Financing Urban Infrastructure and City Development in Asia

Feature | 1 March 2011

Decentralization has made sub-sovereign governments and public utilities increasingly responsible for providing urban infrastructure and services. To do so, they need to overcome constraints to mobilizing sub-sovereign finance through effective approaches and mechanisms that better support emerging fiscal structures and the magnitude of financing required.

Funding Gaps

Urban areas are increasingly becoming the key drivers of Asia's economic growth, with resultant gains in poverty reduction. However, the scale and rapidity of urbanization and mounting fiscal constraints to bridge existing and growing infrastructure service gaps is leading to major shortfalls in coverage, service levels, and quality of urban infrastructure - factors that are critical to (enhancing) the productivity of urban areas.

Estimates vary widely, but somewhere near $100 billion a year worth of new urban infrastructure will be needed to fill prior gaps and keep pace with this unprecedented urban growth. Total financing requirements for water supply, sanitation, solid waste management and slum upgrading in DMC urban areas was estimated at $25 billion per annum from 2006 to 2010 at 2003 prices. The figure goes up to $50 billion if urban roads are included and to $59 billion if mass transit is added. An estimated $32 billion will need to be added to this figure each year for maintenance of the physical urban infrastructure stock.

Challenges to Bridging the Funding Gaps

Current mechanisms for financing infrastructure rely heavily on the public sector to fill the gap between supply and demand. From this perspective, the government's fiscal position becomes the limiting factor in what can get built. Against this sits a smaller amount that the private sector will voluntarily finance under current mechanisms.

Sub-sovereign governments and infrastructure development entities in ADB's developing member countries are increasingly moving towards supplementing their reliance on the public sector with market-based sources of funding. But urban infrastructure continues to lag significantly in generating commercial investment interest, particularly due to lack of enabling structures for private participation and where scope for cost recovery is limited, leading to capital starvation of projects that could otherwise be financially viable in the long term. Private sector financiers continue to assess the risks of financing local government infrastructure, both actual and perceived, to be high. On the supply side, balance sheet constraints of banks and financial institutions allow lending that is characterized by short maturities and high interest rates - terms not very conducive for infrastructure projects. Debt through domestic capital markets has not been used on a significant scale by most countries. Borrowing through issue of bonds has, in most cases, been restricted to a few creditworthy entities.

Tapping Domestic Credit Markets

There is growing recognition that (i) public-sector participation must be more effective in using its relatively scarce budget, and (ii) it must explore ways to attract significantly more private-sector financing to rise above the 20-30% share it currently holds. However, the most critical avenue for sustained financing of urban infrastructure will be domestic credit markets that will help access private domestic savings on a large scale to augment current efforts of governments and international funding agencies in financing infrastructure at the local and regional levels.

In designing local credit initiatives to reduce the private sector's perceived risks of financing urban infrastructure and to mobilize domestic resources through domestic capital markets, ADB's developing member countries have drawn on the experiences of the most developed markets. A number of countries have adopted innovative measures that are some combination of the municipal bonds model of North America and the municipal banks model of Western Europe with access to long-term savings deposits and government contributions.

These initiatives to help mobilize domestic commercial debt resources for sub-sovereign infrastructure finance include the creation of

  • quasi-independent municipal credit institutions - such as the Municipal Development Fund in the Philippines, the Municipal Fund for Infrastructure Finance in the Czech Republic, and the Tamil Nadu Urban Development Fund of India - to channel borrowed and grant funds to local governments
  • credit enhancement mechanisms such as the Local Government Units Guarantee Corporation in the Philippines and the Infrastructure Credit Guarantee Fund in the Republic of Korea
  • special purpose vehicles such as the Water and Sanitation Pooled Funds in Tamil Nadu and Karnataka in India to raise finance for small municipalities through bonds, the Investment Fund for Urban Development in Vietnam, and the Urban Development Investment Corporations in China) to manage specific sectors of urban infrastructure in each of the major cities. Using the special purpose vehicles in China as pilot issuers of municipal bonds is being actively considered.

The experience has been mixed and these initiatives have, at best, had limited impact and, at worst, crowded out private finance.

Local governments and entities can have both bank-based access to infrastructure finance targeted at smaller, less-frequent borrowers, and municipal bond market access for the more creditworthy, sizable issuers. The same municipal financing system and basic legal structure can support both markets as long as neither system is subsidized preferentially. A situation where there is competition between the two systems will not only lower the costs of borrowing for local governments but also increase the flow of information about credit quality. In the end, while differing in their approach to raising finance, the objective is to raise the cheapest possible funds, lengthen the maturity of borrowing, and improve the pricing factor.

Unlocking Urban Infrastructure Investments

Even as progress has been made in ADB's developing member countries to increase the presence of the private sector in urban infrastructure, investments have not matched needs. There are major gaps that can be reduced only through robust and persistent efforts to improve

  • the legal, regulatory, and institutional frameworks within which private sector participation via PPPs is enabled and the authorization, treatment, and use of debt is allowed to operate
  • local variables (e.g., the size, tax base, accounting and debt management) which, in their current form, severely limit local governments ability to tap financial markets
  • the facilitative arrangements (credit enhancement mechanisms, credit rating systems) that enhance the borrowing and repayment capacities of local governments
  • the technical and managerial capacity of cities to become financially credible and accountable

It also requires better coordination among international agencies, and newer and improved modalities in their financing support for urban infrastructure in order to catalyze private sector finance in scale.

In sum, attracting funds requires great improvements in accountability by all participants. That accountability, and the greater trust it can engender, comes from better information flows and the freeing up of incentive mechanisms that lower costs and improve performance. As long as there are alternatives that the private sector perceives as having lower political and operating risk and as easy to arrange, then it will ration funds to infrastructure projects by raising the financial cost. Therefore, in order to improve local governments' effectiveness in their use of funds and to increase the amount of funds raised from markets, incentives (both positive and negative) need to be clear. If useful incentives are clear and distinct, they can motivate better use of resources and the search for better ways to serve the public interest. Likewise, a balance must be kept between the interests of infrastructure users and its ultimate providers, individual savers, and taxpayers.