Recent statements from the Indian government have underlined how much the country needs increased investment if it is to continue being, along with China, one of the economic success stories of the twenty-first century. The sum of what is needed has now been estimated at $475 billion over the next five years, mostly in the energy sector but also a substantial amount in roads, ports and airports.

On the equity side, there has been a rush of international infrastructure funds scrambling to get involved, lured by the prospect of substantial returns. However, on the debt side infrastructure finance remains a resolutely domestic affair, now more than ever after the government further tightened restrictions on external commercial borrowing in August.

The timing could have been far worse as far as roads are concerned. Bureaucracy has caused delays in the tendering of road projects, causing a slight lull in the market. Many bankers believe the current restrictions are just a short-term measure that should be rescinded before a substantial volume of new road deals hits the market. Nevertheless, even without the latest borrowing restrictions in place, until India's rules governing ECB change, projects like Larson & Toubro's Palanpur-Swaroopganj road project, which closed last year using ECB debt, will remain the exception to the rule.

Strong growth

India achieved economic growth of 9.4% during 2006/07, its highest rate in 18 years. But the country's finance minister, Palaniappan Chidambaram, told a parliamentary committee on 6 September that to sustain growth rates of over 9%, the country would have to raise infrastructure investment to 8% of gross domestic product over the next five years from the current level of 4.6%.

"Our infrastructure deficiencies have become more visible because of high growth," Chidambaram told the committee. "The most visible indicators of overstretched infrastructure are India's congested highways, airports and ports. It is imperative to explore avenues for increasing investment in infrastructure through a combination of public investment, public private partnerships and occasionally, exclusive private investments wherever feasible."

The $475 billion estimate comes from the Committee for Infrastructure Finance, headed by HDFC bank's chairman Deepak Parekh, which reported in May that the official estimate of $320 billion was too low. A significant amount of this requirement falls within the energy sector. But according to official government estimates, $49 billion is required for national highways, $66 billion for railways, $11 billion for ports and $6 billion for airports. The report highlights roads, in particular, as one area where these figures are likely to have been underestimated.

Such vast levels of investment beg the question of whether India has the financing capacity to meet such demand, and Parekh's report recommends finding ways of increasing external financing to avoid liquidity problems domestically. This has not been hard to do on the equity side, as the list of announcements of new investment in India proves.

The most recent such announcement came on 7 September from ICICI, India's largest bank, which said it was planning to draw $2 billion, from overseas investors only, into a new infrastructure fund. Credit Suisse is advising ICICI on the fund as the bank attempts to fill it up over the course of the next three months.

Prior to that, private equity firm 3i Group in August said it would create a new fund with the target of building a portfolio of infrastructure investments worth $1 billion. 3i itself will put $250 million into the fund, which will be unlisted. The firm has had a portfolio of investments in India worth $320 million, going back to 2005, but this new fund will be its first major foray into power, ports, airports and road projects.

These two funds follow a trend that has been going on for a while, with the largest fund to be set up being that from Blackstone Group, worth $5 billion, with funding from Citibank, IIFCL and the Indian Development Finance Corporation, formed near the start of the year. Returns to equity of 14% to 20% give a good reason why ICICI and 3i probably won't have too much trouble finding investors for their funds.

The most significant development, however, has been on the $100 billion Delhi-Mumbai Industrial Corridor (DMIC) where Japan has become a partner, which should result in $30 billion of investment in the scheme from the Japanese government and private sector.

The project involves splitting the 1,500km region covering a population of 180 million people between the commercial hubs of Delhi and Mumbai into six mega regions of 200 square kilometres each, with investment going into three ports, six airports, new rail networks, industrial parks and other infrastructure requirements. The project will start in January next year and should be completed in 2016 if all goes to plan.

A company will be set up to plan and coordinate the projects, the Delhi Mumbai Industrial Corridor Development Corporation, which will tender the SPVs that will implement the projects under PPP concessions. Japanese investment in the project will come in the form of government soft loans, corporate involvement and probably also some financing from JBIC, either direct loans or covered financing.

While injections of capital have been forthcoming on the equity side, on the debt side it has become harder rather than easier for infrastructure projects to attract overseas capital over the past year.

Debt stays domestic

Last year's Palanpur-Swaroopganj road project was a landmark deal in Indian project finance, in large part because it was the first time since 1999 that a borrower raised overseas funding outside the hydrocarbons sector. The $113 million loan was lead arranged by Citibank, which split the debt equally into two facilities – an external commercial borrowing facility and domestic foreign currency debt (FCNR).

