The steady pace of urbanisation coupled with the adoption of economic reforms has been creating serious problems for the provision and financing of urban infrastructure. The resource crunch at each level of government in general, and at the local level in particular, has instigated the need for innovative financing mechanisms. Municipal bonds provide an excellent route to tap the capital market for long-term financing of urban infrastructure. Against this background, the paper delineates the problems and prospects related to the municipal bond market along with recent initiatives to propel the development of a viable and vibrant municipal bond system in India.

SOUMYADIP CHATTOPADHYAY

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Hence, there is an urgent need to look for alternative sources of funds to finance various activities, particularly long-term capital investments in infrastructure service. The concept of using capital markets, by local governments, to convert a stream of current revenue into capital for projects that are too large to finance on a pay-as-you-go basis is widely accepted in the US and other developed countries. Municipal bonds are debt obligations issued by cities and urban sector related government entities to raise resources from capital markets to finance urban infrastructure. The concept of municipal bonds as an additional mechanism of raising resources for financing urban infrastructure was first coined in a USAID seminar in 1995. Later the Rakesh Mohan Committee recommended them for commercialisation of urban infrastructure. In particular, the advent of the Indo-USAID collaborative financial institutions’ reforms and expansion debt (FIRE-D) project in 1994 and initiatives of the FIRE-D programme, (through provision of a 50 per cent fund under the housing guarantee programme for 30 years to finance long-term capital investments in urban infrastructure), facilitated the development of domestic capital market in India. Only eight municipal corporations namely, Ahmedabad, Bangalore, Hyderabad, Nashik, Nagpur, Ludhiana, Madurai and Indore, have issued municipal bonds to finance investments in various projects in the urban infrastructure sector. Since bond issuance provides alternate sources of institutional finance not conventionally available to municipal bodies, strong interests have been manifested, in the form of seeking credit rating, by almost 40 urban local bodies to issue similar bonds.

Against this background, the present paper documents the problems and prospects of the municipal bond market in India, along with the initiatives taken at various levels that have exclusive implications for the maturation of this market. Along with this introductory section, the paper has been divided into four sections. Section II delineates the problems and prospects of the municipal bond market in India. Some recent initiatives taken by the government are discussed in Section III. In the concluding Section IV, a brief policy framework is furnished, which may be helpful for further development of municipal bond market in India.

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In the specific context of increasing public debt and concerns about high fiscal deficits worldwide, the importance of careful control and regulation of local borrowing is well recognised for the continued development of a viable and vibrant municipal bond system in India. Largely administrative or rule-based controls on all local borrowing, as laid down in municipal legislation at the state level, exist in India. For any local borrowing, state government authorisation is mandatory. However, studies in three states – Maharashtra, Andhra Pradesh and Tamil Nadu – suggest that state government authorisation is not given within any explicit framework or guidelines. The administrative controls relate to the purpose for which municipal authorities may borrow, and in most cases, the borrowed money is to be used only for permanent works, whereas the rule-based controls are in the form of detailed requirements for the creation of sinking funds and controls for the purpose of investment. Further, some municipal legislation also puts a cap on total borrowing as a multiple of the total ratable value of the properties in that city, which relates to potential, rather than actual, budget performance. The most alarming fact is that these limits are not followed in practice. The estimates for Chennai suggest that the total outstanding borrowing has been more than that permitted by the act. Thus, municipal legislation in India either does not incorporate ceilings on local borrowing or when these do exist, they are not followed rigorously.

Economic and Political Weekly June 30, 2006

In particular, the lengthy and complicated process for approaching capital market funds to finance urban infrastructure has characterised the issuance of municipal bond experiences in India. Clearances from the council of elected representatives of the local body, approval of the urban development department as well as the finance department of the state government are needed for the issuance of municipal bonds. Along with these, the rating of debt instruments is a prerequisite, as SEBI guidelines need all debentures of more than 18 months’ tenure to be rated. Ahmedabad Municipal Corporation (AMC) worked extensively with the CRISIL, India’s largest credit rating agency, to come up with a high ranking for the municipality. Officials from CRISIL spent four months in Ahmedabad while trying to assess its financial circumstances, in terms of legal and administrative framework, economic base of the service area, financial strength, extent of the state government’s dependence, etc. But, apart from some big municipalities, most do not maintain systematic information pertaining to the above parameters. As in the case of Bangalore Mahanagarpalika, CRISIL took almost a year to complete the credit rating process. Sometimes, the whole process, as in the case of the AMC, needed repetition, as the first rating turned out to be insufficient to draw investors’ confidence, particularly for private placements. CRISIL first assigned a credit rating of “A+” for AMC’s municipal bond. Then AMC revised the financial structure of the bond offerings and added several credit enhancement features, including a “no lien” escrow account of octroi taxes collected at 10 collection points. With these modifications of the bond financing structure, AMC received an improved rating of “AA”. But theses procedures, in most cases, remain beyond the financial strength and physical expertise available at the local level.

