Financing Innovations for Urban Renewal

1. Financing Innovations for Urban Renewal Session on Finance Sidharth Sinha Indian Institute of Management, Ahmedabad The views expressed here are those of the presenter and do not necessarily reflect the views or policies of the Asian Development Bank (ADB), or its Board of Directors, or the governments they represent.

2. Financing Urban Infrastructure* • In developing and transition economies, the combined effect of decentralization and urbanization has increased demand on local governments to provide and finance public services. • Against this background, tight fiscal policies have constrained budgetary transfers from central to local governments. • Competing claims for scarce budgetary resources have resulted in large funding gaps for local infrastructure investments. • Private capital will be required if local services are to be brought to minimum standards that support growing urban demand. • Given the largely local currency revenue of local governments it is important to raise local financing for infrastructure. *Source: Local Financing for Sub-Sovereign Infrastructure in Developing Countries: Case Studies of Innovative Domestic Credit Enhancement Entities and Techniques (World Bank, 2005)

3. Access to Credit Markets • The ability to access credit markets is a function of credit-worthiness, which is assessed by prospective creditors on the basis of : • overall quality and efficiency of local (real and financial) asset management; • selection criteria for local public investments, especially the benefits these would yield at the local level; • pricing policies that contribute to the sustainability of service provision; and • laws and regulations regarding such credit-related issues as local asset pledge, bankruptcy and default remedies. • Most urban local bodies do not fulfill these conditions

4. Bond Markets • In the USA, municipal bond markets have been a primary source for local infrastructure finance through • “general obligation” bonds supported by local taxing powers, and • “revenue” bonds secured by the earnings of such projects as water supply and mass transit • Other industrialized countries have relied more on specialized financial intermediaries to provide long-term credit for local governments • In many developing countries it would not yet be feasible for a majority of small and medium-sized local government entities (and even some large ones) to have direct access to long-term credit markets.

5. Bankruptcy Costs and Legal Rights

6. Bankruptcy Costs and Legal Rights • Col 1: The index measures the degree to which collateral and bankruptcy laws facilitate lending. The index ranges from 0 to 10, with higher scores indicating that collateral and bankruptcy laws are better designed to expand access to credit. This is the case when secured creditors are able to seize their collateral when a debtor enters reorganization - that is, there is no “automatic stay” or “asset freeze” imposed by the court; when secured creditors are paid first out of the proceeds from liquidating a bankrupt firm, as opposed to other parties, such as government or workers, and when management does not stay during reorganization, but instead an administrator is responsible for managing the business during reorganization. Source: World Bank/IFC, Doing Business database.

7. Bankruptcy Costs and Legal Rights (continued) • Cols 2 and 3: To measure the differences in contract enforcement, the evolution of a payment dispute is analyzed. In particular, the number of days from the moment the plaintiff files the lawsuit in court until the moment of actual payment, as well as the associated cost in court fees, attorney fees, and payments to accountants and advisors. Source: World Bank/IFC, Doing Business database.

8. Bankruptcy Costs and Legal Rights (continued) • Cols 4 and 5: The examination of bankruptcy covers the whole process leading up to filing for bankruptcy proceedings, including the petition hearing, the court’s decision, and the sale of assets. The time measure captures the average time to complete the bankruptcy procedure, including delays due to legal derailment. The cost measure includes court costs as well as fees of insolvency lawyers and accountants, as a percentage of the estate value of the bankrupt business. Source: World Bank/IFC, Doing Business database.

9. Investor Protection

10. Investor Protection • The original source of the Rule of Law data is the International Country Risk Guide by the PRS Group. It is composed of two measures: the “law” subcomponent assesses the strength and impartiality of the legal system and the “order” subcomponent assesses popular observance of the law. Thus, a country can enjoy a high rating in terms of its judicial system, but a low rating if it suffers from a very high crime rate or if the law is routinely ignored without effective sanctions (for example, during widespread illegal strikes). Sources: Yale University, International Institute for Corporate Governance; & staff estimates.

