Financing Infrastructure: Revisiting the Sources
| August 27,2012 10:54 am IST
In the last decade or so, India had witnessed an unparalleled growth across all sectors. One of the key factors that have ensured rapid growth is the development of infrastructure.
Rapid urbanization has created a necessity of major investments to create additional residential and commercial spaces, subways, metros, roads and railways. Also countrys growth depends on industrial infrastructure comprising of telecom, power, aviation, shipping, communication as well as agriculture. Industry experts and policy makers have always underlined that infrastructure is the key to growth of industry, trade, business as well as overall economic growth and affluence of a nation. In fact, infrastructure development and investment has a straight bearing on the productivity of a country. Moreover investment in infra-structure sector is the key to sustainable and comprehensive growth.
Characteristics of Infrastructure Projects
Infrastructure projects are characterized by elongated maturity and very large investments. A hydropower project may take around 5 year to be constructed along with huge investment but once operational it could easily have a life as long as 100 years. Huge in-vestment for long periods results in very high underlying risks. Factors such as environ-mental surprises demand uncertainties, technology obsolescence etc. are responsible for higher risk. Politics and policy related uncertainty is a key factor in this regard. These projects often have very low and fixed returns in association with the huge investments.
Yields in these projects should be measured in real terms as revenues generated are function of concealed inflation.
Risk in Infrastructure Projects
The key characteristic of infrastructure projects is the high risk associated with them. Based on past experiences many risks could be foreseen in an infrastructure project. Most important of all is the risk associated with legal, political, administrative and dispute resolution policies. Economic and financial happenings in the business environment pose risk on unexpected increase in cost and requirement of more in-vestment apart from forecast-ed amount. Moreover, market risk comprising of business model, traffic evaluation and currency valuation changes al-so poses high risk. Timely completion and environmental aspect poses a huge risk on these projects. Environmental norms as well as public acceptance are very important factor in terms of successful completion of any infrastructure projects. Collection risk as well as wrong prediction or assessment of traffic is also an important risk associated with any infrastructure project. In fact all risk are more or less interconnected and leads to late completion of project which results in huge capital loss and requirement of further funds other than projected capital in the beginning.
Prevalent instruments for Infrastructure projects and constraints related to them
In the past, government has taken the sole responsibility of operations and maintenance of these projects. But infeasibility in managing higher level of fiscal deficit in these ventures and considerations extrapolating that private player would prove cost efficient in terms of timely delivery of services to population leads to encouragement for participation of private partnerships in infra-structure. The promotion of DFIs such as ICICI, IDBI etc. were steps to get private participation, but undercapitalization and under profitability have posed a doubt over them to be viable alone.
The existing prevalent financing modes are incapable of funding the required infrastructure support need. For Infrastructure, there has to be credit enhancement, able of absorbing risk involved with the financing. Commercial banks have driven the increase in infra-structure finance but a continued speedy expansion may not be sustainable because of growing concentration of risks resulting from maturity mismatch because of long duration projects from short duration bank liability. Also many banks are reaching their exposure limit to infrastructure projects as they involve substantial in-vestments. Key restrictions include minimum credit rating for debt instruments and mini-mum dividend payment record of seven years for equity. Due to their long construction period they could never enjoy high credit rating in initial years. Insurance companies financing infrastructure projects are themselves very risky in nature. Moreover they prefer in in-vesting publicly listed company to fulfill their mandate prerequisite in infrastructure and social sector. Moreover a restrictive cap on interest rates has affected infrastructure financing as it demands for higher risk premium because of risky nature of projects.
Equity financing through financial investors is required so that promoters risk capital could be distributed among other projects. But the rules for selldown of equity are quite inflexible and hence act as de-motivator for financial investors who always love flexible exit options. Full capital gain tax is charged on sales of unlisted projects which leads to further reluctance of investors. Moreover the restricted ability of insurance companies and pension funds in India leads to less attraction of foreign investors as they also rely on domes-tic investors to a large extent.
Alternate options available and constraints
Mezzanine financing, which is a combination of debt and equity, could attract investors by reducing their risks. It is still not much explored in India due to lack of adequate and varied pool of projects. Moreover, interest rate caps on ECBs are not sufficient to attract investors for riskier projects as return is very low in comparison of huge investment and risky nature of project. The currency risk to one years for-ward cover, which results in inability to hedge long term risks, poses a big challenge for using foreign investment. High stamp duty and banks inability to mobilize their fund easily due to low liquidity results in restricted use of unconditional take out financing. Infrastructure financing also suffers due to underdeveloped bond market in India. Skewed interest rates, lack of alternative innovative financing instruments, incompetent clearing and settlement mechanism with poor and prolonged enforcement of laws for even common procedures leads to underdeveloped bond market.