By Hemant Sahai
and Anjan Dasgupta,
Municipal bond issuance by special purpose vehicles (SPVs) promoted jointly by the state governments and urban local bodies (ULBs) can be effectively used to fund the staggering capital requirements for developing smart cities in India (see this column in last month’s issue of India Business Law Journal). While municipal bond issuance is normally a feasible funding alternative for SPVs promoted by large ULBs that are financially robust and have a strong balance sheet, it may not work for others.
Small and medium-sized ULBs face difficulties in raising capital using this method, for reasons such as small issuance size, prohibitive cost of issuance, lack of financial wherewithal and lack of knowledge of financial markets and the process of raising private capital. Under these circumstances bond banks or pooled financing facilities offer a mechanism for small and medium-sized ULBs to finance smart cities or other infrastructure projects through bond issuances on a sustainable basis.
A number of countries have used pooled financing structures to accelerate investments in infrastracture projects. In the US, some states have created state-level pooled financing structures or bond banks to support borrowing by smaller municipalities, which would find it difficult to access capital markets directly.
A bond bank is essentially a state-sponsored intermediary which provides local governments with access to capital markets through debt issuance. The bond bank then lends capital to participating local governments by either providing them with direct loans or purchasing their bonds. By virtue of pooling debt in this manner, high credit ratings, larger issue sizes and wider investor coverage have been achieved.
India’s Ministry of Urban Development has approved a scheme for a Pooled Finance Development Fund (PFDF) where a State Pooled Finance Entity (SPFE) is set up by a state government in accordance with the guidelines for the PFDF. The object of the PFDF scheme is to provide credit enhancement to ULBs to access market borrowings based on their creditworthiness through state-level pooled finance mechanisms. To implement the pooled finance mechanism, a state would need to set up an SPFE either in the form of a trust under the Indian Trusts Act, 1882, managed by trustees, or an SPV as a limited liability company under the Companies Act, 2013.
The SPFE would act as an intermediary and provide technical assistance to ULBs in identifying projects for such pooling of funds, undertake bond issuance-related formalities and other related functions. The funds raised by the bond issuance would either be used to purchase further bonds or be disbursed as sub-loans to the participating ULBs.
Each ULB would have an escrow on its current account through which tax collections and other forms of revenue would be routed. A debt service repayment plan would be established upfront and replenished annually, if required by the state government. Additional credit enhancements could be provided by the potential investors, including the state government, the PFDF and donors, which would vary from state to state and would be different for different bonds. The SPFE would then be assigned to access capital markets on behalf of ULBs, manage disbursal and repayment of bonds and increase the size of the debt service reserve fund. The central government has provided an exemption in respect of interest on issuance of such bonds by an SPFE under the Income Tax Act, 1961.
Pooled finance models were adopted earlier in the states of Tamil Nadu and Karnataka. In 2003, the Tamil Nadu Urban Development Fund issued a bond by pooling 14 municipalities for a water and sewerage infrastructure project. In this case, a debt fund named the Water and Sanitation Pooled Fund (in the form of an SPV) was set up to issue municipal bonds enabling the ULBs to participate in the capital markets and channel the private financial resources into infrastructure investments. The proceeds financed small water sanitation projects in 14 municipalities and helped ULBs to connect the outer areas of the state to new water supply schemes and to provide underground drainage and solid waste management. This was the first municipal pooled bond issuance in India.
Subsequently, the government of Karnataka used the concept of pooled finance to raise debt from investors for the Greater Bangalore Water Supply and Sewerage Project. In this case, a debt fund (in the form of a trust) named the Karnataka Water and Sanitation Pooled Fund was set up to act as an intermediary between the local municipalities and capital markets and was used to issue bonds on behalf of the participating ULBs.
Though these pooled finance models have not been widely used by ULBs in India, the success of these issuances could be replicated to enable smart city investments in India. HSA continues to advise diverse stakeholders on legal and structural issues in the development of diverse and innovative models for financing infrastructure development.