URBAN NOTES 35577 LOCAL GOVERNMENT RESPONSES TO HIV/AIDS THE WORLD BANK, WASHINGTON, DC Urban Note No. UN-2 November 2005 Insights from Practitioners' Conference on Urban Infrastructure Finance in a Responsible Fiscal Framework: Lessons from Brazil, China, India, Poland, and South Africa; Jaipur India, January 6-8, 2005 Patricia Annez, Robert Buckley, Lili Liu and George Peterson (Urban Institute) Investment in urban infrastructure in developing countries is central to maintaining growth momentum and to ensuring the improvements in the quality of life that citizens expect as part of the development process. Sound fiscal management is not optional for sustainable long-term growth. Reconciling these two legitimate, but potentially competing objectives in a context of decentralization, has become a pressing--and challenging--policy issue for a wide range of the World Bank's clients. A conference held in India in 2005 examined how these issues are being resolved in Brazil, China, India, Poland, and South Africa. The conference sought to promote a dialog between investment financing perspectives that usually proceed in isolation from each other, while also generating a body of practical, transferable implementation experience. The presenters were primarily senior government officials and representatives of financial institutions, focusing on the experiences of practitioners in formulating and implementing policy. The cases featured included three of the world's largest decentralized nations; together the five countries featured in the conference account for nearly a third of the world's urban population. This note summarizes the insights gained from the conference and some of the issues it raises for further work in urban finance. INTRODUCTION and South Africa. The conference sought to promote a dialog between investment financing Sound fiscal management is not optional for perspectives that usually proceed in isolation sustainable long-term growth. Adequate from each other. The cases featured include investment in urban infrastructure is central to three of the developing world's largest nations. maintaining growth momentum and to They share a broad geographical scope and ensuring the improvements in the quality of diverse and complex economies, and all are life that citizens expect as part of the grappling with managing decentralization in development process. Reconciling these two different forms. South Africa and Poland, while legitimate, but potentially competing objectives far smaller, have experienced interesting in a context of decentralization, has become a economic and political transitions in which pressing--and challenging--policy issue for a urban areas played an important role. Together wide range of the Bank's clients. the five countries featured in the conference account for nearly a third of the world's urban A conference held in Jaipur, India on January population. 6-8, 20051, examined how these issues are being resolved in Brazil, China, India, Poland, A few key initial insights, worthy of further debate and validation that emerged from the 1 Organized by TUDUR and SASEI, in collaboration discussions: with PREM, the Caixa Econômica Federal of Brazil, the Infrastructure Development Finance Corporation The fiscal risks of decentralization are real, but of India, USAID, the National Institute of Urban manageable. Experience in South Africa and Affairs of India, DFID (the UK Department for Poland illustrate that it is possible to devolve International Development), PPIAF (Public Private substantial responsibilities and resources to Infrastructure Advisory Facility), the Council of Europe Development Bank, and co-hosted by the local governments in risky environments Ministry of Finance, Government of India and the without creating long-term macroeconomic Government of Rajasthan, this seminar was problems. Achieving this result usually requires sponsored not only by international donors, but also an iterative process, and second generation by developing country financial institutions. reforms are not necessarily a sign of failure, Page 2 Urban Infrastructure Finance in a Responsible Fiscal Framework November 2005 and may be a healthy adaptation. On the other is only in those cases where an alternative hand, both the Brazilian and the Indian source of funding is available, be it other experience illustrate in different ways that municipal revenues or cross subsidization from controlling local governments to avoid risks captive industrial users, that the necessary may involve substantial costs. While China has revenue base to attract private financing is achieved an impressive record of investments achieved. in certain cities, its experience nonetheless indicates a need to manage the inter- RECONCILING FISCAL DISCIPLINE AND SUB- governmental framework carefully in the NATIONAL INFRASTRUCTURE NEEDS decentralization process. Intergovernmental rules such as the Fiscal Neither reforming the financial sector nor Responsibility Law are one means of achieving eliminating soft money for municipalities are fiscal discipline at the sub-national level, alone sufficient to ensure that municipal although the Brazil case shows these can be governments will successfully tap private something of a blunt-edged tool. Indeed, the capital markets. Municipalities need to have a sub-national debt problem was focused in just minimum threshold of functional responsibility a few major cities and states. Seventy