financing urban infra

7/26/2019 Financing Urban Infra

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Financing urban infrastructure projects

Value capture method

Typically used in land development, Urban Development Authorities across the country raise

considerable revenues from land by selling after minimal or even no development of the land. From

the seller's perspective, this is an inefficient method since the major portion of the value of an

undeveloped land is embedded in the future revenue streams arising from its development. In other

words, the seller exits at the lower end of the value chain.

The developer, in turn garners a windfall after full commercial development of the land. He benefits

from both the land value shooting up and from the incoming revenue streams, whose NPV is in most

cases many times more than the land value itself. The seller of the land (government agency) loses

out from partaking a share in this future revenue streams.

The seller can maximize his returns by an arrangement wherein the land gets leased to the

developer for a fixed period at an annual rental value and a share in the future revenues streams (a

developement premium). Another model is where the developer transfers a portion of the

developed commercial or residential built-up area.

Tax Increment Financing (TIF)

TIF is a mechanism that allows municipalities to earmark the increased tax revenues from property

value growth, due to land re-development or renewal, within a designated area suffering from blight

(a TIF district) in order to finance development in that same area. It dedicates the increased property

tax and other revenues from redevelopment to finance debt issued to pay for the project. It is

therefore a method of using future gains in taxes to finance the current improvements that will

create those gains.

Re-development benefits the municipality by creating more taxable property (and hence tax

revenues) and by increasing the values of land held by it. Vacant land, if any, can in turn be

leveraged to earn more revenues and property tax.

After a municipality designates a TIF, local government units are barred from collecting taxes on the

area’s property value growth. They can tax only the "frozen" property value and properties, as it

stood when the TIF was designated. The tax revenue from growth – the tax increment – accrues

instead to the TIF, to be spent on loan repayment, capital improvements, developer and rent



subsidies, job training, and other expenditures meant to spur new development. The value of this

new development is taxed, the taxes ploughed back into the TIF, and the TIF revenues spent on

creating still more development.

TIF is a popular method of financing investments in poorer areas, since it does not involve any

immediate increase in property taxes and also beacause it mandates the spending of money raised

from the area in that area itself.

Pooled Finance Development

It is an approach under which an appropriate mix of urban infrastructure projects are bundled

together, and the bundle is then posited before the debt MARKET. The projects should be chosen so

as to diversify away and mitigate the individual project risks. This can be achieved by choosing

projects with robust enough cash flows, which imparts an element of credit protection against

revenue shortfall in the other projects.

This method of financing is typically used to leverage investments into smaller municipalities, whose

credit worthiness is often suspect, by mixing them with projects from more credit worthy and larger

municipalities. It can also be used to finance projects with smaller revenue streams, by bundling

them with those having larger revenue streams.

Pooled Finance Development FUNDS (PFDF), set up by governments, can also provide ratings

enhancement facility by functioning as a Credit Rating Enhancement FUND (CREF) and raise the

credit worthiness of the bond offerings (to finance a bundle of projects) to investment grade.

Credit Enhancement Facility

Given the virgin nature of debt market for urban infrastructure, it is natural that lenders have

apprehensions about the riskiness of their investments. In order to facilitate the development of this

market, it may be necessary to increase the credit worthiness of these investments by providing

additional layers of credit protection. Such additional protection would make the project investment

grade, and thereby lower the cost of capital.

Such credit enhancement can be provided directly through a guarantee fund, or by purchasing

guarantees from financing institutions willing to underwrite the risk of a cash-flow shortfall. All this

additional layers of credit protection, over and above the Project cash flows, is meant to mitigate the



risks, lower the cost of capital and thereby encourage the growth of a debt market in urban

infrastructure projects.

Venture financing model

This approach uses a higher equity share to leverage debt at lower cost, on the condition that the

equity holder can progressively withdraw his equity. In other words, the equity is used to "crowd in"

lower cost debt. Under this model, the project commits to achieve certain operational and

commercial benchmarks in its performance, within a specified time schedule, thereby demonstrating

its ability to counter its commercial and operational risks. Once the project stabilizes and the

revenues streams get established, it becomes possible to attract debt at lower cost. The equity

investor can then progressively exit with a handsome return. The equity can then be invested in

newer projects.

This arrangement is similar to the venture financing or angel investing model, in which promising

ideas and projects are financed by providing seed capital. The venture capitalist or angel investor,

exits with a handsome profit once the project becomes established as a success. There can be

institutions that specialize in making such investments.

Impact fee financing Major infrastructure investments results in increased land and rental values in the area. Since the

land owners do not contribute anything to this increase, it is only appropriate that they are priced

for this unearned increment. The gains accruing to the landlord from the positive externality arising

from the investment, is partially internalized by way of an impact fee. This impact fee can be by way

of a higher property tax, a higher building permission fee, or a direct levy.

Tradable infrastructure assets

The infrastructure assets can be created by short term debt or financed by government. An

appropriate pool of such infrastructure assets can then be bundled together, securitized and sold off

as a tradable financial product. Their price and true cost of capital will be determined by the market.

These tradebale assets would be similar to the infrastructure funds that are floated in the debt

market to raise capital for creating specific infrastructure project assets.

