Financing Infrastructure in India: an overview

Institutional and regulatory setup need relook

The prices of commodities especially food articles have skyrocketed over past one year and expected to continue its northward movement owing to increased demand of food articles coupled with supply side constraints. The inefficient supply chain and creaky infrastructure in India are adding to the woes by significant wastages due to lack of storage facilities. It is estimated a whopping proportion of food grains is either rotten or lost due to pilferage due to lack of adequate storage and transportation infrastructure.

Similarly, the increase in passenger and cargo volumes is exerting pressure on airport and railways infrastructure thus requiring fast implementation of new project / augmenting existing infrastructure such as DFC’s. Likewise, Indian appetite for power is expected to increase in coming future mandating huge capacities to be added in the power sector. Planning commission’s estimates that 62,374 MW1 MW of additional capacity should be erected during the Eleventh Five Year plan underscores the importance building capacities in power sector.

These facts emphasize the urgent need of investment in infrastructure sector in India to support the growth of 9%+.

It is undisputed that efficient and good quality infrastructure can boost the economic growth and lack of supportive infrastructure acts as a drag on GDP growth rate. Also, investment requirements are, in general, hovers around 5-6% of a developing country’s GDP2 and this is higher for the lower-income countries where poverty is more entrenched.

Recognizing the importance of infrastructure development and its impact on growth prospect, investment of over USD 500 billion is envisaged in various infrastructure sectors over the Eleventh Five Year Plan (2007-12).

The planning commission reckons that the government funds should be augmented with the private sector investment in the infrastructure and the envisaged share of investments in the infrastructure from various sources are:

Government funding ( Centre and State ) - 65% Private sector funding – 23% Multilateral / bilateral agencies-12%

Back of the envelope calculation reveal that cumulative investment of around USD 80 billion (~ INR 35,000 crores) shall be needed from private debt3 financing and around USD 35 billion (~INR 16,000 Crores) shall be needed in the form of equity. These numbers are substantial and it may be noted that the investment requirement are only over the duration of 11th Plan only.

The scale of investment requires changes in regulatory and institutional setups to enable funds flow to the private sector. This assumes greater importance in the wake of:

Lack of domestic avenues of financing the infrastructure projects Explosion of global capital markets and the associated expansion of private capital flows to

emerging economies like India

1 Mid Term appraisal of the 11 th Five Year Plan 2 Infrastructure and the World Bank : a progress report (2005)3 Assuming 70% of debt , which is case as concessions encourage more debt financing

A high level view of financing avenues

It is worth to appreciate that there are multiple avenues to overcome the financing barriers in infrastructure sector. One of the major sources of financing is external financing which is provided by multiple agencies and have different flavours.

One such avenue of financing is International bond markets. The major advantage of the international bonds is long maturities, where maturities of ten to thirty years are typical. Although, financing through international bond market may be expensive than syndicate loans, the matching of bond tenure with projects prevents projects from the fluctuations.

Another important source of financing could be multilateral institutions such as the World Bank and the Asian Development Bank. Traditionally, funding from these bodies have been limited public sector infrastructure projects. A notable shift is observed in the approach of these multilateral institutions in terms of their willingness to support projects with private sector participation especially PPP projects.

The International Finance Corporation (IFC), an arm of World Bank, which focuses on the private sector, also provides an entire range of financing services with the objective of profits and risk sharing.

Debt financing from banks could be another source of financing the structure, which is evident from syndication for various infrastructure project in India , especially in the PPP domain. However, there are limitations in the borrowing from the banks given the peculiar nature of duration on their assets and liability side. Since the banks have to lock in the loans granted in infrastructure sector for the long gestation period ( typically upwards of 5 years) , funding of these loans through short term deposits poses risks and limit the lending ability of the bank. Due to the asset liability mismatches banks usually lend on floating rates which are dependent on base rates, which are changed frequently, that puts the entire project dependent on the vagaries of interest rate fluctuations. A rate increase of 2-3% may jeopardise the project’s viability. The problem is compounded by non-availability of ratings according to a senior official of leading private sector port in South India. He avers that due to Basel-II norms infrastructure projects like ports remain in non-investible grade for first 3-4 years till they start earning enough revenues. This causes, he maintains, high premium on bank loans raised by the developers/investors, thus rendering the project viability in question.

In addition to the debt financing from banks, an attractive source of financing is domestic debt market. Unfortunately, in India, despite high savings, corporate debt market has not developed yet. The underdeveloped nature of domestic debt markets is further impacted by crowding out effect of fiscal deficits, which drive up cost of debt for non-government borrowers.

Another source of financing which meets the requirement of infrastructure sector is availability of funds institutions like insurance companies and pension funds which have long terms contractual savings. It is natural for these institutions to invest in longer maturity debt to match with long term liabilities. However, in India this sector has also not observed enough momentum in terms of its willingness to fund infrastructure especially with private sector participation.

