Africa Finance Forum Blog
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Raising long term finance, crucial to the growth and economic development of any country, remains a significant challenge in Africa. Financing infrastructure successfully is a key ingredient to achieving sustainable growth in Africa through its ability to transform African economies by supporting productive investments especially in urban infrastructures like power, roads, housing, hospitals, schools, water supply and sanitation.
The cost of addressing Africa’s physical infrastructure investment is estimated at US$ 93 billion per year against the current infrastructure spending of about US$ 45 billion. Aside from loans from national governments, multilateral or bilateral development agencies, there is an increasing number of available financing options for infrastructure and various innovative ways in which African countries can fill the infrastructure finance gap. It would therefore be useful to look at, for instance, the experience of Indian Urban Local Bodies (ULBs) in mobilizing long term financial resources.
In 1998, the Ahmedabad (largest city in Gujarat, India) Municipal Corporation issued India’s first municipal bond without state guarantee to finance a water supply and sewerage project. To boost the municipal bond market, the Government of India decided to provide tax-free status to municipal bonds. Only financially strong, large municipal corporations were in a favorable position to directly access capital markets. To help small and medium ULBs to access the market, the Government of India encouraged the concept of pooled financing. Over 63 ULBs in India have obtained their credit ratings under the initiative (Jawaharlal Nehru National Urban Renewal Mission, JNNURM) undertaken by the Ministry of Urban Development, and the Government of India. Several ULBs and utility organizations have issued bonds and have so far mobilized financing through taxable bonds, tax free bonds and pooled financing.
Role of credit rating agencies
The emerging trends of urbanization in India have encompassed both demographic as well as economic aspects. While in demographic terms, the urban population has grown rapidly, the contribution of the urban areas to the national income has also showed a significant increase. The contribution of urban areas to Indian GDP increased from 55% in 1991 to 70% in 2012. With this backdrop, the substantial unmet needs of public infrastructure and the growing civic awareness towards accountability in municipal governance are being tackled at the national level with a comprehensive performance and delivery based approach.
In India, rating agencies have provided investors with an independent third-party evaluation of the credit strength or weakness of a particular municipal bond issue. Indian rating agencies rate the creditworthiness of a particular debt offering, essentially addressing the ability and willingness of a bond issuer to pay its debts. Ratings of ULBs have established a transparent credit record and a reference framework for current and future performance of local finances and debt management.
In addition, rating agencies continuously monitor the capacity of the issuer to make timely payments of principal and interest throughout the term of a bond. This continued monitoring throughout the life of a bond issue has been important to the effective operation of a secondary market in local municipal bond market. In assessing ULBs creditworthiness, rating agencies have constructed a general framework for evaluation that includes the legal and administrative framework, economic base of service area and municipal finances. In February 1996, Ahmedabad Municipal Corporation received a credit rating for a bond offering, the first rating received by a municipal bond offering in India.
Tax-Free Municipal Bonds
The Indian Income Tax Act provides tax preferences for investments in infrastructure projects. To boost the municipal bond market, the Government of India decided to provide tax-free status municipal bonds. The guidelines stipulate eligible issuers, use of funds, essential pre-conditions, maximum maturity, buy-back, nature of issue and tax benefits, ceiling amount for a project, compulsory credit rating and external monitoring of the tax-free municipal bond. Creating tax incentives for municipal bonds provided a national government subsidy for ULB bond offerings by substantially reducing the interest cost of financing local infrastructure projects.
Financially strong and large municipal corporations are in a position to directly access capital markets in India. Most small and medium ULBs are not able to access the capital markets on the basis of the strength of their balance sheets. Therefore the smaller ULBs pool their resources and jointly access the capital market. In 2003, Tamil Nadu Urban Development Fund issued a bond by pooling 14 municipalities for commercially viable water and sewerage infrastructure projects. A special purpose vehicle, the water and sanitation pooled fund was set up to issue municipal bonds. Subsequently, the Karnataka state government used the concept of pooled financing to raise debt from investors for the Greater Bangalore Water Supply and Sewerage Project. Due to the success of these two pooled finance model, the Government of India created a central fund that enables capital investment to be pooled under one state borrowing umbrella. The rating agencies have played an important role by providing a credit opinion and adding strength to the pooled financing instruments.
The credit rating under JNNURM has got far-reaching significance. It reveals the relative standing of the ULBs and in turn the extent to which the projects in question can be financed on their own strength. It also marks the first step towards ULBs approaching the debt markets to bridge the resource - need gap for the substantial ramp up in Capex envisaged by them. There are many more ULBs in India which are inclined to get their credit rating as it is believed that the rating serve as valuable input for improving their credit profile and further enable them to access capital markets.
Opportunities for African Urban Local Bodies (ULBs)
The ULBs in South Africa have issued bonds and this has developed the depth of the municipal bond market. A few other African countries such as Cameroon and Morocco have also been able to generate interest among investors to subscribe municipal bonds. The absence of active secondary bond market in Africa is one of the major deterrents in attracting potential long term investors. To make bonds issued by ULBs more attractive, the African Governments should allow the investors to book their returns without paying any tax there on. The municipal bonds’ creditworthiness can be enhanced by attaching unconditional and irrevocable sovereign guarantee. The Governments should pay special attention to avoid defaults that undercut investor confidence in municipal bonds. There should be continuous efforts to strengthen credit quality of the ULBs while at the same time the Governments should build contingent liabilities against any potential defaults. The development of deep and liquid domestic municipal bond markets are necessary for African economies to enter a new phase of sustainable development driven by market forces. This will enable ULBs finance the establishment, maintenance, operation and improvement of the physical infrastructures; the engine of economic growth.
Soumendra K. Dash, Ph.D, is a Principal Credit Risk Officer at African Development Bank, HQs, Tunisia. He is responsible for the credit risk assessment of the transactions at the Bank.
Prior to joining AfDB, he was working as Chief Economist at CARE Ratings (Credit Analysis and Research), Mumbai, India. He was looking after the sub-sovereign ratings and credit rating of bonds issued by public sector entities as well as ratings of Micro Financial Institutions. He has carried out extensive research projects and authored many seminal papers in the field of risk management. He has coined several innovative ideas and methods of financing urban local bodies for urban infrastructure development in India.