Municipal Funding Challenges: A Case study of Ahmedabad

A Case from the South: Ahmedabad, India

One of the most central problems faced by municipalities in the fight against poverty is the lack of financial resources to enact programme that will have a real impact on the living standards of the poor. The city of Ahmedabad has developed innovative methods of obtaining additional financial resources by issuing municipal bonds and by borrowing from the international credit market.

With a population of approximately 5 million people, Ahmedabad is the seventh largest city in India. In 1986 the city borders were extended by almost 100% to include many of the surrounding slums, where the infrastructure was inadequate and the available services insufficient. While in the old part of the city water and sewerage services reached the entire population, in the new areas only a few pockets had access to drinkable water or adequate sewerage system. The municipality therefore decided in 1998 to embark upon a programme for the expansion of these services to include the poorest areas of the city.

Funding the project

Given the scale of the proposed project and the amount of investment it would require, the municipality of Ahmedabad had to find additional sources of funding to complement its regular budget. Two possibilities emerged after consultation with the United States Agency for International Development (USAID) Indian Bureau. These were:

  • to issue municipal bonds in order to borrow from the local credit market
  • to borrow from the US lending market with a guarantee from the US government

Municipal Funding Challenges

Municipal bonds

Municipal bonds are a useful way for local governments to raise money by borrowing from the credit market, as long as they are able to foresee a credible means of repayment. Private investors lend money to the municipality for a fixed period of time and at a predetermined interest rate. In most cases, the municipality issues bonds independent of the national government and without a State guarantee.

Although municipal bonds do not have a longstanding precedent in developing countries, Northern municipalities have employed them for years. In the United States, for example, municipal
bonds have been used for over sixty years. As of 1998, 50,000 of the 83,000 US municipalities had used such bonds to generate funding for an entire range of activities and projects. In Ahmedabad, the money was borrowed mainly from the local market for a period of seven years, and was designated specifically for the expansion of the water and sewerage systems.

The First Step: Gaining Trust

The first step to attracting private capital via municipal bonds is to gain the trust of investors. Investors need to be assured that their investments are sound, profitable and can be recovered. The municipality’s first task is therefore to prove its creditworthiness and to build its reputation as a reliable borrower.

In this respect, the most important measures taken by the municipality of Ahmedabad were a series of reforms that reduced the city’s budget deficit. While in 1993 the city owed US $14 million in outstanding debt, by 1998 it had boasted four consecutive years of budget surplus. These results were achieved by:

  1. Improving tax collection. An impartial, efficient and aggressive tax policy proved able to double tax revenue.
  2. Making the government more open and transparent. The move towards more transparent government reduced the level of corruption and waste in the administration of public funds.
  3. Appointing a number of well-trained professionals to increase the technical capacity of the municipal government. To realise this goal, the municipality hired 30 recent management graduates at competitive salaries, who helped to computerise and standardise the collection of property taxes and octroi – duty imposed on incoming goods – while also reducing clientelism and favouritism, thereby helping to realise points (a) and (b).

This was not an easy task for Ahmedabad because no other South Asian municipality had ever issued municipal bonds, and the city, therefore, had no foundation upon which to build. Eventually, however, Ahmedabad was able to establish credibility through being rated by a credit rating agency. A credit rating agency is an independent institution that assesses the ability of a given debtor (company, country, municipality, etc.) to service its debts, in light of its available resources, history and potential for future success. The higher a municipality is ranked, the more easily it can attract investment, and at a lower interest rate.

Ahmedabad worked extensively with Credit Rating Information Services of India, Ltd. (CRISIL), India’s largest credit rating agency, to come up with a ranking for the municipality. Officials from CRISIL spent four months in Ahmedabad while trying to assess its financial circumstances. The city was ultimately rated highly, even ranking above the state of Gujarat, in which it is located. The protocol finally developed to evaluate Ahmedabad has subsequently been used to rate other Indian municipalities, including Bangalore and Hyderabad.