percent and revenue generation capacity, and credible of municipal debt, for instance, is accounted municipal accounting, reporting, and auditing for by three cities. Yet the safeguards in place rules are required to provide comfort to the today--central bank prohibitions on municipal private sector. Even private intermediaries bond issues and balance sheet limitations on need strong support in the start-up stage to financial intermediary exposure to sub-national build the business of municipal lending, and borrowers, are so stringent that there is clear rules regarding municipal bailouts are virtually no flexibility for creditworthy key. These factors are significant in both the municipalities to tap financial markets. The Polish and South African successes and in the conference discussed cases where the disappointing performance of India's cities in workings of financial markets were used as a tapping funding for infrastructure from a complement to government rules to impose financial sector that is exceptional for its depth discipline on sub-national borrowing, as in the of intermediation and scope of financial case of South Africa. While financial systems services provided. may have tremendous capacity and depth, as is the case in India, the scope for their Municipal assets, especially public lands, can involvement in cities will remain limited as long be used successfully to finance infrastructure as the revenue base is not adequate for debt development, either through direct sales or as service at reasonable levels. The share of GDP collateral, and are often underused. In Poland spent by Indian cities--on the order of 0.6 after the transition, and in Shanghai, this percent and unchanged in the twelve years approach was adopted successfully. There are since decentralization commenced--remains a risks, especially in the collateralization small fraction of the levels realized in the other approach, and the aggressive methods used in countries, and infrastructure service gaps in Shanghai are not likely to be replicable in other cities have increased in spite of solid economic contexts. Nonetheless, countries such as India growth over the period. possess massively underused land assets, whose potential value should be unlocked for One Indian presenter from the Ministry of infrastructure finance. Finance discussed the common view in India that expanding revenues and autonomy for Private investment in local infrastructure local governments should take place only after remains a hope in most countries, but one they have proven their capacity and ability to whose performance thus far has lagged well undertake a more significant role. By contrast, behind expectations. Discussions indicated that in both Poland and South Africa, during far- the high hopes placed on private-public reaching economic and political transitions participation (PPP) as a substantial alternative fraught with unknowns and risks, munici- source of funding urban infrastructure may palities were given an important role as drivers well be misplaced. Very rarely have all the of development before they had proven necessary conditions for reducing private themselves. In both cases, changing the roles sector risk to manageable levels been of municipalities was a key element in creating assembled. One of the key issues is, of course, more accountable, democratic governance, and household tariff rates, which are broadly thus part of a broader political process. Both subsidized in most places; specific cases of functional responsibilities and revenue sources Brazil, China, and India were discussed here. It were adapted in Poland as problems arose, Page 3 Urban Infrastructure Finance in a Responsible Fiscal Framework November 2005 but, in addition, binding "failsafe" constraints for local action, transparent financing, and were also placed on the indebtedness of rational incentives and institutions to enforce individual cities and on aggregate municipal accountability. debt. In South Africa, similar process adjustments and revisions were necessary as MOBILIZING FINANCE FOR URBAN reform proceeded, but from the beginning, INFRASTRUCTURE INVESTMENT central government guarantees of local borrowing were prohibited. A well-developed This session examined alternatives for financial sector and a strong local government generating capital financing for urban accounting system at the time of infrastructure, given the special conditions of decentralization also facilitated reliance on each country, and the extent to which financial markets to promote fiscal discipline. successes in one nation carried lessons for others. The current environment in Brazil is dominated by the continuing adjustment process, the Borrowing from the private sector. Much of rigidities imposed by the wage bill expansion in the discussion addressed the potential for the 90's, and the earmarking introduced in the tapping private savings for investment in urban 1988 Constitution. While the constitution infrastructure. Participants agreed that, provides a steady revenue stream to cities, though financial engineering could improve the large portions of those revenues are efficiency of intermediation between private earmarked for social expenditure, and tapping savers and local government borrowers, local capital markets is severely constrained. significant progress in accessing private The resulting inflexibility penalizes spending on savings could be made only if local infrastructure. Two important questions governments had substantial, secure revenue emerge in this tightly constrained streams that they could pledge for debt environment: 1) while adjustment for Brazil repayment. The countries that have managed will necessarily be a long-term process--can to mobilize large volumes of savings from the the current constraints be sustained? 