PROJECT RESULT / CASE STUDY March 2011

Project

Financing Urban Infrastructure and City ADB's Focus on Urban

Development
Development in Asia
Supporting emerging fiscal structures is one of many ways to circumvent constraints
to mobilizing sub-sovereign finance for infrastructure.

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.

Sourced from https://www.adb.org/results/financing-urban-infrastructure-and-city-development-asia