Monday, February 2, 2015

The adverse selection problem with PPPs

Governments across the world see public private partnerships (PPPs) as a means to tide over their fiscal constraints and substitute for public spending. The government in New Delhi is no different. This view of PPPs is misplaced and is most likely to result in their failure. I have written about it here arguing that PPPs are effective when there are real efficiency gains to be had from involving private partners.

In normal times, creditors provide the most rigorous due diligence on projects. Since creditors are foremost concerned about repayment, their incentives are aligned towards ensuring that credit is channeled into financing only commercially viable projects. Such projects have a credibly guaranteed revenue stream to repay the project debt.

But this disciplining power of credit breaks down during the good times, especially during a credit boom. In an environment of cheap and plentiful credit, creditors go in pursuit of yield, assuming ever greater risks. This weakens the screening mechanism that distinguishes the commercially viable projects from the rest. Project developers are encouraged to peddle grandiose projects with large risks and doubtful commercial viability. Credit gets mis-allocated into projects of doubtful utility and commercial viability.

This is a classic case of adverse selection. PPP projects which otherwise would not have achieved financial closure, leave aside commercial break-even, find lenders when the disciplining powers of credit breaks-down as a credit bubble inflates. They get re-negotiated when the bubble bursts. This should not be seen as a symptom of deficient PPP plumbing or regulatory failures. These projects were never suitable for PPPs, should either never have been taken up or have been financed by public spending.

Accordingly, the re-negotiations in India's national highway toll road and ultra-mega power projects due to unrealistic traffic estimations and low-balled tariffs are less a problem of policy failure and more the manifestation of adverse selection. 

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