CREDIT EVALAUATION AND RATING OF URBAN LOCAL BODIES ( ULBs) AND IMPLICATIONS FOR THE URBAN REFORM AGENDA A PRESENTATION BY: SUJATHA SRIKUMAR SENIOR VICE PRESIDENT IL&FS

ABOUT IL&FS Incorporated in 1987 with primary objectives of –Commercialisation of infrastructure projects in India, and –Offering comprehensive range of financial services to the infrastructure sector Shareholders include : –HDFC, CBI, UTI (promoters), SBI –IFC (W), Orix Japan, Govt. of Singapore, Credit Commercial de France Pioneer in infrastructure financing and project development in India –project sponsor, developer, advisor, financier, operator and manager for variety of infrastructure projects

Uniquely positioned to provide end-to-end project development and financing solutions from conceptualization to implementation in urban infrastructure sector Financial advisors and investment bankers to first municipal bond issue - Ahemdabad Municipal Bond Issue Project Developer of first private sector water sector project in the country- New Tirupur Area Development Corporation ABOUT IL&FS

MUNICIPAL BONDS (MBs) Concept of MBs as an additional mechanism for raising resources for urban infrastructure sector first presented at an USAID seminar in 1995 MBs have played a key role in the creation of urban infrastructure assets in United States and Canada Later recommended for Commercialization of Urban Infrastructure in India by the Rakesh Mohan Committee Would open new vistas for attracting private capital to the urban infrastructure sector

WHAT ARE MUNICIPAL BONDS MBs are debt obligations issued by cities, and urban sector related governmental entities to raise money in order to finance urban infrastructure Through MBs, investors lend money to an issuer who promises to pay the investors a specified amount of interest (usually paid semiannually) and return the principal on a specific maturity date

TYPES OF MUNICIPAL BONDS General obligation bonds. Principal and interest are secured by the full faith and credit of the issuer and usually supported by either the issuer's unlimited or limited taxing power. General obligation bonds are also voter-approved. Revenue bonds. Principal and interest are secured by revenues derived from tolls, charges or rents paid by users of the facility built with the proceeds of the bond issue. Public projects financed by revenue bonds include toll roads, bridges, airports, water and sewage treatment facilities, hospitals and housing for the poor.

MUNICIPAL FINANCING IN INDIA Traditionally financed through mix of –budgetary allocations from Municipalitys own revenues –grants from state government –borrowing from insurance companies and specialised national level institutions like HUDCO and state level financial institutions –limited borrowings from banks/FIs Capital Market access yet at a nascent stage – only 4 years since first municipal bond issue Total Value of Municipal Bonds so far - Rs 7.5 bn Strong interest from several municipal bodies to issue similar bonds –a dozen have already accessed capital markets –40 Urban Local Bodies have sought rating Bond Issuance provide alternate sources of Institutional finance not conventionally available to municipalities

MUNICIPAL BOND ISSUANCES THUS FAR

KEY FEATURES OF AMC BOND ISSUANCE First Municipality Bond Issuance in India Issue Size of Rs 1000 mn Rs 750 mn privately placed with 13 banks and institutional investors Balance Rs 250 mn by way of public issue in January 1998 Standalone rating of A+ enhanced to AA(SO) based on Escrow of Octroi collections from 10 identified points (nakas) Credit enhancement (escrow) provided prioritisation of cash flows for payments to bondholders No State / Local Government Guarantee / Support for debt servicing Funds utilised for pre-identified Water Supply and Sewerage Schemes Process took over a year to develop and deliver first time in India

KEY TERMS OF ISSUE Issue Size : Rs 1000 mn Purpose: To part finance Water and Sewerage projects Interest: 14% p.a. (G-Sec yield 13.35%) Tenor: 8 years Redemption: At end of 6, 7 and 8 th years Security: - First mortgage and charge on corporations property subject to minimum 1.25 times cover - Structured Payment Mechanism by way of Escrow Listing: National Stock Exchange Credit Rating: CRISIL AA(SO)

AHMEDABAD MUNICIPAL CORPORATION BOND – 2 ND ISSUE Arranger for AMC City 2002 Tax-free Bonds in March 2002

