By Anand Sahasranaman, IFMR Finance Foundation

Given the magnitude of investments¹ and expertise needed for sustainable development of urban infrastructure in India, it is essential that there be substantial private sector involvement. This post explores how there has been a greater thrust towards private funding models post-1990 and what how policy can incentivize cities to move further in this direction.

Evolution of urban infrastructure financing in India

Prior to 1990, urban infrastructure in Indian cities was financed largely through government grants and Plan funds of central and state governments. Decisions on local infrastructure investments were made by state and central governments. Because of the disconnect between local needs and infrastructure plans drawn up at higher levels of government, these infrastructure investments made were without any clear understanding of local demand. In the absence of inputs on both the nature and extent of local demands, the infrastructure that was built ended up being inadequate, of poor quality and often unrelated to people’s needs.

In addition to these direct government levers of grants and Plan funds, cities were also allowed to access debt from the Housing and Urban Development Corporation (HUDCO), which was directed by the central government to lend to cities². These borrowings from HUDCO were guaranteed by state governments, thereby de-risking the investment for HUDCO by ensuring that the lender was exposed to the state government’s risk and not the particular project’s risk. By design, such an arrangement ensured that the credit discipline that is associated with prudent, commercial lending programs was missing here. The incentives of the lender were completely skewed by disconnecting the lending from the project risk, and the incentive of the city to structure a viable project was also skewed by the knowledge that the ultimate risk of default lay with the state government. This financing structure fundamentally lent itself to the design of sub-optimal, unsustainable projects.

It is interesting to note that most countries, including the now developed ones, started subsidised lending to municipalities through specialized Municipal Banks or Municipal Development Funds. In Europe, specialised municipal banks were set up to provide capital and, in addition, a range of services to complement their lending, such as assistance in preparation of municipal budgets, designing and appraising investment projects, and even managing the municipalities’ financial accounts. The support services and subsidized credit provision were important in the early years of the municipalities’ tryst with credit markets and were made possible because of central government policies of subsidising municipal banks by giving them preferential access to low-cost, long-term savings or to accord them partial protection from competition. This ensured that once the state directed low cost funding taps dried up, these municipalities had the requisite capacity to approach the debt markets on their own. Unfortunately in India, while HUDCO has performed the job of providing subsidised debt to municipalities, it has not directed attention to developing municipal capacities for the long-term, thereby only spawning a culture of dependence and lack of accountability.

Post-1990, there has been a greater thrust towards exploring alternative funding models for urban infrastructure. The impetus for this came from three sources:

• Passage of the 74th constitutional amendment has given constitutional status to urban local bodies (ULBs) and has devolved funds, functions and functionaries to the ULB level
• Economic liberalisation and increased competition has forced more efficient allocation of capital by financial institutions and therefore a move away from inefficient financing mechanisms
• State government finances have been under pressure and they have been unable to continue with a programme for subsidising municipal debt

Analysing the municipal financing environment in India, it is apparent that the last 15 years have seen a substantial evolution from a grant and soft-loan based infrastructure creation program to increasing usage of market based mechanisms that bring in private capital. In our earlier posts, we have discussed how cities like Ahmedabad and Bangalore have accessed municipal bonds. Smaller municipalities, especially in Tamil Nadu and Karnataka have accessed capital markets through the issue of pooled bonds. Since 1997, 25 municipal bond issues have taken place in India, which have included taxable and tax-free bonds and pooled financing issues, mobilizing funds to the tune of nearly Rs. 1, 400 crore³.

Despite these developments, the critical lever for accessing private debt finance, the city’s internal revenue generation- especially through property tax and user charges- remains under-utilised. The Thirteenth Finance Commission estimates that property taxes collected constitute between 0.16% and 0.24% of the GDP, while revenues generated from user charges are also abysmally low in India, at 0.13% of the GDP⁴. To add to this gloomy picture, states in India have also slacked in terms of setting up State Finance Commissions, accepting their recommendations and implementing the same. The quantum and predictability of inter-governmental transfers are crucial in maintaining the stability of a city’s finances and thus, ensuring access to debt markets.

Way Forward

A major hurdle in the development of the municipal bond market is that the policy environment is currently dis-incentivising the use of market mechanisms to raise financing for public projects. One of the criticisms of the JNNURM has been that despite the large quantum of funds it is directing into urban infrastructure, very little, if any, of it has been used to leverage commercial capital. This has sparked concerns regarding the ‘crowding out’ of bond markets by government funds. Cognisant of the reality of the Indian scenario, where central and state governments run huge deficits and capital is very scarce, it is essential that all efforts to promote infrastructure development and service delivery need to incorporate mechanisms to leverage scarce grant funds with debt from the capital markets. Therefore, while all the JNNURM funds may not be suitable for leverage, a substantial portion must certainly be leveraged with commercial debt capital, as this will allow sparse central and state government funds to be spread efficiently across many more critical projects.

A related issue is the need for market makers of municipal debt, with HUDCO being a case in point. Set up to finance housing and infrastructure, HUDCO has shifted its focus to financing larger power and gas projects. As the HPEC (2011) Ahluwalia Committee report points out, its financing for urban infrastructure (to the extent that it does) is subsidised by its profitable lending to larger infrastructure projects. The focus of HUDCO needs to be re-oriented towards urban infrastructure financing, but away from being a subsidised lender. HUDCO could become a market-making institution for municipal debt, thus helping catalyse the municipal debt market. On this role, HUDCO could perform the role of a credit enhancer by activities such as providing guarantees or investing in lower rated tranches of municipal issues so as to enable commercial market investors to participate in low-risk, highly rated municipal investments. The essence of HUDCO’s market making nature should be determined by its arm’s length distance from the municipalities it works with, i.e. the provision of guarantees must be based on HUDCO’s own assessment of the credit risk associated with the municipalities, backed up by a credit rating. HUDCO can thus, one the one hand, expose the municipalities’ true creditworthiness to the market, providing for transparency and incentivising municipalities to address their governance and service delivery issues and on the other hand, help attract commercial funds into investing in credit enhanced municipal debt. This will be critical in view of the extent of investments required for urban public infrastructure development in India.
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