That India’s infrastructure deficit is the single most important factor that constrains the growth of its economy is now well recognised. The government acknowledges that investment in both physical and social infrastructure needs to be greatly enhanced. Prime Minister Manmohan Singh heads an infrastructure committee that reviews progress in key projects such as the National Highway Development Programme, the Golden Quadrilateral Programme and the Urban Renewal Programme.
Montek Singh Ahluwalia, deputy chairman of India’s Planning Commission, told delegates at the annual Asian Development Bank (ADB) meetings in May that India needed to spend an additional 2.5% to 3% of gross domestic product on infrastructure, up from the current level of 4.5% of GDP, to be able to grow at 8% to 9%.
A report titled Asia’s New Tigers: India and China published by JM Morgan Stanley in June said that while China spent $201bn (9% of GDP) on infrastructure in 2005, India spent about $28bn (3.6% of GDP). With the exception of telecoms services, the cost of most infrastructure services is between 50% and 100% higher in India than in China, the report pointed out.
Unlike in China, India’s infrastructure cannot be financed entirely by the government or the public sector. “China was able to make very large public investments in infrastructure way beyond demand, and that helped it sustain [economic] growth,” points out Anita George, the India-based chief investment officer at International Finance Corporation (IFC), the World Bank’s private lending arm.
On account of its fiscal constraints – government debt stands at 82% of GDP – the Indian government must draw private investment into infrastructure. A public-private partnership model is being put forward, but first the regulatory environment and the terms have to be made attractive enough to lure private investors.
Recovering costs
“There is a public policy aspect in urban water supply projects, for instance, where the costs may not be fully recoverable – which makes attracting private investment a challenge,” says Rajiv Lall, managing director at Infrastructure Development Finance Company (IDFC), a specialist financer of infrastructure.
To get such projects off the ground, the Indian government is now prepared to provide an explicit public sector subsidy, Mr Ahluwalia says. When private investors bid for the first phase of the Mumbai metro rail project last year, they specified a ‘viability gap funding’ requirement from the government. The 30-year, build-own-operate-transfer contract was awarded in May to a public-private joint venture led by Reliance Infrastructure and to which the government will contribute Rs6.5bn ($140m) out of a total project cost of Rs23.6bn.
About 30 build-own-transfer road projects were conducted in the same manner in the past year, and the actual 7% subsidy they involved was lower than the government expected, according to Mr Ahluwalia. In a first attempt of its kind, the government levied a proxy user charge – in the form of a levy on fuel – to set up a road fund that is being used to finance new roads. Such moves were critical in encouraging private sector participation in road projects.
Bankable projects
Bankers attest to the fact that now there are far more bankable infrastructure projects than ever before. Several private companies, including foreign companies such as P&O Ports (now Dubai Ports) and Maersk, both of which have already made significant investments in Indian ports, pay fees ranging between $2m and $12m to apply for a licence to carry container traffic on Indian railways. Their keen interest is sparked by the imminent opening up of Asia’s oldest and largest rail network with a private freight corridor expected to be bid out soon.
“Private sector companies are riding with the huge demand for infrastructure services and are prepared to wait for the contractual messiness to get sorted out,” says Ms George. IFC has about $300m invested in Indian infrastructure projects, including investments in financial intermediaries such as IDFC and Infrastucture Leasing and Financial Services (ILFS).
More often than not, the concession agreement is recast after feedback is received from prospective bidders for the project. For instance, contracts to modernise the Mumbai and Delhi airports were awarded after the initial tender documents were revised to incorporate clauses that would protect the rights of private investors.
“The templates are set for private sector participation. The developer can now take a call on traffic projections, the feasibility of toll hikes and hope to make a return on investments,” says Shahzad Dalal, who heads private equity investments at ILFS, whose investments include Noida toll bridge near Delhi, an early public-private sector initiative now listed on London’s Alternative Investment Market. ILFS, a specialist in infrastructure project management and finance, has invested about $250m in infrastructure projects and is currently developing about 1200 kilometres of roads in partnership with the government.
Equity investment is starting to flow in from external investors such as private equity funds as well as from the public markets. JPMorgan Private Equity and India Development Fund, an IDFC-managed private equity fund, invested about Rs5bn in L&T Infrastructure recently. Managing director Rajiv Lall says foreign private equity investors have contributed largely to its latest fund. Of the $650m that IDFC manages in two funds, $220m has already been invested.
Investment stampede
Despite a choppy equity market, GMR Infrastructure, which is executing a clutch of airport, power and road projects, including the Delhi and Hyderabad airports, was in the market to raise more than Rs8bn in an initial public offering in early August. Citigroup venture capital, the George Soros-promoted Quantum Fund and ICICI Venture had picked up stakes in pre-offering placements. Private equity investor Chrysalis Capital paid $10m to buy shares in infrastructure company IVRCL some years back, and saw its investment multiply by three times in less than two years when it sold them, says Kunal Shroff, a fund manager with the firm.
