"First mover disadvantage" in infrastructure finance

One of the biggest challenges facing the infrastructure debt market in India (and many developing countries) is the problem of the "first mover disadvantage" faced by the borrower. This refers to the high risk that in an emerging market, the initial borrowers will be saddled with a deal (cost of capital) that would look unfavorable or even bad, a few years henceforth when the market would have matured fully. I will briefly elaborate the problem below.

In an essentially virgin debt financing market in a particular sector, the lender is faced with numerous risks, many which are not fully understood. There is a huge information asymmetry problem and lenders are apprehensive of adverse selection. This gets exacerbated when government agencies, with their reputation for inefficiency and legacy costs, are involved. There are risks associated with the sector, company, and the project being financed. The fact that very few agencies in the sector have been credit rated, only compounds the problem.

Given the risks inherent in the sector, the credit rating agencies too tend play safe and discount for the general sectoral risks while rating the borrower or the project. The credit rating is therefore never a true reflection of the financial and organizational strength of the specific borrower or the particular project. The lenders hedge for all the risks and pass them on to the borrower as higher capital cost.

With the markets not appreciating the inherent strengths of the company and its projects, even a very credit worthy borrower faces a difficult situation. The onus is on him in effectively signaling to the market his credit worthiness and inherent financial strength, and thereby differentiating himself from the others in the sector. In other words, the borrower needs to differentiate himself from the numerous 'lemons'.

Further, the borrower has exposure to local banks who are willing to lend at much lower rates, albeit for a shorter tenor. The local banks tend to have good working relationships with such borrowers, and have a much better understanding of the borrowing organization. By lending at the lowest possible rates, these commercial banks "crowd out" other more long-term and structured sources of debt and thereby delays the development of alternative debt markets.

But the borrower's biggest concern arises from a fear that he may be left holding a debt, which while reasonable now, may look like a very bad deal after a few years when the sectoral debt market has matured. It is natural that when the sectoral risks have been fully understood, some debt financed projects are successfully implemented and regular repayment is established, and credit rating is a more accurate reflection of the strengths of the organization, the cost of capital will fall significantly.

This coupled with the long-term trend towards lower rates (given the high base rates in many emerging economies), it is inevitable that the cost of capital for the first few projects may look very expensive a few years down the line. In a Government organizational context, such apprehensions makes managers and officials wary of taking innovative financing decisions.

This is the dilemma facing many borrowers in urban infrastructure and power distribution and transmission sector financing markets in India. A recent study of the 63 JNNURM cities by the Water and Sanitation Program (WSP) found that the major demand for debt is coming from those ULBs that are strapped for finances and have weak balance sheets. In contrast, the stronger and richer ULBs are trying to fund their investments from internal revenues, reluctant as they are to venture into the debt market. The major deterrents for these stronger ULBs being the higher cost of capital relative to the cheaper local financing options available and the tortuous process of accessing the debt market.

Similarly, the power transmission and distribution companies have access to assured and easily available loans from traditional financiers like Rural Electrification Corporation (REC) and the Power Finance Corporation (PFC), apart from local commercial banks with which they have their regular banking relationships. Despite the fact that these loans come at very high rates, the ease of accessing them endears such sources to these borrowers. These readily accessible sources have had the effect of "crowding out" the formal long term debt market. The result is that there are no Government sector transmission or distribution companies that have accessed the debt market. In fact, I could not come across even a single distribution company which had got itself credit rated, with a fully disclosed rating.

Let me sum up the story. The lenders are wary of the risks associated with these emerging sectors, and hence charge higher returns on these investments, which forces up the cost of capital. Credit rating agencies refuse to rate borrowers on a stand-alone basis and circumscribe the borrowers within the sectoral risk matrix, thereby making lenders warier still. The borrowers, exposed as they are to inefficient, but readily accessible, alternative sources, balk at the higher cost of capital and refuse to venture into the debt market! We therefore have a classic chicken-and-egg situation!

I have dwelt earlier here and here about how the urban infrastructure financing market was stuck in a stalemated debate between credit rating agencies, financial markets/institutions and the Urban Local Bodies (ULBs). The same is happening in the downstream of power sector too, and the economically inefficient loans from REC and PFC crowds out the emergence of any structured long term debt market.

How do we get out of this chicken and egg riddle? For a start, financial institutions will need to exhibit enterprise by assuming more risks and finance a few credit worthy organizations and projects. Such delayed gratification will invariably benefit the lenders in the long run, as it opens up the way for tapping the massive market in infrastructure finance. The enterprising lenders also benefit from the first mover advantage in these emerging markets.

The Government should consider providing risk mitigation support by way of credit enhancement facilities or even gap funding for these initial borrowers. The borrowers can be reassured of the "first mover disadvantage" by structuring the facility of swapping and/or a floating rate provision for the original debt. All these steps would reassure borrowers and encourage them to actively explore the debt markets.

Once we have runs on the board, with a few project successes to show for, it becomes easier for others to enter the market. As the uncertainties and apprehensions become cleared, and risks more clearly understood, the cost of capital will come down, especially for the more credit worthy projects and organizations. Only then will the risk arising from "first mover disadvantage" will be mitigated.