11. Financial Intermediaries • One way to foster market access and help increase the flows of private funding for local governments could be through specialized commercially viable, well capitalized financial intermediaries • They could provide credit enhancements through guarantees, pooling etc. for urban entities to access capital markets • LGUCG, Philippines • FINDETER, Colombia • They could independently mobilize long-term debt on private markets for on-lending for priority local infrastructure investments. • Urban Development Funds

12. Credit Enhancement Mechanisms • Comprehensive guarantees • Covers principal and interest payments regardless of the cause of debt service default • Local Government Unit Credit Guarantee Corporation (LGUCGC), Philippines • Partial guarantees • Partial credit guarantees • Covers a portion of debt service payments, regardless of the cause of default. • Partial Risk Guarantees • Sharing of borrower default risk is based on the cause of such default e.g. political risk

13. Credit Enhancement Mechanisms (continued) • Debt subordination • Subordinated lender acts as the credit enhancer, taking a junior lien against senior lenders. • Subordinations enhances the corporate reserves backing the senior lender • Liquidity provision and secondary market support • Take out financing • Commitment to take over loans after a specified period • Addresses problem of maturity mismatches for the lender • FINDETER Colombia

14. Credit Enhancement Mechanisms (continued) • Risk pooling • Pooling of small credits into a larger, more efficient grouping • Economies of scale and reduction of transaction costs • Risk reduction through portfolio diversification • Bond banks, Urban development funds

15. Financiera de Desarrollo Territorial(FINDETER), Colombia • Findeter is a legally independent, quasi-public financial institution, established in 1989. Its predecessor was the urban development fund within the National Mortgage Bank. • Its shares are held by the Ministry of Finance (91.5%) and regional governments (8.5%). (1998) • It does not lend directly to municipal borrowers, but operates through the banking sector as a "second-tier" lender.

16. FINDETER (continued) • A bank that makes a long-term loan to a subnational agency can borrow from Findeter up to 85 percent of the loan value with the same maturity (up to 12 years, with up to 3 years of grace). • Commercial banks liable to pay in case of municipality default • Municipal revenues pledged as guarantees and • lower limits on debt service coverage ratios

17. FINDETER (continued)

18. FINDETER - Activities • 70% of loans have tenors more than 8 years • By 2000 FINDETER had financed up to two-thirds of Colombia’s 1000 municipalities • Concentrating on small and medium municipalities • Water, sanitation and roads accounted for 75% of lending • Technical assistance including business plans, financial forecasts, loan application requirements, contracting and procurement

19. FINDETER - Approval Process 1 • Normal process • Borrower applies to a commercial bank (first tier lender). • FINDETER appraises the proposal in parallel and authorizes the bank to make a loan. • Bank makes the loan and receives a loan of matching amount from FINDETER at a discounted rate. • Borrower makes repayments to the bank. • Bank is responsible for servicing the FINDETER loan even if the borrower defaults. • Average wait time 18 months reduced to 6-8 months in recent years.

20. FINDETER - Approval Process 2 • Streamlined process (Loans < $2.6 million) • FINDETER provides banks with guidelines. • Tier one bank confirms that candidates meet FINDETER guidelines. • Rediscounting is authorized “automatically” with no ex ante review. • FINDETER conducts an ex post review. • In 2003, 67% of loans rediscounted were in this category.

21. FINDETER - Risk Management • FINDETER’s credit risk exposure is based on credit risk of banks whose loans it acquires. • Criteria to be satisfied by banks for lending by FINDETER • habitually receive and invest voluntary savings from the public; • are supervised by, and are in good standing with, the Banking Superintendency; and • have been appraised by FINDETER as being creditworthy, able to assess sub-sovereign credit risk and having appropriate financial controls, especially with regard to portfolio performance • So far only two participating banks have gone bankrupt.

22. FINDETER - Voluntary Intercept Provision by Municipalities • A municipality “voluntarily” sets up a special account into which intergovernmental revenue-sharing payments flow. • The first-tier lender has a senior lien on the intercepted revenues as long as municipal loan payments are due. • The bank in turn endorses these liens to FINDETER. • Thus, even if a participating bank becomes insolvent, FINDETER could still collect its dues directly from that bank’s municipal borrowers.

23. FINDETER - Funding • AAA (Local) Rating [Duff & Phelps] • FINDETER traditionally has attracted support from international FIs (IFIs). • To date, FINDETER has not succeeded in markedly expanding (or recently has not needed to expand) its capital base through domestic capital markets. • Domestic long-term borrowing was not a source of funds in 2003. • The main contribution of FINDETER is to provide banks with a long term source of funding to enable them to give long term loans to municipalities.