ILFS has successfully exited some of its investments and earned an enviable internal rate of return of 27%. “Our infrastructure investments are among the most profitable over the last four and a half years – the risk is upfront, but once they start to generate revenues, investors are ready to step in,” says ILFS’ Mr Dalal.
Risky business
Yet while the opportunity may be too large to ignore, there are definite risks to investors. Phase one and two of the ambitious National Highway Development Project, which seeks to build 13,146km of arterial roads connecting four metro cities as well as an east-west, north-south axis, is beset by delays caused by problems related to land acquisition.
“The capacity of the National Highway Authority of India [NHAI] to resolve disputes needs to be addressed,” says IDFC’s Mr Lall. Then there are issues related to traffic forecasts and the ability to collect tolls. In some cases traffic projections were overstated by 30% to 50%.
“It took time for traffic and toll collections to build up to levels that were forecast,” says Sunil Mehta, who heads private equity investments at American International Group, an investor in the Noida toll bridge road. Debt investors took a haircut after a debt restructuring of the project. “It is easy to be cynical about public-private partnerships, but they can succeed if there is the right quality of leadership,” adds Mr Mehta, hinting that the political will of the government plays a crucial part.
Infrastructure projects
Encouraged by abundant liquidity and cheap money in recent times, Indian banks and financial institutions have eagerly financed infrastructure projects. Most of the debt finance has come from them rather than the shallow Indian bond market.
According to ratings firm Crisil, advances to the infrastructure sector grew to 15.5 % of banks’ total bank advances on March 31, 2005, from a meagre 2 % on March 31, 1998.
However, Urijit Patel, executive director at IDFC, points to a possible risk in the future as interest rates start to tighten. “Investments have happened, in part because the economy is on an upswing and helped by low and stable interest rates.”
Krishnan Sitaraman, a financial sector ratings analyst at Crisil, says: “Banks are increasingly borrowing short-term, mainly to improve their margins. Given the hardening interest rates, Crisil believes that this strategy [of funding long-term loans with short-term liabilities] is a risky one, as asset liability management mismatches have increased.”
“Indian banks are pricing project finance as you would a corporate finance loan. This can be slightly dicey,” says IFC’s Ms George. Moreover, they are lending to these projects on a variable rate basis reset every three years, which exposes them to interest rate risks, she points out. Indian lenders are more amenable to taking haircuts and lengthening repayment than international banks would be.
In addition, the contracts have too many open-ended clauses that are not in line with international project finance structures.
The NHAI, for instance, has sweeping rights to ‘step in’ in case the contractor fails to perform. It can take over a project and assign rights to any third party, putting at risk the rights of senior debtors, who have first charge over assets. “The contractual arrangements to take over a project can be seen to dilute the rights of lenders,” says Archana Hingorani, executive director at ILFS.
In most cases the model concession agreement includes a clause that states that senior creditors will be compensated to the extent of 90% of their loans in the event of termination of the contract, spelling out at the outset that they must be prepared for a 10% haircut.
A survey by IFC of international commercial banks to test their willingness to lend to Indian infrastructure projects found that they had reservations on three counts:
- They found the projects to be highly leveraged compared to the internationally accepted 75:25 norm.
- They were uncomfortable with the exchange risk on the rupee, and because the revenue earned is generally in rupees (on a road for instance), there is little scope to raise large offshore debt to finance infrastructure.
- They were uncomfortable with the open-ended termination clauses in the contracts and the variable interest rate terms of the loans.
Bond market financing
Looking ahead, given the enormous funds that infrastructure projects will require, it seems unlikely that banks can finance them entirely off their own balance sheets. Now that interest rates have gone up – the central bank governor raised two key interest rates by 25 basis points on July 25, the second time in two months – the scope by banks to indulge in interest rate arbitrage has narrowed. This could mean more financing from the bond markets.
Securitisation and other bond market innovations could come into play to help more companies raise finance.
“A number of interesting structures are possible in the bond market; we offer a whole range of products in the long-term, fixed-income debt market. We could structure a medium-term programme around a master offer document or a partial credit guarantee for an issuer to raise money,” says Ms George.
But for this to happen, the domestic bond market will need to be deepened and widened to draw in diverse investors and issuers. The long delay in introducing domestic pension reform, restrictions on access by foreign investors and the large government bond issuance have all contributed, in large measure, to stunting the development of a vibrant corporate bond market.
But, as Ms George puts it, there is a “huge hopefulness” in the mood of investors; and that should push the Indian government to put its best foot forward.