Second step: Issuing the bonds

The city of Ahmedabad issued the bonds on the 16th of January 1998 and raised Rs. 1050 Million (equivalent to US$ 20.5 million). Approximately 75% of the money raised came from the Indian general public, while the remaining quarter came from institutional investors (banks, funds, etc.). The amount raised covered 20% of the overall costs of the water and sewerage expansion programmes. It would have been significantly more difficult to obtain this funding, however, had the city not been rated so highly by CRISIL.

Third Step: Debt Repayment

The Municipal Corporation has committed itself to begin repayment five years after the date at which the money was borrowed. In the meantime, investors receive biannual interest payments. Financing for repayment of the principle debt plus interest comes from two different sources.

First, it obtains from the user fees charged for the expanded water and sewerage systems. Second, the government has set aside a portion of the revenues obtained from commercial taxes levied on goods that enter the city. The money raised from the commercial tax has been earmarked for servicing the Bond and is kept in a special account. Each year the funding generated by these two sources is saved so as to eventually accumulate sufficient revenues to repay the debt.

In this respect, transparency and the existence of an accurate and credible accounting system are essential in order to guarantee repayment.

2) Borrowing from international credit markets

The city of Ahmedabad has also developed a close partnership with USAID in order to borrow from the international credit market. A fifth of the funds needed to pay for the water and sewerage projects were derived from loans obtained in the United States. These loans were disbursed under a joint program of USAID and India’s premiere investment and construction agency, the Housing and Urban Development Corporation (HUDCO).

USAID guaranteed US $10 million in loans that HUDCO borrowed from US capital markets, as part of a wider USAID project referred to as FIRE (Financial Institutions Reform and Expansion). HUDCO borrowed the money by issuing promissory notes – written agreements to reimburse a loan plus all interest accumulated, by a specific date – to US financial institutions, which carried a USAID guarantee. For HUDCO, one of the most attractive features of borrowing through USAID is that the loans are to be repaid in thirty years time and there is a ten-year moratorium on the payment of interests.

The Results

The expansion of the water and sewerage systems began in 1999, and by 2000 almost 50% of the work was complete. Both projects were designed and executed with management assistance and technical support from USAID. The combined projects are projected to service a population of 3.5 million residents, 1 million of whom are classified as “slum-dwellers”.

The funding generated by issuing municipal bonds and borrowing from the US credit market clearly accelerated the implementation of these projects. The creation of Ahmedabad municipal bonds also helped foster pride and civic awareness among the city’s residents. Municipal bonds are currently being employed in a number of developing cities in Asia and Latin America.

Recommendations for the implementation of municipal bonds:

  1. Keep the budget under control: Municipal bonds require the existence of an accountable, transparent, and financially sound local government. These qualities are essential if the project is to represent more than a mere additional burden on the financial resources of the local government. In cities that consistently experience budget deficits, the decision to issue municipal bonds must be preceded by a profound reorganisation of city finances. This is important for both establishing credibility and ensuring ability to repay the debt.
  2. Implement the project quickly: Speed in project implementation is essential for a variety of reasons. First, if repayment is to be financed through user fees, the project must be finished as soon as possible so as to begin to generate the revenue needed to meet repayment deadlines. Second, project completion will prove to private investors that money is being appropriated efficiently and will thus make it easier to borrow again in the future.
  3. Invest in revenue-generating activities: The loans obtained on both local and international markets do not necessarily have to be spent on anti-poverty policies in order to have an impact on poverty alleviation. They may in fact be spent on activities that are more likely to raise the revenue needed to pay back the debt. This extra revenue liberates part of the regular budget that can in turn be used to finance other poverty-fighting measures. Regardless, outstanding debt and late interest payments have an adverse effect on poverty, so punctual reimbursement of all borrowed funds is an effective means of combating poverty.
  4. Create an adequate legal and institutional framework
    • In order to issue municipal bonds, a municipality must have the legal ability to borrow directly from the credit market. The procedure becomes extremely complicated in countries where local governments cannot take such fiscal measures independently from the national government.
    • Credit markets require adequate legal and regulatory frameworks that cover all stages of the process: debt issuance, settlement and repayment. A framework is necessary to establish clearly both creditors’ and debtors’ rights and responsibilities.