A journey along most roads in India swiftly reveals the extent of the country’s need to invest in infrastructure. Pot holes and poorly laid surfacing test the suspension of any car, while shoddy drainage regularly leads to flooding and further erosion during the monsoon season.
Add into this electrical brownouts, badly maintained railways and telephone lines that often don’t work, and the sheer scale of work needed to mend India’s infrastructure becomes distressingly apparent.
For years New Delhi has prevaricated over these problems, lacking both the funds and the political will, to offer a fully effective solution. But with concerns mounting that the country’s infrastructure inadequacies are crimping the country’s economic growth potential, New Delhi appears to be willing to invest more political will into solving the problem.
In his first budget speech since being reappointed minister of finance on February 28, P. Chidambaram emphasised the importance of promoting infrastructure investment, and highlighted several initiatives to help foster private capital into the sector, through infrastructure debt funds and tax-free bonds.
Chidambaram’s focus makes sense. The amounts of money required to upgrade India’s infrastructure is so great that private capital will play a vital role in meeting it. The Asian Development Bank (ADB) estimates that the country needs to invest about US$1 trillion to improve its infrastructure over the coming years.
“Fifty percent of that US$1 trillion figure is meant to come from the private sector, and with a 70:30 debt-to-equity mix that means the private sector needs to raise US$350 billion,” notes Vivek Rao, senior finance specialist in the public management, financial sector and trade division for South Asia at the ADB.
Private corporates are working on India’s various infrastructure, either in conjunction with the public sector through public-private partnerships (PPPs) or via concessions from India’s various state governments. But their ability to secure projects has been crimped, in part by the labyrinthine bureaucracy of India’s layers of government, but also by a lack of funding options.
Infrastructure works in most developed countries are usually funded at first on a non-recourse basis by banks, with the loans being taken out by long-term debt financing after a few years. But India’s private sector bond market lacks the depth to support long-term bonds. So projects have entirely relied on long-term bank funding.
Rao says that bank lending to infrastructure has grown at a compound annual growth rate of 40% between 2000 and 2010, at which point it reached around US$100 billion. This is mostly long-term funding, yet India’s banks themselves rely on short-term financing, which has left them with a rising asset-liability mismatch.
“The RBI [Reserve Bank of India] is getting concerned about this explosion of infrastructure-related lending,” says Rao. “They have been able to manage it so far because liquidity has been strong, but a variety of external and internal reasons means that liquidity is tightening. So the banks are moving towards an annual reset of the loans that they offer. That creates problems for the projects, as the banks’ floating rate of lending has led the profile of the projects’ revenues to become unrelated to their liabilities.”
In other words, resetting the loans each year leaves the project builders with no certainty about how much they will eventually owe, and whether they will make much money given their revenue projections. It is increasing the risk of building infrastructure, which in turn lessens the incentive to do so.
Encouraging infrastructure investment in India will require a multi-pronged strategy by New Delhi. The government needs to continue trying to develop model concession agreements at the federal and state level, offer clarity for states to develop projects on a non-recourse basis and provide clarity over land and environmental laws.
But it also needs to give private investors enough incentives and certainty to risk their money. The good news is some encouraging developments are finally taking place. But New Delhi needs to ensure that it turns these concepts into a fully fledged infrastructure funding channel.
BUILDING A BOND MARKET
During his budget speech in February, Chidambaram made several comments that have heartened observers of India’s infrastructure sector.
The finance minister mentioned several means to promote more projects, including long-term debt funds and tax-free bonds of up to INR500 billion (US$9.21 billion) to support more infrastructure projects.
The government’s pinpoint agency for infrastructure development is the India Infrastructure Finance Company (IIFCL). Established in 2006, the state-owned agency’s agenda is to facilitate private capital into infrastructure projects in the country.
The IIFCL has approximately US$4 billion in long term resources including the funds it has raised via bonds on the strength of its own balance sheet without government backing (last year it issued 30-year rupee bonds for the first time without a government guarantee). It is also supported by the ADB, which has supplied two lines of credit, in 2007 and 2009 respectively, for a combined US$1.2 billion. Meanwhile Germany’s KfW has also offered 35-40 year lines of credit to support the agency.
This money mostly goes to public-private projects (PPPs), which receive 80% of its loans. Of course these efforts still barely scratch the surface of the country’s needs, so the IIFCL and the ADB intend to offer new forms of support.
“We are working with the IIFCL to create more innovative capital market solutions,” says Rao. “The first is the usage of guarantees. Essentially it’s a model in which the IIFCL provides a partial guarantee issued for local bonds that are issued by a project-specific SPV [special purpose vehicle].”
A partial bond guarantee helps because it raises the credit rating of a bond issue from an infrastructure special purpose vehicle (SPV) from around ‘BBB’ to ‘AA’. The higher rating is important because it lets pension funds and insurance companies buy the debt and broaden the investor base.
“A lot of other institutions provide infrastructure financing such as the commercial banks and non-banking financial companies,” says Harsh Kumar Bhanwala, executive director at the IIFCL. “We only helped execute infrastructure projects to find the correct [credit rating] grades through our pilot projects on a partial credit guarantee because most of the infrastructure projects are set up on a non-recourse basis. On this standalone basis their credit rating may not be sufficiently high for insurance companies and pension funds. We try and bridge this through one of our products.”