2) Over private market--Poland, South Africa, and the long term, what are the costs to the China--share the characteristic of having economy of the inefficiencies imposed by clearly identified and substantial local constraints that work strongly, even if revenues. Borrowing to finance infrastructure, unintentionally, against investments in without adequate capacity to service debt, only infrastructure while driving large amounts of generates future fiscal crises. money into the social sectors, and can they be mitigated? The value added of private sector involvement in intermediary institutions financing In China, decentralization was seen as infrastructure investment is an important inevitable in the transition to a market related issue. Experience ranged from a 100% economy, and in this regard, was remarkably privately-owned infrastructure fund in South successful. Shanghai's no less than spectacular Africa (INCA) to private management and results in transforming their urban minority private equity in a public infra- infrastructure, however, are far from structure fund in Tamil Nadu (TNUDF), and the representative. While some cities such as transition of borrowing by Polish municipalities Shanghai tapped multiple sources of finance in from a public environmental fund to borrowing a growing economy, including reliance on from private banks. The consensus was that monetizing the value of land assets, others the discipline of the private market should be have not fared so well. Some practices, in introduced as fully as possible to local particular collateralization on the basis of infrastructure borrowing, but that the future land values, represent a potential risk to feasibility of privatization of the local credit the financial system. Tighter regulations are market depended upon the history of financial reining in these practices; and combined with sector development of each country. In reform of the financial system, they should TNUDF's case, for example, private strengthen further the infrastructure financing management in allocating loan resources framework. The lessons from China are according to market principles might well be significant, but nuanced. Decentralization and more important than private ownership of the local autonomy work, as they promote lending institution. Polish and South African competition among cities and better participants emphasized certain key accountability for service provision; but they characteristics that private sector lenders could work only within a functioning inter- provide--namely, fast response time, non- governmental fiscal system, clarity on the rules political allocation of resources, insistence on Page 4 Urban Infrastructure Finance in a Responsible Fiscal Framework November 2005 loan repayment and the discipline that implied, on urban water provision: São Paulo state in and careful financial monitoring that helped Brazil, Shanghai, and India. municipal borrowers identify and resolve financial problems at an early stage. In China, the national government has shown leadership on the issue by announcing a policy Private sector investment in urban of full cost recovery, with targets for phasing in infrastructure. Private investment in local the transition. Implementation varies across infrastructure remains a hope in most local governments, and those with ample countries, but one whose performance lags resources have funded subsidies to ease the well behind expectations. The individual transition. For example, cost recovery in examples in all five countries that were Shanghai is significantly lower than other cities discussed each relied on special local including Beijing. Shanghai's strategy features circumstances that will rarely occur elsewhere. (i) conducting public hearings on levying or Private investment in urban infrastructure is increasing user charges, (ii) providing direct attracted by a tariff regime that permits full lump-sum support to the low-income groups to cost recovery, including an adequate return on ensure a minimum standard of living taking invested capital, and as little exposure to into account the cost of the consumption political risk as possible. At present, these bundle, and (iii) containing costs by regulating conditions are most likely to be met in service providers, enforcing competitive circumstances where very large cross- bidding, and setting performance standards. subsidization from well-off industrial and commercial users can be implemented, and The constraints to cost recovery in India these necessary conditions are found include, among others, a significant gap infrequently. Workshop participants noted the between "willingness to pay" and "willingness apparent inconsistency between the high hopes to charge". The discussion raised the issue of being placed on private investment (as fragmented governance of urban service exemplified by Brazil's recent public-private delivery (water being a serious case in point). partnership law) and the track record of the Local governments with limited revenues and past six years. control over investments are typically