Funding your municipality: Are we there yet?

Cyrill Shroff and Arjun LallImagine a city where the roads do not flood during monsoon, the sewer system works efficiently, the electricity grid ensures 24x7 electricity supply. The ‘smart cities’ mission statement released by the Government of India last year proposes to make such cities a reality. It is estimated that approximately Rs 1,00,000 crore will be required for the development of 100 ‘smart cities’ as envisioned by the Union Cabinet, and half of this amount shall be met by the state governments and municipalities. This highlights the need to generate additional capital, and one way this might be realised is through municipal bonds.While not novel to India, market analysts believe that the municipal bonds market in India failed to take-off due to a variety of reasons, including lack of incentives for investors, lack of project implementation and financial expertise in municipalities, and more importantly, opaque municipal governance laws. Taking cognizance of the same, the securities market regulator — Securities and Exchange Board of India (SEBI) – sought to address issues that are specific to municipal bonds by promulgating the SEBI (Issue and Listing of Debt Securities by Municipalities) Regulations, 2015.

These regulations categorise municipal bonds as either general obligation bonds or revenue bonds, based on the nature of assets that would be utilised to service the related principal and coupon payments. The regulations prescribe that issuing entities can be municipalities (nagar panchayats, municipal councils and municipal corporations) and corporate municipal entities (companies that are subsidiaries of municipalities). Corporate municipal entities (CME) can also raise funds on behalf of a municipality or even a pool of municipalities. The procedure for issuance of municipal bonds under these regulations is similar to that of a debt listing by a company under the relevant debt listing regulations.On the whole, the regulations seem to be well thought out. For instance, to ensure that the issuer has sufficient skin in the game, the regulations mandate that at least 20 percent of the project cost must be met by the issuer through its internal revenues. Targeting compliance with project timelines, issuers are also mandated to establish a separate project implementation cell. Clearly, SEBI has sought to build sufficient mechanisms to ensure greater transparency, and consequently, efficient and robust municipal bonds market.But as is the case with every new regulatory framework, there are gaps that need to be filled to make the regulations ‘market ready’. To ensure credit worthiness of the bond issuances, a 100 percent asset cover sufficient to discharge the principal amounts of the issue has been prescribed. However, it is unclear how this requirement will be satisfied by a CME, since none of the underlying assets will be owned by it. It is also unclear whether CMEs will be required to comply with the corporate debt listing regulations. Further, under the regulations, the consequences of any non-compliance or omissions by a municipality are vague.In addition to concerns that are specific to the securities market, a variety of substantive legal issues also exist. Unclear municipal bankruptcy laws, ambiguous procedural rules, excessive control of state governments, and lack of concrete precedents on security enforcement against municipalities remain formidable regulatory hurdles. Even if such issues are overcome, there are economic and taxation policy issues that may prove to be a wet blanket for investors.

All is not lost however. With China’s municipal bond market estimated to acquire a size of USD 322 billion by the end of 2016, and USA’s bond market at USD 3.2 trillion, precedents affirm the success of municipal bonds’ market. Further, as supported by the experience of Ahmedabad Municipal Corporation, we anticipate that repeated bond issuances, with the influence of market forces, will usher in greater efficiency and transparency in the functioning of municipalities. It is thus the need of the hour for the central and state governments to act together, as they did to make the foreign direct investment regime a success. By addressing the issues in the overall regulatory framework, the municipal bond market can finally become an alternative but healthy source of funds for urban infrastructure development.Cyril Shroff is Managing Partner and Arjun Lall, Partner, Cyril Amarchand Mangaldas.