Bond Market Financing by Sub-national Governments:Indian

Experience

Dr HK PradhanProfessor of Finance and Economics

XLRI Jamshedpur, IndiaEmail: pradhan@xlri.ac.in

September 30-October 1, 2004

India: A Three-tier Federation

First Tier: Central Government at the National Level

Second-Tier : State Governments in 28 States & 7 Union Territories

Third-Tier: Numerous Rural and Urban Local Bodies

Rural Local Bodies 2,47,033

Panchayats 2,38,662

Autonomous Councils 83,410

Urban Local Bodies 3,682

Municipal Corporations 96

Municipalities 1,494

Nagar Panchayats 2,092

Rank Cities 1 Greater Mumbai 16.372 Kolkata 13.223 Delhi 12.794 Chennai 6.425 Bangalore 5.696 Hyderabad 5.537 Ahmedabad 4.528 Pune 3.769 Surat 2.81

10 Kanpur 2.6911 Jaipur 2.3212 Lucknow 2.2713 Nagpur 2.1214 Patna 1.7115 Indore 1.6416 Vadodara 1.4917 Bhopal 1.4518 Coimbatore 1.4519 Ludhaina 1.4018 Coimbatore 1.4519 Ludhaina 1.4020 Kochi 1.3621 Visakhapatnam 1.3322 Agra 1.3223 Varanasi 1.2124 Madurai 1.1925 Meerut 1.1726 Nashik 1.1527 Jabalpur 1.1228 Jamshedpur 1.1029 Asansol 1.0930 Dhanbad 1.0631 Faridabad 1.0532 Allahabad 1.0533 Amritsar 1.0134 Vijayawada 1.0135 Rajkot 1.00

Total 107.8

India's 35 Million Plus Cities

Source: Census of India, 2001

• Octroi• Property tax• Other taxes

• Water / sewerage• Building license• Vehicle/ animals• Fines• Investment income

• Stamp Duty• Electricity tax• Motor vehicle tax

• State government• Other agencies

Ow n Tax Ow n Non-Tax Shared Tax Grants

Revenues of ULBs

Wide diversity in terms of revenue raising capabilities and economic performance

Framework of Financing Urban Infrastructure in India

OtherCentral

Governmentsponsored Schemes

Central Government : Budgetary resources/borrowings

IntegratedDevelopment of Small and

MediumTown

Mega city scheme

Acceleratedurban water

supply programme

State Government: Budgetary resources/borrowings

Water supply and

DrainageBoard

PublicWorks

Department

HousingDevelopment

Board

OtherState Level

NodalAgencies

Urban Local Governments: Budgetary Resources/borrowings

Exte

rnal

Ass

ista

nce

Institutional Structure in Indian Financial Markets Operations Name Activity All India FIs ICICI Lending to corporate sector IDBI IFCI SIDBI Small scale industries IIBI Companies referred to BIFR Banks Lending to households and Corporate Sector EXIM Bank Export-Import financing Specialized FIs IL&FS Infrastructure, financial services HUDCO Housing and Urban Infrastructure IDFC Infrastructure development and financing Refinance FIs NABARD Agriculture Sector NHB Housing sector Investment FIs UTI Mutual funds LIC Insurance GIC Non-life insurance State Level FIs SFCs Lending to medium and small scale companies SIDC Industrial and infrastructure development

Financial market is yet make a strong impact on financing subnational governments and urban

infrastructures

Potential benefits of bond market access by the local governments:

• Leverage the internal resources with long term bonds for financing infrastructure;

• Make lumpy investments through bond issuance rather than limited pay-as-you-go financing

• Results in credit discipline by the city governments, by promoting fair discloser and accounting, and better management practices

• Make feasible one of the vital objective of the 74th Constitution Amendment by balancing the revenue raising capabilities with expenditure responsibilities.

