The payment woes of the Municipal Corporation of Greater Mumbai

Reports suggest that contractors and vendors could set off their dues, such as property tax and penalties imposed by MCGM, using credit notes

The Municipal Corporation of Greater Mumbai (MCGM) is reportedly proposing to settle its dues to its vendors and contractors in the form of credit notes. The formal documentation recording this policy is not yet available in the public domain. However, reports suggest that contractors and vendors can set off their dues, such as property tax and penalties imposed by MCGM using these credit notes. The credit notes are reportedly tradable as well. The MCGM will, presumably, repay these credit notes over a period of time if they have not already been set off against dues. Many details are unclear. For instance, whether these notes will be interest-bearing, what will their maturity be, whether they will be issued and held in physical or dematerialised form, how will the set-off process work, and so on.

 
News reports have hailed this proposal as a step towards 'going-cashless' as the initiative will allow the MCGM to implement projects without paying any cash to vendors. We believe that this description of the intiative is erroneous. In fact, it would be more appropriate to call this initiative a partial debt restructuring effort by the MCGM where it is solving its liquidity challenges by pushing the burden on to its vendors. In doing so, it has appeared to not have given much thought to the overall system level impact that this initiative might have.
 
In this article, we argue that the MCGM's proposal to adopt the practice of issuing credit notes to its vendors and contractors as a form of payment is a bad policy idea and should not be implemented. Instead, municipal bodies, like private firms, must be prepared to tide over such crises by using the standard playbook of liquidity and solvency risk management: raising debt, liquidating their assets to repay their dues or even considering collective insolvency resolution.

 

Credit notes are not money
A firm supplying goods or services or performing works contracts for the state, derives its revenue from its contracts with the government. In many sectors, the state is the biggest buyer of such goods, services and projects. Such contractors rely on the revenue stream from the state to defray their costs. This includes paying salaries to employees, paying downstream vendors for purchasing raw materials and stores, paying power bills, running and managing offices and plants, paying interest on debts and so on. Paying taxes to the state is only a part of the overall expense of running an enterprise. Even within taxes, taxes to state governments and municipalities are only a part of the overall tax payments.

 
When a customer, such as the state, insists on paying the supplier through a credit note, it disrupts the revenue stream of the supplier and hampers its ability to pay its own expenses. In a sense, the state is forcing the vendor to invest in debt paper, which is what these credit notes are, of the state. This is a problem for several reasons. First, the reason the state is issuing credit notes is because its credit quality is poor. Forcing this poor quality investment on to a firm will impact its business model. Second, credit notes are not money. To meet its own expenses, the supplier firm might be forced to raise debt. What is highly likely is that the return on the credit notes will not be enough to compensate for the additional costs the supplier has to bear. In such a case, the supplier firm will be left in a net negative position.

The credit note system also locks in suppliers and contractors in a closed loop system. The parties in that system are the state and only the participants that do business with the state. This is inefficient as well as costly for the supplier/contractor.
 
The imbalance of power in public contracts
One of the key problems in public contracts is the asymmetry of negotiating power between the state and the private contractor. The terms of a government tender document are standardized and often allow no scope for negotiation. Since the state is a large and repeat procurer in many sectors, for many firms, losing the state's business, will be debilitating or fatal. Therefore, firms choose to participate in government tenders even though they are aware of the vagaries of dealing with the state: red tape, rent seeking, delayed payments and so on. In fact, many firms may set themselves up precisely to work in an environment of this type.

 
Academic literature suggests that firms that are exposed to governments as customers are more vulnerable to financial distress and even insolvency. Substituting the mode of payment with credit notes does not augur well for such firms. For one, firms have little choice but to accept this sub-optimal method of payment. Second, it exacerbates their operations and financing related vulnerabilities and exposes them to potential insolvency.
 
The procurement problem
Another serious problem with this mode of payment by the MCGM is that it will likely bias the public procurement process in favour of large firms that are cash rich or have ready access to finance. These are the firms that will be able to deal with the financing gap that getting paid in credit notes will generate. However, there is some anecdotal evidence that large, well functioning firms are often not interested in participating in contracts of municipal bodies. This is because even in the space of government business, municipal contracts represent far greater uncertainties and risks.

 
The credit note system might work for precisely the firms that are not interested in participating in municipal contracts while disincentivising those that are interested. This may make the space of municipal procurement and projects more worse off that it already might be.
 
Credit notes are not liquid instruments
There are two ways in which the credit notes may be immediately monetised, namely, through trading them in the open market and invoice discounting. Trading these credit notes imply inherent transaction costs. First, it is unlikely that these credit notes would be listed as bonds in the market. This is because the regulations governing the public issue of municipal bonds place several restrictions on the kinds of bonds that can be offered to the public, such as obtaining a credit rating and identifying the source of the revenue that will service the bonds. In the unlikely event that the MCGM does get these credit notes rated, trading these bonds on the secondary market would involve dealers or brokers, adding to the transaction costs for the contractor or vendor. Second, India's experience with building liquid debt markets indicates that it will take some time before a liquid market for municipal bonds can be built. Thirdly, the price of the bond in the secondary market is inherently linked to the financial health of the issuing entity. This would expose the MCGM's vendor or contractor to extreme uncertainty in the repayment of its dues. A contracting firm may also discount these credit notes with a bank or other financial institution. However, this too implies transaction costs and a likely discount on the principal amount of the bond. Pertinently, none of the ministries or government departments or municipal bodies that regularly incur contractual liabilities towards private firms are listed on platforms such as TReDS that facilitate invoice discounting.

 
Conflating sovereign's taxation powers with commercial contracts
Another problem with this proposal is that it offers the carrot of allowing the penalties and property tax to be set-off against the MCGM's dues to the contracting firm. This skews the incentives of the municipal body to penalise firms and inflate the amount of tax due from them. This hypothesis is underpinned by the Nobel prize winning theory of public choice, which models the behaviour of government servants as rational individuals. It is likely that the state, just like private firms, will inflate the amount due as taxes and penalties to allow itself a larger set-off. Allowing taxes and penalties to be set-off against the commercial dues of the state dilutes the fundamental notion of the separation of the sovereign's power to tax and penalise from its role as a commercial economic agent when it enters into contracts with private persons. This is deeply problematic.

 
Way forward
The MCGM's proposal to issue credit notes in repayment of its dues to its contractors, raises critical questions on the remedies available to the creditors of municipal bodies in India. When private firms default on their debt, they are sued, re-organised or liquidated. Since municipal corporations in India are constitutional bodies, this is not possible when the MCGM defaults on its debt. Given the extensive commercial role that the state plays in development, this should be a grave cause of concern.
 
In the last three years, 94 municipal corporations across 19 states have submitted themselves to credit evaluations and obtained formal credit ratings, indicating their intention and willingness to raise debt from the public markets. The MCGM is not one of them. If the MCGM is truly facing a liquidity crisis, it must not transfer the burden of this crisis on its vendors and contractors. It must do what good contracting parties are expected to do - borrow from the market or sell its assets to honour its payment obligations. This is fair. It is also rational as it will avoid increasing the costs of procurement.

The authors are Mumbai-based researchers