On restless pinions

Second-generation issues in the infrastructure sector have not received the level of scrutiny they deserve.

As India embarks on a trillion-dollar infrastructure investment programme over the next five years, its financing is a matter of critical import. Given the scale of investments required, it is inevitable that domestic financiers and local developers will have to bear the major share of responsibility. A number of large infrastructure projects were initiated with private participation in the last decade. Now that many of these projects have been, or are close to being, commissioned, several second generation issues have started to surface. The biggest concern comes from the increasing strains on the balance sheets of both infrastructure firms and their financiers.

On one side, aggressive bidding, construction delays, cost overruns and regulatory uncertainties have adversely affected the profitability of infrastructure firms. Stressed balance sheets have become the norm. This is reflected in the disproportionately large numbers of ratings downgrades and debt restructurings among infrastructure firms; a Crisil study of 24 infrastructure firms found a rise in debt-equity ratio from 1.5 to 3.7 times and fall in interest cover from 3.2 to 1.7 times between 2007-08 and 2011-12.

On the other side, the unsustainability of the prevailing model of financing infrastructure projects is becoming clear. In the absence of a debt market with sufficient depth, over half the funding for infrastructure projects between 1995 and 2007 came from commercial banks, predominantly public sector ones. Many of these banks are close to their regulatory limits on infrastructure sector lending exposure and their balance sheets are showing asset-liability mismatches arising from the long-term nature of infrastructure loans. A recent Morgan Stanley report estimates that the share of impaired (that is, non-performing and restructured) loans will rise sharply from 4 per cent in 2009 to 9 per cent this year and touch 12-15 per cent by 2015.

Over the past decade, infrastructure firms have rapidly accumulated a large portfolio of projects with attendant debt repayment obligations. A recent report by Credit Suisse found that the combined debt of the 10 most indebted Indian firms, all infrastructure related ones, exceeded $100 billion this fiscal. This has depleted their capital reserves and these liabilities sit on their balance sheets, thereby constraining them from new project investments.

In this context, the decision by a few large infrastructure firms to monetise their project assets assumes significance. Clearly, their decisions are motivated by cash flow constraints on repaying accumulated project debts and financing new projects. It appears to be the beginning of a trend.

International experience in this regard is instructive. There are at least two ways in which the liabilities associated with such long-term projects can be taken off developers' balance sheets. The most widely used option is to securitise the project entity. This can be done by floating the project entity in the equity markets through an IPO, or by issuing long-term bonds in the debt market. This can be used to swap both commercial loans and pare down project equity exposure. In recent years, long-term toll-collection concessions (and even privatisation) on highways, after construction, have become popular in the US. The differential between the interest rates on publicly traded debt instruments and commercial bank loans offers the potential for mutual benefit to investors and the company. As this trend gathers pace, the limited depth and breadth of India's debt market will emerge as a binding constraint. Pessimism about future growth rates could be another constraint. But, with appropriate policy measures, there is an excellent opportunity to develop this market.

Another alternative is to directly sell the developer's stake to specialised project management firms. Most recent transactions in India appear to belong to this category. Unlike securitisation, this would involve transfer of management responsibilities. In theory, the new owners would have superior project management skills and be able to increase the returns on the assets. However, there are several problems with this alternative.

First, given the operation and maintenance (O&M) interest in these long life-cycle projects and the public interest involved, any change in management that results from a financial restructuring would distort incentives and necessarily raise important regulatory concerns. For example, outright sale would limit the role of the original project operator in a long-term concession into that of a construction contractor. Or the original contractor could dilute his equity gradually, as happened with the Delhi Airport Express Metro Link. Both trends raise concerns about O&M commitment. Second, the absence of an active market in the provision of these services and the paucity of firms with good track records in project management and O&M raises questions about its potential effectiveness. There could be well-founded regulatory concerns about the capabilities of the new sub-contractor or service provider. Indeed, the fear could be that the new owners would increase returns not by greater managerial effectiveness, but by shrugging off contractual and regulatory obligations through dubious means.

This brings us to a third issue. During the last decade, public-private partnership (PPP) in infrastructure was regarded by the Planning Commission and others as the standard or default policy, almost to the level of religious orthodoxy. A rigorous and honest evaluation of the results of this policy is urgently needed. The evaluation should cover questions like whether the PPP approach has (vis--vis public sector-executed projects) actually reduced the fiscal burden (factoring in cash and non-cash subsidies), whether it has resulted in quicker and more cost-effective project execution, and whether it has resulted in lower overall costs and better O&M. Preliminary evidence suggests strongly that a more nuanced approach (a project-based mix of public sector execution, perhaps with O&M concession, and PPP, without an ideological preconception either way) will serve India much better.

Such second-generation issues in the infrastructure sector have not received the level of scrutiny they deserve. Their resolution is important for both the sustainability of ongoing projects as well as attracting future investments. Without appropriate policies, there could be private profiteering at public expense with poor quality asset creation and O&M, and our ambitious infrastructure plans would remain stillborn.

The writers are members of the IAS. Views are personal

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