Substack

Wednesday, November 14, 2007

Credibility premium and cities

It is commonplace in world of finance to refer to country risks, or the political and strategic risks associated with investing in a country. Country risks are factored in by rating agencies in their sovereign ratings and by investors when making their investment decisions. It reflects in the cost of capital for investment in the country. A similar risk premium is associated with cities too. For lack of better word, I will call this a credibility premium.

Vijayawada has a serious problem with its credibility, and this gets manifested as a risk premium. Any investor or developer who ventures into Vijayawada will be hedging himself with a few percentage points of additional credibility premium, over and above his normal expected rate of returns. The external investment can be in capital investments, contracting for Goverenment agencies etc.

What are the reasons cities experience a lack of credibility? The most commonly cited credibility problems arise from
1. Political opposition to reforms
2. Precedent of going back on contracts
3. Precedent of loan default
4. Resistance to adopting newer ideas, processes and technologies
5. Labor militancy
6. Political factionalism and strife
7. Payment defaults and weak finances

The Vijayawada Municipal Corporation (VMC) had floated a few projects under Public Private Partnership (PPP) for development of vacant land assets owned by it. These projects, under both the revenue sharing BOT and floor space sharing models, evoked good response from potential bidders. However, an analysis of these bids revealed a trend of bidders hedging themesleves against the potential city specific risks and adding the credibility premium to their expected rate of return. This meant that VMC ended up getting a worse deal than it would have got without the attendant credibility risks.

Similarly, the VMC had called various tenders for outsourcing the Operation and Maintenance (O&M) of its water, sewerage and some other services. In all these bids it was observed that the bidders factored in the credibility premium in their financial bids and quoted more than they would have in other cities.

The Council of VMC has been consistent in its opposition to reforms in its City governance structures. Blanket opposition to ideas like PPP, outsourcing, water meters, user charges, tax increases etc has not helped in improving the credibility. Absence of a good track record of project execution, financial strength, process re-engineering, manifested by lack of good working examples has incresed the credibility premium.

Despite being one of the major Tier II cities, it has not received any notable industrial investments in the past few years. Its impressive strength as an educational center has not helped attract software and other knowledge based industries. Some of the richest entrepreneurs in the State come from Vijayawada, and interestingly very few of them have invested their wealth in their own City.

A credibility premium is a deadweight loss, in so far as its benefits do not accrue to anybody, and is an economically inefficient situation. The premium is mostly transferred out of the City by the external investors, while its costs are borne by all the entreprenuers and citizens of the City. It is effectively a penalty or a tax imposed on the City and its citizens for the additional risks specific to the City. The entreprenuers face a higher than necessary cost of capital, and the citizens suffer by way of higher taxes, lower and poorer quality civic infrastructure facilties and services. The investor too does not benefit by way of the additional credibility premium, as he expends a significant amount of time and resources in combatting the local problems.

How do we lower this credibility premium? The surest way to do this is to get some runs on the board by getting a few successful examples of reforms and external investments. Such examples would go a long way in allaying the fears of outsiders on investing in the City. Bringing in financial discipline, reducing wastage and inefficiency, adopting newer technologies can all go a long way in reducing teh credibility premium. But all this takes time.

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