Saturday, July 12, 2008

Financing Infrastructure II

There is an increasing belief among multi-lateral lending agencies and policy making circles in India that the private sector resources can replace Government funds in meeting the massive requirements of funding the infrastructure sector. This post will argue that this belief is misplaced and end up harming the development of our infrastructure sector (atleast certain sectors), if not dispelled conclusively and at the earliest.

The last couple of decades have seen pathbreaking developments in infrastructure financing. Till the eighties, Governments used to finance all infrastructure expenditure in India. The nineties saw the emergence of private sector as possible investors in infrastructure sector. The whole idea of private investments in infrastructure took off initially with the telecommunications sector and the BOOT/BOT projects in the roads developed under the Golden Quadrilateral. It gained further currency with the interest shown by private developers in the development of ports, airports and power generation.

Buoyed by the recent successes in privatization of national highways, ports, airports, and power generation, an impression has gained ground that there is massive amounts of private funding available and Governments can therefore exit from making investments in infrastructure. It is felt that at best, the Government role in infrastructure should be confined to providing viability gap funding or bridge financing investments.

It is in this context that three proposals pending before the US Congress deserves attention. These proposals come at a time when high profile events like the Minnesota bridge collapse and the sewer line bursting in New York's Times Square has brought to focus the bad state of infrastructure in America.

The National Infrastructure Bank (NIB) would be an independent federal entity with a five-member board of directors appointed by the President and confirmed by the Senate. The bank would evaluate and finance infrastructure projects "of substantial regional and national significance" with a potential federal investment of at least $75 million. It would be authorized to issue $60 billion in bonds, the proceeds of which could be used to finance direct subsidies, loans, and loan guarantees.

The Treasury would pay the interest on the bonds, and although the bills specify that the NIB would be responsible for paying the bonds’ principal, the Treasury would have ultimate responsibility for that also, because the bank would be a federal entity and the bonds would carry the full faith and credit of the United States.

The National Infrastructure Development Act would create a National Infrastructure Development Corporation (NIDC) and a subsidiary National Infrastructure Investment Corporation (NIIC). Initially, both would be federal corporations, but the bill would give the NIDC five years to develop a plan to convert both entities to Government Sponsored Entities (GSEs).

The NIDC would be capitalized with up to $9 billion in appropriations authorized over three years. Thereafter, it would be self-financed through business income, presumably through fees on users of infrastructure, and (once converted to a GSE) through the sale of public stock. The NIDC would be authorized to make senior and subordinated loans and to buy debt and equity securities issued by others to fund infrastructure projects; the NIIC would be authorized to insure and reinsure debt instruments and loans, insure leases, and issue letters of credit.

The Build America Bonds Act would grant consent and recognition to a transportation finance corporation established by two or more state infrastructure banks. The corporation would be under the control of the participating states, but it would be authorized to issue up to $50 billion in bonds providing federal tax credits in lieu of interest. The rate of the credits would be set so as to equal the average yield of longterm corporate debt obligations at the time the bonds were issued.

All the three involve substantial commitment of Government investments in infrastructure. The underlying premise, as CBO Director, Peter Orzag said in his testimony before the Senate Finance Committee, is that Government is able to raise funds at much lower rates than the private sector. He writes, "an infrastructure entity (like an SPV) that issued its own debt would incur higher interest and issuance costs than the Treasury does and could expose the federal government to the risk of default on such debt".

The four major dimensions of any infrastructure project are - project selection, project financing, project construction and operation and maintenance (O&M). The private sector has a core competency in more efficiently operating and maintaining utilities and assets, and it is therefore appropriate that private operators maintain public utilities. It is also best positioned to bear the risks associated with construction of the project assets. Further, the fact that the projects are proposed by the private sector will ensure that it is demand driven and commercially viable, and thereby eliminate some of the common project selection problems associated with government infrastructure projects. About financing such projects, the "best practice" model assumes that the financial markets are best suited to financing them.

However, such "best practice" assumptions fail to take into account the reality that private finance most often comes at a very high cost, and this incremental burden becomes the deciding factor between the viability or otherwise of a project. It is therefore important that we pay attention to "second best" models like loans from Government agencies and credit enhancement support from Government. The importance of lower cost of capital in infrastructure projects, and the role government can play in achieving it has been outlined in an earlier post here.

In developing economies like India, where the infrastructure projects have deep and inherent linkages with the Government and its agencies, no private entity, however established and credible, will be able to convince lenders about having mitigated the risks involved. These risks include construction risks, Operation and Maintenance (O&M) risks, and expansion risks. This inability to signal convincingly enough to lenders will translate into higher cost of capital for the project, thereby saddling the project with often unsustainable debt service burdens, under the weight of which it fails. This is especially true of sectors like water, sewerage, solid waste management, electricity transmission and distribution, and even urban mass transit systems, all of which involve significant public service dimension and interface with citizens.

There is therefore a strong case for the Government (or its agencies, backed by a sovereign guarantee) to borrow money and finance major infrastructure projects. The extent of funding can vary depending on the project, and should preferably be limited to the amount required to make the project financially viable and thereby incentivize private investments.

Another alternative to mitigate risks and lower the cost of financing is to provide credit enhancement support that would act as an effective guarantee against default. The extent of credit enhancement support can vary from a share of the debt to the total debt, depending upon the project and the sector being financed. This should be decided based on a detailed financial and economic analysis of the viability of the project without the support.

The Government of India have recently set up a Pooled Finance Development Fund (PFDF) of Rs 400 Cr ($100 mn) for the 10th Five Year Plan period for financing urban infrastructure projects. This PFDF will provide ratings enhancement facility through a Credit Rating Enhancement Fund (CREF) and raise the credit worthiness of all bond offerings to investment grade. This additional credit protection to the Urban Local Bodies (ULBs) and the lenders/investors is expected to reduce the costs of capital. The ULBs will have to access the market through a State Pooled Finance Entity (SPFE). While laudable, the amounts involved are modest and will hardly make a dent in our huge infrastructure financing requirements.

In this context, our massive and growing foreign exchange reserves can be deployed more efficiently by utilizing a small share for providing credit enhancement support for infrastructure projects involving External Commercial Borrowings. It may also be worthwhile to explore options with lending institutions whereby the same credit enhancement support can be used to guarantee multiple projects with appropriately balanced risk patterns.

However, such direct Government loans or credit enhancement support should be provided only after strict and professional due diligence that clearly establishes the financial and economic viability of the project. It is important that this activity is not done within the traditional institutional framework like the Planning Commission and involves more professionally competent agencies with adequate sectoral and financial experience. It should also be confined to sectors like water and sewerage, solid waste, power distribution, and urban mass transit, where there are considerable commercial risks.

The flip side with such Government loans raised from the market, would be its effect on "crowding out" private capital requirement. It may be interesting to quantify the extent of this effect. If the benefits accruing by way of cheaper cost of capital for the infrastructure projects, exceeds the crowding out effect, then such government intervention would be beneficial. I am inclined to believe that this benefits would be greater since every rupee spent in infrastructure exerts a larger multiplier effect on the economy than a similar consumption in another sector by a private investor.

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