Municipal bonds for urban local bodies: A call for financial reforms - Hindustan Times

Municipal bonds for urban local bodies: A call for financial reforms

ByHindustan Times
Feb 16, 2024 07:04 PM IST

This article is authored by Hitesh Vaidya and Pankaj Goel.

In the interim budget for 2024-25, finance minister Nirmala Sitharaman extended the 50-year interest-free loans for capital expenditure to states with a total outlay of Rs. 1.3 lakh crore. This ambitious vision not only envisions economic prosperity but also recognises the pivotal role of Indian cities as engines of growth. However, cities constantly evolve, presenting unique challenges and opportunities requiring innovative financial solutions, particularly in meeting the escalating demand for robust infrastructure development. This paper explores the readiness of urban local bodies (ULBs) to navigate the complexities of issuing and sustaining municipal bonds without the sovereign guarantee of the State.

Union finance minister Nirmala Sitharaman speaks in the Lok Sabha during the interim budget session of the Parliament, in New Delhi (ANI)
Union finance minister Nirmala Sitharaman speaks in the Lok Sabha during the interim budget session of the Parliament, in New Delhi (ANI)

Indian cities play a crucial role in driving economic growth. To meet the growing demand for infrastructure, they must manage their finances effectively. The financial well-being of a city directly impacts residents' quality of life and its appeal to businesses and investors. Municipal finance goes beyond numbers; it is vital for communities striving for progress.

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To achieve sustainable development, cities must address challenges and adopt innovative financing approaches. This will help in building solid foundations for resilient and thriving urban areas. Indian cities should be positioned as critical contributors to the structural transformation of the national economy.

However, ULBs face financial challenges due to poor collection efficiency. This hampers their ability to provide adequate services to citizens. Traditionally, municipalities have relied on funding from sources like capital receipts, grants, and borrowings from multilateral agencies supported by the government. While these sources are essential, India's urban financing system must adapt to meet the scale of infrastructure growth envisioned.

One innovative solution that has the potential to revolutionise urban financing is the adoption of municipal bonds. Despite being considered a novel external financing source, municipal bonds have seen limited uptake by ULBs in the Indian context. The primary hurdle lies in the necessity for regular debt servicing, demanding ULBs to generate ample revenue independently.

Cities' financial statements, guided by the National Municipal Accounting Manual (NMAM), provide a snapshot of their revenue and revenue grant receipts. However, critical financial metrics such as Earnings Before Interest, Tax, Depreciation, and Amortisation (EBITDA), interest coverage, and debt service coverage ratio are not mandated by the NMAM, leaving a gap in assessing ULBs' ability to service debt.

Comprehensive reforms are required to unlock the full potential of Municipal Bonds as an alternative source of financing. The 15th Finance Commission's emphasis on tying grants to the growth of property tax underscores the importance of financial self-sufficiency for ULBs. If embraced and supported through essential reforms, municipal bonds can emerge as a powerful catalyst in addressing the challenges Indian cities face.

The issuance of municipal bonds involves a complex process spanning several months, including project finalisation, ULB rating, SEBI compliance, and debt servicing considerations. Further, the financial statements of ULBs are prepared per the format given in Chapter 31 of the NMAM, which provides a mix of own revenue and revenue grants receipts and no information about EBITDA.

Thus, the financial statements of ULBs don’t provide any picture of ULBs’ position to service debt, and most ULBs don’t calculate interest coverage and debt service coverage ratio to test their position to service debt as it is not mandated by the NMAM. Many cities' financials indicate that revenue payments exceed revenue receipts, necessitating reliance on revenue grants from the state government. Even if state grants cover some establishment expenses, their income remains limited to meeting interest and finance charges, placing them in a critical position when accessing the bond market. Looking at the vast potential of municipal bonds as an alternative source of financing, the following reforms are required:

  • Amend NMAM manual format of financial statements: NMAM shall be amended to amend the format of financial statements to show surplus from own revenue separately before interest and finance charged and depreciation. This will indicate whether ULB can service interest and how much minimum is required to earn service interest. Calculating and presenting Interest coverage and debt service coverage ratio shall be mandatory as part of the financial statements.
  • Amendment in Municipal Act: Before the issuing of bonds, the State Municipal Act shall have the provision for borrowings like the Jharkhand Municipal Act, 2011 has Chapter 16(Section 132-Section 150), which empowers states and municipalities to borrow the money and how to use the proceeds from municipal bonds. Jharkhand Municipal Act Section 150 mentions that the funds to be raised from the Bonds shall be used for capital investment for the development of urban infrastructure in the spheres of water supply, sewerage, drainage, solid waste management, markets, roads, bridges, urban transport, and for reforming and improving the efficiency of existing systems of municipal administration and for repayment of loans for the purposes as mentioned earlier raised through earlier issues of municipal bonds or otherwise.
  • Engagement of professionals: The bonds issue is a legal process that involves a lot of steps and compliances to be followed by the state or city like getting a credit rating agency and transaction advisor appointed, timely availability of audited annual financial statements, getting project Detailed Project Report (DPR) ready against which bonds shall be issued, getting financial improvement plan prepared, SEBI compliances and other related procedures. Thus, the state or city shall engage professionals like urban planners and chartered accountants. Like the states of Tamil Nadu and Jharkhand, the state can appoint a Project Management Unit (PMU) at the state level, which can help coordinate all such services relating to the issue of bonds.
  • Capacity-building: No reform can be implemented unless there is existing staff knowledge and skills capacity. Thus, MoHUA/state and city shall engage different organisations and professional expertise in the field of urban/municipal finance to train their staff members through seminars or workshops at the national/state/city level to generate awareness about bonds as a source of finance and prerequisite for issue of bonds. Such rating will infuse capacity among staff, and they will prepare their state/city for the issue of bonds
  • Augmentation of own revenue: Steps shall be undertaken by the state government to augment own revenue, like the adoption of a based revenue sharing model like Jharkhand with the Project Management Unit to resolve the issue of 3 Us: unassessed, assessed and unpaid households. Steps taken by Jharkhand have been given below, which other states/cities may follow:

- Revenue assessment of sample ULBs to assess the gaps in the augmentation of revenue in the year 2015-16 by appointing three agencies

- The PPP-based model intends to cover and enhance municipal revenues from property taxes, water user charges, and trade licenses against commission based on collection.

- Reforms by implementation of Property Tax Rules as per Municipal Act in 2011

- The Annual Rental Value (ARV) method, which is self-assessment based on trust and verify basis, was introduced

  • Incentives for issue of municipal bonds: Provided incentive to issue bonds in terms of interest free loan or incentive of 13% for the issue of 100 crore, some additional incentive like making bonds tax free or bringing investment in municipal bonds as additional deduction under income tax may be provided to push issuance of municipal bonds.
  • Double entry accrual accounting: Followed accrual-based audited annual financial statements are the basis for credit rating. Thus, the state shall ensure that all ULBs must follow accrual accounting for daily transaction accounting and preparation of financial statements as per NMAM and State Municipal Accounting Manual and Accounting Standard for Local Bodies (ASLB) issued by ICAI may also be referred

To unlock the potential of municipal bonds, a substantial shift in accounting and disclosure practices is necessary to pave the way for the success of the municipal bonds market in the years to come. Viksit Bharat can pave the way for sustainable urban growth and economic prosperity by promoting financial self-sufficiency and encouraging innovative financing mechanisms.

This article is authored by Hitesh Vaidya, former director, NIUA and former country manager, UN-Habitat, India and Pankaj Goel, financial specialist and short-term consultant, The World Bank.

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