Investment challenge: Smart cities need smart funding options

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August 15, 2015 10:14 PM

One of the biggest challenges on the growth front for successive governments in India has been infrastructure development.

smart citiesBuilding smart cities and transforming metros need a lot of funds. The states are not in a position to shell out the huge requirements (Illustration by C S Sasikumar)

One of the biggest challenges on the growth front for successive governments in India has been infrastructure development. And the challenge has become even more daunting after several companies, which were into building infra projects over the last few years, are struggling to manage their debt burden.

Now that the Modi government has announced big-ticket urban development plans, financing and execution of these grand dreams will prove to be the real test.  The NDA government’s mega urban development plans which are expected to cost Rs 98,000 crore — the Smart Cities Mission, under which 100 smart cities would be built, and the Atal Mission for Rejuvenation and Urban Transformation (AMRUT) for 500 cities with outlays of Rs 48,000 crore and Rs 50,000 crore, respectively — over the next five years will pose challenges to both the Central and state governments, urban local bodies (ULBs) and private partners. While there are specialised state-sponsored finance companies such as India Infrastructure Finance company, Hudco and sectoral fund raisers in power and railways, the fund requirements are huge and over a longer period.


Banks have been  major fund providers so far. Outstanding bank credit to the infrastructure sector, which stood at Rs 9,500 crore in March 2001, has increased gradually to Rs 10,07,400 crore in March 2015, a compound annual growth rate (CAGR) of 39.5 per cent over the last 14 years. However, there are road bumps ahead. The  reason: bad loans or non-performing assets in the infrastructure area. “ The growing level of stressed assets in the infrastructure sector is a serious concern impinging upon the lenders’ ability to purvey more credit to the sector,” Reserve Bank Deputy Governor HR Khan said at the infra conclave of SBI Caps. “While the primary drivers of stress in the banks’ books are global and domestic economic slow-down, contribution of other factors like delay in obtaining statutory and other approvals in respect of projects under implementation as well as weak credit appraisal/monitoring by banks during the high growth years is also significant.”

The RBI says the stress in the infrastructure sector is a cause for major concern. According to the June 2015 Financial Stability Report (FSR) of the Reserve Bank of India, infrastructure, which constituted 15 per cent of total advances of the scheduled commercial banks, had a much larger share of around 30 per cent in total stressed advances.

Private players in construction and infra development whose balance sheets are stretched are not expected to play a big role in urban projects in the wake of the huge and growing investment requirements coupled with fiscal imperatives. Public sector players have their own constraints in fund mobilisation. This essentially means that the Central Government will have to extend substantial support to the two mega urban plans. In the proposed Smart City Mission, which will be operated as a centrally-sponsored scheme, the Central government proposes to give financial support to the Mission to the extent of Rs 48,000 crores over five years — on an average Rs 100 crore per city per year.

An equal amount, on a matching basis, will have to be contributed by the state governments and urban local bodies, thus facilitating Rs 1 lakh crore of  funds for Smart Cities development. The Centre has proposed the SPV (special purpose vehicle) route with the State, ULBs and private players as equity partners.

While the two mega urban projects are only part of the government’s initiatives, the government has to fund urban infrastructure development plans involving road transport, ports, power, telecom and Railways. It has to bankroll the Affordable Housing Partnership Scheme aimed at providing ‘Housing for All’ as there will be an estimated shortage of 20 million houses in urban areas by 2022.

The government is making budgetary allocations to finance these projects. It is taking care of only part of the problem. During 2011-15, the World Bank Group (including IFC) has, on an annual average basis, financed projects to the tune of $25 billion and the pattern is expected to continue. From the Asian Development Bank (ADB), India has received cumulative lending grant and technical assistance in infrastructure space of about $27 billion. The New Development Bank (NDB) — BRICS Bank — is expected to serve as a powerful instrument for financing infrastructure investment and sustainable development projects. The Asian Infrastructure Investment Bank (AIIB) is in the process of getting ready. “Given the enormity of our requirements, these efforts, though welcome, are not enough. Hence, we have to look for other sources,” the RBI says.

Where’s the moolah?

Building new smart cities and transforming decrepit metros need huge funds. The Central and State governments are not in a position to shell out the entire requirements. That offers one major fund source: the markets. Fund raiser: urban local bodies (ULBs).

“Given the enormity of the vision, stakeholders, especially the urban local bodies, have a significant task on hand. Financing through municipal bonds is an alternative that the ULBs can focus on,” the RBI says. The three decade old municipal bond market in India is yet to take off with municipal bonds playing a limited role as a source of finance for funding urban infrastructure projects. In India, just one per cent of the total ULB contribution is funded by municipal bonds as against about 10 per cent in the US. The size of the municipal bond market today is rather limited and is distributed over a few strong municipalities of Ahmedabad, Nasik and Nagpur.

According to RBI Deputy Governor, HR Khan, it is worth noting that in spite of weak finances, none of the municipal bond issues have defaulted in repayment to date. This indicates that although bond financing is feasible for ULBs there are constraints affecting both the supply as well as demand for capital. The central bank says several steps can be taken to strengthen the municipal bond markets. These are some of the proposals put across by Khan at the SBI Caps conference:

* The regulatory and legal conditions that currently hinder the municipal borrowing in India, needs to be altered to encourage appropriate expansion of the scope of bond financing.

* It is important to introduce flexibility in setting interest rate cap for issuance of municipal bonds by linking it to a benchmark market rate. Issuers also need to have the option to offer long tenor bonds for implementing urban infrastructure projects with a repayment period ranging about 15 – 20 years and could include variants, such as, guaranteed, non-guaranteed bonds, taxable and tax free bonds, pooled financing, etc. Treating tax free municipal bonds in the same way as other tax free instruments is necessary, the RBI says.

*  Change in perception. Very often the urban local bodies are still considered to be riskier than the corporates with similar rating largely because the risk perception is significantly linked to financial position of their states as they depend significantly upon the devolution of resources and grant from the state government. Therefore, the outlook for ULBs would depend upon the outlook on the financial position of the state concerned.

* Ring-fencing the municipal bond funds is very essential by clearly earmarking the same for a defined project and is thus, insulated from interventions.

* To gain investor confidence, municipalities need to obtain credit rating for raising funds from the market.
n Introduction of a bankruptcy law applicable to municipal bodies could improve investor confidence and boost demand for municipal bonds. As a backstop arrangement in the eventuality of default, there needs to be partial or full guarantee by the Centre/states.

* There is need for improving transparency in accounting and budgeting and disclosure of all the material facts regarding the management, administration, financials, operations, projects, revenue generation, risk factors, etc. Timely audit, putting in place a framework for legal remedy against defaulting ULBs and assurance against diversion of fund will have to be addressed.

* Pooled finance mechanism: This was initiated for small and medium sized ULBs to hedge risk for the investors and thereby avoid huge transaction costs.

The RBI has suggested that in order to widen the investor base, insurance companies, National Pension System, and provident funds may be allowed to invest in the rated securities of ULBs or Municipal bodies as also foreign portfolio investors and mutual funds. Sebi has since put out a framework for issue and listing of debt securities by municipalities. “There are demands for further fine-tuning of these regulations. Besides, concerted efforts are needed by the Central, State and the municipal bodies to address the above concerns for developing a more reliable and additional source of financing for certain infrastructure through municipal bonds,” the RBI said.

For ULBs which are expected to play a big role in the development of smart cities, fund mobilisation through the bond market could be an effective channel to support big urban projects.

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