Bond Market Financing by Subnational Governments:Indian Experience

1
Bond Market Financing by Sub-national
GovernmentsIndian Experience

• Dr HK Pradhan
• Professor of Finance and Economics
• XLRI Jamshedpur, India
• Email pradhan_at_xlri.ac.in
• September 30-October 1, 2004

2
(No Transcript)
3
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

4
(No Transcript)
5
Wide diversity in terms of revenue raising
capabilities and economic performance

• 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

6
(No Transcript)
7
(No Transcript)
8

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

9
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.

10
(No Transcript)
11
(No Transcript)
12
Subnational Bond Issuance in India

• Bonds issued by state sponsored institutions
• Bonds issued by ULBs
• Urban Development Funds

13
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

14
Noida Toll Bridge Company Limited

• SPV promoted by ILFS 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 million
• FCDs Rs 208 million
• ILFS (World Bank) Rs 600 million
• Term loans Rs 1075 million
• Deep discount bonds Rs 500 million
• Credit rating - AAA (SO) by CARE
• Put option Investors have the put option to sell
  the bonds to ILFS 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

15
Municipal Bonds
Municipal 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
16
(No Transcript)
17
(No Transcript)
18
TamilNadu Urban Development Fund

• A Trust established in 1996 under the Indian
  Trusts Act, 1882, by GoTN, ICICI, HDFC and ILFS
  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 ILFS (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.

19
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

20

• 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.

21

• 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.

22
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

23
Environment promoting Subnational bond issuance
should include..

• Broadening of the issuers and investors 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

24
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

25
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

26
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.

27
Regulatory Structures

• Issuance of debt instruments by local bodies are
  governed by multiple legislations
• Too many regulators, with less effective
  regulations

28
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 MUDPA and the MOF
• State governments themselves regulate borrowings

29
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.

30
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

31

• 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

32
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

33
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

34
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

35
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

36
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
37
It is to be recognized that developing
Subnational bond markets can be more complicated,
time-taking, having both national and regional
dimensions
38
Thank You