Creating financially sustainable cities in India

The HPEC Report on Indian Urban Infrastructure and Services (2011) estimates that India will need urban infrastructure investment amounting to Rs 39.2 lakh crore in 20 years between 2012 and 2031. Even after taking into account own revenues and inter-governmental transfers, Urban Local Bodies (ULBs) will face a funding deficit of between 0.15 per cent and 0.39 per cent of the Gross Domestic Product (GDP). In this context, ULBs will have to resort to market borrowings (in the form of pooled finance, municipal bonds, and institutional finance); new project execution mechanisms like PPPs; and land-based financing instruments for providing critical urban services in our cities. In the concluding piece of this two-part series, Vaibhav Anand and Vishnu Prasad explore how the Jawaharlal Nehru Urban Renewal Mission-II (JNNURM-II) aims to bridge this deficit by incentivising cities to pursue market-based mechanisms for both the financing and delivery of urban infrastructure and services.

One of the major drawbacks of JNNURM-I was that it failed to incentivise ULBs to leverage funds from non-budgetary resources. For instance, out of the overall sanctioned investment of about Rs 1.15 lakh crore under JNNURM-I, about 53 per cent came in the form of assistance from the Central Government. While this undoubtedly shows that investment in urban infrastructure as a whole has increased, it also reveals the inability of ULBs to attract private investment, utilise land financing, and other innovative financing models. One of the key objectives of JNNURM-II, therefore, is to promote financial sustainability and accountability of ULBs, and to attract more private investments through People Public Private Partnerships (PPPPs). The proposed structure of JNNURM-II looks to achieve this through the following key design and institutional elements:

Capacity building measures: A Mission Directorate for Capacity Building and Reform (CBRM) will be set up at the central level to focus exclusively on strategic capacity building measures through:

• the creation of a dedicated PPPP cell, which will develop model bid documents, and provide management support to ULBs.
• the creation of a cell on municipal finance that will provide ULBs with a framework for leveraging land financing, and structuring other financing models.

Preparation of city level Financial Plans (FPs): JNNURM-I was criticised for its project-centric approach that inhibited ULBs from taking a long-term view of finances. JNNURM-II looks to overcome this challenge by requiring cities to prepare FPs that will project financial inflows and outflows over a 10-year timeframe. The FPs are meant to complement the Development Plans (DPs), which are designed to be holistic plans with individual projects fitted within the overall development plan of the city. FPs will enable the market to better assess the true potential and risk of financing projects planned by cities.

Leveraging funds under JNNURM-II: Unlike JNNURM-I, where the leverage ratio was determined with reference to specific projects, JNNURM-II has proposed to fix the leverage ratio with reference to revenue streams from all other sources including grants from upper tiers of government, municipal borrowings and own revenue. Further, in order to fully exploit the potential of larger cities, the leverage ratio increases in proportion to the size of the city. The Table below summarises the recommended ratio for each city type.

Reform-linked devolution of funds: JNNURM-II proposes to rigorously tie the release of funds to the progress made on urban reforms. For this purpose, a score will be assigned to each mandated reform and funds will be released to only those cities that have attained a benchmark score. According to the proposed design, “mission-cities” of JNNURM-I will need to attain a score of 7.5 on 10 for enhanced funding at the end of the two- year transition period. Additionally, cities and states are rewarded for completion of second generation reforms (like creation of a municipal cadre, amendment of rent control laws, undertaking investments through the PPPP route and leveraging funds through non-budgetary streams) through the Incentive Fund (10 per cent of total funds under JNNURM-II).

Although the proposed design of JNNURM-II seeks to incorporate learnings from the first phase of the mission, we believe that the creation of truly financially sustainable cities in India will depend on the following:

Ensuring sustainable own revenue generation: Municipal revenue constitutes approximately 0.94 per cent of GDP in India. This is well below the benchmarks set by emerging economies like Brazil and South Africa, where corresponding figures are at 5 per cent and 6 per cent respectively. Additionally, the share of own revenue in municipal revenue has been declining over time, from 63.48 per cent in 2002-03 to 54.94 per cent in 2007-08. While transfer of funds from upper tiers of government is essential, it needs to be ensured that local governments are capable of sustainably raising their own revenue by means of taxes and user charges. JNNURM-II requires ULBs to attain 75 per cent efficiency in the collection of property tax, and levy user charges that will cover 100 per cent of Operation and Maintenance (O&M) costs. The transition period between the two phases of JNNURM should be used strategically to unwind the strong moral hazard created by JNNURM-I, which led to the 'crowding out' of non-grant revenue sources. High dependence on inter-governmental transfers could potentially hurt ULBs in the long run as private or commercial debt finance will favour cities which have the inherent ability to repay debt over the long term. Ensuring the robust and sustainable flow of own revenue, thus remains a necessary condition for attracting private financing.

