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Understanding Urban Local Body Financing through Municipal Bonds

Madhur Sharma, Anwesha Mallick

13 March 2023

In the first part of our blog series on municipal financing, we explored the different forms of Urban Local Bodies (ULBs) and their conventional sources of revenue. The blog also talked about the lack of fiscal autonomy ULBs face and the consequent resistance towards urbanisation from rural pallets in the country. The second blog in the series will delve into some non-conventional sources of revenue, like Municipal Bonds, which can help strengthen the financial health of  municipal bodies.

Revenues and expenditures by Indian ULBs have stayed at approximately 1% of the GDP for the last decade. This is very low. For context, the figures are 7.4% of the GDP for Brazil and 6% of the GDP for South Africa. While presenting the Union Budget for the year 2023-24, the Finance Minister emphasised the need for strengthening urban civic bodies to improve their finances and credit worthiness and help them raise funds through municipal bonds.

Understanding the Municipal Funding Landscape

Before unpacking municipal bonds, it is important to understand the funding landscape for local bodies. In terms of major fund resources, the Fifteenth Finance Commission has placed emphasis on empowering the third tier of government by recommending grants of ₹4.36 lakh crore to local bodies for the five year period of 2021-22 to 2025-26. This is the largest-ever share of grants to be assigned to local bodies. But it is important to note that most of this money will go to the Panchayati Raj Institutions or PRIs (the approximate sharing ratio between PRIs and ULBs is 60:40). 

Similarly, the introduction of the Goods and Services Tax (GST), while allowing for sharing one-sixth of GST proceeds with PRIs and ULBs, also increased the dependence of local bodies on higher tiers of government. Moreover, while GST was introduced in lieu of Octroi (a local tax), the subsumed taxes such as the entry tax, local body tax, advertisement tax, and other consumption related taxes levied by the ULBs were not compensated properly, narrowing revenue collection channels.

Non-Conventional Revenue Sources

Despite various grants to local governments from external sources, the availability and quality of municipal services in urban India has remained consistently poor. With rapidly rising populations, the requirements for housing and urban infrastructure are at an all-time high. Meeting these needs will require innovative and unconventional long-term financing mechanisms.

Opening up local governments to the capital market has been considered as a way forward for ULBs to acquire funding and financial autonomy. This has been done by issuing municipal bonds which can be divided into three categories:

1. General Obligation bonds: These are not backed by assets and are instead secured by the issuer’s creditworthiness and revenue generating power.

2. Revenue bonds: These are backed by earnings or collections amassed from a specific project such as highway tolls or lease fees.

3. Hybrid mechanisms: If user charges are inadequate, these employ the general revenue of the body as backup to service the bond.

Municipal Bonds: A One Fit Solution?

Some big municipal corporations in Bengaluru and Ahmedabad were able to harness growth from the bonds market in the late 1990s. This exercise was suspended with the introduction of the Jawaharlal Nehru National Urban Renewal Mission (JnNURM) in 2005, which allocated grants worth ₹1 lakh crore from the Union government; this again made the urban local governments reliant on higher tiers of the government. Recently, however, many municipal corporations have resurfaced in the bonds market by raising approximately ₹3,840 crore between 2017 and 2021.  In comparison, the municipal bonds market in the USA was valued at 4 trillion USD as of March 2023, according to the Securities Industry and Financial Markets Association (SIFMA).

Evidence, however, suggests that only large ULBs with good technical competencies can meet the necessary requirements of bond issuance (RBI, 2022). For other smaller urban bodies, there is the option of pooled financing. This approach suggests the issuance of a common bond by combining the resources of several ULBs in the state. 

The Budget for FY 2023-24 announced incentives for cities to improve their creditworthiness for bond financing through governance reforms for property tax and segregating a portion of the user charges on urban infrastructure. Similarly, in 2006, the Union government tried to incentivise pooled financing by launching the Pooled Finance Development Fund (PFDF) Scheme to provide credit enhancement to ULBs through a state-level pooled finance mechanism. Income tax exemptions were also granted to bondholders to boost demand for pooled bonds. However, the PFDF got a lukewarm response from stakeholders due to market constraints (MoHUA).

Encouraging Stakeholder Interest in Municipal Bonds

The  Union government has announced a Urban Infrastructure Development Fund (UIDF), which will be managed by the National Housing Bank and can be used by public agencies to create urban infrastructure. According to the Budget speech for FY 2023-24, an amount of ₹ 10,000 crores is to be allocated for the UIDF, this amount can make the municipal bonds of Tier 2 and 3 cities secure investments.

There are many challenges to this at present. Firstly,  investors in the private capital market demand stable and strong investments. One of the most important determinants of a safe investment includes credit rating. Since the municipal bonds market is new and still developing, a credit rating for ULBs can attract new investors. Both the Smart Cities Mission and the Atal Mission for Rejuvenation and Urban Transformation (AMRUT) programmes, the two largest  centrally sponsored programmes for urban development in the country, include credit ratings for various municipal bodies. 

Secondly, the law allows for ULBs to enter the market but only with the approval of state governments. Currently 10 cities across six states have their municipal bonds listed on the National Stock Exchange (NSE). These include Pune, Ghaziabad, Lucknow, Hyderabad, Visakhapatnam, Indore, Bhopal, Surat, Ahmedabad, and Vadodara. The recent focus from the Centre on ULBs and their finances might encourage more states to approve of bond financing as a viable option for fundraising.

Another obstacle is an underdeveloped secondary market for municipal bonds, which hinders the investors’ ability to sell and buy municipal bonds, unlike the stock market. Currently, there are not many buyers and therefore, it is difficult to set up a market which will allow for easy transactions. On 22nd Februrary 2023, the NSE introduced India’s first-ever municipal bond index. The Nifty India Municipal Bond Index acts as a performance tracker for municipal bonds issued by various municipal corporations across maturities with investment-grade credit ratings. This can be the first step towards making municipal bonds popular and secure investments which can thrive in the stock market.

Lastly, India has 4,999 ULBs, it is difficult to standardise a financial empowerment system for ULBs to follow because of differential vulnerabilities and diversity in population, geography, climate risks, etc.

However, all of this prompts a need to look for financing mechanisms beyond grants and reduce the dependence of ULBs on higher tiers of government. Entering the market might also encourage ULBs to build on their financial portfolios and follow better accounting practices.

Madhur Sharma and Anwesha Mallick are Research Associates at the Accountability Initiative.

Also Read: Building the Ayushman Bharat Digital Mission Ecosystem


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