cost of funds is tax deducted. To enhance their appeal, Kapur suggests that banks should be allowed to invest in municipal bonds as part of their priority sector lending obligations.

The Finance Ministry could also lift the cap of 8% on tax-free bonds, or it could allow municipalities to issue taxable bonds bearing a higher rate of interest, and a part of the interest could be subsidised with interest earned by the bond service reserve fund. This is a fund created with grant from the central and state governments to provide comfort to investors that has to be kept as an insurance against default through the life of the bonds.

Here is a verbatim transcript of the exclusive interview with Dr. KP Krishnan on CNBC-TV18. Also watch the accompanying video.

Q: Before taking up this present assignment way back in early 2005 you were Managing Director of KUIDFC-The Karnataka Urban Infrastructure Development Finance Corporation and you were instrumental in Rs 100 crore Pooled Bond issue to part finance water supply and underground drainage in eight municipalities adjoining Bangalore. What is a reason that between then and now conditions have turned adverse but there have been no subsequent issues?

A: To do that you need a large enough guarantee facility. Rs 100 crore bond issue requires a certain amount of money to give confidence to the investors that there will be a repayment. If you want Rs 1,000 crore issue the money has to be larger. So, you need to increase the amount of money available to guarantee these bonds and also make sure that the municipalities are financially sound so that in the first event they are able to make the repayments. It’s only when there is a default that the other mechanisms takeover. So, Rs 100 crore municipal bond issue that you spoke about actually was preceded by a series of measures for instance take one municipality, Byatrayanapura; we did a complete survey of properties in Byatrayanapura and you will be surprise to know that even without a Rs 1 increase in the tax rate the potential increase in property tax alone of Byatrayanapura was going to be of the order of 900%.

Q: Are you suggesting that because their finances are not in a proper shape these municipalities do not borrow at all?

A: Yes that’s one major reason. Finances need to be in good shape for the municipality to be able to borrow. In addition if you keep other softer options why would a municipality go for the harder option? Even in the case of the Karnataka Pooled Municipal Funds, the bonds the eight municipalities had to be gently persuaded and coxed because they always have the option that if you go and make enough noise and bring enough pressure on the State Government the State Government would underwrite the entire excise either by guarantee or by an outright state borrowing so therefore unless you chance the entire municipal finance framework municipalities do not have an incentive to borrow because a borrowal means repayment out of their resources. So if you give them a softer option they will not borrow.

Q: And they have a softer option now in the form of National Urban Renewal Mission grants?

A: I will not say the Urban Renewal Mission is a softer option. The Urban Renewal Mission in an Rs 800 crore project will come in for a part or the equity project. It will not make the debt part any easier other than making it easier for the municipality to borrow.

Q: If I get you right what you are saying is that because there is no hard budgetary constraint these municipalities do not borrow either in the form of bonds or even from other agencies and do not also have an incentive to improve their tax collections?

A: You are entirely right; market discipline is what a borrowing mechanism is supposed to be ensure that if you borrow Rs 100 crore from the market since you have to repay this money, since you have to service this loan you cannot afford to spend those money irresponsibly; you need to be able to collect taxes to repay. All of these are responsibilities which you will be willing to undertake only if there is pressure on you.

Q: There is no pressure on them also because they are not responsible for service quality. If they were responsible for service quality then they would have to upgrade their infrastructure and they would have to hire to find ways and means of financing that infrastructure?

A: Exactly. In American literature on public finance they talk about voting with your feet. What it effectively translates into is if you are living in a certain municipality; you don’t like the services that the municipality provides whether its school services or water supply or parks you just leave the municipality. You sell your property or the house that you are staying on; on rent you leave it and move to a neighbouring municipality because it offers better services.

Q: Coming to the demand side we find that there are no takers even for tax free bonds because mutual funds are already taxfree?

A: If you look at the original municipal bond scheme they were all written at a time when interest rates were much lower.

Q: You don’t think that the cap of 8% on tax free bonds is restricting?

A: Maybe the best way to approach that would be to not put a numerical level but prime lending rate; the PLR+ (Prime Lending Rates) kind of mechanism rather than a particular number.

Q: I was talking to the Former MD of TNUDF (Tamil Nadu Urban Development Fund) and he was saying that one of the ways in which we can create excitement or interest in the municipal bonds is to allow them to issue taxable bonds that carry a higher rate of interest and to allow them to make up for higher interest with the interest earned from the bond service fund?

A: If your project is unviable at that particular rate of interest unless you subsidise the project the bonds will not work.

Q: I thought this subsidy would be needed just to develop the municipal bond market?

A: I do not think the municipal bond market needs a subsidy as much as market development. A part of the market development could be if you take a project like underground sewage. Underground sewage all over the world fundamentally would require a subsidy. The social benefits of an underground sewage project are far higher than the financial benefits.

Q: Alternatively do you think that municipal bonds should be reserved for projects that pay for themselves?

A: I think that will be a good idea to start with to develop this market. I think it will be a good idea to start municipal bonds for projects which are financially viable.

Q: But you think that the legal and regulatory framework is all there?

A: I think the legal and regulatory framework is almost entirely in place. The regulations issued by SEBI (Securities and Exchange Board of India) in the beginning of this year on debt instruments includes all kinds of body’s corporate namely municipality included. So in terms of the capital market regulatory framework for bonds, I do not see a problem and I think this is something which will work.

Q: So you think that the issue is more on the supply side than on the demand side?

A: I would think it’s primarily supply of municipal bonds as the bigger problem and therefore fundamentally issues of financials other kinds of restructuring of municipalities.