Smart Financing: Methods to achieve the civic upgradation goals

Methods to achieve the civic upgradation goals

Brijgopal Ladda, Director, Urban Practice, Urban Practice, CRISIL Infrastructure Advisory

Smart cities may be creating a buzz in urban development today, but financing the associated infrastructure needs is easier said than done.

It is estimated that smart cities would have to raise three times their revenues – including mission grants and convergence – over last year to meet the funding requirements. However, most urban local bodies (ULBs) are grappling with age-old issues such as low coverage of the tax net, non-revision of tax rates and low user charges, which limit their revenue-raising capacity. Also, there is a general aversion towards accessing the market by leveraging assets.

To establish ULBs as a self-sufficient third tier of government, the 74th constitutional amendment was enacted in 1992, with the objective of enabling devolution of functions, funds and functionaries. A quarter of a century later, ULBs are still struggling to deliver on their functions while ensuring that the two ends of income and expenditure are balanced.

Mehali Patel, Associate Director, Urban Practice, CRISIL Infrastructure Advisory

Over the years, there has been much support from the centre by making reforms an integral part of flagship urban programmes. The Jawaharlal Nehru National Urban Renewal Mission (JNNURM), implemented between 2005 and 2014, was the first such programme that provided funds to ULBs – Rs 1,000 billion to 65 mission cities and other smaller towns – to achieve a set of mandatory and optional reforms.

Learning from the JNNURM experience, the Atal Mission for Rejuvenation and Urban Transformation (AMRUT) – designed to support 500 cities – provides a service – level benchmarking process, a guided effort at changing the objective of capital investment from asset creation to service provision.

The Smart Cities Mission (SCM), designed for 109 select cities, goes a step further. It is the central government’s first successful effort towards sparking competition among cities for winning project funds and has introduced the project financing approach in ULB administration. The central government proposes to give the mission financial support to the extent of Rs 480 billion over five years. An equal amount, on a matching basis, will have to be contributed by the state/ULB. Special purpose vehicles, the project implementing arms of the smart cities, will need to look into various aspects of project development along with their financing framework. The SCM, too, seeks financial reforms to strengthen financial resources and their management by ULBs.

Given that their own revenue sources have gradually weakened and the dependence on grants has increased, ULBs need to look at new tools for financing urban infrastructure. In this context, four tools assume importance – municipal bonds, credit enhancement, value capture financing, and land monetisation along with public-private partnerships (PPPs), and rationalising their own tax revenues and user charges.

Municipal bonds

This tool has been around in India since 1997-98 when Ahmedabad and Bengaluru had issued bonds, though the market never quite took off. However, recent bond issuances by Pune and Hyderabad are expected to act as a spur. It is estimated that municipal bodies across the country would raise around Rs 60 billion through municipal bonds over the next three years.

Availing of this opportunity requires cities to enhance their own revenues, financial management, auditing and public disclosure.

In a recent credit rating exercise initiated by the Ministry of Housing and Urban Affairs, 15 cities have secured a credit rating higher than A and eight more have secured A-. These 23 cities, with focused improvements and appropriate credit enhancements are relatively better placed to secure a rating of AA+ or higher, which seems to be a threshold requirement for a successful bond issuance in India’s capital market.

Credit enhancement

This is an important tool for improving the ULBs’ credit rating and thereby their ability to raise resources through the issue of bonds, though designing a credit enhancement depends on the structure of the local financial market and the level of sophistication of both the borrowers and the lenders. The options include:

Credit guarantee

Credit guarantees are the most common form of direct credit enhancement for debt providers. These could be comprehensive/full credit guarantees or partial credit guarantees.

Comprehensive/Full credit guarantee is the simplest form and covers the principal and interest payment regardless of the cause of the debt service default. Here, the lenders are provided with a guarantee of uninterrupted debt service (principal and interest) in lieu of some upfront charges towards guarantee fees from the borrower, which is collected at the time of receipt of loan funds. In case of a default, the guarantor draws upon the borrower’s reserves and reinsurance policies or exercises an intercept provision. The guarantee must be based on a risk assessment that reflects the likelihood of default. This support has declined significantly of late given the legislative guarantee limits defined in the Fiscal Responsibility and Budget Management Act, 2003. Most state governments are no longer willing to provide guarantees as these have already assumed alarming proportions.

