Infrastructure DFIs – Issue of Sustainability

The various newspapers report about intention of the government to set up an infrastructure focussed Development Financial Institution (DFI), which will cater to demand of the sector. The Prime Minister also called for Rs. 100 trillion target for infrastructure investments during 5 years period till 2024. India certainly needs this investment as also highlighted by high powered committee on urban infrastructure some years ago. But given the current situation in infrastructure, covid -19 impact, coupled with diminishing headroom for more public expenditure, achieving this target could be daunting specially in absence of new avenues of financing these investments. DFIs dedicated for the sector could be considered a panacea for this.

The Central Government is already working on the structure of a new DFI – a specialised institution to offer long term funds to the sector, where borrowers are unable to get it from other sources. We already have DFIs categorised as All-India or State / regional level institutions depending on their geographical coverage of operation. Functionally, All-India institutions can be classified as (i) term-lending institutions extending long-term finance to different industrial sectors (some of which turned into commercial banks later on) , (ii) refinancing institutions extending refinance to banking as well as non-banking intermediaries for finance to agriculture, SSIs and housing sector, respectively (iii) sector-specific / specialised institutions, and (iv) investment institutions. Besides, we have state governments financed DFIs working at state levels.

The presence of all these DFIs have not been able to meet the specific needs of infrastructure sector in a self-sustainable manner. Further, the operating model for infrastructure for private investors like HAM has itself undergone frequent changes in recent times; reflecting that developers are unable to sustain for long even when majority of risk is being taken by the public sector.

The long-term sources of fund for infrastructure are turning scarce each day and new avenues are not opening up. It is well known fact that in India, commercial banks have been primary sources of commercial lending and now are having big hole in their balance sheet due to increasing NPAs from this sector.

In view of this, it is but natural to discuss nature and model of such dedicated DFI before we move ahead with adding another monolith backed by typical government support and then finding it difficult to sustain its balance sheet. Infrastructure require really long term sources of funds, and scale of investment as in PM’s vision statement certainly require a big DFI but model can not be like before. With commercial banks facing asset-liability mismatch in lending of resources for infrastructure, such need acquires more teeth.

There can be two basic models of such DFI- government backed or stakeholders supported with a private sector character. In case of it being a government backed institution, there is advantage of ease of fund raising. Further, the securities from such DFI could be made Statutory Liquidity Ratio (SLR) eligible and thus encourage banks and other financial institutions (FIs) to subscribe to such securities to meet SLR obligations. However, the moment it acquires government control, there is heightened chance of oversight from 5Cs – CBI, CVC, CAG, CIC and Courts. The most of prudent decision could be termed malafide in hindsight. A DFI with a private sector character, will first require the political will to believe the private sector and maintain distance (arms length relationship) from the institution say in form of directed lending. For example, government in such set up can keep its stake limited to 26% or 49%; not acquiring majority role.

However, subscription of banks to securities of this DFI will be only one source of such DFI. In view of absence of mature corporate bond markets in India, subscription from public, pension funds, and other patient capital like sovereign wealth funds, private equity could also be stakeholders.

The question is whom it will lend to – only commercially viable (or so to say economic) infrastructure or capital-intensive ones like rural infrastructure as well. Most of these investments are municipal levels, and so it is imperative to look at the pattern of expenditure at this level. For example, the high-powered committee on infrastructure in its report projected urban infrastructure expenditure in 2021-22 at Rs. 3,30,242 Crores and in 2031-32 at Rs. 7,31,605 Crores. The capital expenditure is around 54% of such investment, whereas O&M and establishment charges constitute 25% and 21% respectively for the year 2021-22.  This data clearly shows that half of the investments are non-recoverable as we already know in India, focus is still on recovering O&M than capex. In such a scenario, will the DFI be willing to take such sustainability risk. On one hand, it will be required to lend at sub-prime rate due to under-pricing norms of credit lending to infrastructure sectors and other hand investing money in avenues where 2/3rd of the investments can’t be recouped.

