India’s urban population has been constantly growing since independence and the current urbanization rate is close to 31.2 percent. However, in absolute terms, India is second only to China in total urban population. The existing infrastructure has failed to keep pace with the rapid growth in urbanization resulting in inadequate service provision and environmental degradation.

As per the Fourteenth Finance Commission (FFC), total ULB revenues in 2012-13 were Rs.96,640 cr. Of which, own source income was only 51.6% (Rs. 49,913 cr.) while the remaining was from other sources including market borrowings. The study indicated that only 1.4% of the total revenue came from market borrowings. The FFC observed that municipal bonds have played a limited role in funding urban infrastructure projects and hence should be explored as a option for infrastructure financing. The FFC recommended a grant of Rs. 87,143.8 cr. to the ULBs for the period 2015-2020.

Status of Municipal Bond market in India

A municipal bond is a debt obligation issued by a local authority with the promise to pay the bond interest on a specified payment schedule and the principal at maturity. They can be either general obligation bonds, where the principal and interest are guaranteed by the issuer’s overall tax revenues or they can be revenue bonds, where the principal and interest are secured by revenues from a particular project of the ULBs. It could be derived from tolls, charges or rents from the facility built with the proceeds of the bond issue.

The Government of India allowed ULBs to issue tax-free municipal bonds in 1999-00 and has amended the Income Tax Act (1961 vide the Finance Act 2000) inserting a new clause (vii) in Section 10(15), whereby interest income from bonds issued by local authorities was exempted from income tax. The GOI issued guidelines for issue of tax-free municipal bonds in February 2001. It has been clearly specified that the funds raised from these tax-free municipal bonds are to be used only for capital investments in urban infrastructure like potable water supply, sewerage or sanitation, drainage, solid waste management, roads, bridges and flyovers; and urban transport.

Ahmedabad municipal corporation (AMC) was the first ULBs in India to issue tax-free municipal bonds for water and sewerage projects. In April 2002, AMC issued a tax-free 10-year bonds worth Rs 1000 crore followed by Tamil Nadu Urban Development Fund (TNUDF) in 2003 which issued a bond by pooling 14 municipalities for commercially viable water and sewerage infrastructure projects. Subsequently, the Government of Karnataka used the concept of pooled financing to raise debt from investors for the Greater Bangalore Water Supply and Sewerage Project (GBWASP).

On July 2015, SEBI notified a new regulatory framework for issuing municipal bonds in India. Some main features include investment grade ratings for ULBs, no default in last 365 days and positive net worth, a mandated guarantee from the State Government or Central Government, compliance with the state’s municipal account standards or the National Municipal Accounts Manual to be eligible for the issue, etc. Further streamlined the system of the municipal bond market in India.

International Experience

Three main approaches to the regulation and control of municipal borrowing can be identified internationally (World Bank). Firstly, market-based where decisions about municipal borrowing are made by the borrowers and lenders within an overall legal framework and some level of administrative oversight. (Example: USA and South Africa). Second is rules-based where decisions about borrowing are made within a more tightly circumscribed set of parameters outlined in a detailed set of rules that are constant. (Example: Serbia, Poland). Lastly, direct control where the emphasis is on the ad hoc approval of specific municipal transactions by higher levels of government, which have extensive discretionary powers in respect of the approval process.

With regard to these three basic approaches to the regulation of municipal borrowing market, the system in India is most accurately understood as a de facto direct control system.

Developing countries like South Africa, Hungary, Russia, and Mexico also have relatively well developed municipal bond markets. One leading example is the Infrastructure Finance Corporation Limited (INCA) of South Africa.

The municipal bond market is largely untapped in India. It has a huge potential for fulfilling the massive investment requirement in the urban infrastructure sector. However, we need to increase the penetration and efficiency of the market by working on the various supply and demand constraints that exist in the market to harness the full potential of the instrument.