24. Local Government Unit Guarantee Corporation (LGUGC), Philippines • LGUGC was formed as a financial services corporation under the incorporation laws of the Philippines. • A separate trust document specifically gives guaranteed bondholders a beneficial interest in the corporation’s reserves and placed these reserves under the control of a trustee bank (the DBP). • LGUGC ownership • 16 private member banks (represented by the Bankers Association of the Philippines [BAP]) own 49% of equity • Singapore-based Asia Credit Services, Ltd. 2% • DBP owns a minority of 49%

25. LGUGC (continued) • The LGUGC guarantee is a “straight” insurance of the periodic debt service payments (both principal and interest payments) of the borrower. • The guarantee is irrevocable and immediately payable in the event of a notice of default on payment by a bondholder. • Upon guarantee call and payment, the bondholder’s rights in the guarantee transaction are transferred to LGUGC, which then steps in to enforce the bondholders’ claims against the security provided by the borrower. • Thus far, there have been no defaults of LGUGC guaranteed bonds.

26. LGUGC (continued)

27. LGUGC (continued) • LGU Issuer gets bond guarantee from LGUGC if it qualifies. • LGUGC steps in to continue paying debt service to investors if the LGU fails to pay debt service. • Guarantee policy requires GFI (government financial institution) trustee to intercept payments (IRA and other pledged revenues) and pay to LGUGC. • Donor may provide equity to LGUGC, reserves and/or a stand-by loan agreement if it has liquidity problems in meeting payments.

28. LGUGC (continued) • Security • All LGUGC guarantee policies to date have involved the assignment of the project revenues, project assets and the right to intercept the Internal revenue Allotment (IRA) payments. • Guarantee Fee • set according to the risk characteristics of the LGU and the project that is the subject of bond issue. • may range from 0.50% to 1.25% per annum of the face amount of outstanding principal • payable up front at the time of bond issuance calculated on the basis of the net present value of the annual premiums • In 2000, it entered into a co-guarantee (reinsurance) agreement with USAID, which backstops 30% of LGUGC guarantees issued for qualifying projects.

29. LGUGC - Risk Management • LGUGC has an internal credit rating system with two components: • An initial screening process used primarily for marketing purposes to identify LGU issuers that might qualify for insurance. Approximately 1,500 governments are in the file as of 2002. • Upon application for an insurance policy, a second, more intensive examination considers the LGU issuer in the context of the specific proposed debt transaction. • The rating technique’s numeric scoring is combined with a review by a rating committee to arrive at a final rating in order to qualify for insurance.

30. Contribution of LGUGC • Private sector investors have no experience with LGUs and have little, if any, access to information about the underlying credits (or ability to analyze the data) • LGUGC provides information through the rating process • The LGUGC will undertake the difficult jobs of exercising the intercept and dealing with the LGUs, a contract enforcement role that private investors (including PFIs) do not relish from a public relations standpoint.

31. Tamil Nadu Urban Development Fund(TNUDF), India • In 1988 the Government of Tamil Nadu (GoTN) launched the Tamil Nadu Urban Development Project, and established the Municipal Urban Development Fund (MUDF) to provide municipalities, also referred to as Urban Local Bodies with subsidized loans, combined with grants. • In November 1996, MUDF was converted into an autonomous financial intermediary - the Tamil Nadu Urban Development Fund (TNUDF) - and began lending operations in March 1997. • In contrast with the MUDF, the TNUDF is located outside the government. It was established as a trust fund with private equity participation.

32. TNUDF - Administration • TNUDF is administered by a board of trustees, nominated by the government and participating financial institutions. • The fund is managed by Tamil Nadu Urban Infrastructure Financial Services, Ltd. (TNUIFSL), an asset management company. • This company is a joint venture between the government, with an equity stake of 49%, and three financial institutions with a collective stake of 51%. • The aim of this structure is to facilitate a private sector orientation in investment decisions.

33. TNUDF - Objectives • The restructured fund has four objectives: • To finance urban infrastructure projects that improve living standards; • To facilitate private participation in infrastructure through public-private partnerships and joint ventures; • To provide grants to finance poverty alleviation projects; and • To improve the financial management of Urban Local Bodies (ULBs) so as to enable them to access capital markets.

34. TNUDF - Financing Packages • Financing packages depend on the economic characteristics of the investment in question - • For projects such as toll roads and bridges, the fund prefers to rely on project cash flows to service debt. • Other projects, such as internal roads, must rely on general revenues. • Basic environmental infrastructure may require a mix of debt and grant financing.