Although pricing was the same on both facilities, at 150bp over Libor, and terms were also the same, under India's regulatory regime, the FCNR debt has to be refinanced after three years when the sponsor, Larson & Toubro (L&T), has the option of converting it into rupee debt that would be benchmarked against three-year government securities.

The project was also notable for having the longest tenor on an Indian deal, at 16.5 years, and also the highest gearing for an Indian project financing at around 90%.

After Palanpu-Swaroopganj, L&T returned to the market to close the Vadodara-Bharuch Tollway, raising debt for the Rs6.6 billion ($163 million) project from SBI Capital. Meanwhile, the Rs11.5 billion Kundli-Manesar-Palwal Expressway – sponsored by a consortium of DS Construction, Apollo Enterprises and Madhucon Projects – closed earlier this year, becoming India's largest road PPP to date. SBI also arranged the debt for this project, together with IDBI. However, neither of these deals involved ECB.

Various regulatory and natural restrictions make it harder for sponsors to use ECB in road projects. Of the former type of restrictions, the fact that India does not permit refinancing of ECB and imposes ceilings on the all-in cost of finance makes lending to Indian projects riskier for international banks. Furthermore, there is no natural foreign exchange hedge on rupee-denominated debt, where the project's receivables are also rupees. Road deals are also typically rather small in India, ranging in value to no more than the equivalent value of $200 million. Together, these factors explain why ECB has not been a prominent feature of Indian PPP in general, and road PPPs in particular. Reasons why Palanpur-Swaroopganj was an exception include the strength of the sponsor and the strength of the economic fundamentals underlying the concession.

However, even such limited involvement is now ruled out after the Reserve Bank of India (RBI) issued new guidelines in August that said any external borrowing by an Indian company worth more than $20 million of any one currency must be "parked" overseas, unless prior approval is obtained from RBI. This effectively allows continued ECB for the importation of goods, but acts to stop people from exploiting arbitrage opportunities created by India's high interest rates that could potentially undermine the country's macroeconomic stability further down the line.

The change in guidelines was the third this year following previous interventions in April and May. One of the changes brought in when RBI intervened in May was to reduce the cap on ECB all-in pricing from 350bp over Libor to 250bp, which is applicable to debt with a tenor of over five years. For debt with a shorter tenor, the cap was reduced from 200bp to 150bp.

The changes have been made necessary by the strength of the rupee, which has this year been Asia's best performing currency after gaining more than 9% against the dollar. The first five months of this year saw Indian companies borrowing $14.97 billion through ECB, presumably much of it investors taking advantage of interest rate differentials between India and the rest of the world.

This has already caused problems for the Rs24.6 billion Dhamra Port PPP project in Orissa state, a 50:50 joint venture between L&T and Tata Steel. The project closed in February with Industrial Development Bank of India acting as the arranger for the commercial debt, but with an ECA tranche arranged by BNP Paribas remaining unsigned. Belgium's ONDD is in place to provide the ECA funding for the deal, but that is now in limbo until the restrictions on ECB are lifted.

Most bankers, nevertheless, see the measures as a temporary. "The central bank has taken a stand not to allow money in unless it is for equipment from abroad because it is worried about inflation," says one. "We expect the restrictions will soon be lifted for infrastructure.

Quiet phase

As far as roads are concerned, however, bankers say that in any case there has been a slowdown of deals coming through the pipeline. The latest plan, the National Highway Development Programme Phase III, comprising the upgrade of 10,000km of national highway, was only launched in 2005 and bureaucracy has slowed the programme. But the market will pick up again in six months to a year when these projects will be ready to launch.

If ECB is not at present a serious option for supporting these financing needs, the question then becomes one of whether India's domestic banking sector has sufficient liquidity to take care of them themselves. India's bankers generally insist that they do. The CEO of ICICI, which recently completed a $5 billion public offering, was reported early in September as saying his bank could mobilise up to $75 billion over the next three to five years by leveraging this. This would take care of a significant proportion of India's financing needs.

Nevertheless, Deepak Parekh's committee questions in its report whether the banking sector as a whole is sufficiently capitalized to meet the challenge thrown up by India's infrastructure needs. He also points out that commercial banks' exposure to infrastructure has already grown by 57% in the past five years, and that possible mismatches between sector exposure levels and maturities may impose further constraints.

But India is not lacking potential for growth within the financial sector. One obvious area for this is in capital markets, which remain underdeveloped. Then there is also the IIFCL, which at present is still finding its feet in the world of Indian project finance, according to some bankers. But IIFCL is backed by RBI, which is currently sitting on $200 billion of reserves that are not being put to great use. One way of easing liquidity problems, should they arise, would be to release some of these reserves into the infrastructure sector through IIFCL.