Institutional support from different levels of governments are needed to smoothen up the stumbling blocks in the pre-issuance period. The AMC with the help of the state government changed the existing municipal legislation to switch the base of property tax computation from annual rental value to the area detail system. Some stringent measures were adopted to improve octroi collections. In case of AMC, favourable attitudes from all quarters aided to reach the desired goal. But, in some cases, myopic political compulsions impelled local politicians to thwart these initiatives and the local bureaucracy were left with only option: to obey the unfortunate dictum of local politicians. In Pune, the overwhelming negative contribution of elected representatives resulted in the failure of the innovative financing mechanisms of a water supply sewerage project through private sector participation [Bagchi 2001].

Furthermore, most state governments continue to take decisions on matters related to the property tax coverage, imposition and rate of user charges, levy or withdrawal of octroi, etc, with little reference to the municipal bodies affected most by such decisions. Now, the dependence of municipal bodies on the state, not only for the development of cities but also for their survival, has resulted in their precarious financial health. As sound financial health of municipal bodies is an essential prerequisite for accessing the capital market, these developments have had a deleterious impact on the capacity of municipal bodies to access the benefits of municipal bonds.

The age-old budgeting and accounting system for urban local bodies (ULBs) in India lacks transparency. The real picture of the income and expenditure of municipalities are not properly reflected in the common single entry system of accounting, as it has several defects resulting in misappropriation of assets, nonpreparation of profit and loss statements and balance sheets. As a result, the accounts have remained volatile and can be manipulated at will to receive a good rating. In other words, the absence of balance sheet for most of the municipalities, except a few larger corporations, has affected the entire rating procedure of rating agencies. Another crucial aspect that has adverse implications for the financial strength and physical expertise available at the local level, is the non-availability of qualified personnel. A non-competitive salary structure has exacerbated this problem. It is worthwhile here to mention that the AMC hired 30 recent management graduates at competitive salaries, who helped to computerise and standardise the collection of property taxes and octroi, with simultaneous reduction in clientelism and favouritism. This helped to improve tax collection and make the government more open and transparent.

growth rates in both the sub-periods. Nagpur panchayats (NPs) and municipal corporations, at the all-India level experienced an increase in the growth rate of per capita non-tax revenue (PCNTR) in the second sub-period.

On the other hand, at the all-India level, each tier of ULBs registered improvement in the growth rate of per capita other revenue (PCOR) in the later half of the 1990s (Table 2). This implies that ULBs continued to depend to a large extent on other revenue and on municipal corporations and municipalities, to some extent, for moderate financial health. Along with this, per capita expenditure of each tier of the ULBs is increasing at a much faster pace than per capita revenue and thus widening the resource gap of the local bodies. The narrow tax base of the ULBs, problems related to property tax in terms of the valuation procedure, legal disputes, abolishment of octroi in most states, limited or zero implementation of user charges, and high incidence of administrative and establishment expenses have contributed to this sorry picture of municipal finance. Some serious rethinking at all levels of governments is necessary to ward off these anomalies.

Against this background, the key financial documents in municipal bond transactions are the disclosure (prospectus) documents containing financial statements, nature and characteristics of the project being financed, nature of the security pledged, in some cases specific additional information, and the trust indenture, which is a binding legal agreement between an issuer and a trustee acting on behalf of the bondholders. The prospectus of the AMC was written to comply with SEBI’s disclosure guidelines, for corporate offerings. Although the prospectus provided a general overview of the economic, environmental and fiscal condition of the AMC and identified internal as well as external risks to investors, the degree of detail and specificity fell below international standards. Moreover, it appeared that an attempt was made to explain away risks rather than provide the investors with all the necessary information to reach an independent evaluation of those risks. Similarly AMC’s trust indenture overlooked many critical areas that will be in great demand as the market matures [NIUA 2003].

An inauspicious matter pertaining to municipal bond issuance which deserves special attention is that there are no specific statutes in India that contemplate the insolvency of local bodies, leave alone govern the procedures of their insolvency. Several procedural laws govern, by and large, the issues relating to corporate insolvency, and do not apply to local bodies. The only legal remedy available to an investor, in case a local body defaults, is to seek relief by way of a writ in the relevant high court, as provided under Article 226 of the Constitution. However, the process of seeking remedy against local bodies would be more complicated, as the courts would be reluctant to enforce any security offered by a local body as these are protected by the principle of sovereign immunity. Moreover, there can be more than one body involved, for example, in a project for water supply or purification that pass through more than one state and local body. Further, the lack of any judicial precedence in which a local body is a defendant in a suit for insolvency complicates the entire scenario [Pradhan 2002].

