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The vexed question of financing Indian cities

LiveMint logoLiveMint 25-07-2017 Nandan Sharalya

About 814 million people are expected to live in Indian cities by 2050. Just in terms of scale, the task of effectively managing cities in India will potentially be touted as the world’s greatest managerial challenge. And while China might have an almost equal number living in its cities, it is better poised to handle its urban explosion than India.

The numbers paint a disappointing picture. A 2010 McKinsey report estimates that India will need to spend $1.2 trillion by 2030, a far cry from current spending estimates. India’s annual per capita spending on cities stands at a measly $50. The corresponding figures for China and the UK are about $362 and $1,772, respectively.

The financial health of Indian cities is in such a pathetic state that revenue generated by urban local bodies accounts for less than 0.9% of the total GDP (gross domestic product) despite cities contributing almost 60% towards GDP. Several urban local governments have to also rely on state governments to fund even basic operational expenditure like employee salaries. In tier 2 and tier 3 cities, urban local bodies and municipal corporations have had little or no autonomy or capacity to raise revenue.

The government’s flagship urban development schemes fund only a fraction of the required investment and cities are tasked with finding other ways to bridge the funding gap. For example, under the Smart Cities Mission, the government has allocated $15 billion for 100 cities to be disbursed over four years, with equal contributions from the Central and state governments. This amount is by no means sufficient. The grant is to be seen as a starting point to attract funding from external sources.

Over the last decade, public-private partnerships (PPPs) have been the preferred route for infrastructure creation in India. But PPPs have not worked as well as they were expected to owing to the poor rate of return for the private sector and other inefficiencies. Many experts now argue that the famed PPP model is broken and unless the government finds a way to minimize financial risk and disputes, the situation will only worsen. With the banking system heavily stressed with bad debts, urban rejuvenation might not receive the necessary impetus from the private sector in the short term.

In the meanwhile, the government must commit to developing a city’s creditworthiness. Credit rating of cities is the first step towards raising money through the bond market, subnational governments, and international lenders. Ratings are assigned based on the assets and liabilities of urban local bodies, revenue streams, resources available for capital investments and implementation of credible double-entry accounting mechanisms.

Naveen Kumar Saini/Mint

More recently, the government announced that 94 of the 500 cities have already obtained such ratings, necessary for issuing municipal bonds. However, only 59% of the cities assessed were found to be worthy of investment.

Cities rated AA are considered safe investments and may access the market directly without any intervention. Most of the metropolitan cities fall under this category. Cities rated A and BBB are less desirable in comparison but are still considered worthy of investment. However, these cities may need some sort of financial cushioning from the government. In the scenario that the investments hit rough waters, investors need to remain reassured that their investments are still protected and that cities aren’t defaulting on interest payments. This could take the form of a separate contingency fund or funds parked in an escrow account.

Cities rated BB and below may find it difficult to raise funds. Even if they do manage to elicit investments, these are bound to come at much higher rates of interest, which might be economically infeasible. As the bonds are not tax-free, the government is considering setting up an interest subsidy fund of Rs400 crore to offset the high interest rate.

Despite the optimism and investor appetite, municipal bonds may prove to be successful only in fast-growing metropolitan cities. Pune is on the verge of raising Rs2,300 crore, an amount well over what has been collected so far cumulatively by all cities till date. Ahmedabad, New Delhi, Bengaluru, Hyderabad and Chennai might follow soon. However, as is apparent, this mechanism does not solve the problem of financing for small- and medium-sized Indian cities and towns.

Over the last decade, property prices in tier 2 and tier 3 cities have been on a steady upward trajectory. Against this backdrop, a move worth pursuing is the deployment of land value capture instruments. When a government invests in developing a particular area—for example, building a new airport outside a city—land prices around the area rise. A portion of this benefit could accrue to the government either through betterment charges, tax increment financing, developer extractions, or impact fees. Several states like Tamil Nadu, Karnataka, Andhra Pradesh, Maharashtra, Gujarat and West Bengal are slowly beginning to explore this instrument as a method to generate revenue.

P.K. Mohanty, in his book Financing Cities In India, also makes a strong case for cities to be able to access a broad portfolio of taxes such as motor vehicle tax, professional tax, fuel tax, excise, business and financial taxes, entertainment tax, etc., all of which are currently appropriated by state governments. This would involve amending the Constitution to have these taxes included in the municipal finance list. He also advocates for the inclusion of a city GST (goods and services tax) rate within the state GST rate, a formula-based mechanism to ensure municipalities get their share.

Some of these reforms require immense political will and a real understanding of the problems cities face. Unfortunately, despite being the breadwinners of the economy, Indian cities have seldom been able to assert themselves strongly enough.

Nandan Sharalya is a German Chancellor Fellow and visiting scholar at the Institute for Industrial Organization, WHU, Otto Beisheim School of Management.

Published with permission from Ideas for India, an economics and policy portal.

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