Institutional investment in the recently introduced IDFs will require sovereign guarantees. Projected not merely as a factor of a single project but for several projects in a developmental cluster, such government guarantees can reduce the chances of the risk.
In order to boost funding for infrastructure projects, the central government and Reserve Bank of India (RBI) recently introduced the concept of InfraÂstruÂcture Debt Funds (IDF). Government expects various investors including banks, pension funds, insuÂrance companies, World Bank, Asian Development Bank (ADB) to participate in the IDF.
However, for the World Bank and Asian Development Bank (ADB) to contribute capital to the IDF, government has to provide sovereign guarantee, since such guarantees greatly facilitate investment by reassuring the investor. But they also place a responsibility on the government, because in case of a default, the government has an obligation to step in. This is a subject that has been heavily debated internationally. With big-ticket infrastructure projects both in the works and in prospect, the debate has come to India's doorstep too. To look away from it will mean decision by default, India's chief economic advisor Kaushik Basu commented in the Economic Survey 2011-12.
Valid warning: In the Economic Survey, the former Cornell professor of economics talks about the risks associated with such sovereign guarantee and analyses the subject from an academic point of view. Providing such a guarantee may do nothing immediate to the govÂernment's fiscal arithmetic, but it amounts to underÂtaking future fiscal expenditure. Since there is always the probability that even a guaranteed project will fail in the future, each such guarantee amounts to a certain additional expected expenditure by the government in the future, Basu says.
Hence, such guarantees, given recklessly, can lead to unsustainable fiscal deficits in the future with all their attendant problems, such as inflation, collapse in invÂestment, and, ultimately, economic recession.
While this warning is valid and governments ought to keep it in mind, there are circumstances where some strategic and well-designed guarantees or 'comfort lettÂers' from the government can be desirable in the overall interest of the nation. This can happen in a buoyant nation on the verge of take-off and considering a high growth in a number of infrastructure projects, it is an argument that has direct relevance to their success. There is typically a lot of positive externality among infrastructure projects: A new road that will be operated by a toll system is more likely to be successful if the residential township at the end of the road comes up; and the residential township being contemplated by the developer is more likely to be successful if the road gets built.
Project as factor of development: In order to illusÂtrate the point, Basu gives the following example. Suppose there are three projects, pertaining to a road, a township, and a power project. Each entails an initial cost of 100. If the project succeeds, it yields 150; if it fails, the entire initial cost goes unrecovered. If all three projects are undertaken, each project is more likely to succeed, because of the kind of positive externality menÂtioned; let us suppose that the probaÂbility of success of each project, when the other two are implemented, is 0.95.
If, on the other hand, the other two are not implÂemented, then assume the project that is implemented has a probability of success equal to 0.5. If government gives a guarantee to the investor for a project, then for an investor it is worthwhile investing in the project, since she incurs no risk of default. In the event of a default, government pays off the investor the 100 that she had invested.
Suppose the government now gives a guarantee to only one project. Assuming that the other projects are not undertaken under the circumstances, there is an expected loss of 50 units of money to the goÂvernment, since the probability of failure is half and in the event of a failure government has to pay the investor 100. Hence, the expected fiscal deficit rises by 50.
Now suppose government gives guarantees to all three projects, then all three projects get implemented; and the government's expected fiscal cost of this is only 15 (3 × 0.05 × 100), since there are three projects, each project has 0.05 probability of failure and, in the event of a project's failure, government has to pay 100 units of money. If these projects create socially valuable wealth, which is worth more than 15 units of money, it is arguÂable that guarantees to all three are desirable; even though it may not be worthwhile giving a guarantee to any single project.
This simple arithmetic is not a reason to rush and give out guarantees or even comfort letters (comfort letters often, in effect, turn out to be like guarantees in the eyes of the law) but it alerts us to the fact that for a nation on the verge of take-off, and with complemenÂtarities between projects, the calculus of guarantees and fiscal deficits is not as simple as may seem at first sight.
We should evaluate the benefits and fiscal costs of govÂernment trying to give a coordinated big push to a cluster of infrastructure projects, and recognise that the costs and benefits would not be the same if we worked this out for each project separately and then simply added them up.
German credit agency rates RIL Better than Sovereign
Although international lenders are getting more skeptical about the Indian environment, transnational infra-finance deals are far from over: German export credit agency Euler Hermes for the first time assigned “better than sovereign” rating to a corporate borrower, as German Development Bank KfW signed off on a $2 billion loan for major expansion of Reliance Industries' petrochemical projects.
Don't write off international banks as infrastructure's funding source just yet. In a major cross-border financing for one of the biggest oil and gas projects in South Asia, law firm Milbank, Tweed, Hadley & McCloy LLP has represented Germany's state-owned development bank KfW IPEX Bank GmbH as lead arranger in a financing for expansion of several petrochemical projects in India operated by Reliance Industries Limited (RIL). The financing, which closed on 7 May, was covered by the German export credit agency Euler Hermes Deutschland AG, which for the first time accorded to RIL a “better than sovereign” rating.
Whether sporadic but significant deals such as this one can reverse the downbeat mood and recent skepticism among foreign investors about India's infrastructure sectors remains to be seen. The deal is noteworthy for several other reasons. Besides being the largest underwriting ever by Euler Hermes, the $2 billion represents the biggest financing ever for KfW, which is jointly owned by the Federal Republic of Germany (80 per cent) and the States of Germany (20 per cent). The loan, which has a 13-year maturity period, will help diversify RIL's funding sources and significantly extends the maturity profile of its long-term debt in a cost-effective way. Reliance is expected to primarily use the loan to finance purchase of goods and services from some 40 German suppliers in expanding its petrochemical facilities in Jamnagar, Hazira, Silvassa and Dahej.
The deal was very well received by institutional buyers, drawing a 50 per cent oversubscription. V Srikanth, Joint CFO of RIL, expressed his delight at the 'landmark financing', and said the deal received strong support from international banks, particularly from German lending institutions.
KfW IPEX-Bank GmbH arranged the Euler Hermes cover, while the following nine banks participated in funding the facility: KfW, Citibank NA, Commerzbank AG, Nord LB, Banco Santander SA, Landesbank Baden-Württemberg, DZ BANK AG, BHF-BANK AG and ING Bank.
Milbank's financing team was led by London-based project finance partner John Dewar, along with finance Of Counsel Anthony Morton in Frankfurt.
“Although this type of financing is not by itself new, it represented several important milestones and innovations, including Euler Hermes' flexibility and approach to the loan, its 'better-than-sovereign' rating accorded to a corporate issuer, the approach to future supply, and the sheer size and speed of documentation and execution,” Morton explained. “German banks and Euler Hermes have demonstrated to purchasers and suppliers of large-scale petrochemical equipment they can deliver large-scale financing quickly.”
Dewar added, “This is a landmark transaction which will have a positive impact on both the Indian and German economy creating value and jobs. The transaction has also showcased Milbank's expertise in German and English law governed export credit and project finance.”
Glenn Gerstell, Milbank's India practice group leader, said he was pleased to have helped structure such a high-profile financing bridging key European funding sources with one of the preeminent industrial companies in South Asia.
RIL is the first Indian company to be ranked among the Fortune Global 500 list and ranks 119th amongst the world's Top 200 companies in terms of profits, while Milbank, Tweed, Hadley & McCloy LLP is 150-year-old law firm headquartered in New York.
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