Incentivising cities to compete on service provision: While the prescribed reforms for state governments include the creation of a Municipal Regulator, who will monitor service delivery norms and regulate pricing of services, state governments should also be encouraged by JNNURM-II to incentivise cities to compete on service provision. This is a model that has been effectively used in South Africa, where cities are encouraged to provide higher level services while maintaining fiscal discipline, through an annual benchmarking exercise, where the service provision status of different cities is compared. In South Africa, this has resulted in a situation where cities such as Johannesburg and Durban compete with each other to provide better services. Such measures will help to improve transparency and can be used to selectively guarantee market debt for high performing cities.

Encouraging ULBs to innovate on service delivery: There are several global examples of cities that have used innovative models to ensure effective service delivery. For instance, Johannesburg Water, formed in 2002 as a corporate entity that is wholly owned by the city of Johannesburg, has been able to provide affordable, clean water while remaining a financially sustainable entity. Corporatisation allowed the municipality of Johannesburg to set policy and service standards, and hold the entity accountable for meeting these standards, while simultaneously offering greater autonomy and flexibility to the corporatised entity to introduce commercial management practices. JNNURM-II should use the incentive fund to encourage cities, especially larger ones, to develop such innovative service delivery models. The office of the Mission Directorate for CBRM should be used to provide technical support to such cities and disseminate information regarding observed best practices.

Developing a municipal debt market: There is an urgent need for market makers of the municipal debt market in India. For example, the focus of HUDCO needs to be re-oriented towards its original mandate of financing housing and urban infrastructure. HUDCO should move away from its present role as a subsidised lender to become a market-making institution for municipal debt by providing guarantees, or investing in lower rated tranches of municipal issues so as to enable commercial market investors to participate in low-risk, highly rated municipal investments. This will set the stage for the development of a vibrant municipal bond market in India and offer wider avenues for ULBs to access market-based capital. Initiating a longer term reform agenda: While JNNURM will initiate progress on vital urban reforms, India must also set the agenda for a longer term transformation of municipal financing mechanisms in the country. For example, the HPEC Report recommends that India must create a “municipal finance list” that will specify taxes that can be collected exclusively by local governments. This will ensure that ULBs have the financial autonomy that is commensurate with the functional autonomy entrusted by the 74th Constitutional Amendment Act.

Conclusion

JNNURM-I rightly focused attention on the much needed reforms in urban governance and service delivery in India. Although the first phase of the mission failed to match the high ambitions that it set for itself, one could argue that the lessons from the implementation of JNNURM-I has been critical in driving the urban reform agenda in India forward. JNNURM-II looks to build on the momentum created by JNNURM-I and has proposed to build in a stronger set of incentives for effecting urban reforms. While this is indeed a welcome development, urban policy in India needs to do much more, in terms of creation of missing markets for municipal financing, and development of innovative models for service delivery and financing, to truly unlock the potential of our cities.

References

• Ahluwalia, Isher Judge. Report on Indian Urban Infrastructure and Services. High Powered Expert Committee (HPEC) for estimating the investment requirements for urban infrastructure services. March 2011
• Mohanty, P.K et al. Municipal Finance in India: An Assessment. Development Research Group, Reserve Bank of India. December 2007
• Report of the Thirteenth Finance Commission (2010-2015). Finance Commission, India. December 2009
• Sahasranaman, Anand. Pragmatic Municipal Finance Reform in India: Lessons from Policy in South Africa and Brazil. Environment and Urbanization Asia. Vol. 3 no. 2, pp. 407-422. September 2012
• Ahluwalia, Isher Judge; Kanbur, Ravi and Mohanty, P.K. Urbanisation in India- Challenges, Opportunities and the Way Forward. Sage Publications India. 2014.
• Maira, Arun. Report of the Committee on JNNURM-II: Clean Bastis, safe communities and peopleÆs cities. Planning Commission of India. March 2012.

The authors (L: Anand) are with Chennai-based IFMR Finance Foundation.