The idea is for infrastructure SPVs to issue bonds a year after completing their project (which is typically four years after the project gets the go-ahead and is constructed) and use the proceeds to pay back their more expensive bank loans. The banks can then offer the money to other infrastructure SPVs about to commence building.
The upshot is that the banks’ capital is less tied down and their asset-liability mismatch is greatly reduced, while the projects get cheaper financing.
“It’s a huge opportunity, as the insurance and pension sectors have US$300 billion of capital and this is largely going to government securities,” says the ADB’s Rao. “They have a requirement to lend 15% [of their investment fund assets] to infrastructure requirements but they need to be ‘AA’ rated, which has been a stumbling block.”
Bonds backed by the IIFCL are tax-free too, meaning they can provide a lower spread for the borrowers and cost less for investors.
RESTRICTIONS APPLY
While it’s a good idea, there are some restrictions. For a start the IIFCL only has finite capital to provide guarantees, meaning that it is limited in the number of infrastructure bonds it can support. The ADB has stepped in to take 50% of the risk, but even combined the two agencies can only supply a fraction of the debt required by the infrastructure sector.
Additionally, to date no deal has been guaranteed. The IIFCL executed its first bond guarantee for GMR Highways toll road project on January 16, but the bonds are yet to be issued as 74% of the project was sold to Macquarie SBI Infrastructure Investments and SBI Macquarie Infrastructure Trust. Rao notes that the guarantee is still in place in the event the project wants the funding.
The IIFCL and the ADB are looking to potentially support another toll road project to issue bonds supported by their guarantee, which is expected to be inked between May and June.
The plan is to build up momentum, with the IIFCL eventually gaining more government resources and the ADB being able to withdraw. “It’s a temporary arrangement that’s been approved for three years,” says Rao. “During that time we plan to work on guaranteeing three to five transactions.”
Bhanwala is even more confident. He believes that the IIFCL with the ADB’s support can guarantee five or six bonds during the current financial year, and that it would have to provide capital for issuing such partial credit guarantees.
The ADB has other plans to help support India’s infrastructure development too, including establishing a bond guarantee fund that acts like a monoline insurance vehicle, again improving the bond rating of any deals issued by infrastructure SPVs. The concept has been approved by the ADB board and resources made available by the Japan Fund for Poverty Reduction, although it’s early days and the eventual size of this fund has yet to be confirmed.
Meanwhile the IIFCL is conducting a subordinated debt scheme to support infrastructure PPPs on a partly mezzanine basis. Bhanwala says that the agency has already done so once, and it will likely invest into more projects in such a fashion during this year.
BUILDING INVESTOR SOPHISTICATION
The hope is that the combination of bond initiatives and incentives to create infrastructure-focused funds (see box, right) foster a deeper understanding and appreciation of infrastructure-linked financing in India.
The ultimate goal is to foster an environment in which investors are willing to buy long-term infrastructure debt on its own merits and venture further down the credit curve when doing so.
But realising this ambition will require more than bond guarantees and specialised funds.
Bhanwala says that pending reforms are needed across a swathe of sectors in order for infrastructure project approval to accelerate, and for more private sector money to become comfortable in the sector.
He notes that the government has just recently initiated enacting land laws and environmental rules to help set a clear regulatory landscape in these areas vital for infrastructure projects. But further development is needed to help create model concession agreements in newer sectors and to help states develop projects on PPP basis.
Meanwhile urban infrastructure projects will likely be implemented by local bodies which require more capacity to undertake PPP projects and to enhance their financial capabilities.
“These sorts of reforms are in the pipeline as the project development over the next few years is critical for growth in the country,” Bhanwala says.
In the financial sphere the sticking point is over bond defaults. As things stand India’s highly bureaucratic regulatory system leaves investors uncertain about their rights in the event a borrower stops paying its outstanding debt.
“When an issuer provides a security to a lender they need to be able to access the security in the case of default, and this is particularly important with lower-rated credits,” says Rao. “The trouble in India is that it’s hard to access a security once a company defaults.”
Complex regulations surround declaring a company to be in default. Creditors first have to get a company to be officially recognised as being in default, and then to demonstrate to the Board for Industrial and Financial Reconstruction (BIFR) their legal rights to the security. It’s a costly, bureaucratic and time-consuming process, which is why most investors prefer buying ‘AAA’ or ‘AA’ rated bonds that stand little chance of defaulting.
New Delhi needs to work with the Securities and Exchange Board of India and the Board for Industrial and Financial Reconstruction to make the process of declaring a borrower in default or bankrupt easier. This is particularly important for the sort of long-term bonds required to support infrastructure.
Chidambaram is spearheading a genuinely revolutionary means of addressing India’s infrastructure woes – and improving the scale and understanding of the country’s bond market as well. But he needs to work with other ministries to address the bureaucratic hurdles surrounding the sector in addition to the financial ones.
The quicker he does so, the faster the country’s struggling motorists, train passengers and a populace periodically left in the dark will see conditions improve.