Structure of Indian Bond Markets: Issuers and InstrumentsIssuer Instruments

National Central Government Treasury Bills, Dated Securities, ZeroCoupon Bonds, Floating Rate Bonds,Inflation Index Bonds

DFIsCommercial Banks

Bank Bonds, Infrastructure Bonds,Zero Coupon Bonds, CDs, CPs

Public Sector Companies Bonds, Taxable and Tax free bonds, CPsPrivate Sector Companies Bonds and Debentures, Zero Coupon

Bonds, Floating Rate, CPs

Subnational State Governments State Government loansSate Level PSUs and FIs Government guaranteed PSU BondsSPVs& Statutory Boards Bonds, often with revenue dedication, with

or without government guaranteeMunicipal Corporations Municipal Bonds, with revenue dedication,

with or without government guarantee

Indian Debt Markets(Rs Crores)

Amount Amount AmountGovernment 59 14280 146 58020 158 34834

Central Government 53 13483 89 46643 110 26514

Commercial Enterprises 52 13383 86 45576 103 22337

Statutory Bodies 1 100 3 1067 7 4177

Private Sector 1869 19235 428 19363 247 12586

Indian Private Sector 1839 18471 383 14673 204 11042

Foreign Private Sector 30 764 45 4689 43 1543

State Government 6 797 55 11127 48 8320

Commercial Enterprises 3 296 29 5561 23 4362

Statutory Bodies 3 500 25 5416 23 3837

Total 1928 33515 574 77383 405 47419

1995-96 2000-01 2001-02

No.of Issues

No.of Issues

No.of Issues

Subnational Bond Issuance in India

• Bonds issued by state sponsored institutions

• Bonds issued by ULBs

• Urban Development Funds

Issuance by State Sponsored Institutions

• State level Statuary Boards( such as water supply and swerage boards), state owned corporations( such as power, irrigation), state initiated SPVs,, with limited recourse to Government

• Are the second largest issuers in Indian bond markets component of the local bond segments

• Issued as private placements, most of which are government guaranteed

• Taxable or tax-free, often in the form of structured issues or carrying credit enhancement features such as revenue dedication: usually known in India as “structured obligations(SO)”

• Have created significant fiscal risks for the state governments, as discussed

Noida Toll Bridge Company Limited • SPV promoted by IL&FS for the Noida-Delhi toll bridge project,

which include constructing a bridge across the river Yamuna on a BOOT scheme(operations started in February 2001):

Equity : Rs 1016 millionFCDs : Rs 208 millionIL&FS (World Bank) : Rs 600 millionTerm loans : Rs 1075 millionDeep discount bonds : Rs 500 million

• Credit rating - AAA (SO) by CARE• Put option: Investors have the put option to sell the bonds to

IL&FS and/or IDFC at a predetermined price at the end of 5th year and 9th year from the date of allotment.

• Credit enhancement mechanism: By IDFC & ILFS

Municipal Corporations(Amount in Crores of Rupees) Municipal Corporation

Issue Date

Maturity (Years)

Coupon (%)

Rating Agency Amount Guarantee

Bangalore 1997 7 13 A-(SO) CRISIL 100 Yes Ahmedabad 1998 7 14 AA-(SO) CRISIL 100 No Nashik 1999 7 14.75 AA-(SO) CRISIL 100 No Ludhaina 1999 10 13.5-14 LAA(SO) ICRA 10 No Nagpur 2001 7 13.43 LAA-(SO) ICRA 50 No Madurai 2001 15 12.25 LA+(SO) ICRA 30 No Indore 2001 7 11.50 - - 10 Yes Hyderabad 2002 8.5 7 AA+(SO) CRISIL 82.5 No TNUDF 2001 5 11.85 LAA+(SO) ICRA 106 No TNUDF (Pooled)

2002 15 9.2 30 No

Municipal BondsMunicipal issues are in the nature of revenue bonds, with fixed interest rate, with or without government guarantee, maturity 7-15 years, are in the form of Structured Obligations(SO), taxable or tax free

Municipal Bond Structure in India

Municipal Bonds

Principal + Interest

Project Cash Flows

InvestorsS

peci

alG

uara

nte

eR

ole

of T

rust

ees

ULBs

Escrow Debt Reserve Fund

Guarantee byDFIs / MDBs

CounterGuarantee

Municipal Bonds With AMC as an Intermediary

Principal Municipal Interest Bonds

Bonds

Principal + Interest

Project Cash Flows

Investors

AMC

ULBsLoan/Bonds

Escrow Debt Reserve Fund

Guarantee byDFIs/MDBs

TamilNadu Urban Development Fund

• A Trust established in 1996 under the Indian Trusts Act, 1882, by GoTN, ICICI, HDFC and IL&FS with a line of credit from the World Bank, to fund urban infrastructure needs.

