India has a long history of DFIs. A comprehensive analysis of previous experiences, including with private participation, and the reasons for their failures is documented in the comprehensive study here.
In light of these learnings as well as global experiences, some factors to consider while designing a DFI are outlined below.
1. Ownership - The experience of European, East Asian countries and BNDES in Brazil points definitively to government ownership and control as an essential requirement for the DFI to prioritise its development objectives. India’s own experience with the likes of IDFC points to the limitations of privately-owned entities performing the role of a DFI in maintaining focus on the development objectives. The incentives and requirements of private investors are incompatible with the need for a DFI to be a catalytic institution to boost investment in infrastructure.
2. Source of funding - If it is to deliver on its mandate, a DFI should have access to both fiscal support as well as cheaper sources of capital. As examples, whereas the European DFIs source capital from the market at cheaper rates leveraging public ownership, DFIs in East Asia and BNDES obtain significant budgetary support apart from being able to raise cheaper capital. A wholly government owned DFI would benefit from being able to access capital at cheaper rates. It should be allowed the benefits of other concessions in the form of tax exemptions for their bond issuances, some form of interest subvention subsidy in certain cases, eligibility for SLR considerations, preferential lower risk weights for DFI bonds in various portfolios and so on. The Government of India should also solicit funding from the multilateral and bilateral lending agencies.
3. Where to invest?
a. The financing priority should be projects in water and sewerage, solid waste management, urban mass transit, electricity distribution, and social infrastructure (riskier sectors) which face challenges with commercial viability and will struggle to attract commercial capital on their own. Direct lending operations of the DFI should prioritise such projects. Lending to such projects should have an element of concessionality so as to de-risk and make the residual investment opportunity commercially attractive enough for private investors.
b. Greenfield projects involving construction is the highest risk phase of infrastructure projects and therefore should be a priority for DFIs. In general, private capital is loath to finance greenfield projects given the risks and uncertainties associated with both construction and the revenues forecast. It is an area where DFI capital can act as a bridge to finance the construction and pass on the asset to private capital post-construction, as well as to act as a risk-mitigating capital for private investors during construction.
c. In addition, DFI could undertake financing of projects in telecommunications, power and gas generation and transmission, highways, ports and airports (all mainstream sectors) in very rare cases for exceptional reasons, where private capital is otherwise not forthcoming. In general, they should avoid direct lending to such projects because they would effectively be displacing private capital. Accordingly, direct lending as the primary lender should actually be of secondary importance in case of mainstream sectors. It should be done only to keep its overall balance sheet a little less and get some net interest income going.
d. The DFI should not compete to invest in projects where there is already private interest. In this context, the role of NIIF is illustrative. Since its inception, it has consistently sought to compete with private investors in completely de-risked mainstream sectors. Its current portfolio consists exclusively of projects which could have been financed by commercial investors. This goes against the crowding-in role expected of a DFI. It then functions as a Sovereign Wealth Fund, instead of a DFI.
4. Manner of financing
a. In less commercially viable projects, DFIs will sometimes have to perform the role of being the lead financier to de-risk the project, especially in the construction phase. It may also have to assume concessional financing role to attract private capital, especially in the O&M stage. In these projects, a far greater additionality than senior lending can arise, as required, from subordinate financing.
b. In addition to sub-ordinate lending, the DFI should prioritise the use of guarantees and different forms of debt back-stops or buffers to de-risk lending to riskier sector projects. Partnerships with banks and other financial institutions to support such financing would be a very good use of DFI capital.
c. Further, equity financing will be something which private capital, even in case of brownfield projects, will be less willing to commit. The DFI can play a role in bringing in equity capital, especially subordinated equity, so as to crowd-in debt from private sources, in certain important types of riskier projects.
5. Governance
a. Given their role, management and governance depends on the way in which the DFI interacts with its owner (government), its clients (market), and its regulator. Arms-length relationship with the owner, rigorous project appraisal and prudent lending practices and robust regulatory oversight are essential requirements.
b. There should also be strong internal controls that separate the loan appraisal and lending activities and the respective personnel involved. The appraisal staff should be incentivised to undertake rigorous due diligence.
c. It is also important that the true economic cost of the concessions provided by DFI are captured and that financial models reflect them. The costs could be assessed for reasonableness with respect to appropriate benchmarks. This should also be prominently reported and monitored to ensure lending discipline. This also has a critical role to play in assessing the performance of the DFI with respect to achieving its stated objectives.
6. Capacity
a. The DFI should develop very strong internal capacity to appraise projects. In fact, other creditors, especially banks, could rely on its appraisal in their lending decisions to those infrastructure projects. However, this would require being able to recruit and retain qualified professionals. In this context, the experience with IIFCL is instructive. Despite being a large infrastructure lender, it piggybacks on the project appraisal conducted by others in the lenders’ consortium. While this passivity has allowed it to remain a lean organisation, perhaps even book profits, it has come in the way of acquiring the internal expertise to appraise and evaluate project risks. This deficiency of expertise evidently comes in the way of true risk assumption – the vast majority of its assets are secured loans. More importantly, this is a big detriment to the DFI realising one of their most important objectives, in setting industry standards.
The GoI could try to get some professionals on deputation from the World Bank or Asian Development Bank, especially for some important leadership positions like the appraisal division. This would also likely make the appraisal division work more independently from the investment division of the DFI.
b. Since one of the most important problems that bedevil infrastructure projects is the poor quality of project preparation, the DFI should support the development of a shelf of projects. In fact, they should actively support with project development and help create a pipeline of procurement and financing-ready projects. This will also help the DFI build a robust pipeline of deals for financing. This would require the use of grants. The India Infrastructure Project Development Fund (IIPDF) facility available with Department of Economic Affairs (DEA) could be leveraged to support project development.
c. The DFI could become the implementation agency for the Government of India’s Viability Gap Funding (VGF) scheme, currently administered by DEA. This would help the DFI, especially in its initial stages, quickly build up a portfolio of projects. Besides, the DFI is better placed than the DEA in appraisal of PPP projects.
The paper has details about each of these suggestions above.
To summarise, there are perhaps five essential requirements for any DFI:
1. Full government ownership.
2. Fiscal support and access to low-cost funding sources.
3. Confine to de-risking of less commercially viable and riskier projects, where private capital is unwilling to invest. Never compete to invest in commercially viable projects.
4. Robust governance mechanism, especially important given the areas targeted for investment, the lack of market-based discipling mechanism, and government ownership of the DFI.
5. Acquire strong capacity to appraise projects.
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