The importance of infrastructure for sustained economic development is well known. High transaction costs arising from inadequate and inefficient infrastructure prevents an economy from realising its full growth potential, regardless of its progress on other fronts. While a one to one correlation between spending on infrastructure and a nation’s GDP growth rate cannot be established concretely, for India, over the past decade this correlation has remained largely positive and closer to one. The Planning Commission of India, in its midterm review of the 11th five-year plan, noted that infrastructure bottlenecks has reduced India’s growth by an average of one to two percentage points.

Over the next decade India will need to sustain a double-digit rate of growth, but in order for that to happen, spending on infrastructure development will need to be close to 10% of GDP on a sustained basis. Accordingly, no less than $500 billion will need to be invested in developing India’s physical infrastructure in the five years to 2012 – and in the following five years, a whopping $1 trillion. In other words, assuming a 5% rate of inflation and 9% growth rate, government and private sector will need to spend Rs65 trillion, in nominal terms or completion cost basis, by the end of 2017. Another way to look at this massive investment target is to say Rs32.5 trillion should be raised for developing the physical infrastructure as debt and equity, assuming the other half comes in as budgetary support.

This goal, though not impossible, will be a tough one to achieve. For example, assuming commercial banks, external commercial borrowing (EBC), insurance companies and infrastructure non- bank financial companies continue to fund the debt requirements of infrastructure in the same proportion as they have over the past five years, it translates to lending by commercial banks alone to the tune of Rs10 trillion to Rs12 trillion. Now, even if the gross outstanding of the commercial banks grows at a 20% compound annual growth rate and the share of lending to infrastructure is pegged at 8.17%, the historical average, only Rs7.5 trillion and in the best case scenario, up to Rs8 trillion, will be available through from commercial banks.

Opening up infrastructure debt markets

So, the need to increase infrastructure’s share in the credit supplied to the non-food sectors by the banks is extremely important, and fresh capital raising by banks looks likely. The Indian government has recently announced plans to recapitalise the balance sheet of the State Bank of India, the country’s largest lender to infrastructure projects. As the next five years unfold, one can hope to see similar capital infusions or stake dilutions in other financial institutions such as REC, PFC and other nationalised banks. Currently, the banks’ balance sheets are stretched to an extent that fresh lending to infrastructure looks hard to come by, and without efforts to free up balance sheets, bank funding for infrastructure projects looks challenging.

According to a planning commission report from the working group on savings, there will be a funding gap of Rs14 trillion over the 12th five-year plan, including all sources of funding. There will have to be fresh investment from non-traditional sources of capital. Government has suggested that infrastructure debt funds will be one way to close this gap. This would be a welcome development, because debt for infrastructure projects has largely been confined to commercial banks. But these loans have become expensive, with rates that currently stand at 12% to 15%, and banks are fast approaching their lending limits. Debt funds would buy loans from banks for projects that have completed construction and entered into commercial operation. To protect investors from default, the funds would be backed by a government guarantee. Foreign investors can diversify their risk by holding a portfolio of projects and pension funds, which have stayed away from infrastructure, can take advantage of the operational projects’ steady cash flows. As cash flows stabilise, valuations will become more certain, which should simulate global investor appetites.

The State Bank of India, with its large portfolio of infrastructure assets, is well positioned to make a market in this segment and policy measures that ensure this must be adopted without any further delay. Broadly speaking, any policy measures and changes should follow these guiding principles:

(1) Supplementing/broadening the traditional sources of infrastructure funding:
a.Regulatory reforms for insurance companies and pension funds so that more savings at these important sources are mobilised for infrastructure.
b. Reforms that ensure higher ECB and other forms of capital inflows.
c. Reforms like infrastructure debt funds (IDFs)

(2) Development of financial products and markets
a.Reforms that ensure infrastructure funding is not limited by the depth and width of the financial market.
b. Reforms that encourage the development of new financial products for infrastructure financing to attract a wider variety of risk capital is.

(3) Creation of a growth-enabling eco-system
a.Regulatory changes that allow for the replacement of committed but unused debt capital from commercial banks with other forms of financing.
b. Reforms that lead to the development of a frame-work that helps reduce the market risks in infrastructure financing and the asset-liability mismatch at banks.
c. Reforms that give commercial banks more flexibility in turning over their portfolio of infrastructure assets.
d. Revitalising the market for takeout financing, refinancing and securitisation.

Solutions that follow these principles include: the development of a corporate bond market, allowing nationalised banks to issue infrastructure bonds, increasing the limit of tax exemptions on infrastructure bonds from say, Rs20,000 to Rs100,000, permitting banks to fund domestic acquisitions to simulate the market for leveraged buyouts, relaxing aggregate group exposure limits for infrastructure, which should be given priority sector status, and the development of a municipal bond market. The author hopes that in the coming five-year plan (2012-2017) a lot of these policy changes will take effect, creating an environment that encourages growth.