in no position to take potentially costly political Converting other state-owned assets into positions to improve services and raise tariffs. infrastructure. Discussion brought out the The case study on the Tirupur Water Supply extent to which local infrastructure investment project, the first private provision of water in Shanghai, and China generally, has been supply in India, presently under construction, financed by the sale of traditional state-owned illustrates some of these issues and one assets--municipal enterprises of different attempt to overcome them. This project took types, but principally municipally-owned land. ten years to negotiate, in spite of a pressing These assets were either sold, with the and well-articulated demand for water from proceeds invested in infrastructure, or were textile exporters with ample willingness to pay. used as collateral for balance-sheet borrowing The project will seek to combine more efficient to finance infrastructure projects. The heavy service delivery with user charges that strongly reliance on increasing land values carried risks subsidize residential consumers, cross- for the financial system as the viability of bank subsidized by high industrial rates. These rates loans became dependent upon continuance of are considered viable given the premium these a strong land market. In other countries, exporters place on plentiful and reliable water particularly India, the public sector held very supply. Given the complexity of the financial valuable urban land parcels that were structure, the time it took to prepare, and the institutionally managed outside any market particularities of Tirupur's industrial base, framework. Converting publicly-owned urban participants questioned whether this project, land to cash could provide a significant boost even if it operates successfully, illustrates a to infrastructure finance. replicable solution for providing better water services or underscores weaknesses that must RECOVERING CAPITAL COSTS FOR URBAN be addressed in the Indian environment. INFRASTRUCTURE AND SERVICES The Brazil presentation discussed the role and For those infrastructure services amenable to limitations of cost recovery in a tightly individual charges, cost recovery can be a constrained fiscal environment. It pointed out powerful tool in securing revenue streams to the limited budgetary flexibility remaining in service loans. The panel discussion featured São Paulo state, once debt service three different experiences focusing primarily requirements (about 13% of total revenues) Page 5 Urban Infrastructure Finance in a Responsible Fiscal Framework November 2005 constitutional earmarking for education (30%) government, users, and investors. Finally, and health (12%) are taken into account. Cost endowing local governments with assets such recovery discipline is thus essential to as land, and allowing them to use them as a providing for further investment in means of finance, while not without its pitfalls, infrastructure. SABESP, a water supply can open up financing opportunities. parastatal servicing 65% of the state of São Paulo's water market through concession agreements with municipalities, has fully recovered operating costs for some time, and taps private capital markets, including the New More Information York Stock Exchange. Arguably, SABESP could mobilize more on private capital markets were Please visit our website for papers and it not for borrowing restrictions it faces due to presentations: government limits on parastatal borrowing. http://www.worldbank.org/uifconference SABESP achieves this result through cross subsidies from industrial users to all residential consumers, who are subsidized across the board. (South Africa has also funded a substantial subsidy to residential water users using cross subsidies.) However, the viability of cross subsidization over the long term is questionable, as the industrial user base erodes as a result of price sensitivity, even in the relatively low-cost Brazilian environment. It is also of interest to note the tenacity of very broad-based subsidies for residential users. In spite of tight fiscal restraints, all residential users in the richest state in a middle-income country benefit from what is likely to be a dwindling cross-subsidy base from industry. The situation for other sectors is not nearly as good, as the figures presented on two mass transit companies illustrated. The presenter argued that even if there is a strong economic case for subsidizing mass transit, the massive subsidies required by these companies crowd out funds for further investment. CONCLUDING THOUGHTS The conference generated insights that can help us frame operational approaches. While decentralization complicates fiscal manage- ment, the risks are manageable; measures such as strong accounting and transparency, prohibitions of guarantees from higher levels of government, and avoiding excessive fragmentation of local governments are instrumental in doing this. Repressing the financial sector has important costs, since financial intermediation appears a more promising channel for financing municipal infrastructure than direct private investment in urban infrastructure facilities. The latter has not lived up to expectations, partly because it has proven difficult to design schemes for sharing risks of urban service delivery between the public sector and private investors and to establish user charges acceptable to