Whalesbook
India's Urban Infrastructure Push
India needs substantial capital for urban infrastructure, estimated at ₹80 lakh crore by 2037, to support rapid urbanization and economic growth. Cities are expected to contribute about 70% of the nation's GDP by 2036, highlighting the need for strong urban finance. To meet this, the central government has launched the ₹1 lakh crore Urban Challenge Fund (UCF). This is a major change from relying solely on grants, shifting towards market funding for city governments. The UCF requires them to raise at least 50% of project costs through municipal bonds, bank loans, or public-private partnerships (PPPs). The central government will cover 25% of costs, with states or cities paying the rest. This approach aims to improve financial management, increase transparency, and boost cities' credit ratings, making them vital for smaller urban centers to tap into capital markets. The difference in borrowing costs for municipal bonds compared to the RBI Repo Rate has narrowed significantly, falling from about 480 basis points in FY20 to around 155 basis points in FY26, showing increased investor confidence and lower perceived risk.
Municipal Bonds: A Nascent Market
The Indian municipal bond market is still in its early stages, though it shows signs of recovery. Since FY18, only 17 cities have issued municipal bonds, raising about ₹45.4 billion. This low volume indicates a large, untapped funding source. The Reserve Bank of India recently allowed municipal bonds to be used as collateral in repo transactions, aiming to increase market liquidity and potentially lower borrowing costs for cities. Historically, municipal bond issuances have been small, with a major slowdown between 2006 and 2016, partly because government grants were readily available. Schemes like AMRUT have encouraged some issuance, with total amounts reaching about ₹4,540 crore by March 2026. However, this market is a small part of global figures. As of September 30, 2025, India's municipal bond market is estimated to be less than 0.06% of all outstanding corporate bond issuance. The market for these bonds is also largely illiquid, with a weak secondary market that limits investor exit options, making them less appealing than other investments.
Challenges for Smaller Cities
The UCF's focus on market funding creates major hurdles for smaller Tier-II and Tier-III cities. These city governments often struggle with limited independent income sources, generating less than 0.4% of GDP from their own revenues, far below global averages. They rely heavily on grants and transfers from central and state governments. This dependence worsened after old tax sources like octroi and entry tax were absorbed into the Goods and Services Tax (GST), weakening their financial independence and certainty. Adding to this, most Indian municipalities are rated below investment grade, unlike about 99% of US municipalities. Smaller cities also have less ability to prepare project proposals ready for funding, set up dedicated project companies, or draft comprehensive PPP documents compared to major cities. As a result, less than 10% of urban PPPs happen outside large metropolitan areas.
The Credit Repayment Guarantee Scheme, designed to help smaller towns, may have limitations. Similar guarantee schemes for small businesses have often seen high default rates and might not be enough to reduce lending risks for entities with fundamentally poor finances. Prioritizing 'own revenue' for credit assessment while downplaying crucial grants poses a key challenge. It could shift the financing burden to residents without guaranteeing better services. Public-private partnerships (PPPs) in urban development, while common, have had limited success in delivering city infrastructure and services, often due to a lack of capacity. With the current 10-year government bond yield around 7.05%, municipal bonds must offer competitive rates that account for credit risks to attract investors. This is difficult for smaller, less creditworthy cities.
Potential Solutions and Outlook
Regulators like SEBI are proposing reforms to make municipal bonds more attractive. These include allowing debt refinancing and introducing pooled financing structures to assist smaller municipalities. Experts expect municipal bond issuances to continue growing, supported by government policies and rising investor interest. Annual issuances are projected to range between ₹2,500–₹3,000 crore from FY26 to FY34. However, the UCF's ultimate success hinges on fixing the underlying financial problems and lack of resources in smaller city governments. This is crucial for ensuring fair development and avoiding too much debt without corresponding improvements in infrastructure and services.