While debt funding to infrastructure projects requires policy reforms to operate as a well-oiled machine, big infrastructure firms will need to undergo equity dilution in order to operate at optimal leverage levels. Leverage has soared over the years, thanks to a boom in infrastructure and the encouragement by government of private participation, coupled with a relaxation in statutory liquidity ratio holdings at the banks and consequent lending to infrastructure projects. The balance sheets of infrastructure firms are debt-laden and many firms are lookingfor refinancing. Low rupee levels and high interest rates may be a hindrance to their refinancing efforts. A further dilution of the equity of the big listed infrastructure firms will enable them to scale up their operations. This may come, however, when existing projects become operational.

But India is heavily reliant on budgetary support and bank credit for funding its infrastructure needs. In many countries, long-term debt, in form of corporate, sovereign or municipal bonds has major share of infrastructure finance. However, Indian secondary debt markets lack depth and breadth. Infrastructure projects have a long pay-back period and require long-term financing in order to be sustainable and cost effective. Depth and liquidity in the corporate bond market has to improve, and infrastructure development risk should be distributed to different investor bases, and not be assumed only by banks and equity.

Measures such as an increase in the foreign institutional investment limit for corporate bonds by $20 billion and the creation of special vehicles such as dedicated infrastructure debt funds with reduced withholding tax and tax exempt income, the continuation of the additional deduction of Rs20,000 for investment in infrastructure bonds, and so on, are a step in the right direction. But the 12th five-year plan calls for more that doubling the amount of spending that has taken place over the last five years.

Creating a supportive framework

There are also some systemic risks in the system that require the urgent attention of policymakers and investors. Any physical infrastructure project’s primary need is land. Land acquisition in a country like India is not only a very onerous task but is also exceedingly time-consuming. In past, projects have been delayed for as much as decades as they get embroiled in land acquisition and resettlement and rehabilitation issues. The equilibrium solution that has emerged over the years is not a favourable one for promoters. One simple way to alleviate this situation is that government carries out land acquisition before bidding for the project starts. Advanced technology micro-siting and data warehousing is required to create land banks, ascertain appraisal values and establish historical ownership.

Since land ownership is in question, a national-level institution needs to be set up in collaboration between state and central governments to oversee the task of land management. Finally, land can be allocated to project developers much more quickly using mechanisms such as competitive bidding. There are talks underway at the ministerial level, and states such as Gujarat have taken the right steps, by setting up firm land allocation policies, especially for renewable projects, where land is provided by the government on a lease basis, leading to speedy implementation of projects.

Indian secondary debt markets lack depth and breadth. Infrastructure projects have a long pay-back period and require long-term financing in order to be sustainable and cost effective. Depth and liquidity in the corporate bond market has to improve, and infrastructure development risk should be distributed to different investor bases, and not be assumed only by banks and equity.

Additionally, the scope, terms of reference and obligatory process for environmental clearance need to be standardised and a suitable group or independent consulting companies should be fostered to help bidders and developers obtain clearances at a faster pace. Environmental and land acquisition issues should be addressed proactively to balance the interests of all stakeholders. The ambitious $1 trillion-plus infrastructure investment target is only achievable when these two concerns are addressed urgently and at a systematic level as opposed to on a project-by-project basis.

Power project progress?

Moving on to sector-specific issues, some recent developments in power sector deserve special mention. The electricity sector needs an urgent solution to the severe shortage of fuel supply and the financial health of the state electricity boards. Securing a firm fuel supply for power projects is critical. It is estimated that the total coal requirement for the thermal power plants will be 614 million tonnes in the period 2013-14. The total domestic coal production in India is expected to be in range of 450 million tonnes, resulting in a deficit of around 165 million tonnes. In order to bridge this deficit, either domestic captive mining activity or imports of coal need to increase. Longer periods between standing linkage committee meetings creates uncertainty surrounding the allocation of coal linkages to new projects.

Inter-ministerial meetings have addressed address fuel supply issues and recent changes to fuel supply agreements (FSAs) to ensure coal supply at an 80% minimum guarantee is great news for the sector, because no new FSAs have been signed in the past three years. Due to uncertainty in obtaining coal linkage and the lack of availability of captive coal blocks, power projects have to depend upon imported coal for power production. The imported coal is costlier and the higher costs associated with acquiring raw material and transportation render imported coal-based projects financially unattractive. If CIL (Coal India Limited) manages to supply coal as promised in an FSA, projects will once again become financially viable and attract investors’ risk capital.