Changes and issues

A number of experienced international companies (examples include Maresk, Dubai Port etc,) and multinational agencies (IFC, ADB etc.) are interested in investing in infrastructure development in India especially when the investment climate is attractive. In addition, with access to cheap and suitable financing structure, participation of domestic developers/investors in infrastructure is likely to increase further, as shown by few successes in PPP projects

The appropriate changes in regulatory and institutional setups may provide necessary fillip to new infrastructure projects (especially marginal in terms of commercial viability) in India by way of cheaper financing by ensuring the available avenues.

Some of the changes have been introduced by the authorities. This article attempts to highlight some of the important developments on regulatory and institutional fronts envisaged to encourage investment in the development of infrastructure by channelizing the funds supply through these changes.

One noticeable development for encouraging investment in the sector is introduction of Viability Gap Funding (VGF scheme) by Department of Economic Affairs (DEA). In order to ensure better allocation of funds for developing infrastructure, government authorities have recognized the importance of participation of private sector and to encourage competition even in financially unviable projects through various mechanisms including VGF scheme.

The VGF scheme is devised to provide financial support in the form of capital grants to infrastructure projects undertaken through public private partnerships and through competitive bidding process. The scheme has provisions for both one time and deferred capital grant. The extent of total Viability Gap Funding is limited to the lowest bid for capital subsidy, but subject to a maximum of 20 percent of the total project cost. The project sponsor (the Government or statutory entity), in its discretion, may provide additional grants out of further twenty percent from its own budget. Although the scheme has been successful for the investments in the road sector but failed to have impact on other infrastructure sector most noticeably in the port sector. The limited success of VGF scheme in the sectors other than road calls for tailoring the scheme suitable for each infrastructure sector.

For example, longer construction period in the port sector may expose project developer to inflated costs of development and this shall require escalation in tariffs. However, VGF can only be fixed before the commencement of project and tariffs needs to be fixed beforehand. This aspect is likely to limit the investment in marginal projects.

Government has also attempted to provide institutional focus by setting up of special purpose vehicle called India Infrastructure Finance Company Limited (IIFCL). The need for such institution is mandated by the prevailing limitations for debt financing of infrastructure projects. The constraints for long term debt financing are due to multiple factors owing to peculiar nature of financing needs in infrastructure sector. The long gestation and breakeven period required for infrastructure projects require long term debt which is not easily available through banking system.

In addition, risks from these projects are still not well known since the private participation in infrastructure is still at fledgling state. Due to nature of industry, there is a near absence of benchmark rates at which market can provide the long term debt.

To overcome these barriers, IIFCL has been setup to provide infrastructure funding through long term debt, refinancing or any other mode approved by Government of India (GOI) from time to time. The funding from IIFCL to the project is limited to the maximum of 20% of total project cost. The loan is made available to the lead bank .IIFCL has also been allowed to provide subordinated debt to the PPP( Public Private Partnerships) projects under certain conditions.

The funding from IIFCL is made available to eligible infrastructure sector as defined in the scheme.

In yet another initiative, Government has attempted to broaden the corporate bond market by awarding the tax-free status of infrastructure bonds. This is likely to enable banks to match the duration of their assets and liabilities in infrastructure sector.

Infrastructure Bonds which have a lock in period of 5 years may be raised by the banks and approved FIs to fund the infrastructure projects and increase their ability to manage the assets. The salient point of these bonds is that the Government exempted credit rating for infrastructure bonds. ..

On the regulatory side, changes have been effected to provide developers one more avenue of cheaper finance. In this direction, External Commercial Borrowing has been made accessible to all infrastructure players under automatic route.

However, the ECB routes have posed its own set of problems. The first problem arises on account of fluctuations in exchange rate variations. Depreciation, for example of rupee against US dollar, would tend to cause greater outflow for project developer than anticipated while appreciation would translate into profit by lesser outgo. Second problem arises when a firm tries to hedge the risks against currency fluctuations. The foreign exchange (forex) risk could be mitigated by judicious utilization of derivatives such as forward rate contracts; however, forward rates are rarely available for more than 8 years of duration according to industry sources. Even if forward contracts are available for longer duration they require exorbitant premium.

Other changes include income tax benefits available to infrastructure developers4 under section 80 IA. Under this section a deduction is allowed for an amount equal to hundred per cent of profits and gains derived from infrastructure business for ten consecutive assessment years out of fifteen years from the beginning of operations. The additional cash flow generated through the tax benefits could be utilized to serve long term loans which are in short-supply.

Moreover, deduction is allowed to Financial Institutions to take off 40% of the profit arising from long-term lending to infrastructure from the total income while computing taxable income.

Although the steps taken in the direction of facilitating the finances towards the infrastructure have shown encouraging signs, a more calibrated approach for tailoring and fine tuning the above schemes is needed. Further some schemes need to suit the needs of individual sectors as in the case of VGF.

In conclusion, a robust framework needs to be established to understand a high level needs for sector wise equity and debt needs and issues and necessary action may be taken to iron out the deficiencies and provide effective facilitation mechanism.

4 The 80 IA benefits are not available to contractors ( such as EPC) etc. and restricted to the developers only