It is evident that, despite several problems and constraints, the municipal bond market in India has been making headway in the right direction. Several reform measures related to local capacity building, necessary legislative changes and conditional fiscal incentives as well as other indirect support measures such as sustainable credit enhancement options, rationalisation of state-local fiscal relationships and financial empowerment of local governments, etc, have already been commenced at each level of government. This is in order to pave the way to improve financial strength and physical expertise at the municipal level, which would have telling implications for developing a viable and vibrant municipal bond system in India.

In an attempt to supplement the urban reform agenda, the ministry of urban development and poverty alleviation (MoUDPA), with the help of the FIRE project, has developed the Model Municipal Law (MML) to assist ULBs in the areas of accounting reforms, resource mobilisation and the entry of private sector partnerships. MoUDPA is developing guidelines for the involvement of the private sector in infrastructure to ensure a

Table 1: Financial Indicators of the ULBs for All StatesTable 1: Financial Indicators of the ULBs for All StatesTable 1: Financial Indicators of the ULBs for All StatesTable 1: Financial Indicators of the ULBs for All StatesTable 1: Financial Indicators of the ULBs for All States

Notes: RA: Revenue autonomy ratio which is defined as the ratio of own income (tax as well as non-tax) in the ULB’s total income. FA: Financial autonomy ratio which is defined as the ratio of ULB’s total expenditure funded out of own revenue, i e, own revenue/total expenditure. *:Ratios are calculated without considering the relevant figures for Maharashtra, since the ULBs there incurred huge expenditure. **:Ratios are calculated without considering the relevant figures for Maharashtra and Andhra Pradesh, since the ULBs there incurred huge expenditure.

Source: Calculated on the basis of information provided by the Eleventh Finance Commission Report, 2000.

Table 2: Growth Profile of Municipal Revenue and ExpenditureTable 2: Growth Profile of Municipal Revenue and ExpenditureTable 2: Growth Profile of Municipal Revenue and ExpenditureTable 2: Growth Profile of Municipal Revenue and ExpenditureTable 2: Growth Profile of Municipal Revenue and Expenditure

Notes: *: Other revenue includes grants from the state governments and shared/assigned taxes. Per capita figures are computed assuming that Classes III, IV and V towns of the census have NPs, classes II and I (other than municipal corporations) have municipalities existing in 1991. The Urban Non-Manual Labour Force Index at 1984-85 prices is used as the deflator. The trend growth rates are based on the semi-logarithmic functions.

Source: Calculated on the basis of information provided by the Eleventh Finance Commission Report, 2000.

Economic and Political Weekly June 30, 2006 transparent and competitive biding process that will not only protect consumers but also enhance the integrity of the process. Further, as property tax constitutes the most important autonomous revenue source for urban governments, several initiatives related to tax assessment, tax collection, etc, have been undertaken by relevant government authorities to utilise the potentiality of property tax to fullest possible extent [Mathur 1999; Bagchi 2003]. The new system of financing through municipal bonds calls for reforms in the existing cash-based accounting system. The USAID assisted FIRE project has extended support in this regard. At the state level, Tamil Nadu has switched over to a new accrual based double entry accounting system with technical assistance from the FIRE (D) project. Several other city governments have started to replicate the recent efforts of the GoTN to introduce improved accounting and auditing practices, as well as computerisation. These kinds of innovations taken up by the municipal bodies have great potential to enhance resource mobilisation capacities and need to be replicated with greater vivacity.

The central government announced tax exemptions in the case of bonds issued by municipal governments and other local authorities, constituted under the relevant state government statutes like the Water Supply and Sewerage Board (WSSB), etc, to increase investments in urban infrastructure. Under Section 81(1)

(A) of the Income Tax Act, the definition of infrastructure has been expanded and it includes water supply, sanitation and sewerage projects. Tax exemptions are allowed in the form of interest, dividends and capital gains under various sections of the Indian Income Tax Act. Detailed guidelines were issued by the MoUDPA on February 8, 2001 for regulating the issue of tax-free municipal bonds. Moreover, restrictions on foreign direct investment (FDI) in urban infrastructure facilities have been removed. In case of external assistance, special emphasis has been given on the need to adopt a programme approach rather than a project approach for availing external assistance.

to the states to improve the financial profile and quality of the service delivered to local residents in a sustainable manner. Detailed guidelines for the pooled finance development fund are being prepared by the MoUDPA.