So, the solution is not merely creating a DFI, a monolith like before and again landing at same problems of funds mismatch. It is well established in finance, that full cost recovery plus margin of safety in form of profit only can sustain an investment, related service level and avoiding asset-liability trap. If the governments of the day, can think of outsourcing establishment cost along with O&M in its projects to private entities, we can see potential savings in these costs due entrepreneurial spirit along with efficiency gain. The rest part, that is capex can be borne by the government at least in short run.

Counter to this view could be that ULBs, or municipal level organisations do generate sufficient tax and non-tax revenues and so need to worry about sustainability of funding but if we see, their own revenue is only half of their total revenue and total revenue is only 0.9 percent of the GDP much lower than the revenues of urban local governments in other countries. The increase in non-tax revenue is also accounted for by one-time events like land sales. However, as we have already seen, this is not sustainable.

Question that remains is how this DFI will be sustainable in its lending? Is the government intention only in rerouting of funds without adequate return on its investments? Will a DFI with private sector nature be willing to lend to a non-commercial project? If not what is the solution. Certainly creating a DFI can’t be a panacea if we really want a solution of the problem but recovery of costs is something that government of the day will have to see for long term sustainability of projects and so monetary environment. For example, we can’t any longer afford to fund the subsidy to huge irrigation sector at a cost of marginal taxpayers and like so in other sectors. A DFI could be an approach and not a solution to the problem of infrastructure financing unless the projects are made self-sustainable. Assuming DFIs operate with no ALM mismatch, their cost of borrowing will rise. This rise will ultimately affect the shareholders through lower profits and the projects through higher cost or both. Since DFIs are expected to fund projects on a large scale, this issue can be significant.

While talking of ALM risk, we mostly think of the maturity mismatch. But the real (as against contractual) maturity of a loan is heavily influenced by the movement in interest rates. Most infrastructure projects have clauses for interest rate reset. While the fall in interest rate is enjoyed by the borrower but increase in rate is not easy to pass to the borrower, if it is performing well. This is because our banking system lacks atomistic competition and is dominated by a few large banks.

The public sector banks (PSBs) as well as privately owned lenders have systematically under-priced the credit risk for infrastructure projects. The PSBs have under-priced mainly on account of misaligned incentives and weak credit assessment capability. As a result, the private lenders have also had to under-price risk on account of competitive pressure from the PSBs.               

The negative effect of the aforesaid mispricing of risk is not visible when the economy and the loan book keeps growing fast. A rising tide lifts all boats. This was the case during the period 2004-12. However, the lenders become exposed to the accumulated credit losses whenever the loan book growth slows down, as happened in 2012 onwards. The result has been that a huge amount of infrastructure loans has turned into non-performing assets.         

To summarise, the setting up of DFIs is not the only way to solve our problem of project finance. It will effectively put the onus of financing in the court of the government. The real problems of our financing sector are related to governance and risk management at macro as well as micro levels. The government needs to strengthen the incentive framework and the lenders need to improve on their risk management capabilities including need to recognise project sustainability. These need to be recognised and then addressed for sustainable benefits. That will not change unless the fundamental reasons like sanctity of contracts, time bound recovery of dues, and overall ease of business are credibly addressed.

Views expressed are personal

References:  

1.      High Power committee report on Urban Infrastructure, “Report on Indian Urban Infrastructure and Services, 2011”

2.      Development Bank for Infrastructure Funding, 7 Sep, 2020, https://www.drishtiias.com/daily-updates/daily-news-analysis/

3.      After years, Govt Plans new development bank for big infra funding, 6 September, 2020; https://indianexpress.com/article/business/economy/development-bank-dfi-sitharaman-6584723/

DFI Is Not The Solution For Infrastructure Projects, 25 August, 2020, https://www.businessworld.in/article/DFI-Is-Not-The-Solution-For-Infrastructure-Projects/25-08-2020-312737/