Friday, May 20, 2016

Chasing chimera - credit rating for infrastructure projects

The Business Standard informs that six credit rating agencies are working together on a new rating system for infrastructure projects that is a more accurate signal of its credit-worthiness. It writes,
The new ratings system will look at variable risk factors in public-private partnership projects to assess their viability. The new ratings will differentiate between credit rating of contractor versus the project.
Unfortunately, I am afraid that like with all such search for simple solutions to complex problems, this too is unlikely to work. The fundamental premise is that the reckless lending and borrowing of the last decade with the attendant current banking sector woes could have been avoided with better signalling. In other words, the rating agencies and their ratings could have made up for the banker's failure in accurately assessing project risks. Alternatively, the banks could have outsourced the due-diligence activity to rating agencies. 

It is facile to assume that such ratings can be a substitute for painstaking and rigorous due-diligence by lenders. For a start, it assumes that it is possible to make accurate ex-ante assessments of project risks and betrays an ignorance of the manner in which those risks surface. No type of ex-ante ratings, concluded even before the financial closure, could have been any more reliable in predicting the construction delays and cost over-runs. The commercial risks are project specific, readily identified, and amenable to being assessed with greater certainty than construction risks. Emergent market risks are in any case uncertain by their very nature. Such risk assessments and environment surveillance is extremely costly and require competence that goes far beyond those available with rating agencies. There is simply no substitute for building good risk due-diligence institutional competence in lenders. It just cannot be outsourced.   

As to differentiating between the contractor and the project, it is a first order distinction between corporate finance and project finance. In case of the former, the contractor's rating assumes significance, whereas in the latter, the project gets rated. It cannot be helped if the lenders relied on the wrong rating!

It does little to address the fundamental problem with the prevailing ratings model - the conflict of interest arising out of the rating agencies being paid by their clients. Further, recent experiences with rating agencies give us no reason to repose such faith in their ability and intent to make reliable assessments about project risks.  

Finally, experience from across the world and across history provide ample evidence that financial markets cannot be insulated from credit risks at all times even with measures that mitigate information asymmetry. It has been a feature of these markets that they lose their discipline when credit is plentiful and financiers indulge in risky lending. This would be all the more likely in the context of countries like India, with its massive capital investment requirements and large available shelf of infrastructure projects, and intense pressure on governments to get them rolling.  

A more reliable assessment of the project risks is to use the concept of "optimism bias" that countries like Australia and UK have used to calibrate project risks. As I have blogged earlier, this can be extended to discount the delays associated with individual contractors as well as nature of projects. This may be a more relevant information for creditors, contractors, as well as governments in assessing project risks. And it does not require any rating agency, but can be consolidated and maintained by an institution like the envisaged P3 Institute. 

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