KEY HIGHLIGHTS Nashik – AA(SO) –Escrow of octroi –Inability to implement security structure led to rating downgrade - subsequently restored Ludhiana – LAA-(SO) –Escrow of non-tax revenues like water charges Hyderabad – AA+ (SO) –Combination of escrow and cash collateral –Replicable model for corporations with substantial revenue surpluses Bangalore - Guaranteed by State Government; Rated A+(SO) –Non-utilisation of proceeds resulted in negative carry on bond interest Madurai – LA+(SO) credit enhancement by GoTNs guarantee –Escrow of Toll collections on Madurai Inner Ring Road Nagpur – LAA-(SO) –Escrow of property tax and water charges

MUNICIPAL BOND ISSUES - KEY LEARNINGS SO FAR Implementation of commercial accounting framework Institutional preparedness to identify, implement and profitability operate projects and schemes Important to position municipality on stand alone basis without state government cover Development of appropriate payment security mechanisms to raise investor confidence and rating Stagger resource raising to align with projected spend profile and in present context also take advantage of softening interest regime

WHAT IS CREDIT RATING? Rating agencys opinion on relative degree of safety regarding debt obligations being met on time u Its an opinion not a recommendation u Relative degree of safety vis-a-vis other debt instruments u Timeliness in meeting debt obligation u Instrument specific - could be different for a structured instrument and stand-alone u Assigned by a committee of experts in finance, management & economics, after a detailed and in- depth discussion

CREDIT RATING - WHY? u Independent & unbiased evaluation of credit quality u Increased accessibility to funds from the capital markets for infrastructure projects -Helps the investors in pricing the debt offer u Increased marketability of debt issues by municipal entities u Improved visibility - facilitate flow of international capital u Indicative of transparency

CREDIT RATING - WHY? u Benchmarking with other municipal entities and corporate entities - highlights strengths and weaknesses u Use of market borrowings to bridge demand-supply gap in critical infrastructure can accelerate economic growth in the municipal area u Municipal corporations like Ahmedabad, Bangalore & Nasik have used market borrowings to fund capital expenditure u Helps in monitoring overall debt level & finances

RATING METHODOLOGY FOR MUNICIPAL BONDS CRISILs Rating Methodology involves an in-depth assessment of the following factors Legal and administrative framework Economic base of the service area Municipal finances Existing operations of the municipal body Managerial assessment Project specific issues Credit enhancement structure

LEGAL AND ADMINISTRATIVE FRAMEWORK u Municipal functional domain as defined by the relevant act u Decision making process u State government transfers u Tax rates & basis of assessment u Borrowing powers & ability to pledge revenues u State government & municipal linkages

ECONOMIC BASE OF THE SERVICE AREA u Population base and growth rate u Level of industrial and commercial activity u Diversity and elasticity of tax base u Per capita income levels u Prospects for widening of tax base

MUNICIPAL FINANCES u Accounting quality u Overall surplus/deficit on revenue account u Profile and trends in tax and non tax revenues u Property tax effort: Demand raised, rates, systems, coll. eff. u Dependence on SG transfers: Stability & transparency u Expenditure profile: Head wise & activity wise u Capital receipts and expenditures - Trends u Debt profile: Cost, tenure, coverage u Future sources of revenue growth u Measures to curtail revenue expenditure

EXISTING OPERATIONS u Range of services: obligatory/discretionary functions. u Core services: Water, sewerage facilities, primary education & health, etc. u Systems in place for delivery of these services u Level and trend of past expenditure on these services. u Proposed level of service enhancement u Major projects undertaken

MANAGERIAL ASSESSMENT Linkage between financial health & initiatives taken by a proactive management. u Organizational structure u Administrative systems and procedures u Project management skills u Level of control on expenditure u Initiatives taken to enhance resources and improve collection mechanisms

PROJECT DETAILS u Proposed projects u Project tenure and funding patterns u Debt servicing requirements due to new projects u Existing level of service & improvements envisaged

CREDIT ENHANCEMENT STRUCTURE u Escrow of specific tax revenues: -Ensure non co-mingling of cash flows -Level of collateralisation -Reliability of source (e.g. octroi) u SG guarantee -Credit quality of guarantor -Legal validity -Conditional/unconditional -Irrevocability -Trustees powers to invoke guarantee

CARES CRITERIA FOR EVALUATING MUNICIPAL BONDS

Considers the following parameters: Fiscal profile of the bond issuing municipal body Project being financed and its related risk factors Economic Factors Revenue streams for repayment of Bonds Level of local government autonomy Administrative Capability of the officials at the local government level