The O&M of the assets can then be auctioned off to franchisees by competitive bidding, thereby

helping consumers get the best deal in service pricing.



Viability gap funding or bridge financing

This approach is suitable when an investment is financially unviable, since the investment costs are

too large to be compensated (or repaid) by the relatively smaller revenue streams. In such projects,

the government does the bridge financing required to make the project financially viable, most often

as a grant. This amount can be offset against the subsidy provided by the government, by way of

lower tariffs on water or sewerage systems.

Government guaranteed debt

In major projects, where the SPV accesses the debt market, the cost of capital is invariably higher

than if the debt was raised by the government or any of its agencies. In emerging MARKETS like

urban infrastructure, no private entity, however established and credible, will be able to convince

lenders that it has adequately addressed the issue of construction, commercial and operational risks.

This inability to signal convincingly enough to lenders will translate into higher cost of capital for the

project, thereby saddling the project with often unsustainable debt service burdens, under the

weight of which it fails.

The portion of such government raised debt, can vary depending on the type of project and its

financial viability. This debt can become a junior debt tranche, to senior debt raised in the regular

debt markets.

Land as a source of financing urban infrastructure

At a fundamental level, it can be argued that internal revenue sources are the most critical funding l

available to a municipality because without effective, predictable generation of internal revenues, it

will be impossible to attract new, external sources of funding. External sources, whether in the form

of bank loans, bonds or other capital MARKET instruments, will be available to municipalities only

on the basis of the internal revenues they generate now and are expected to generate in the

future. Additionally, the internal revenue generation of a municipality is but a reflection of the

quality of its governance, and the transparency and accountability of its administration. Any

assessment of the internal financing capability of a municipality is, therefore, a judgment on its

governance standards. A better governed municipality implies better information availability, better

assessment capability and better collection efficiencies that are then reflected in the quantum of

revenues generated through internal funding levers. Therefore, any attempt to substantially



improve the infrastructure provision scenario in India will need to begin by giving a significant

thrust to improving the assessment, enforcement and collection of internal revenue levers.

While the generation of internal revenue is critical for a city, the use of land as a source of financing

urban infrastructure can be a very useful supplementary mechanism. Traditionally, urban

infrastructure has been financed by savings of local government, grants from higher levels of

government and capital borrowings. However, at a time when government budgets are hard pressed

and large-scale borrowings are hard to come by, land-based financing presents an important option

for local infrastructure finance. By leveraging the sensitivity of land values to urban economic growth

and the principle that benefits of infrastructure are capitalized into land values, land-based financing

instruments have come to play a key role in complementing other sources of capital finance.

Land-based financing introduces significant advantages to infrastructure financing decisions,

reducing dependence on debt and its associated fiscal risks. It has the advantage of generating

revenues upfront, sometimes before the infrastructure is undertaken, making it easier to finance

infrastructure projects that call for massive investments. The scale of land-based financing is also

much larger in magnitude when compared to other sources of urban capital finance. Further,

mobilizing finance from land transactions strengthens efficiency of urban land MARKETS and

rationalizes the pattern of urban development by sending out price signals to the market.

While land-based financing holds the potential for closing the infrastructure financing gap and

supporting the sustainable development of cities, its role is restricted as an instrument of capital

finance. It is not a permanent and recurring source of revenue as land sales cannot continue

indefinitely. Thus, revenues from land financing should ideally not be used to finance operating

expenses and must be directed only to the capital budget. Further, we need to keep in mind that the

volatility inherent in land MARKETScould simply reflect an asset bubble and world-wide economic

conditions. Thus, extrapolating past trends to prepare future INVESTMENT plans could be risky. Also,

the magnitude of revenues raised from land financing breeds the risks of favoritism, corruption and

abuse of government power if land-based transactions lack transparency and accountability.

Land financing has been widely used to finance urban transportation projects or the infrastructure

required to service new urban developments. It has been less frequently employed to finance

investment in existing basic infrastructure services such as repair or upgrading of water supply,

waste-water collection, or solid waste removal. The fact that water supply and other basic services

agencies do not own excess land that can be sold or developed explains the lack of land-based

financing in these areas. A possible solution would be to establish a consolidated capital budget that

could automatically allocate part of the land finance proceeds for the delivery of basic services. Also,



when governments are responsible for providing the entire range of infrastructure services,

employing land financing to pay for particular investment projects frees up FUNDS for investment in

basic services. This calls for special measures to be taken to make land-based financing support

investment in existing infrastructure services.

Categorising land-based financing instruments

Land-based financing instruments can be broadly classified under three categories: developer

exactions (including impact fees), value capture (betterment levies, land sales) and land asset

management (including private investment in public infrastructure). The following table discusses

the working of land financing instruments and recounts select cases of their employment.



All of the above lists one-time payments and capital play. This has the detrimental effect of higher

prices for infrastructure that affects the city's economy due to higher upfront capital payments. The

property taxes collected rarely reflect earnings values of the property but a registered value.

It may be worthwhile for corporations to consider integrating an element of revenue flows into their

infrastructure plans. These will provide cash flows to service debt/capital plus surpluses to redeploy.