The Shunglu committee recommendations have come into the public domain at the right time to address the concerns about the financial health of the state electricity boards, but a coordinated inter ministerial effort must continue. Inherent in these recommendations is the fact that restructuring the financial losses of a newly formed SPV would require coordinated efforts from banks, the RBI, PFC and REC. With this is mind, measures must also be simultaneously taken to ensure that commercial banks are not constrained in providing fresh funds because their balance sheets are over-stretched.

The losses at state electricity boards, the most likely buyers of power from projects, have grown from Rs70 billion in the 2006 financial year to Rs295 billion in the 2010 financial year. A curtailment of fresh loans by banks and financial institutions to distribution companies could trigger defaults leading to an overall sector downgrades. Delayed payments by distribution companies can have a domino effect, with delayed payments to generators leading to delayed payments to coal suppliers and equipment suppliers severely stretching their working capital cycles, with adverse effects on their leverage. Permitting also needs to move more quickly, since developers require at least 7-8 clearances, in some cases even more, to set up power projects. The process currently takes around 1.5 to 2 years, with substantial transaction costs. Instead of this, a single window clearance system should be implemented with specific guidelines for time-bound approvals.

Transport tracks up

The ports and roads sectors, which typically operate under the model concession agreement and competitive bidding framework, have their own issues. Aggressive bids render projects financially unviable. A reduction in the gap between bids for a project and the start of construction would reduce project costs by controlling increases in material costs due to inflation, and expedite implementation. Frequent changes to agreement templates such as the model concession agreement, request for proposals, and request for quotations, should be avoided as it results in bidders spending a lot of time, effort and money performing due diligence. The current bidding process involves increases in premiums of 5% per year, leading to negative cash flows in initial years and requiring much longer- dated debt. Refinancing and take-out financing measures could address these funding issues, but these do not offer win-win solutions to all stakeholders.

Disagreements about project costs between nodal agencies and concessionaires/promoters and the way costs influence linked termination payments and viability gap funding grants remain an issue. Apart from the information asymmetry between the principal (the National Highways Authority of India) and the agent (the concessionaire), different valuation expectations at these parties and different risk/return profiles for the two further add to uncertainty in the bidding process. In case of ports weak hinterland connectivity is a challenge for most Indian ports, reducing accessibility and leading to sub-optimal use of the facilities. To mitigate this problem, the Ministry of Shipping and Maritime Boards, in association with the Ministries of Railways and Roads could form a joint venture with the private party to develop this infrastructure simultaneously. Rail-road connectivity should form an integral part of the grantor’s responsibility as this is key supporting infrastructure for port projects.

The major ports are governed by the Major Port Trusts Act of 1963 and the minor ports by the Indian Ports Act of 1908. Boards of Trustees are appointed by the Government of India to administer ports, and represent government departments involved with port operations, labour and service providers such as stevedores, shipping agents, and so forth. Sometimes the interests of different parties may be at cross purposes, and may not be in interest of smooth port operations. All new ports should be set up as companies under the Indian Companies Act and existing Port Trusts should also be gradually corporatised so that they are run on commercial principles and make it possible to evaluate their performance, as expressed in their profitability.

In the past there may have been exuberance about the Indian infrastructure story, leading to a haphazard boom but not all of it was irrational. What option does India have but to continue to grow and expand its physical infrastructure? The issues with any sort of boom have become apparent, but the good news is that these issues are recognised and government has moved with unheard of alacrity to address them. Be it fuel supply issues in the power sector or adopting measures to encourage refinancing or the advent of infrastructure debt funds, there is a timely acknowledgement of these issues has been done and a search for serious solutions.

Infrastructure development will continue to remain the top most priority for any Indian government in the coming decades. Accordingly, policy changes will include increased investment from foreign institutional investors, sovereign wealth funds and pension funds. The Union Budget of India at the time of writing of this article has not been announced but it is hoped that it will be friendly to infrastructure investment. It is also important to realise that India’s policy framework also needs to be continuously strengthened to increase projects’ viability. There needs to be regulatory and policy certainty, so that a project’s fate depends only on market dynamics and contractual arrangements. It is important that all necessary clearances and approvals for infrastructure projects are provided upfront. Government should also consider setting up a body to provide support to a pool of projects, which could be funded through budgetary allocations and contributions from multilateral agencies. To reduce the dependence on budgetary allocation, we need to increase the role of other players like banks, insurance funds, equity markets and foreign direct investment. The private sector needs to continue to play an important role in meeting infrastructure financing needs in India. The coming five years can decide the way how its physical infrastructure grows for decades to come.

Author: Rajat Misra is a senior vice-president at SBI Capital Markets in Mumbai.