• The share holding pattern of TNUDF is GoTN (49%), ICICI (21%), and HDFC and IL&FS (15% each)

• Management responsibility is taken up by ICICI, the lead institution in the arrangement.

• ULBs, statutory boards, and joint sector projects are the eligible borrowers, with maturity varying from 12 - 15 years

• Special recovery mechanisms such as escrow accounts of property tax, water charges and hypothecation of movables are generally used.

Pooled Financing in Tamil Nadu

• A State level pooled financing mechanism launched in Tamil Nadu, with the financial assistance of the USAID

• For smaller and medium sized municipalities Under the arrangement, 14 smaller ULBs, who are unable to access capital markets due to weak financial position and lack of capacity, pooled some water and sanitation projects under a special purpose vehicle (SPVs) called the Water and Sanitation Pooled Fund(WSPF), and raised about Rs 300 million from the bond market at an interest of 9.2 per cent for 15 years maturity

• Tamil Nadu Experience is unique, needs to be replicated, in the urban and semi-urban areas of developing countries.

• The financing of local infrastructure met by market based funding techniques with beneficiary participation (loans and grants are blended for the poorer municipalities).

• Bringing to one platform a number of stakeholders: governments at the levels of central, state and municipality, multilateral donor, domestic financial institutions, and private investors;

• The Fund has built significant capacity by improving the financial, managerial, administrative, and technical performance of the municipalities, and has the potential of ultimately turning them into creditworthy and well functioning entities.

• Direct and positive environmental benefits in the urban areas through solid waste and sanitation facilities, storm drainage and water supply facilities.

• Established significant participatory governance, whereby City Development Strategies are undertaken through a consultative process involving elected officials, municipal officers, community and professional groups, business and industry representatives and government agencies.

The TNUDF has the potential to revolutionize the concept of development financing and empowering local communities, and could serve well as an effective tool towards the fulfillment of Millennium Development Goals.

Deepening of Subnational Capital Markets and Bonds Markets

• Depends much on the growth and diversity of the national bond markets, and its constituents, its institutional structure and regulatory framework

• Securities regulations are not designed in segments; should be viewed as part of an overall system, existing alongside and complemented by established national systems of regulations

• Create the enabling environment, thereby enhancing the attractiveness of the Subnational securities, by reducing transaction costs and risks for investors

Environment promoting Subnational bond issuance should include..

• Broadening of the issuers and investor’s base• Credit ratings of the Subnational bodies • Securities regulations covering issuing, listing,

trading, and settlements• Defined borrowing powers • Bankruptcy regulations with defined and

enforceable debt contracts• Fiscal incentives such as taxation and credit

enhancement such as guarantees

Issuers• Broadening of the issuers base, through capacity

building efforts

• Financial restructuring of the SPVs and salutatary boards, making them creditworthy

• Bringing medium and smaller urban areas into municipal bond markets

• Promotion of pooled financing structure

Investors• Most of the central and state government securities are held

by the institutional investors

• Subnational securities are generally seen as high yield, but more risky

• Attracting more and more retail investors, and by designing customized bond structures, in order that the risk perceptions improved, wider publicity, improving transparency of local bodies

• Innovative mechanisms such as embedded options, pooled financing/bond banks, specialized funds, securitization, “take-out financing” etc will strengthen this markets

• Building capital market relationship, making investors aware of the issuer profile, familiarity with market intermediaries and regulatory environment

Secondary Markets• Presently the secondary market trading comprises

mostly the central and state government securities. • Investors in municipal bonds effectively held to

maturity • Municipal issuers will benefit from listing and

trading in secondary market, as this will greatly enhance trading and visibility.