Moreover, as the efficiency of financial market depends on the plurality of players with divergent perspectives and different objectives, it is equally or more important to create an active secondary market for these issues. The secondary market trading, presently, comprises mostly of central and state governments securities. Municipal bonds are eligible for trading in the permitted category of the National Stock Exchange (NSE). Municipal corporations of Ahmedabad and Nashik have listed their bonds on NSE, although trading is very thin. Listing on the NSE, which has terminals in most Indian cities and allowing nationwide access to investors and to trade in the secondary market will have a salutary effect for municipal bond issuers in terms of enhanced trading and visibility. Here, it is necessary to produce a model prospectus (disclosure) document to avoid shortcomings in the structure and security of bond transactions. SEBI launched an initiative to furnish separate disclosure guidelines for municipal bonds as part of the Malegam Committee review of the existing guidelines.

RBI has issued a series of measures to deepen secondary market activities. The introduction of a negotiated dealing system (NDS) on NSE, on and from February 15, 2002, provides online electronic bidding facilities, screen-based electronic dealing and reporting as well as dissemination of real time trade information, which would provide an anonymous transparent system of trading in debt. Moreover trading in demat form; formation of the Clearing Corporation of India (CCIL) for providing counterguarantees; the abolition of stamp duty on bond transfers, which acted as a deterrent for secondary market trading; transformation of the Discount and Finance House of India and the Securities Trading Corporation of India into primary dealers, in particular; and strengthening the system of primary dealers, in general, are the other steps that have been undertaken by the relevant authority. Among them CCIL, being the central party offering a settlement guarantee in respect of clearing and settlement, is the key market infrastructure to significantly improve market efficiency and integrity. The CCIL and NDS, along with the entire market design, is to introduce transparency, market efficiency and nationwide markets and offer investor protection. It has been argued that with an improved environment of disclosure and secondary market trading, local investors would consider local securities more desirable. Hence, this would be an opportune time to position municipal bonds [Pethe and Ghodke 2002].

Several policies and legal frameworks to facilitate urban local governments’ access to capital markets in India are already in place and, as a result municipal bonds, although limited to few municipal entities, are available as an alternative mode of financing urban infrastructure. Nevertheless, concerted as well as earnest efforts from the central, state and local governments are needed for the appropriate implementation of policies to encourage further development of municipal bond market in India. Endeavour at the central government level is required to carry out the MoUDPA’s urban sector reform agenda by implementing the 74th constitutional amendment in totality and, in particular, through the proper devolution of functional responsibility along with the creation of commensurate financial capacity. Furthermore, it is necessary to improve the disclosure and transaction documents of municipal bonds through the adoption of a model prospectus and trust indenture by SEBI for municipal bonds. Issuing a prospectus and continuous credit rating, irrespective of public or private placement, should be made mandatory for municipal bonds. It is also necessary to create a separate statute for municipal bankruptcy. A system of grading municipalities by developing certain urban indicators would be helpful for the ULBs, in terms of identifying their strengths and weaknesses and infusing a sense of competitiveness among them.

At the local level, enough attention must be paid to various aspects related to capacity building and efficient urban management in terms of recruitment of competent professionals; training programmes of the existing staff in fiscal and financial management; conceptualisation and development of commercially viable projects; proper costing and pricing of services, familiarity with the public private partnership process including bid evaluation; bid process management, acquaintance with the process of accessing capital markets; related legal and regulatory framework; use of modern technology, e g, geographic information systems (GIS), in municipal governance; and proper auditing of financial documents along with the implementation of a double entry accrual-based accounting system. These initiatives, if properly implemented, will go a long way to improve the credibility of the municipalities among citizens and investors and these, in turn, will enable more municipalities to access the capital market for financing urban infrastructure in the long run.

Without the financial empowerment of municipalities, it is difficult to make them market-oriented and capable of mobilising resources from the capital market. Innovative tax rate setting and efficient collection of property tax and octroi, the two most buoyant sources of municipal revenue, tariff setting power of the municipalities under certain special circumstances, use of vacant land commercially for raising additional revenue, etc, also need to be ensured. The recommendations of the State Finance Commissions (SFCs), related to the assignment of taxes, duties, levies and tolls to local bodies and transfers on account of revenue sharing and grants in aid, should be implemented by state governments to improve the financial health of municipal bodies. Thus, with the help of measures related to local capacity building, financial empowerment of municipal government, rationalisation of the state-local fiscal relationship and necessary legislative changes, the role of different levels of government would be critical in developing a viable and vibrant municipal bond system in India.

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Email: soumyadip_23@yahoo.co.in

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– (2003): ‘Politics and Economics of Property Taxation’, Economic and Political Weekly, October 18.

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Pethe, A and M Ghodke (2002): ‘Funding Urban Infrastructure: From Government to Market’, Economic and Political Weekly, June 22. Pradhan, H R (2002): ‘Local Government Finance and Bond Market Financing:

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