In today’s Finshots, we explain why cities in India are increasingly tapping the bond markets for their infrastructure needs.

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Uttar Pradesh is on overdrive.

A few days ago, an RBI report said that banks and financial institutions were falling over themselves to fund projects in the state. It revealed that UP had attracted the most financing for the second year in a row.

Then there was the news that 4 cities in UP are getting ready to launch something called municipal bonds. Kanpur, Prayagraj, Agra, and Varanasi want around ₹500 crores from the public. They want to improve their water supply facilities.

Now at first glance, the two news bits might seem disconnected. The banks are funding private company projects. And the city civic bodies are simply trying to raise money to build stuff that makes the life of their residents better.

But what if we told you there could be a link here?

See, if you’re a state that’s competing with 27 others in order to attract businesses, you need to put your best foot forward. You need to show them why they should choose you for their factories and offices. You might say things like, “We plan to make Kanpur a hub for robotics and Varanasi into an R&D spot.” And then you’ll launch business-friendly policies. You might give land and electricity at subsidized rates. You might tweak labour laws. You might dole out financial incentives if the business fulfils certain parameters.

But…that’s not enough. Most importantly, you still need superb infrastructure so that the lives of people who chose to work at these companies are made easier. They need good roads. They need good quality and consistent water supply. There have to be streetlights across town. They’ll need a good public transport system. And they need a proper sewage and waste disposal system.

Now quite often, the responsibility of setting these up falls into the hands of municipal corporations. They’re the ones in charge of the cities. And they have to execute the ground-level stuff.

But where do cities get the money for this, you ask?

Well, you’d expect them to raise funds on their own through various taxes, right?

But there’s a bit of a problem. Over the years, municipalities have slowly been losing their financial autonomy. Even though they’re the ones with their ears to the ground and know local issues better than anyone else. They’re increasingly dependent on the central and state governments — 40% of municipal revenue comes from this source.

And guess what?

The RBI think that this financial dependence makes our municipal system one of the weakest globally. In India, municipal revenue is just 1% of our GDP. Whereas in Brazil and Africa, it’s at 7.4% and 6% of GDP respectively.

Also, during 2015–2020, the allocation from the Central Finance Commission to these municipalities worked out to be a measly ₹500 per capita per year. Peanuts, right?

And this is a problem because cities contribute 70% to India’s GDP. But if they don’t have enough control over the money needed to improve their infrastructure, cities can quickly crumble. It’s also concerning because the future lies in cities — the bulk of the $1.4 trillion in infrastructure investments needed in the next few years will be in urban areas.

So without a steady stream of money coming in from the top, municipalities need to turn self-sufficient and access money quickly.

Enter municipal bonds.

Now this is just like any bond issued by a central government. It has a maturity period of say 5-10 years. It pays regular interest. And there’s a final payment of the investment. Just that all this happens at a local level. It’s for local development.

And this isn’t really a new concept. Municipal bonds have been around since 1997 when Bengaluru and Ahmedabad issued them. A few others followed suit. But these bonds haven’t really been available to the public. They find big players who’re willing to invest and it’s kind of like a private transaction. The market for these bonds hasn't really grown either.

Also, for investors, it can still be a bit scary to lend money to a municipal corporation. They’re not really the epitome of sound governance or business efficiency.

But the government and the Securities and Exchange Board of India (SEB) has been trying to change that. They want municipal bonds to gain popularity. They want people like you and me to invest and spur development of cities. And one by one, they’re trying to address issue surrounding it.

See, one of the biggest worries that gets people to think twice about municipal bonds is — transparency. Investors are worried if the balance sheets are clean and capture relevant information. So the government has introduced a uniform reporting system based on international standards. There’ll be a database of audited annual accounts and that will instill trust and credibility.

And they don’t want financially weak municipal corporations going this route either. They need to first get a credit rating which has to be above BBB-. Then they have to prove they haven’t defaulted on any other loans recently. They need to contribute to 20% of the project cost from their coffers. And the revenues from the project has to flow into a dedicated bank account too.

Basically, these bonds will be “ring-fenced to user charges” too. This simply means that the revenues from a project are linked to the payouts.

For instance, let’s take Indore which issued a bond recently. The city needs 540 million litres of water every day. And it gets this from the Narmada river. But the electricity needed to make this work costs around ₹60 crore each year. So they decided to switch to solar to power this. And issued a green municipal bond to raise nearly ₹250 crores. Now Indore can tell investors that they’ll make payouts based on the revenue it generates from this water supply. There’s a clear use-case and revenue linked to it.

And that gives investors more visibility.

Also, even though the government is not giving an explicitly guarantee and saying, “Look, we’ll come in if the municipality fails,” they’re trying to make life easier for municipalities willing to take the plunge. When the Lucknow Municipal Corporation raised money a couple of years ago, the government promised to give it ₹26 crores to subsidies its interest burden. And that incentive meant that the interest burden automatically fell by 2% as well.

So yeah, with all these changes, you can see municipalities have slowly been tapping the bond markets — over ₹2,500 crores worth of bonds has been issued since 2018 by cities such as Lucknow, Surat, Vadodara, Ghaziabad, Indore, Pune and Hyderabad. And with Uttar Pradesh doubling down on it now, it does seem like municipal bonds are the next big financing thing for cities.

What do you think?

Until then…

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