DUAL-RATED BONDS: MARKETS WITH A CONSCIENCE?

DUAL-RATED BONDS: MARKETS WITH A CONSCIENCE? 

Estimates for building out the much-needed urban infrastructure in our cities - municipal roads, waste management, water and sanitation systems, basic services to .the urban poor, etc. - are a whopping Rs.28,000 crores p.a. over the next 10 years.  

With cities taking increasing responsibilities for public services, they are also being tested on their financial resources. Unfortunately, India’s public finances are top-heavy. Of the total public expenditure across union, state and local governments, less than 2% is spent at the municipal level. This is in contrast to that of many other countries where the comparable figures are often ten to twenty times higher. State Financial Commissions (SFCs) were meant to bring balance to this fiscal skew, by ensuring that more funds were devolved to local governments. Unfortunately, SFCs are new structures with most states showing minimal political appetite for them.

As for their own sources, urban governments are not able to generate optimal resources from property taxes, user charges and so on. This inability is partly due to overbearing state governments that have not allowed urban bodies sufficient elbow room, and partly due to weak internal systems that result in poor compliance.  

Hence our cities and towns have to find other resources for the urgent capital investments they need to make, while they go about addressing these structural issues. It is here that they will have to look to the financial markets for support. Across the world, market-based funding of public infrastructure is substantial. In the United States, for example, the municipal bond market was estimated at $1.2 trillion in the mid-90s, while municipal credit markets across other parts of the world are growing. There are some positive arguments for market-based public infrastructure funding – the focus in demanding project viability and the discipline in ensuring recovery are two that are immediately apparent.  

However, there are also drawbacks in accessing public capital– specifically in the human and environmental price that many projects extract. Community groups and civil society institutions express real concerns about this aspect of the financial markets, often manifested through commercial banks or agencies like the World Bank, ADB etc. These institutions negotiate terms and conditions with state and local governments, but are removed from the ground realities of the people who are faced with the consequences of these contracts. While this criticism could sometimes be harsh and extreme, there is no denying the element of truth in it - that in the final analysis, bankers care primarily about the cash flows of their projects, often giving short shrift to components for public participation and environmental impact in the projects. Given the incentive structures in all financial institutions - be commercial banks or multilateral agencies - it is hard to see how this can change.  

To an extent, the financial markets have themselves recognised this gap. A few years ago, a cross-section of global financial institutions agreed upon a declaration called the “Equator Principles” for project financing. These were essentially a set of guidelines - standards in environmental and social impact - to be adopted by each participating institution on a self-regulated basis. While the Equator Principles are a good beginning, they fall far short of what is necessary to move the markets much closer to the grassroots.

We are left therefore with the question, “Is it possible to harness the power of the markets and yet infuse a human dimension into the process?” This is not a trivial problem. Indeed, given the context of India's growing urbanisation and urgent financial needs, this is a very real problem. 

One possible solution could be the concept of a Dual-rated Municipal Bond. In the current system, bonds have a rating based on a thorough financial review - project structure, cash flows and so on. However, the same intense scrutiny is rarely conducted on the social dimension of the project. Imagine instead if municipal bonds came with a dual rating – a financial rating, as well as a social rating. Imagine, for example, a municipal bond with a rating of AAA-(5), the ‘AAA’ indicating that the project had strong financial fundamentals, and the ‘(5)’ indicating that the project had the highest social rating as well. This social rating could be composed of a set of indicators that evaluated a number of social factors - the level of public participation, degree of universal benefit, environmental impact etc. A social rating of ‘5’ could indicate that the project was conceived by the people with complete participation in determining all aspects of the project, that the project has as its beneficiaries a substantial portion of the poor living in the affected area of the project, and so on; lower ratings would not necessarily mean that such projects would not to be taken up, but the gaps on the social rating front would be well understood by all.  

Introducing a dual-rating system for public projects could have a transformative effect on public finance. In the same way that firms have investment policies not to invest in anything less than investment-grade instruments, decisions on minimum social ratings could also evolve, making these a part of the idiom of financial markets. This would also address the incentive systems within financial institutions: market players would be happy to apply universally-accepted standards in their work. Dual-rated bonds could deliver the power of the markets, harnessed by the conscience of public engagement. 

As Indian cities face the urgent need to build infrastructure, they are likely to turn to the financial markets. How the projects are chosen, and whether these have genuine value to the affected people are questions that need addressing, especially given the corruption, opacity and lack of participation in public decision-making that is prevalent today. Dual-rated Municipal Bonds could go a long way in allaying public concerns, and increasing public support for urban infrastructure built with market funding.
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The author is founder of Janaagraha. He can be reached at ramesh@janaagraha.org