More funding, please

India has become the world's biggest market for project finance, but it still needs more money.

As India gets serious about fixing its roads and power supply, as well as its ports, railways and urban infrastructure, a huge opportunity is emerging for global project finance arrangers.
 
The country's infrastructure deficit is large by any measure. India's Planning Commission estimates that, between 2007 and 2011, private and public investors will spend more than $500 billion on infrastructure projects, and that figure is set to double to more than $1 trillion by 2016. It is hardly surprising therefore that India has become the world's biggest market for project finance.
 
According to a study by Power Finance International, published in January 2010, last year India raised $30 billion or more than one-fifth of the global total, up from $19 billion in 2008. Also, for the first time, an Indian investment bank ranked number one on the global project finance charts -- SBI Capital Markets took the top spot after arranging almost $20 billion in fresh capital. Three other Indian banks dominated the Asia-Pacific rankings, including IDBI Bank, Infrastructure Development Finance Corp (IDFC) and Axis Bank. Project Finance International rankings include only lead arrangers' mandates and exclude participation in syndicates and loans to real estate and companies.
 
"While power and roads have gained a lot of traction, there is a large unmet demand in sectors like ports, urban infrastructure and railways," said Siddharth Rath, president of Axis Bank's infrastructure business in Mumbai. "Government supports infrastructure projects by playing the role of an active investor through seed investment, grants and viability gap funding. Typically, government support to a project in any sector would be capped at 40% of the total project cost."
 
That implies a huge role for private funding, which is expected to play the biggest role in airports (70%), telecoms (69%), ports (62%), storage (50%), roads (34%) and energy segments (28%), according to Vikram Limaye, executive director of IDFC in Mumbai. He said that in addition to the 78 gigawatts of generating capacity being created by the government in 2007-2011, private players will build 130GW to140GW by 2016. Total investments in power generation, transmission and distribution will exceed $193 billion. "Going ahead, private sector capacity addition in the energy segment in India is expected to surpass the new additions by government," he said.  
 
But making the most of this opportunity is proving a challenge. The problem lies as much with the limited capabilities of the banks and financial institutions as the onerous regulations under which they operate. Bank balance sheets are stretched and their short-term deposit base does not permit them to fund projects with a payback period stretching 15 to 20 years. "Presently, banks are funding some of the projects where 50% to 60% of the debt gets amortised over a 12-year period, with the balance 50% being a bullet repayment at the end of 12 years," said Limaye. "This repayment schedule faces a refinancing risk at the end of the 12th year, as project cash flows will not be sufficient to service them."
 
Secondly, the Indian project finance market is nascent. There are few large lenders with the ability to assess project risk. So the financial risks, especially of large projects, tend to get concentrated in a few hands. With the average size of projects rising (1GW being the norm in power projects today) the problem is only made worse, requiring banks to be recapitalised to keep lending on this scale. "Indian lenders are increasingly facing a challenge based on their existing single-asset and single-industry exposure norms, which are meant for protecting the stability of the financing system," said Limaye. "We need to improve the capacity as well as the sophistication of the financing system to distribute risks."
 
Another constraint in the Indian project finance market is that "the funding of projects continues to be on a recourse or limited recourse basis," said Rath of Axis Bank. "True non-recourse financing has not yet found ground in India." Current regulatory policies treat lending to special purpose vehicles (SPVs) floated by infrastructure companies as loans to the promoter group. So, even if an SPV is created to start a new business, without the involvement of the promoter group, loans to the SPV would be secured against (or provide recourse to) not just its own assets but also those of the promoter group.

This undercuts one of the most important advantages of project finance, the flexibility allowing projects to be funded solely on the strength of their balance sheets. It also limits project funding to the group's overall borrowing limits. This is partly a legacy issue, said S. Vishvanathan, managing director and CEO of SBI Capital Markets in Mumbai. "Banks are apprehensive of the ability of the lenders to recover their dues without the explicit support of the promoter," he said.

But it also reflects the uncertainty about project implementation. If a project takes significantly longer than planned, revenue streams and therefore repayments are delayed, said Rath. Banks work around the problem by securing loans against the promoter's other assets and through personal guarantees during the implementation stage, after which they can be securitised.
 
The world over, the preferred vehicle of project finance is the infrastructure bond, with maturities of 20 to 30 years. But banks in India are not allowed to hold more than a fraction of their asset portfolios for a long duration. As Vishvanathan explains, infrastructure bonds are typically long-tenor securities and are required to be marked to market. This exposes bank balance sheets to the fluctuations of the bond market.

The solution, he says, is to encourage insurance companies and pension funds, "natural applicants" for long-term investments, as he puts it, to invest in infrastructure bonds. The problem is that given the uncertainties over project implementation and timely repayment, these bonds don't command investment-grade ratings. Vishvanathan argues their ratings can be "enhanced to investment grade" if specialists banks like his can guarantee them. That would allow his bank to apply its project appraisal and risk management skills to a wider class of assets, allow some of the biggest pools of capital in the world access to these assets and provide a potentially vast source of funds for India's infrastructure development. 
 
The government recently took a number of steps to expand the availability of funds for infrastructure, including expanding the remit of the India Infrastructure Finance Corp, expanding the retail market for infrastructure bonds and creating a new class of infrastructure non-banking finance companies that can borrow from the banks and expand lending to infrastructure projects.
 
With half its population below 25 years of age, a declining dependency ratio and a fast-growing population of savers and consumers, India has the resources to fund growth. Its saving rate, at 37% and growing, provides a long-term cushion to fund the infrastructure investment needed to sustain an average GDP growth of 9% a year during the next decade. The challenge is to create the mechanisms, whether regulatory, legal or administrative, to channel these savings into creating productive assets.

This story originally appeared in the April edition of FinanceAsia magazine.

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