• NSE would be the preferred exchange, has terminals in most of the Indian cities, allowing nationwide access for investors.

• Listing and trading requires continuing disclosure requirements for the local bond issuers.

Regulatory Structures

• Issuance of debt instruments by local bodies are governed by multiple legislations

• Too many regulators, with less effective regulations

Regulatory Design for Local Debt Markets

– The Public Debt Act 1944

– The Securities and Exchange Board of India(SEBI) Act of 1992

– The Local Authorities Loan Act 1914

– The Companies Act 1956

– The Securities Contracts (Regulation) Act 1956

– The Depositories Act 1996

– Subnational bodies taking the tax exempt status come under the MUD&PA and the MOF

– State governments themselves regulate borrowings

Case for Integration of Different Regulatory Agencies for subnational issuance

• Case to have a single law or single window clearance for bond issuance by local bodies.

• State Finance Commissions (SFCs) is expected to deal with assignment of powers relating to taxes, transfers, but extremely limited role in so far as borrowing powers are concerned.

Borrowing Powers

• Local Authorities Loans Act of 1914 is very old and have outdated provisions

• Estimates of borrowing powers are made based on the annual rental value, which have not been revised for long

• Few States have passed laws on guarantees, but none has passed a law on capping borrowings

• Necessary for a clear policy on borrowing powers• It will also bring in market discipline and fiscal

stability

Credit Ratings• Mandatory rating which along with a statutory limitation on

borrowing powers of Subnational bodies would bring in considerable market discipline

• Credit rating is definitely not just a regulatory issue as much as a measure of market discipline

• Government guarantee is not a substitute for important disclosure through credit ratings

• Socio-political changes at the local level need to be captured by rating agencies

• Rating agency should monitor the ULBs as part of its surveillance during the tenor of the bonds

• State governments could take important initiatives in making available the credit ratings of their local bodies, something like pre-screening of the potential issuers or in the form of comparative urban indicators

Municipal Bankruptcy • The existing framework of insolvency in India mainly

relates to corporate insolvency• Not relevant insofar as enforcing secured assets of or

bringing about insolvency proceedings against the ULBs

• Need for laws relating to Municipal Bankruptcy:– Promulgation of a law to lay down a separate insolvency

process (in the nature of a fast-track recovery process) for local bodies.

– Constitution of separate insolvency courts to try matters pertaining to borrowings by and insolvency of, local bodies.

– Promulgation of a separate statute setting out the revised manner of constitution of local bodies, in order to facilitate greater transparency and responsibility in fiscal dealings

Fiscal Incentives

Tax exemptions allowed under various sections of the Indian Income Tax Act from the following:– Interest received from bonds– Capital gains from bonds

• Tax rules and rates are prone to changes every year

• Tax environment should be stable and predictable

Capacity building in capital planning process ULBs

• Municipal Bond Issuance Process• Project Feasibility study• Capital planning process• Prepare for Disclosure • Decision to Issue• Credit Rating• Formation of Bond Parties (underwriter, trustee, State

government guarantee) • Information Memorandum• Audit and Standing Committee Approval• GOI and SEBI approval• Issuance of bonds• Listing• Use of Funds and Follow Up

Enabling Environment• Existence of viable infrastructure projects, with

definite cash flows• Regulatory framework enabling private sector

participation in local projects• Cash flow generating capability of projects

through defined user charges • Fiscal and financial capability of the city

governments• Strong accounting and disclosure standards and

good corporate governance • Human resource development, with requisite skills

Investment financing for urban infrastructure creation, with bond financing as one component, seems to have been more

successful where the state governments and the supporting institutions have established

complementarities

It is to be recognized that developing It is to be recognized that developing Subnational bond markets can be more Subnational bond markets can be more complicated, time-taking, having both complicated, time-taking, having both

national and regional dimensionsnational and regional dimensions

Thank You