And linked to overall economic growth - so there is a direct stake in the corporation making the city

successful in income terms (that can't be fudged so easily) rather than capital value terms (that

create bubbles).

Examples of these:

i) The Corporation takes up an equity stake in commercial developments based on land price at time

of transfer to developer. Downstream sales will thus contribute earnings to the corporation.

ii) Specific area based taxes for newer developments. E g if road, water/sewage and electricity

footprint is expanded - this is a geography footprint. All the property in that area benefits from it in



terms of prices etc. A small fee (calibrated to not kill profitability) will contribute a steady income to

the city corporation. Won't affect older areas.

The sale of assets on capital value creates an incentive for land owners (viz., govt) to work towards

higher values. This pushes up prices or worse still cost of living, as accompanying services become

expensive for residents. This directly proliferates "slum living" and overconstruction in areas outside

city control

Pooled Bonds Method

As per the estimates of the Ministry of Urban Development the Urban Local Bodies (ULBs) in India

require cumulative capital investments of Rs.39.2 lakh crore over the next 20 years in order to

address prevailing urban infrastructure and service gaps1. The Jawaharlal Nehru National Urban

Renewal Mission (JNNURM) provides assistance to ULBs in the states to the extent of 35-90% of the

cost of projects being approved under this mission. However, ULBs face constraints in meeting the

remaining part of the cost of such projects in view of their limited financial resources and the

absence of a domestic market for long term municipal debt. Grants from the State Government and

loans from the State nodal agency are currently being provided to partially bridge this gap.

However, with an estimated Rs.1 lakh crore worth of projects having been sanctioned since the

inception of the JNNURM, this alternative is also reaching its limits.

The challenge before the Government of India is to find the resources to fund the massive

infrastructure requirements of the urban sector. Even if the Government were to somehow mobilize

its share of funding, it is inconceivable how ULBs, particularly the small and medium towns, could

bring in their contribution under the existing arrangement without taking recourse to a substantial

increase in property tax, which is the principal source of ULBs’ own revenue, or a manifold increase

in tariffs for services, both of which are politically sensitive options.

On the other hand, thanks to a healthy growth rate in the GDP and the high domestic savings rate of

our economy, there is enormous opportunity to tap the f inancial market for meeting ULBs’ funding

requirements. However the market for municipal bonds in India is almost non-existent, unlike in

countries such as the US where this is the principal mode of financing urban infrastructure.

Retail investors and their proxies, viz. mutual, pension and insurance funds have been the main

subscribers to such pooled municipal bonds as they have traditionally looked at long term

investments with tax-free returns.

The basic premise behind the pooled bond structure is that by combining program equity with a poolof loans, the risk of a single borrower loan default causing a bond default is reduced. The more the



size and diversification of a pool increases, even with the inclusion of smaller and less creditworthy

borrowers, and the more the concentration of the largest participants decreases, the more the

default risk spread, thereby improving the creditworthiness of the pool and lowering the cost of

funds. The structure provides four key benefits:

1. Each individual borrower has access to the capital market at a much lower interest rate than it

would otherwise get if it borrowed on its own.

2. Transaction costs are spread among participants, providing a further efficiency

3. Resources once used to fund grants can instead be used to make subsidized loans, spreading the

resources to a larger group of beneficiaries.

4. Bonds used to finance loans can receive higher ratings than those of the underlying borrowersdue to pool diversity and program equity.

India presents a similar opportunity to tap into the growing pension, insurance and provident funds

to fund urban infrastructure. To avail of it, however, certain structural issues need to be addressed

first. To begin with, it has to be realized that debt financing is a more efficient mode of capital

delivery to urban sector projects as it brings an element of discipline. With an obligation to repay,

ULBs are compelled to judiciously plan, design and execute projects that can maximize revenues,

while minimizing O&M costs in a sustained manner throughout the asset life span.

Therefore, GOI needs to proactively develop the municipal bond market.

Having identified the principal players who may have an appetite for such instruments, it may

engage with them to understand their concerns. The recent experience with tax-free pooled bonds,

especially under the Pooled Finance Development Fund (PFDF) Scheme, should be closely studied to

address market concerns and the concept modified so as to attract more investors.

A schematic diagram of the pooled bond structure as exists at present is given below:



However the scheme must be open to taxable bonds, without any cap on the coupon rate, in line

with market expectations. Others include declaring such bonds as either SLR equivalent paper or

qualifying under priority sector norms in order to encourage banks to participate. There are certain

other suggestions relating to taxation and interest subvention that also require to be looked into.

Accessing External Financing – A Possible Approach



1. The core idea is to create a Fund structure where GOI and State funds under JNNURM are

used as a combination of equity and junior debt to leverage and access funds from the

capital market, rather than be deployed as grants into the ULB projects.

2. The focus here is to use GOI/State funds to create a vehicle for raising external resources to

meet the financing gaps for ULB projects in a sustainable manner.

3. A key benefit in creating such a vehicle will be to ensure that public resources are more

effectively used for creating urban infrastructure within the country, besides the

establishment of financial intermediaries that encourage the injection of external capital to

finance urban infrastructure.

4. The proposed approach would complement JNNURM by building on the initial experience of

the Pooled Finance Development Scheme of MoUD and deepen the Municipal Bond market

in India.

