Traditionally, infrastructure investments have been financed with public funds. Governments were the main actors in this field, given the inherent “public good” nature of infrastructure and the positive externalities often generated by such facilities. However, public deficits, increased public debt to GDP ratios and, at times, the inability of the public sector to deliver efficient investment spending, have in many economies led to a reduction in the level of public funds allocated to infrastructure.
As a consequence, it is increasingly acknowledged that alternative sources of financing are needed to support infrastructure development. In this context, much attention is being focused on the institutional investor sector, given the long-term nature of the liabilities for many types of institutional investors and their corresponding need for suitable long-term assets.
India has witnessed a major shift from the traditional development financial institution (DFI)-led lending to core and infrastructure sectors, to commercial banks. DFIs’ inability to raise statutory liquidity ratio (SLR) bonds as a cheap and ready source of funds, pursuant to the recommendations of the Narasimhan Committee report, made that model unviable.
This shift, in the early 2000s, of without-recourse project finance from DFIs to commercial banks coincided with an extended phase of low interest rates, high liquidity, high GDP growth rates and widespread enthusiasm and optimism amongst all stakeholders, including developers and lenders. This had two consequences. The good part included banks getting on to the learning curve in project lending (a major shift from their earlier principal role as working capital financiers); developers putting together the “heft” to go for previously unthinkable large projects; and the actual creation of some large infrastructure assets, including roads, often with a user charge – a far cry from the era of all infrastructure being offered free by the government.
The downside was a gross miscalculation of the ground realities, coloured by an excessively optimistic vision of the future. The new class of lenders too, with some notable exceptions, was not fully adept at understanding the nuances of cash-flow-based long-term financing. They were still on the learning curve.
The rest is history. It is known how infrastructure financing has panned out and the dire situation that commercial banks find themselves in today. In hindsight, it is easy to pin the blame on all the players. Yet, the painful years leading up to the pile-up of huge non-performing assets have not gone waste. There has been critical learning for all – developers, lenders, policymakers and regulators. There is recognition of the fact that infrastructure financing cannot be left to public sector banks, given their huge need for growth capital from the government. Alternative sources are desperately needed. This realisation, remarkably early on, led to the creation of Indian Infrastructure Finance Company Limited (IIFCL). But the statutory limitations on IIFCL have prevented it from becoming a major infrastructure lender in the country. But that is a separate story.
The preceding paragraphs provide the setting against which the subject of alternative funding needs to be approached.
Bonds
Globally, bonds have been proved to be a practical and one of the most effective fund-raising options for the infrastructure sector. Bonds are possibly key to the revival of the Indian infrastructure sector as well due to various advantages. They are long term in nature and can be structured as per the borrower’s requirements. Back-ending of the cash outflow along with staggered interest payments help long-gestation projects. But the economy has been waiting forever for the Indian bond market to mature. With very few institutional investors and with practically no appetite for bonds below a AA level of rating, this remains a pipe dream. Logically, all bonds in the investment category should have a market. The only differentiator should be the coupon.
There are some developments in the form of rupee-denominated (masala) and green bonds. Typically, both have been possible because the investors are overseas. There is a constraint of India’s sovereign rating being capped at BBB- and that obviously raises costs.
A lively market for partial credit enhancement is also a crying need. A well-capitalised entity could be set up to be in this business. This would give a fillip to the Indian bond market with more paper in the AA or better category.
Most developed economies have sustainable municipal bond markets. The situation is different in India. With the exercise of credit rating of cities and towns gaining momentum, 94 of the 500 cities included in the Smart Cities Mission and Atal Mission for Rejuvenation and Urban Transformation have obtained credit ratings necessary for issuing municipal bonds. Of these, only 55 are rated “investment grade”. That too does not help, inasmuch as only six municipalities have a rating of AA and above and can hope to place their bonds with some degree of ease. There could be some borderline cases where internal structuring and collateralisation could enhance the rating to investible territory.
To make municipal bonds a possibility, it is required to seriously look at the health of municipalities in the country. To address this issue, there is yet another domain of infrastructure financing: value capture financing.
Value capture financing Whenever better infrastructure significantly improves quality of life in any part of urban/ suburban India, there is a need to make users pay for such improvements, maybe through increased property tax or cess, and capture this source for reinvesting further into that geographical area. Municipal corporations will have a major role to play here. Such future cash flows are amenable to various kinds of innovative financing structures like securitisation. Much like access-controlled expressways, the general population will not mind paying more if good quality assets are made available and the quality is sustained. This concept will also gel well with the rolling out of smart cities.
Typically, value capture goes beyond user charges or fees that agencies collect once services start being delivered from the infrastructure project. Value capture is a type of public financing that recovers some or all of the value that public infrastructure generates for private landowners. Value capture relies more on the intrinsic accretion of value increase in the location of the private land once public infrastructure is implemented in its vicinity. This area of infrastructure financing needs a serious look.
Pension funds
Pension funds play a major role in infrastructure financing in developed economies. Some of the large pension funds have shown interest in the Indian infrastructure space. Typically, they are keener to invest in completed revenue-generating projects. This makes a case for monetising quality infrastructure assets and using the corpus for a further infrastructure push.
The Indian pension fund space has its own problems. The pension fund market is highly underpenetrated. Of an estimated workforce of 321 million, only 12 per cent is covered by pension schemes. The total pension fund assets with the Employees’ Provident Fund Organisation were to the tune of 4.6 per cent of GDP compared to 50-100 per cent for most developed economies. Exposure to equities is negligible, compared to 40 per cent in developed markets.
However, structural issues remain – pension funds are only notionally funded. More than two-thirds of the funds exist in the form of special deposits with the central government. Under the existing stipulations, these funds cannot be withdrawn for deployment in other avenues. A significant portion of the remaining funds are deployed in government securities which remain locked too.
Hence, it will take time for the Indian pension funds market to mature. Until then, the appetite of foreign funds, including sovereign funds, for completed projects, could be tapped.
Other instruments
Infrastructure debt funds, alternative investment funds and infrastructure investment trusts offer good promise. But a point to note is that these are only enabling structures, and there is still the need for global investors who would invest into them. What attracts global investors, apart from mitigation of project risks, is a durable structure. That is what these products offer. The distinctive features of each of these categories are widely known and are not being detailed here.
Finally, there is need for a product that insures lenders/investors against project risks like cost overruns. This product has been on the drawing board for some time now. Some variants have been discussed. Much more needs to be done in this regard and fast.
Conclusion
Eventually, no matter what route is taken for channelling investment into infrastructure, the key challenges need to be ironed out. The good news is that there is widespread awareness today about what ails the sector and enhances the risks for both developers and lenders/ investors. While concerns regarding appraisal standards, risk recognition and mitigation, equity shortfall, excessive leverage in promoter balance sheets, delays in land acquisition, environment clearances, etc., are well known, some areas that need immediate attention include the following:
- Dispute resolution: At present, disputes between parties are one of the major causes of delays in projects. The arbitration clause is poorly defined or is one-sided. Furthermore, arbitration is generally not binding. Therefore, most cases go into further litigation. Nonhonouring of long-term contracts like power purchase agreements and not respecting the escrow mechanism are some areas that need quick redressal. Such events directly affect developers and investors.
- Regulatory risks: Each infrastructure sector needs an independent regulator. Often the concessioning authority doubles up as a regulator as well.
Fine-tuning of these areas of concern will increase lender/investor confidence, including of overseas investors, who could show keenness to take construction risks as well.
Deepak Chatterjee, Chief Executive Officer, IIFCL Projects Limited