ICRAS CRITERIA FOR EVALUATING MUNICIPAL BONDS

ICRA looks at the overall profile of the issuer municipality in terms of –Service area and extension –Demographic profile within the municipal limits –Social economic indicators in the district in which the municipality is situated –Detailed financial assessment of the past financial performance

CRITERIA USED BY THE INTERNATIONAL CREDIT RATING AGENCIES

STANDARD AND POORS CREDIT RATING METHODOLOGY The analytical methodology focuses on : –Range of economic system and administrative factors –Budgetary performance and flexibility –Entities own financial position –Evaluates Sovereign related factors and credit profile of local governments

KEY HIGHLIGHTS AND LEARNINGS Few municipal entities with high stand alone credit quality Declining operating surpluses on account of rising revenue expenditures due to 5th pay commission impact Pressing need for creating urban infrastructure assets to improve quality of civic services Administrative reforms are the key to improving overall profile and credit quality of local bodies Credit rating has now become widely accepted as a self evaluation tool and a feedback for reform initiatives undertaken

FINANCIAL BENCHMARKING OF MUNICIPAL ENTITIES

COMPARISON OF REVENUE SOURCES

CAPITAL EXPENDITURE / TOTAL EXPENDITURE COST RECOVERY ON KEY SERVICE

DSCR : Operating surplus / debt service ( int, sink fund)

EMERGING TRENDS IN URBAN SECTOR Urban sector is at the cross roads Availability of resources in the financial sector is not a constraint Channeling these resources to the urban sector is crucial Flow of resources to the urban sector will be facilitated by enhanced perception of credit quality of these entities in the financial markets and well structured projects Few municipal entities with high stand alone credit quality Sharp distinctions in credit quality between octroi and non - octroi levying bodies.

EMERGING TRENDS IN URBAN SECTOR Improving the credit/fiscal profile of Urban Local Bodies in the crux of Urban Sector Reforms –Financially sound entities would be in a position to invest in civic infrastructure –They would also be in a position to attract private sector capital - both through capital markets as well as PSP

LESSONS FROM MUNICIPAL BOND EXPERIENCE Urban local bodies are open to new concepts and ideas Number of Local bodies have attempted to improve their finances and quality of civic services through administrative measures –Ahemdabad, Surat, Ludhiana, Vijaywada, Vizag……… While initiative for these administrative reforms may have come from pro - active CEOs there is a broad based acceptance at both political and employee level of the need to change

LESSONS FROM MUNICIPAL BOND EXPERIENCE Ahemdabad, Surat have had a demonstrative effect on other cities, this competitive spirit needs to be encouraged While actual number of municipal bond issuances have been few, credit rating has now become widely accepted as a self evaluation tool and a feedback for reform initiatives taken Credit rating, fiscal incentives now offered on municipal bonds, Proposed Challenge Fund need to be judiciously used to sustain the momentum of reforms in the urban sector

IMPLICATIONS FOR THE URBAN SECTOR REFORM AGENDA Administrative reforms at the local level need to be pushed to improve financial profile under existing legal framework –Accounting and MIS improvement –Tax assessment and collection processes –Enhancing own revenue base in existing tax structure –Expenditure control, manpower rationalization need to be looked into –Norms for expenditure also need to be evolved, particularly R&M –Commercialization of operations –Professionalism in management

IMPLICATIONS FOR THE URBAN SECTOR REFORM AGENDA Training and technical assistance should focus on the following to maximize the impact of reforms –Project conceptualization and development, financing and management –Financial Accounting and MIS, Computerization –Treasury management –Costing and pricing of services –Public Private Partnerships including familiarity with Bid Evaluation, Bid process management

IMPLICATIONS FOR THE URBAN SECTOR REFORM AGENDA Policy level issues –Is municipal bond driven financing of urban projects more workable than private sector investments in projects at this juncture –Should smaller private sector projects be encouraged first? –Improving creditworthiness hinges on enhancing revenues through property tax reforms, levy of user charges, rationalizing costs, improving MIS and facilitating private investment, wherever feasible

POLICY ISSUES While some municipal entities may be able to achieve an improvement in financial profile, structural changes involving higher levels of government may be necessary in other cases The City Challenge Fund seeks to provide incentives to cities to embank on reforms that will lead to sustainable improvement in financial profile and quality of services delivered to the residents In order to ensure sustainability of municipal finances and service delivery, cities would need to choose a comprehensive and far reaching reform agenda which needs to be developed to meet specific local requirements. Further, local ownership of the same is critical in order to facilitate its implementation

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