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Credit ratings: Need for a different rating mechanism

Credit ratings: Need for a different rating mechanism

Conventional investment credit ratings-typically lower than desirable for infrastructure projects-constrain financing infrastructure investments in India, says Dhruba Purkayastha. So should the methodology be revisited?

The often discussed debt gap in financing Indian Infrastructure Investments is of the order of $50 billion in the current Five Year Plan, and is exp­ected to be of the order of $235 billion in the 12th Five Year Plan. It is also understood that the debt gap has not yet surfaced because of slower roll out of infra­structure projects, and expected to be constraint soon as recent government initiatives on rolling out PPP projects begin to show results.

Various policy and institutional initiatives are being directed towards increasing financial intermediation to infrastructure sectors, and these include enabling policy and regulation for infrastructure finance companies, debt funds, revised external commercial borrowing norms, buyback/refinancing of loans from commercial banks, take out financing and credit enhancement/gua­rantees for infrastructure financing. It is also recognised capital markets do not participate much in financing infrastructure, and it may be possible that, creating dedi­cated infrastructure debt funds would provide a way for institutional investors to invest in bonds issued by oper­ating infrastructure assets.

Enabling infrastructure finance has two sides to the story-the supply side, and the demand side-and they have to find a common ground for credit markets to work for financing infrastructure projects. While all these initiatives are relevant at the policy and insti­tutional levels in the context of facilitating infrastructure project finance as private, public and PPP SPVs from the supply side, there remains a credit market failure at the infrastructure project level, which possibly requires some correction. At the heart of this market failure is the propensity to use or benchmark conventional credit rat­ings for financing infrastructure.

The interminable B to A journey

Infrastructure projects are considered risky by rating agencies given that the cash flows arise from a single asset, and because of higher non-commercial risks (mainly political and regulatory risks).

Assigned ratings are usually at BBB levels, which means, a default probability of around 8.8 per cent in one year. The application of this concept and the rationale for classifying infrastructure projects at this level is however not clear as there is lack of adequate historical data to confirm this. Some research studies carried out on UK PFI and European project financed projects have also shown that infrastructure project finance risk (and more so for infrastructure PPP projects) the default likelihood may be same or lower than that of corporate finance. It may be important to note that commercial risks in infrastructure project finance should actually be lower because of steady cash flows, near monopoly market structures, relative pricing power and low technological obsolescence which characterise such projects.

The peril of risk aversion

While project loans are supposed to be non-recourse project finance, in most cases they are backed by collaterals, debt servicing structures and other partial guarantees, which effectively reduce the extent of possible credit loss, if at all. Limited historical data and lack of institutional mechanisms to capture project default data leads to risk aversion by regulators, lenders and rating agencies. For rating agencies, there is no commercial incentive to address these issues from a holistic financial sector perspective. Financial investors have no choice but to adhere to given regulation, which again relies on conventional credit ratings. This leads to a risk aversion behaviour which may not be founded on real hard facts or economic logic.  
These issues create a variety of problems for infra­structure projects, developers and lenders both, such as higher or mispriced loans for the projects, greater capital requirements for banks and financial institutions and eventually impose higher cost of ser­vice to the tax payer or poor quality of infrastructure services. Access to bond markets remains constrained and does not allow inv­estment from longer term sources such as pension and insurance (stipulated requirements being AAA or AA rated securities).

It is time we reduce this reliance on conventional credit ratings for financing infrastructure (particularly PPP in infrastructure) and look for alternative yardsticks/benchmarks or revise infrastructure PPP rating scales to reflect more real (based on capture of historical infra­structure project default data) rather than based on perceived risks.

Piercing India's Sovereign Rating

It would be difficult for FIIs to invest in Indian infra­structure projects directly or even through debt fund structures. Attracting foreign funds would need credit enhancement to the fund itself to pierce the sovereign rating to be become investible by foreign long term funds. Credit enhancement mechanism utilising guara­ntee stru­ctures can possibly bridge the rating gap betw­een the inv­estment norms and/or risk perceptions of foreign investors and the actual ratings of Indian entities. This mechanism will also help in attracting the domestic insurance and pension funds. The credit enha­ncement may also need to be done at the level of the banks and infrastructure finance companies and not the projects.

The author is President-Risk Management, Feedback Infrastructure Services.

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