5. While, in the past, Municipal Bond schemes have tended to focus on providing a tax-free

status, experience in Tamil Nadu and elsewhere shows that it may be useful to instead

provide flexibility of raising resources instead through taxable bonds with no cap on coupon

rate.

6. However, in order to limit the interest burden on ULBs, it is proposed to reduce the

effective cost of financing even with the relatively higher cost of the external financing

component, by providing interest subvention.7. Under the proposed structure, the SPFE (an SPV) would float taxable (or tax-free, as the

need may be) pooled bonds to raise the counterpart funding for a pool of ULB projects being

found eligible for assistance under JNNURM.

8. Each issue of bonds would be collateralized by a suitable Debt Service Reserve Fund (DSRF)

as determined by the rating agency so as to target a minimum rating, say AA. Such DSRF

may be provided by the GOI/State as equity to the SPV. The interest earning on the DSRF

corpus could be used to provide interest subvention on the ULB loan from the SPV that

would be raising external debt at market rate through the bond issue.

9. Since the tenor of the pooled municipal bond would be decided based on marketability,

typically in the range of 5-10 years, or with put/call option at suitable interval, whereas loans

to ULBs may be necessarily of longer duration, say 7-20 years, asset-liability mismatch would

have to be handled by the SPV either through its internal resources, including equity, or

through securitization of its assets.

10. For the purpose of building the pooled municipal bond market, the GOI/State could

underwrite the initial few bond issues till the SPV establishes itself or the market matures.



Alternatively, in the beginning, issues could have a senior debt (bond proceeds) and junior

debt (GOI/State contribution), in order to provide greater comfort to investors.

11. Bond issue proceeds would be on-lent to the ULBs participating in the pool at concessional

terms, including soft rate of interest (through interest subvention using the earnings of the

DSRF) and long tenor. Alternatively, the SPFE could in turn utilize the proceeds to subscribe

to bonds issued by such ULBs.

12. Repayments by ULBs would be routed through an escrow account and in case of default, this

would trigger an appropriate release from the DSRF to ensure timely payment to

bondholders. Erosion of DSRF would be replenished by suitable intercept by the SPFE of the

releases of the State Finance Commission devolution grants. In case these credit

enhancement measures do not suffice, third party guarantee by the State Government,

could be resorted to.

13. The SPV at the state level may be created jointly by GOI, State and select financial

institutions such as IIFCL and IDFC that are mandated to invest in urban infrastructure. The

SPV would be managed on behalf of the stakeholders by a financial intermediary, which

may be in the nature of a PPP with GOI/State holding not more than 49% equity so as to give

it a private fund manager status, which would enable it to attract talent from the market.

14. The SPV could float a dedicated issue for a group of ULBs in a state, pooling together their

requirements for identified projects. These could either be developed projects awaitingfinancial closure or projects already pre-financed by other entities during the construction

phase.

15. The SPV can kick start a consistent and a regular stream of issues to raise capital periodically

and such issuance can follow appraisal of existing / proposed shelf of projects including an

analysis of project viability and debt servicing / financial strength of the sponsoring ULBs.

As repayments from earlier bond issues start coming back from ULBs and bond instalments

are paid, the equivalent portion of DSRF could be freed up, and go towards strengthening

the next bond issue. This would further collateralize the pooled bonds and improve the

issue and the SPFE’s rating and consequently reduce the cost of borrowing from the market.

At some point of time, the SPFE may become sufficiently capitalized so that GOI/State may

not need to provide any support, except targeted capital grants for hardship communities.

16. A range of project pooling, structuring and payment security options, such as those

suggested above, need to be examined and developed to manage and mitigate risks and

meet debt servicing and rating expectations of potential investors for such issuances.



17. Needless to say, this would also require the financial intermediary (SPV) to have project

structuring and appraisal skills as well as capabilities in financing and raising funds from

capital markets.

However, pooled financing offers certain challenges, as enumerated below:

Need for legislative sanction in order to give statutory footing to SPFEs, on the lines of SRFs

in the United States would be necessary. Similarly, environmental legislation on the lines of

the Clean Water Act and the Safe Drinking Water Act would compel ULBs to hasten the

creation of water and sanitation infrastructure, which would provide the right impetus to

the pooled bond mechanism by unleashing demand for funds.

Development of a sound programme structure for the pooled financing mechanism, which

would address issues such as whether the SPFE would sub loan to ULBs or subscribe to the

latter’s bonds; whether the GOI/State contribution would be the equity piece for the DSRF

or would constitute junior debt, etc.

Implementation tools need to be developed, which would include toolkits and standardized

documents for bond issues, loan agreements, project covenants, project monitoring and so

on.

Capacity building at National, State and ULB level, so that implementation agencies are

equipped to handle the transition to such new forms of market financing. The rich

experience of entities in the US, notably the SRFs, bond banks, underwriters and rating

agencies, could be tapped in the initial phase.

Education of all stakeholders, such as investors, underwriters, rating agencies, lawyers, etc.

about the pooled financing mechanism as it is a nascent market; this could take the form of

conferences, newsletters and publicity material.

