Not enough credit enhancements

While in theory, the idea behind setting up IDFs is sound, the two structures proposed by the Ministry of Finance at present do not appear to have enough credit enhancement mechanisms to bring in domestic and foreign long term institutional investors, says Amit Dinakar.

India currently faces a significant deficit in infrastruc­ture which is estimated to cost the country 1-2 per cent of GDP growth every year. Current funding trends indicate that there will be a shortfall of over $300 billion (about $235 billion in debt and $78 billion in equity), posing a serious supply side financing constraint to India's in­­fra­structure story and the reasons for this are explored further below. The challenge is facilitating the flow of large amounts of capital into infrastructure. Among the inno­vative ways of bringing in new sources of debt finance ­- domestic and international – into the infra­stru­cture sector is the recently announced Infrastructure Debt Fund (IDF).

So far, infrastructure debt financing in India has been led primarily by the banking sector. However, the large si­zes of these loans, fast growth in infrastructure asset crea­tion, and the low numbers (15-20) of large developers has meant that banks are fast approaching prudential sectoral and group limits. This will force them to pare the growth of their infrastructure loan book going forward. Other fina­ncing sources need to step in and fill the resultant gap.

Need for effective credit rating

From an asset-liability matching perspective, the logi­cal long-term investors in infrastructure debt are life insurance companies and pension funds which have long-term sources of funds and are seeking a fixed long-term return. The key issue is that such investors are extremely risk averse (rightly so) and given the inherent 'riskiness' of infrastructure projects (most are rated BBB or BBB-), they do not fall in the AA/AA+ 'safe' category that such investors would desire from a risk management perspective. They are not equipped to successfully assess and manage project level risks and hence, at present they choose not to invest at the project Special Purpose Vehicle (SPV) level, and subscribe instead to safer bonds, give loans to banks or infra-NBFCs which are effectively safer exposures to a company and hence meet their con­servative investment criteria. Indian life insurance com­panies, for example, can subscribe to such instruments to the extent of 20 per cent of the investee company's capital. However, their inability to invest at the project SPV level leads to little support to banks from the perspective of prudential sectoral group exposure norms, which are now close to being breached.

Hence, there is a need for suitable forms of credit enhancement to enable a rating increase to AA/AA+ for domestic insurance companies and pension funds to invest at the project SPV level. The problem is further exacerbated for foreign insurers and pension funds which look at international ratings and India's overall country rating while taking an investment decision. At a country level, India is rated BBB-, which is barely investment grade. Thus, AAA rated Indian institutions are effe­ctively BBB- at an international level and do not fit into the investment guidelines of foreign life insurance and pension funds. The problem here is even more acute as suitable credit enhancement measures are needed to breach India's low country rating to attract foreign life insurance companies and pension funds into India. These (eg, US and Japanese) funds have very low yields on their debt investments in their home markets and are looking to increase returns as their home populations age. If suitable modes of credit enhancement to breach the sovereign rating are conceptualised and implemented, these funds' investment criteria would be met and a large volume of capital at low rates would be available to the Indian infrastructure sector.

International experience in credit enhancement

The above issues are not unique to India; the same problem exists in other countries as well and they have tried to explore innovative solutions around it through involvement of non-banking intermediaries (private, government, PPP) to bridge the gap and take this risk. In several developed countries, infrastructure finance paper can attract life insurance and pension fund investors mainly through credit insurance by the private AAA (global) rated monoline insurers, which effectively credit-enhanced the paper to AAA instruments. The subsequent decline of their business model was caused mainly due to excessive exposure of the monolines to poor quality mortgage paper; in contrast the infrastructure paper has performed reasonably well. However, infra­structure finance in these countries has since suffered as a consequence of the decline in the monoline insurance business model and they are now exploring alternative models as well. Government sponsored institutions like TIFIA in the US have performed credit enhancement through taking subordinated debt in project SPVs as well which is a funded form of credit enhancement. Closer home, in Asia, Korea has set up the Korea Infrastructure Credit Guarantee Fund under the Korea Credit Guarantee Act to act as a bridge. A pan-Asia collaboration-the Credit Guarantee & Investment Mechanism sponsored by ASEAN, China, Japan, Korea and ADB-is proposed to also fulfil the same purpose in the participating countries. While internationally, non-funded forms of credit enhancement have been more prevalent, in India, the capital requirements for doing non-funded credit enhancement is likely to make such a proposition uneco­nomical and funded credit enhancement techniques like subordinated debt are likely to be more attractive unless the RBI should relax its stand on capital requirements for credit guarantees.

