India’s power sector has been starving for years, and there are plenty of reasons why investors are leery of it.
Artificially low power tariffs have saddled the country’s state electricity boards (SEBs) with US$35 billion in debt. Meanwhile, private power providers are struggling to operate their plants simply because there is just not enough fuel and gas. A volatile rupee makes imported coal costs unstable, and some private companies are legally tied into power purchase agreements that obligate them to provide power at costs that are unsustainable.
Although the country will need to obviously speed up reforms on environmental approvals and raise power tariffs, as well as force state coal provider Coal India to ramp up production and distribution, these needs will not extinguish the power producers’ desperate need for funding to refinance debt and help finance plant construction.
But the country’s banks will become increasingly reluctant to lend to these power producers as losses mount, and this will only make their debt snowball. In this environment, dollar funding becomes a viable option to garner much needed funding.
Power Grid’s chief financial officer told Bloomberg that it is planning to issue its first dollar bond debut by December 15, and this may be well replicated by India’s power sector generators.
One of the biggest reasons why these companies should consider obtaining dollar funding is because the weak rupee has made it more difficult for them to pay back foreign debt. Ebitda to interest for companies like Adani Power is expected to deteriorate from 20.6 times in FY2010 to 1.9 times in FY2014, according to HSBC. Lanco Infra, JPVL and Tata Power are also forecast to see those ratios erode.
Power companies can use dollars to refinance this debt, and possibly at a cheaper interest cost or a longer tenor as industry estimates suggest that coal price benchmarks used in long-term contracts between Indian companies and Indonesian coal suppliers may fall as much as 30% in 2013 from this year. That may allow Indian power producers to persuade investors that their cash flows may get some relief and lower operating costs.
Companies such as Adani or Tata may be able to achieve funding at 400 basis points (bp) over similar-rated Treasuries, according to a market source. If additional costs were factored in, these power producers may be able to borrow in dollars at a rate of 8%- 9%, compared to a typical bank loan of 10%-11% on a five-year loan.
These companies are also exempt from a rule that caps offshore borrowing costs to 500bp over Libor.
Dollar funding can also be used to help the power producers pay their international coal suppliers. For example, Adani Power’s Mundra plant uses imported coal that is paid in US dollars. At a time when the rupee continues to be volatile amid a political tug-and-war between reform and opposition, currency depreciation hurts earnings.
Using dollar funding may temper the erosion in earnings, as analysts estimate that Adani’s Ebitda for the 2013 financial year will fall 6% because of currency depreciation. That would be higher compared to those in the two previous financial years.
Although the prospect of dollar funding may be close to a dream come true for some of the treasurers at these power companies, it is also important to address ways in which they can extinguish inevitable investor concern especially after power producer Lanco Infratech defaulted on its debt worth INR8 billion (US$145 million) due in 2012 and 2013.
Power companies may want to consider using their plants as collateral to secure a dollar bond. Companies like Adani Power may be able to refinance foreign debt through the US dollar bond market by putting up its three Mundra plants, which is expected to increase capacity to 6.6 gigawatts by the end of next year.
A fixed income strategist estimates that secured bonds may help Indian power producers shave an extra 100 basis points off interest costs.
Another solution may be to persuade investors such as Srei Infrastructure to participate in these dollar bond deals. Srei has received approval on November 15 from the Securities and Exchange Board of India to launch a US$500 million mutual bond fund investing in infrastructure. Foreign institutional investors (FII) investing in this fund will be exempt from paying a withholding tax.
Such an arrangement will not only provide FII funding in the form of dollars to the troubled companies, but it may give offshore investors the comfort they need by lending money to a profitable infrastructure investment provider rather than a more riskier borrower.
The dollar bond market may still be high-hanging fruit for Indian power companies. But at a time when quantitative easing creates excess liquidity in the global bond markets, financial expertise and creativity may help funnel in just the cash the power sector needs.