As India continues to experience rapid urban expansion, public and private leaders at the national, state and local level are looking at better ways of managing the growing urban agglomerations. Poor infrastructure in urban spaces drives away agglomeration economies and is inimical to the economic growth and productivity.

The Smart Cities mission, launched under Prime Minister Narendra Modi’s leadership in 2015, is an ambitious multi-year effort in this direction. This mission envisages to improve urban infrastructure and build world class living environment in 100 of India’s rapidly expanding cities by improving urban governance and deploying technological solutions.

The central government has pledged Rs 48,000 crore in support of these efforts, spread over five years, with the condition that an equivalent amount of funds have to be collectively raised by the urban local bodies (ULBs), the respective state governments and a consortium of private entities.

The urban development ministry has already selected 33 cities for development and the Union Budget 2016-17 has earmarked Rs 3,205 crore for the same. The improvement of smart cities in India, however, will essentially hinge on the ability of those cities to improve their own revenue, raise local finance and attract greater private investment.

Poor financial record of ULBs

In 1992, the 74th Constitutional Amendment Act paved way for the improvement of institutional capacity of ULBs and opened their routes for raising independent revenue by directly levying taxes, fees and accessing capital market. However, the ULBs in India heavily depend on grants-in-aid, subsidised loans from the state and central governments and support from successive finance commissions, for their financing needs.

Following a variety of reforms in past few decades – including the passage of 74th Constitutional Amendment Act and prior national urbanisation programmes such as the Jawaharlal Nehru National Urban Renewal Mission (JnNURM) – many regions across India have assumed greater control over managing and financing their urban development.

Nevertheless, states and ULBs still widely vary in the amount of control they exercise in these matters and are continually exploring new ways of raising their own resources and meeting their investment requirements. One predominant feature of ULBs in India has been the lacklustre flow of private capital. This feature not only affects the financial kitty of ULBs, but also disincentivises the participatory role of citizens in city improvement.

Tapping private capital

As India’s cities consider more flexible and reliable ways of paying for improvement of smart cities, municipal bonds can serve as a valuable future model for significant source of financial capital and citizen participation.

Currently, India’s municipal bond market is largely untapped, which is highlighted by the fact that so far only a total of Rs 1,353 crore has been raised through the issuance of municipal bonds. Because of severe constraints in both supply and demand, only a limited number of ULBs have the experience of raising funds through municipal bonds.

India’s ability to deepen its municipal bond market and to raise finance for its infrastructure needs several key reforms. The opportunity to expand municipal bond market is extensive in India, but the existing institutional and legal framework limit its potential growth.

As JnNURM data from November 2012 highlights, about half of Indian municipalities carry investment grade ratings. Further, recent central government efforts to urge state governments to notify and convert 3,784 census towns into statutory towns is only expected to raise the potential of the municipal bond market in India.

In principle, these ULBs should raise capital from market and propel their growth engines, but the individual and institutional investors do not find municipal bonds sufficiently rewarding for the associated risk.

The federalist Indian government can learn from the US and its highly advanced municipal bond market. India’s ability to replicate the US general obligation bond model will largely depend on the ensuing capacity of local governments to pay their obligations with a good track record. This will, in turn, necessitate a robust and growing tax base and an expansion of their own revenues.

In addition to general obligation bonds, India should also examine the potential of revenue bonds. Special purpose vehicles (SPVs) are an important consideration in this regard. SPVs will operate independently, and if executed correctly, will control specific revenue streams to serve as collateral for private investment. In US, an enormous range of regional bodies, from the Bay Area Toll Authority to the Port Authority of New York and New Jersey, have issued revenue bonds.

Indian investors are often conservative by nature. Banking data demonstrate that they generally prefer fixed deposits, small saving schemes or gold as instruments for personal savings. Indian consumers, however, have historically shown great faith in financial instruments floated by the Indian government. Bonds issued by municipalities with good financial track records could be a strong alternative investment opportunity. For this to succeed, the credibility of the local government as the institution of governance for local matters will be central in the eyes of investors.

The ability of local individual investors to track projects should also motivate them to contribute to such instruments, which will enhance the citizen’s participation in local institutions. Municipal bonds may also be a good option for private placements with large investors such as provident funds, pension funds and insurance companies. Since these entities can better assess the risks of individual projects and concerned municipalities than individual investors, a deeper municipal bond market will likely raise the competition among ULBs to access capital.

This competition, in turn, should incentivise market discipline for meeting long-term objectives for project delivery and sustainable funding. Not only will municipal bonds serve as a market signal for the performance and capabilities of ULBs to execute and complete projects, but they will also direct more private capital toward better performing ULBs. Many wealthy investors are attracted to municipal bonds because of their tax-free status. However, regulations limit the issuance of tax-free bonds by municipal bodies to a maximum interest rate of 8% per year. Since this ceiling may limit potential investors, we recommend lifting the 8% cap and investigating more flexible regulations.

Indian urban areas can no longer rely solely on public capital flows. Increased private sector engagement via public private partnerships, should be a paramount goal. This requires a more active and coordinated leadership in project management, technical guidance and risk mitigation across different levels of the government. Although SPVs mark a step in the right direction towards clarifying project priorities and establishing a clearer business environment, additional institutional arrangements and incentives will likely be needed. For example, having a more predictable permitting process, a standardised review period and dependable sources of information to track sector-specific projects, could help build more momentum behind these investments.

SPVs should also devise a framework for reduceing the cost of capital and meeting financial obligations more efficiently by addressing the current shortcomings of ULBs as reflected in their municipal credit ratings.

Shamika Ravi is a Fellow of Development Economics at Brookings India and Ankit Bhatia is a Research Assistant at Brookings India.