Objectives and Assessment of IDF

With this background in place, we can now explore the concept of IDF in more detail. The IDF is being set up to act as a non-banking intermediary and fulfil the following two main objectives.

1) Bring in new sources of long-term providers of debt (domestic and foreign) viz, insurance companies, pen­sion funds through suitable modes of credit enhancement;
2) Free-up commercial banks balance sheet either by buy­ing infra portfolios from banks through what is called 'take-out' financing or funding project SPVs directly.

On the asset side, the proposed IDF is expected to take exposure at SPV level through direct lending or 'take-out' finance; freeing up balance sheets of the ban­king sector. On the liability side, it will put in place suitable credit enhancement measures to attract funding from domestic and foreign life insurance companies/pension funds. While theoretically, the idea is sound, the two structures proposed at present do not appear to have enough credit enhancement mechanisms to be successful in bridging the gap and the reasons are as follows.

IDF as trust: The trust structure envisages the IDF as a pass through structure with the entire credit risk being borne by the end-investor. While this will result in some reduction in risk from pooling of assets, it is unlikely that this will be enough to reduce the risk from BBB- to AA/AA+ (India). Given the risk profile of units issued by the trust to raise money from long term institutional investors, this structure may not succeed in attracting even domestic long-term institutional inve­stors who would be unwilling to bear such a high level of risk. Foreign investors who are even more risk averse would definitely not find the risk levels acceptable. In addition, the proposal to issue units in rupee denominated units would not be attractive to foreign investors who would not want to manage the currency risk. Because of these reasons, this structure is unlikely to be successful and it is unclear how this mechanism will translate into more flow of funds into the sector.

IDF as company: Setting up the IDF as a company will mitigate the risk for long-term investors to a greater degree as the credit risk now lies with the IDF. The proposed exemption on withholding and income tax will enhance returns, which is a welcome measure.

The proposal to extend lower risk weightage to IDFs will reduce capital requirements and further enhance returns but may not be looked at favourably by rating agencies as this negatively impacts the IDF's ability to withstand a downturn. This fund is expected to invest in debt securities of only PPP projects which have a buy-out guarantee and have completed at least one year of commercial operation. Refinance by IDF would be up to 85 per cent of the total debt covered by the concession agreement. Senior lenders would retain the remaining 15 per cent for which they could charge a premium from the infrastructure company. This structure should succ­eed in issuing AAA (India) bonds with minor modi­fications and attract domestic long-term investors. The key issue with this structure is that apart from the tax and regulatory advantages, it does not offer anything substantially unique to the current scenario. Take-out schemes like this can be launched by incumbent non-bank project financiers as well. The constraint of dom­estic life insurance companies not being allowed to inv­est more than 20 per cent of the investees capital will limit the scale of this kind of fund unless the government works with the IRDA to sort out this issue. In any case, despite the tax exemptions, it will definitely not be able to attract foreign long-term investors as it will be con­strained by India's sovereign rating of BBB-. Thus, the debt gap projected in the next Five Year Plan is un­likely to be bridged through this type of fund.

Proposed structure

Setting up an ideal structure would involve inter­vention by the government to pull in the key stakeholders as sponsors – large AAA (India) rated public sector banks (who as sponsors will now have a larger incentive to down-sell their infra loan book to this fund), LIC (which will provide a substantial corpus as loan to this entity), GoI/IIFCL (to indicate sovereign support) and a multi­lateral agency (to provide guarantees to bonds issued overseas and effectively breach the country rating). The modes of credit enhancement should be customised sep­arately for domestic and foreign investors based on their risk appetite. The first loss tranche (10-15 per cent) should lie with the lead bank to contain moral hazard. Given the strength of the promoter group and adequate equity capitalisation, this entity should be AAA (India) and attract funds from domestic institutions. In addition, the promoter group (barring LIC) could invest in sub­ordinate debt instruments to take the second-loss tran­che and provide a further rating enhancement. Bringing in foreign institutions would need a mechanism to pierce the sovereign rating and in the short-term the only way to achieve this is to bring in a multi- lateral to par­tially guarantee the bond issue using its international AAA rating.

Leaving the IDF to be set up by any entity in the abs­ence of appropriate credit enhancement mechanisms to bring in domestic and foreign long-term institutional investors will not help to increase funding flow to infrastructure.

The IDF needs to be pursued in conjunction with opening up the domestic corporate bond market as well as other measures to improve liquidity and attract long term investment into infrastructure, viz, development of credit/interest derivative market and long term currency hedging. The issue of infrastructure financing is a structural issue with no simple solution. It needs an innovative structural solution led by the government to put the right sponsors and structures in place if we are to meet the ambitious $1 trillion target.

The author is Associate Director, KPMG.