Support, especially at the policy level, for establishing SPFEs in States (something that has

not yet materialized, except in a couple States) and rolling out the pooled bond programme.

Loan tracking system and customer service support will be crucial to the sustenance of the

model.

A separate Grant Fund to be set up to handle hardship grants / viability gap funding and to

be administered at the SPFE level on rational principles.

Project Development is critical to any such programme and for this, investments by the SPFE

through a dedicated Fund may be required.

Innovative instruments like bridge financing (to insulate investors from construction risk)

and take out financing (to handle asset liability mismatch) may have to be explored.



Sustaining Debt – Unlocking Land Value

The most critical but neglected area in the urban finance sector is the debt sustainability of ULBs.

Given the limitations in exploiting traditional revenue modes such as taxes, fees and tariffs, if ULBs

are to cumulatively absorb on an average Rs.1 lakh crore every year, most of it in the form of debt,

and if there are serious impediments in structuring successful PPPs in infrastructure creation and

service delivery (as has been the experience so far), then we need to look at other options to

generate revenue, such as by unlocking the value of land.

Since most ULBs have very limited commercially exploitable lands, and since sale of family silver is

not a sustainable proposition, a more feasible way of appropriating

value resulting from better infrastructure and service delivery is by imposition of betterment levy on

lands situated in areas that benefit out of investments in urban infrastructure. This has to be made a

pre-condition for accessing GOI assistance and can become part of the mandatory JNNURM reform

agenda.

Such betterment levy may ideally be linked to the area guideline value / circle rate and guided by the

capital cost of the optimal infrastructure and the economically feasible maximum tax rate. Such levy

may be, for obvious reasons, deducted from capital gains calculations. It may be collected as a one-time recoupment by the ULB at the time of seeking planning permission by the owner of the land.

Additionally, it may have a recurring component (say 2% of the one-time betterment levy)

collectable every year for maintaining the assets created from all occupiers of the lands that benefit

from the creation of infrastructure in the area.

The other way of unlocking the intrinsic value of land is to apply the tools of town planning, on the

lines of the Gujarat Town Planning Schemes. Typically zonal Detailed Development Plans (DDP)

should follow the Master Plan of any city. The DDP is basically a land use zoning plan on a micro

level, which also spells out the infrastructure requirements that need to be planned for.

Unfortunately the City Development Plans (CDPs) that are currently being prepared by cities, with

the help of consultants, as a pre-condition for accessing finance under JNNURM are largely

investment plans that do not explore the possibility of raising revenues from land through re-zoning

or re-development.



Microfinance

When developing city-wide infrastructure, one cannot simply assume that the whole city benefits.

Many times technical designs only provide infrastructure upgrades for households that already have

access to services. Other times, infrastructure expansion only includes main or secondary lines, but

not distribution networks within neighborhoods. This is fine for new housing developments for

middle- and high-income residents or government projects where the builders pay for the

distribution networks, but it is problematic for retrofitting older neighborhoods and servicing the

poor. Currently, 33% of India’s urban population lives in slums, and India has more slum dwellers

than any other country in the world. Cities can no longer pursue urban development, infrastructure

improvements, or economic growth without also including slums. To do so would ignore a third of

the cities’ population.

Urban slums grow because Indian cities attract all types of people aspiring to take advantage of new

economic opportunities. However, the growth of infrastructure and housing has failed to keep up

with population growth. With an inadequate supply of acceptable quality, affordable housing and

land, people live in miserable conditions without basic services or secure tenure.

There is a common belief that slum dwellers cannot afford to pay for proper infrastructure services.

However, successful pilot projects around the country have contradicted this belief. In Dewas,

Madhya Pradesh and Thane, Maharashtra, for example, the FIRE (D) Program focused on orienting

city-wide projects to extend networks into the slums. Infrastructure extension into slums is a

marginal increase to the cost of a large capital project, and paying for it can be financed like any

other part of a network improvement. In Bhubaneswar, Orissa, the FIRE (D) Program is

demonstrating that household access to water and sanitation services can be expanded within

slums, partially using a microfinance model. In the Gyannagar slum of Bhubaneswar, the FIRE (D)

Program introduced microfinance and attained full sanitation coverage, with 95% of the households

opting for household water connections and toilets. Encouraging households to invest in on-plot

work and legal connections helps ensure long-term sustainability of infrastructure systems because

slum dwellers become regular paying customers.

slums develop without the provision of infrastructure within the neighborhood. Slums frequently

develop on land that is not formally part of the city and its service delivery area. As a result, there is

no formal mechanism to expand infrastructure to these areas. This situation is complicated by the

fact that slum households have difficulty paying for high utility connection fees as well as for the



necessary costs of pipes, taps, meters, and other household-level items. Most also lack the formal

documentation that many utilities require for household connections.

From an affordability perspective, slum dwellers have difficulty paying the full cost of extending the

distribution network into their neighborhood. However, microfinance has enabled slum dwellers to

pay modest connection fees for a house connection with home improvement loans. Slum dwellers

are often willing to invest in on-plot work, since the household directly benefits from improved

services and appreciated property value. Ankuram Sangamam Porum (ASP), a microfinance

institution (MFI) in Andhra Pradesh, conducted a survey in 2004 that showed that 79% of households

were interested in home improvement loans, and 18% of the MFI’s borrowers reporting that they

used part of their business loans for housing anyway.