In such a scenario, local governments can explore any of three partial guarantee options:

  • A partial guarantee, where a state government can guarantee 50 per cent of the interest and principal obligations on a ULB’s bond issue. The option could be used to control the guarantee levels.
  • A partial tenor guarantee, where a state government can guarantee all the interest and principal repayments falling due in the first three years of the bond’s date of issue. This is beneficial when the ULB’s stand-alone credit profile is expected to improve sharply after the guarantee period.
  • A partial interest guarantee, where a bank can guarantee the entire principal on maturity and one or two interest repayments at any point of time on a rolling basis. This credit enhancement mechanism ensures that fluctuations in cash flows do not impact the ULB’s repayment capability.

The central government is providing Rs 4 billion of interest guarantee for the first 14 municipal bond issues by ULBs.

Debt subordination

Debt subordination is another credit enhancement technique that has been used in larger international or corporate transactions and to a limited extent in the area of local government lending. In this case, the subordinated lender acts as the credit enhancer, taking a junior position with respect to the senior lenders.

Subordination can be used in the debt structure of a municipal borrower or in the capital structure of a financial intermediary.

Pooled financing

This offers a way for smaller ULBs to access the market. Here, small ULBs pool small credits into a larger, more efficient grouping. This technique offers a reduction in risks through diversification. Ultimately, such pooling results in a reduction in the cost of borrowing. The financial intermediary plays an important role here – it bundles the local government debts and then sells its bonds to investors in the capital market.

The basic idea of pooling is to develop a portfolio of loans that can then be remarketed in bulk to the securities markets as bond bank obligations. A pool’s diversity improves its default probability and, hence, its credit profile becomes superior to the credit profile of individual ULBs. In addition, this approach can help obtain a target rating. In India, we have a working example of the Tamil Nadu Urban Development Fund, which has a good payment track record. Similar efforts are under way in other states too.

Value capture financing

Value capture financing (VCF) has been recognised as a promising avenue for augmenting financial resources for funding urban infrastructure. Public investment leads to housing, access to jobs and transportation, and most importantly to the emergence of commercial, cultural, institutional or residential developments in the influence area. For sure it leads to value increment of land and property.

VCF tools seek to secure a share of the value increment for the municipal body. Property tax, vacant land tax, development charge, stamp duty surcharge, betterment levy, saleable floor area ratio, compounding fee and project-based impact fee are some of its examples. All these are charged on an area basis, so a property located in a fringe area or in the best commercial area would pay the same development charge. Instead, these tools need to be levied based on the capital value of the property.

Mumbai levied area-based development charges until fiscal year 2010. The area-based charge of Rs 350 per square metre yielded a revenue of Rs 1.32 billion in fiscal year 2010. Later in 2010, the rate was changed to 2.5 per cent of the land value as recorded in the Ready Reckoner. This resulted in a revenue of Rs 3.07 billion in fiscal year 2012. Even in this case, the rate was linked to the land value only.

Had the rate been linked to land plus construction, revenues would have skyrocketed and would have kept on increasing every year.

Revising property tax rates that are levied on an annual rental value base are dependent on political will. The resolution here is to levy property taxes based on capital values. Any revision in capital value and the tax gets revised automatically. Property tax is the only tool governed under the Municipal Act and is somewhat under the ULB’s control, although ULBs have to seek permission from the state government for a tax revision. All other tools are implemented under town and country planning regulations that require state intervention for any modification. Land being a state subject, its role is very important for implementing VCF tools that are linked to land and increments in land value.

The state government’s role becomes very important for the revision of building rules, issue of government orders, and amendment of acts. In addition, state governments can initiate the development of detailed guidelines for each of the VCF tools to be implemented across all the ULBs in the state.

Land monetisation

Most cities in India own valuable land and old structures. They need to develop a plan to put these land resources to use through mechanisms such as PPPs, lease and/or sale, if need be.

PPPs have not seen much success in urban infrastructure, but efforts have started once again for making these work. A wholehearted concerted effort by ULBs for financial reforms that improve buoyancy of taxes – capital value-based property tax, user charge for full cost recovery, and policies for implementing VCF tools – is therefore a must. This should be coupled with leveraging the grant money. Municipal bonds and PPPs will bring in finances and afford expertise for urban services. Only then can ULBs transform into an entity that is in the business of providing basic services to citizens.