Municipal Bonds Market In India: How To Make Them Work?

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(This is the second of a two-part series (Please read the first part here) on the need to recognize how Municipal Bonds in India can be used to drive its’s rapidly growing urbanization requirement. Municipal bonds can potentially serve multiple stakeholders by granting financial autonomy to Urban Local Bodies (ULBs) as well as becoming a highly effective and untapped investment opportunity.)

Municipal bonds are bonds issued by Urban Local Bodies (ULBs) – municipal bodies and municipal corporations to raise funds for financing specific projects in the urban landscape, particularly infrastructural projects.

Even as constitutional legitimacy has been provided to ULBs in terms of autonomy, they remain feeble on the financial side of things. Tapping into the municipal bond market can be a starting point towards rendering the ULBs financially autonomous.

Have Municipal Bonds Worked in India?

As per a report on Urban Infrastructure and Services, 2011, Indian ULB’s are among the world’s weakest in terms of financial autonomy and their capacity to raise external capital.

In India, only 1% of the total urban local bodies’ requirement is funded by municipal bonds, compared to around 10% in the United States. It is observed that no municipal bonds had been issued since 2007 until recently when Pune Municipal Corporation successfully raised INR 200 crore via issuing municipal bonds as the first tranche of INR2260 crore plan to be raised in a 5-year time frame.

According to the government sources, municipal bonds in India were able to garner only $275 mn (INR 1750 cr) in India as opposed to the US $304 billion in 1 year and South Africa’s $1.8 billion raised in a single quarter.

Both demand and supply issues have been the prime factors behind the poor performance shown by municipal bonds in India. On the demand side of things, lack of financial transparency and lower operational efficiency reduces the creditworthiness of municipalities and thereby attract unimpressive interest from the investors.

Nagpur Municipality planned to raise INR128 crore in 2007 but was able to procure only INR21 crore. Similarly, as noted by the Fourteenth Finance Commission, borrowing restrictions placed on the municipalities and incomplete devolution of powers, constraints on the capacity of the municipalities to leverage the municipal bonds market. While bigger municipal bodies can go for bond issues easily as they are backed by state and federal governments assurance, the smaller municipalities often find it difficult to access the market due to lack of capacity and scale.

Therefore, the respective governments should guarantee such bonds issued by smaller yet progressively performing ULB’s and their projects. Further, the provision of tax exemption only for bonds earning interest >8% makes them unattractive, especially for retail investors. Also, as per the regulations, retail investors can only participate in secondary markets.

This has further marginalized the interest of retailers and muted retail investments, the secondary market of the muni bonds virtually don’t exist. The listing of the municipal bonds as exchange-traded bonds would increase the liquidity situation and ensure broader participation. The retail participation can be enhanced by extending appropriate tax concessions on returns and also by providing competitive return rates.

Also, the institutional investments would spike if securitization of these bonds gets the green signal so that these bonds could be used as a collateral asset as per the funding requirements. The inclusion of muni bonds under the priority sector lending obligations or counting them as a part of SLR holdings would boost the credibility but also the demand from large banks and financial institutions.

Further, high transactional costs, lack of operational autonomy for ULBs (only “revenue bonds” allowed to be publicly issued. “General obligation bonds” can only be issued via private placements) and low revenues for ULBs which weaken their financial profile have been some of the significant supply-side factors which restrain the scope of municipal bonds in India which attract immediate attention and resolution.

SEBI Guidelines

The Securities and Exchange Board of India (SEBI) has recently brought out regulations on the issue and listing of debt securities by municipalities. However, some restrictive measures such as Municipalities not being allowed to issue unsecured bonds or a ruling mandating them to contribute at least 20% of the project cost greatly restricts their autonomy.

Though the freshly issued guidelines are welcome to structure the municipal bond market, more concrete steps need to be taken to encourage these instruments for investment. Conclusively, it can be said that Municipal bonds hold a great promise for solving the urban infrastructural problems. While granting constitutionally legitimacy to municipal bonds empowers them to a great extent, such authority without real financial autonomy is futile. Steps must to taken to ensure that the ULBs are both constitutionally and financially independent.

(The article was originally published at Transfin.)

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