35. TNUDF - Risk Management • Eligibility criteria • ULBs, need to keep their total annual debt service payments at less than 30 percent of total revenues, • All of the loans are protected by offset agreements, under which TNUDF can tap the state governments grant fund to cover shortfalls (up to a certain limit) in loan repayments. • The state government in turn deducts the shortfall in repayments from the transfers of shared sales tax receipts it makes to the ULBs.

36. TNUDF - Resource Raising • US$60 million of World Bank financing catalyzed urban infrastructure investments of US$ 128 million. • Mobilized US$28 million of private co-financing for infrastructure. • Raised US$25 million through issuance of non-guaranteed bonds in the domestic markets.

37. TNUDF - Resource Raising (continued) • TNUDF has pioneered: • the first revenue bond in India for Madurai ring road (US$6 million); • the first pooled finance initiative in India with USAID (US$6.3 million); • PSP in municipal solid waste management; and • BOTs for toll bridge and underground sewerage. • TNUDF has encouraged better cost recovery in water by requiring tariff increases before approving loans to ensure sustainability of projects.

38. Madurai Bypass Road • First toll road in Tamil Nadu State • TNUDF provided loan to Madurai City Corporation • After the project construction and materialization of toll revenues, Madurai Corporation issued 15 year bonds. • The bond was less risky because the construction risk was no longer relevant. • The project has also demonstrated a history of toll collection • Bond was used to replace the loan from TNUDF for the project. • Madurai could reduce loan costs • TNUDF could re-deploy the resources for other projects

39. Pooled Financing Mechanism • In August 2002, the Water and Sanitation Pooled Fund (WSPF) was incorporated as a trust. • The WSPF’s first bond issuance through private placement provided for the refinancing of outstanding loans previously made to 12 ULBs for small water and sanitation projects and one ULB for underground drainage. • These projects were all previously completed, with tariff mechanisms in place.

40. Pooled Financing Mechanism (continued) • Bond Subscribers to the private placement included banks (Rs 302.5 million) and the Provident Fund Trust (Rs 1.6 million). • The bond is to be repaid through project revenues, such as from water tariffs and interest on the deposit of connection fees from the participating ULBs. These repayment monies go into an escrow account of WSPF.

41. Managed by Asset Management Company Fund from bond issue Private Placement Bondholders Water and Sanitation Pooled Fund Trust Debt service payments Loan Urban Local Bodies Debt service payments ULB Cash Flows Escrow Account Bond Service Fund USAID Guarantee

42. Pooled Financing Mechanism (continued) • This issuance also included several additional levels of credit enhancement, as follows: • First level: The escrow of the bank accounts of the participating ULBs where their property tax and other collections are deposited. In case project revenue payments are insufficient, the WSPF may withdraw funds from these accounts. • Second level: A debt service reserve fund to be set up by the state govt. This will have liquid investments of an amount equal to about one-and-a half times annual debt service.

43. Pooled Financing Mechanism (continued) • Third level: A partial credit guarantee provided by USAID via its Development Credit Authority (DCA), covering 50 percent of the principal. This would replenish the debt service reserve fund as needed. If this guarantee were to become exhausted, the state government has ordered that the reserve Fund would be replenished by deducting that ULB’s respective share of the revenue transfer.

44. Pooled Financing Mechanism – Assistance to ULBs • Successfully collaborated with all the ULBs in introducing: • accounting reforms such as double entry accrual based system of accounting, • e-governance systems for effective tax administration, registration for births and deaths, solid waste management, complaint registration and redress etc. • Assisted the larger ULBs to prepare city corporate plans. • Organised training programmes for elected and official level functionaries in urban financing, project preparation and execution, receipt and expenditure management etc.

45. Design of Fund Ownership • The design of the Fund ownership provides for participation by private sector financial institutions. • This was expected to provide the necessary edge for • raising funding for projects by accessing the debt market, • introducing professional outlook in appraisal of projects and ensuring sustainability of the project financing structure.

46. Results of the Fund Operation • It has resulted in an arms length relationship between the government and the local bodies. • Proper governance systems were put in place in ULBs. • It has established an alternative funding mechanism apart from state budget grants for urban projects. • Concept of self-sustainability in project financing has gained acceptance among all the user agencies. • Tolls and user charges were introduced.

47. Results of the Fund Operation (continued) • Upfront user contribution (varying between 10% to 30%) for project equity was used in some projects. • This experiment has also enhanced the confidence levels in the urban local bodies to access debt markets on their own or in association with other local bodies as a pool finance arrangement.