Microfinance for Household Water Connections and Toilets

Most households in the pilot did not have enough money saved to cover the full toilet costs up-

front, and therefore opted for MFI financing. For the most part, Bharat Integrated Social Welfare

Agency (BISWA), the MFI, wanted the pilot to fit its typical loan parameters. The loan carried 20%

annual interest, repaid monthly in 24 constant installments. Closing costs included 2.5% of the

principal for loan processing, Rs. 15 (US$0.33) for bonding any group loans, and Rs. 120 (US$2.60) for

stationary costs of the documents. These closing costs were financed as part of the loan.

Mandatory savings of Rs. 50 (US$1.10) per month, prior to and during the course of the loan, served

as loan collateral. Low-cost life and health insurance for each household also served as collateral and

became mandatory parts of the pilot project.

Each borrower had to be a member of a community self-help group (SHG) through which s/he

deposited his/her monthly savings in a non-interest-bearing bank account. Except for emergencies,

SHG members did not have access to the savings until after their loan repayment. With these loan

terms (which comply with Reserve Bank of India [RBI] rules and are competitive relative to other

MFIs in India), the average monthly costs for each “typical” option .

Home improvement lending in urban areas became a new market for the local MFI. It had lent for

toilet construction in rural areas, but primarily for pit latrines under the Government of India

Community Led Toilet Scheme. MSDF facilitated the MFI’s entry into this new sector by paying for

planning and community mobilization costs. The FIRE (D) Program helped develop the right pilot

design, focusing on household affordability: the combined analysis of (1) borrower capacity to pay,

(2) borrower willingness to pay, (3) lending terms, and (4) cost of home improvements.



In addition to loan repayment (associated with each construction option listed above), households

have to pay several other ongoing costs. At the minimum, households have to be able to

comfortably

afford the water and sewer tariffs to use the services. The project team incorporated these ongoing

costs into the affordability analysis to help determine the borrowing capacity for each household

Households have to be able to afford these ongoing expenditures to participate in the project. It

would not be sustainable to build a toilet or provide a water connection if the beneficiary could not

pay the monthly water and sewer tariffs.

Together, the water and sewer tariffs, insurance, and mandatory monthly savings for loan collateral

is Rs.155/month (US$3.50). Although this appears small, the amount is in excess of all routine

household expenditures prior to this project, as well as the new loan.

Affordability Strategies

It is essential that the monthly payment capacity of each household matches the microfinancing

terms of the desired water/sanitation option. Affordability analysis is a fundamental part of

reviewing the credit risk of each household. The analysis partially stems from household surveys and

partly from discussions with the SHGs to understand how much financing they are comfortable with.

The primary parameters include:

Household income and types of jobs

Use of loan (whether it will increase household income or decrease monthly expenditures)

Current savings and expenditures patterns

Terms of loan product offered by the MFI

Individual versus group loan structure (whether the SHG shares the liability jointly for all

member loans)

If a household desires a particular option but cannot afford it, then an alternative strategy needs to

be implemented. In the pilot project, more than one household could share a single

connection/toilet, or a household could join a livelihood enhancement program (operated by the

MFI and the city’s Slum Improvement Office) to help boost income before taking a loan. For the

poorest households in the pilot project, community toilets (operated as a microenterprise) offered

the lowest-cost option for proper sanitation. For small monthly installments of approximately Rs. 30

(US$0.66), households gained access to toilet facilities maintained by one of the community SHGs.

The community toilets are connected to the water and sewer lines and have electricity. Locks

prevent nonmembers from using them. A grant from MSDF paid for building the community toilet. In



the pilot project, most of the households were ultimately able to finance their access to water and

sanitation through micro-loans

The Future of Microfinance for Infrastructure

India has a huge market for water/sanitation microfinance specifically and for home improvement

more generally. The market potential represents 45% of total Asian and African demand, based

on the 2008 survey by the Gates Foundation of 38 countries in those regions.

That portion equals approximately Rs. 270 billion (US$5.4 billion) in loans and 56 million borrowers.

Although the market for water/sanitation microfinance is enormous, serious limitations constrain

the sector’s immediate growth.

Relatively few microfinance organizations work in the home improvement sector, of which toilet,

bath, and water tap/piping upgrades are a part. Although several Indian MFIs are entering the

market, only Ahmedabad’s Self -Employed Women’s Association (SEWA) is well established in urban

lending. In fact, unlike other countries, urban lending is underrepresented in Indian microfinance.

