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Analysis: Balancing requirement and availability

Analysis: Balancing requirement and availability

While the gap in debt requirement versus availability towards meeting the 12th Plan target is enormous and requires focused effort to address, equity investors will now look for steadier long-term investments, writes Manish Agarwal.

If much of the 1990s effectively focused on sector restructuring and reforms to enable private sector participation in infrastructure, the last decade has seen significant progress in creating the frameworks for bankable projects. However, the bottleneck has been in the project pipeline, and the domestic market has been able to finance projects that were ready. In the next decade, it is expected that the project pipeline will swell considerably, leading to potential bottlenecks in availability of appropriate financing. While this is a challenge in furthering the country’s infrastructure capacity addition, it is also an opportunity for innovation and reform in the infrastructure financing world.

The investment response on both the debt and equity side from the private sector has been encouraging during the 11th Plan period. Investment in infrastructure in the first three years of the 11th Plan period has exceeded the target of Rs 981,119 crore.

According to Planning Commission figures, the actual investment was recorded to be Rs 1,065,828 crore, which is 7.1 per cent of the GDP and 109 per cent of the targeted expenditure.

The dire need for a regulatory environment to ease investments in infrastructure has triggered the government to undertake some significant measures.

The banking sector has also responded to the infrastructure financing needs. Reserve Bank of India’s data reflects that in August 2009 the credit flow to the infrastructure sector grew at 44.7 per cent versus 36.1 per cent in 2008.

THE 12TH PLAN PROJECTIONS

The 12th Five Year Plan of the Planning Commission estimates investment requirement close to $1 trillion (~Rs 41 lakh crore), to meet India’s infrastructure needs. Of this, 50 per cent contribution is expected from the private sector, almost equal to the entire investment in this sector projected in the 11th Plan.

BRIDGING THE GAP: SOURCES OF FUNDING

Equity investment: On the equity side, both private equity (PE) and capital markets have been tapped by the infrastructure sector. The domestic developers have successfully leveraged their equity contribution by roping in PE houses. Most of the leading PE funds have significant interest and exposure in infrastructure, and are the vehicle for foreign equity investors to participate in the Indian infrastructure story. The preferred mechanism is for the PE funds to invest at the Holding Company level, which may own SPVs with projects at different stages – development, construction and operations. Investing in the holding company enables the investors to participate in growth, as more SPVs get added, as well as exit when required without violating the concession terms at the SPV level. The high level of PE interest in the sector underlines the high-risk nature of the sector, necessitating high return expectations. As some of the sectors mature, it is desirable that the investors with low-risk steady-return expectations become more visible.

The capital market also continues to be an important source of equity funding for infrastructure. A significant share of IPOs has been in this sector. Going forward, it is expected that foreign investors may also tap the domestic capital markets to enhance their competitiveness in the Indian market.

Debt investments: Currently, debt funding in infrastructure is primarily provided by banks and NBFCs. However, the banking system may not be able to substantially meet the enhanced requirement, in terms of volume as well as nature of products required. In spite of Asset Liability mismatch, banks have been able to stretch tenors to 12-15 years. Some of the new sectors, like Mass Transit – Metro, will require much longer debt terms to be viable. Second, the banks have been lending largely on the back of sponsor support. As sponsors’ capacity to provide recourse diminishes with additions to their portfolio, banks will need to move closer to pure non-recourse financing, and develop capabilities accordingly. Finally, the sector caps and group limits, with a limited number of developers, will impede banks’ ability to continue to finance infrastructure projects.

Bond markets can be very useful to channelling longer tenor funds into infrastructure. However, insufficient depth in the Indian bond market for various reasons including regulatory bottlenecks restrict the primary issue volume for the developers. The government bonds, the most liquid component of bond market, constitute over 90 per cent of the total bonds. The corporate bond market is still emerging and comprises largely the privately placed debt of public financial institutions. The corporate bonds constitute only 3.3 per cent of the GDP compared to 10.6 per cent in China 41.7 per cent in Japan, 49.3 per cent in Korea among others. The current easing of regulations for infrastructure NBFCs is a step towards addressing debt issues, but much more is required to address the large gap.

Domestic pension & insurance funds: The Deepak Parekh Committee proposes that the India Infrastructure Debt Fund (IIDF) be set up and managed as a trust, with an initial corpus of Rs 50,000 crore, approved and regulated by SEBI. These recommendations follow from similar practices followed in the US where three institutions – National Infrastructure Bank (NIB), a National Infrastructure Development Corporation (NIDC) and a subsidiary National Infrastructure Investment Corporation (NIIC) were established to raise money from the market as long-term debt, and then fund public and private investments in infrastructure.

Employees Provident Fund (EPF) can invest only 10 per cent of its investments in private sector bonds/securities which must have a minimum investment grade rating. A minimum of 15 per cent of the funds from the traditional plans of life insurance policies need to be invested in infrastructure. However, a small part of this gets channelled into private sector-led projects since the infrastructure projects do not meet the credit rating requirements. Lack of liquidity in debt markets and lack of credit derivative market further impacts risk perception and ability to manage risks. Finally, in the current state, most life insurance companies (except LIC) have limited long tenor liabilities (the liabilities being primarily ULIPs), and hence have limited appetite for long-term investments. However, as this changes, it will be critical to remove bottlenecks to attract the insurance and pension funds into infrastructure in much larger volumes.

Foreign funds: Even after addressing the bottlenecks in the domestic banks/NBFCs and the insurance/pension segments, the debt funding gap is estimated to be of the order of $80-100 billion. Thus, increasing the flow of foreign debt into the country is a key imperative. There have been a number of attempts to attract international banks to the Indian infrastructure sector. Given the External Commercial Borrowing (ECB) limits, the entry barriers and operating restrictions on foreign banks and the fact that there is an absence of a long-term foreign exchange market, there is limited ability to use international lenders in the Indian infrastructure market. Few international banks have Indian currency deposits and therefore could only lend in US Dollars or another international currency. In the absence of long-term currency swaps, the currency risk is a key barrier. There is also a limited ability to fix interest rate risk through the use of interest rate swaps. There are many examples in developing PPP markets where in the absence of a long-term swap market, the Government takes this risk through a benchmarking arrangement. The India Infrastructure Debt Fund is a focussed attempt at channelling this potential source into infrastructure. A credit-enhancement mechanism may be a necessary adjunct to address the barely investment grade of the country, and therefore the likely sub-investment grade rating of the projects that the fund invests into.

In conclusion, a number of regulatory and other initiatives are necessary to remove the supply side constraints to infrastructure financing. Some of these are short-term and sector-specific, while others like development of Bond, Currency and Derivatives markets impact the entire financial sector. The industry-specific measures include the need for credit enhancement mechanisms to enable domestic pension and insurance funds and also to pierce the country rating ceiling to attract foreign long-term debt. A refined take-out financing scheme, that better addresses the cost-benefit-risk trade off, will also contribute to better alignment of debt servicing cash flows with project cash flows.

Such measures, supported by tax incentives, for eg, providing withholding tax concessions for overseas lenders providing non-recourse project finance, could attract new sources of capital.

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