The added complexity of urban settings might be one explanation for relatively low market

penetration. Also, the origin of microfinance in India is very rural based. Historically, the primary

driver for microfinance has been the joint liab ility, savings group model that focuses on women’s

empowerment. MFIs have worked with women to form self-help and savings groups, which then

borrow as a single entity. The group shares both asset creation (and benefits of the asset) and the

loan liabilities. This makes sense from the gender and microenterprise perspectives, because MFIs

have focused on improving livelihoods of women. The approach also fits well into RBI regulations

that prevent MFIs from mobilizing deposits and savings

RBI regulations do not permit MFIs to function as depository banks, and they are prohibited from

offering savings accounts to members. Instead, SHGs deposit their savings in other commercial or

state banks. For small-scale lending, savings is the safest form of collateral tying the borrower and

institution together. Saving deposits are also the cheapest way for MFIs (as well as commercial

banks) to raise capital for lending. Without this tool, MFIs in India have to rely on a limited supply of

grants and very expensive commercial capital. In the water/sanitation sector, MFIs have to pay 15% –

20% interest for capital from domestic banks, and the debt has to be repaid over short terms. In

addition, domestic banks require significant fixed deposits before lending to MFIs. This really

constrains the size and terms of loans that MFIs can offer its borrowers, it increases the interest

rates that MFIs charge borrowers, and it limits the growth rate of the sector overall.Supplying larger



home improvements loans with longer repayment periods will be difficult for most MFIs in India

right now due to how their own capital is structured.

For this reason, MFIs are reluctant to change their lending models, even though the traditional

model is not completely appropriate for the new sector (i.e., joint liability is not as appropriate for

individual asset creation and ownership).

The Government of India’s lending programs add further complexity. For example, the Interest

Subsidy for the Urban Poor8 provides loans at 5% interest, well below market rates. Unfortunately,

this interest subsidy is designed to flow through state-owned banks that do not work well with low-

income communities. Compared with MFIs, state banks do not have community mobilizers that

work hand-in-hand with slum households in designing interventions and ensuring repayment.

Where MFIs have high (95%+) repayment rates, state banks experience much higher default rates

among the poor. This experience reinforces negative attitudes toward the poor and makes the banks

reluctant to participate.

In this difficult regulatory environment, it is unlikely that MFIs can scale up lending for large slum

upgrading programs. Building on the experience from the Bhubaneswar pilot project, the FIRE (D)

Program has proposed a revolving fund for the poor, which can be established by cities through a

state’s urban infrastructure fund (UIF) (see Article 6.6). These funds can be used to capitalize MFIsfor specific types of slum improvement lending, thereby increasing MFI capital for water/sanitation

lending and reducing interest rates for the poor.

Unlocking land values

The installation of infrastructure (e.g., roads, water, sewer, and electricity) increases the value of the

land in the vicinity of the infrastructure investment. Unused land owned by local governments or

state government has a market value that can be put to use to accomplish development objectives

highlighted in a city development plan (CDP). Converting land values into resources needed to pay

for infrastructure is an important alternative to using debt financing and is being used in rapidly

growing cities like Bangalore, Mumbai, and Pune.

There are a number of different ways to convert land values into infrastructure investment.

Betterment levies are a one-time tax on the increased value of private land that benefit from

service improvements as a result of public infrastructure investment.

Developer land sales recover the cost of infrastructure installed by the developer (public or

private) by adding those costs to the price of the land offered for sale.



Sale of public land adjacent to an infrastructure project enables the government to capture

the increase in land value resulting from a project.

Sale of development rights is a way for government to raise money for infrastructure by

selling developers the permission to develop their private property to a higher level than

would otherwise be allowed due to zoning or building regulations.

Developer extractions or impact fees are mechanisms to directly shift the cost of

infrastructure from the government to the private sector developer whose project stands to

benefit from a public investment.

Sale of underutilized public land is a way for government to convert underutilized or unused

land assets into cash for investment in infrastructure.

Betterment levies

Betterment levies are an easily understood means of taxing the financial gains of property owners

who benefit from the installation of infrastructure, though they have proven difficult to implement

in most developing countries. The value of a property in an area that is deemed to have benefitted

from infrastructure improvements is assessed and compared with the assessed value of the same

property before the introduction of the improvements. The increase in value is then subject to a

one-time betterment levy at a fixed rate (as much as 50% –60% in some cities). The tax revenue is

then used to pay off the financing that was initially used to fund the infrastructure. This has the

advantage of providing a means of taxing existing properties that benefit from infrastructure

improvements (rather than just new properties as in the case of developer extractions and impact

fees). However, betterment levies are complex to administer and require carefully maintained and

frequently reassessed property value registers. It also requires significant consensus building among

the public at large, so that they realize the link between the betterment levies and improved

infrastructure (connection charges can partially capture new investments if designed correctly). For

this reason, only a few developing cities have chosen to employ betterment levies significantly (e.g.,

the Ahmedabad town planning scheme).

Developer land sales.

Another simple way to use land to finance infrastructure is for a property developer (government or

private) to add the cost of the infrastructure to the price of the land or buildings sold. Commercial or

residential property development projects that are destined for sale to the public can be required to

provide the local government with all necessary “onsite” infrastructure as a condition for permitting

their construction. That way, the developer will build the cost of the onsite infrastructure into the

price of the property sold at the end of its project, and the local government will acquire completed



infrastructure without having to finance it. If the property development project is large enough, the

required onsite infrastructure may include schools, clinics, and police/fire stations in addition to

roads, water, sewer, electricity, and telecom.

Sale of public land adjacent to an infrastructure project

A variant on the sale of government land involves the sale of “excess” land that the state or local

government acquired to implement a specific infrastructure project. For example, there may be

excess government-acquired land available along the right-of-way of new roads or adjacent to a

public transportation terminal or a bus/rail transit station.

The land is acquired in order to build the infrastructure improvement, but after construction, not allof the acquired land is needed for operation of the infrastructure/service. The land adjacent to the

infrastructure improvement will have increased substantially in value compared to its market value

at the time it was acquired by the state or local government for the project. Depending on the

amount of excess land owned by the state or local government and the per unit increase in value, a

public sale or development of the excess land may bring in enough money to pay for the entire

infrastructure improvement project. This mechanism was considered for use in Bangalore, where

excess land owned by the state government adjacent to the newly developed airport could have

been sold at market rates to generate enough capital to build a new access road from the city to the

airport. And it has been used very successfully in Delhi to fund a portion of the new metro rail. This

mechanism has the advantage of linking the proceeds from land sale to a specific infrastructure

project so that the chances of the funds being diverted are minimized. Its disadvantage is that it

does not generate funding in advance of project implementation, so other funding (usually debt

financing) has to be mobilized to acquire enough land and build the infrastructure before benefiting

from land sales.

Sale of development rights

A more complex approach to capturing land value for development of infrastructure is to sell

development rights. Where development controls, such as the floor area ratio (FAR) or restrictive

zoning, are enforced by local governments or state government, the opportunity exists for

permitting developers in a specific area to exceed established restrictions in return for a payment

that is used to finance infrastructure in the area. This is the approach being used to mobilize funding

for the redevelopment of Dharavi slum in Mumbai, as well as redevelopment projects in other Indian

cities. Dharavi landowners pay a substantial fee to the Mumbai Metropolitan Redevelopment



Authority (MMRDA) in return for permission to build high-rise buildings that would not normally

conform to the FAR. MMRDA (and the developers themselves) use the funds derived from the sale

of development rights to construct infrastructure in Dharavi at a level that will accommodate the

projected demand from the increased development. The private developers have to calculate

whether they can recoup the large fee paid to MMRDA from the sale or lease of the additional floor

area they are allowed to develop.

In other cities like Pune, development rights are made “transferable” so that the owner of land in an

area designated for infrastructure improvements can buy development rights based on his land

holding in that area, but use or sell the development rights to increase the intensity of development

on a different land holding elsewhere in the city (often only in designated development areas where

authorities are able to accommodate higher levels of development). While this can be an effective

way to mobilize substantial amounts of capital for infrastructure, it requires detailed and up-to-date

knowledge of land markets and land values by a local government, a state government, or other

authorities. It also requires a sophisticated monitoring system in cases where developers agree to

build the improved infrastructure (e.g., low-income housing) to ensure that the targeted

beneficiaries actually receive the agreed-upon benefit

Sales of development rights can be used strategically by local governments during periods of rapid

growth. But the mechanism should only be considered a temporary way to advance development

objectives. Over the long term, overly restrictive zoning laws prevent private sector development in

cities (i.e., development that responds to market demand). In the face of rapid growth, the

government needs to find all ways possible to facilitate quality construction. By restricting formal

development, builders consequently resort to illegal and haphazard construction, which is difficult to

guard against after the fact.

Developer extractions or impact fees. However, a property development project also increases the

burden on infrastructure beyond the boundaries of the project itself (e.g., the supply of water to the

neighborhood under construction). To pass on the cost of the necessary “offsite” infrastructure

improvements to the project beneficiaries, the developer can be charged an extraction or impact fee

as a one-time charge based on the cost of the infrastructure improvements necessitated by its

project. The developer then builds this cost into its property sales price. All of these mechanisms

have the effect of shifting the cost of infrastructure improvement from the state or local

government to the property developer, and creating a strong linkage between the beneficiaries of

the infrastructure improvements and the people who pay for it. However, these types of



infrastructure financing can be complex to administer and can lead to “special deals” and other

corrupt practices unless they are managed in a highly transparent manner.

Sale of underutilized public land

The most straightforward way to convert land value to funding for infrastructure is to sell

government land. A local or state government may already own underutilized properties, which,

because of their location, have a significant value to private developers. To determine if this is the

case, the local or state government first needs to identify all of its land holdings (including land with

buildings) and how each of the land parcels is being used.

Next, the list of land holdings needs to be analyzed to determine if particular parcels are

underutilized or no longer essential to the government. These parcels should then be examined to

estimate their potential value if offered in the market. The FIRE (D) Program assisted Indore

Municipal Corporation in carrying out this asset identification and valuation work with a real estate

agency, as part of its broader resource mobilization effort. If the appropriate officials in the local or

state government approve the sale of specific parcels, they can then be offered to the market in

some form of competitive sale. The proceeds of the sale should be placed in a special account

(preferably an escrow account) dedicated to funding infrastructure improvements. This mechanism

has the advantage of providing funding for infrastructure projects without the government going

into debt. Its disadvantage is that the funding is not necessarily closely linked to a specific

infrastructure project, and there is always the temptation for cash-short governments to use the

funds to support the annual operating budget rather than capital investment in infrastructure. This

would be a mistake because the sale of land and other assets is limited to what government owns,

and therefore should be considered as one of the main financing tool

financing urban infra

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