The Problem with the Yield Curve

The Story

There’s an easy way to think about interest rates. Long term loans equate to long repayment periods. More uncertainty during these long periods can translate to higher risks. And to compensate for the high risks involved, banks quote higher interest rates when corporates borrow from them to build and operate stuff.

However, when banks borrow from the RBI they are borrowing over short intervals. And so they get charged lower interest rates. Ever so often, the RBI cuts rates in the hopes of making loans more accessible to banks. They are hoping banks will also extend this benevolence to their customers by cutting long term interest rates.

But right now, banks are scared. They don’t think the corporates can pay back. So they are keeping long term rates at elevated levels despite borrowing at consistently low rates from the RBI. And Andy Mukherjee wrote an excellent piece a couple days ago explaining what happens when the gap [between long term and short term rates] keeps growing. Here’s an excerpt from the story to drive home the point.

The surge in India’s yield differentials [ difference between short term and long term interest rates] has been both pronounced and problematic: Capital wasn’t cheap to begin with for corporate borrowers, and it’s getting more expensive. This comes just as migrant rural workers have been driven out of urban production centers because of shuttered factories, unpaid wages, and — in many cases — no food or shelter. Even if this labor is safely put back on, say, road construction, concessionaires [think private road contractors] might still go bankrupt before completing any projects. That’s because their annuity payments from the government are linked to falling short-term policy rates, whereas their long-term borrowing costs are both high and sticky.

Unfortunately, if you are a newbie, you probably did not fully understand that last bit. So let’s break this down and see what’s really happening here. But before we do that, a short note on how these construction projects are executed.

So, NHAI is the National Highways Authority of India and is largely responsible for building and maintaining roads. Its preferred method to get the job done is to deploy what is called the BOT model.

The Build-Operate-Transfer (BOT) model, as the name suggests is a way for NHAI to offload its responsibilities of road building to private contractors. These private contractors build the road, operate it, make money off of collecting toll, and after about 10–15 years, they hand over the road back to NHAI.

However, there aren’t enough private contractors willing to bid for such projects because — hey, maintaining and operating a road is a pain, especially if you have to wait 15 years to recoup all the money you had to pour in to build the damn thing.

In contrast, under the EPC (Engineering, Procurement & Construction) model, NHAI pays private contractors first, so that they can help NHAI build the road. The contractor does not operate or collect tolls here. Instead, it can walk away scot-free with money in its coffers once it’s done building the road.

But it’s hard for the government to shore up all the resources required upfront.

So they often walk the middle path through HAM— the Hybrid Annuity Model. It's a nice little mix of both EPC and BOT which means NHAI pays some money upfront in fixed installments (usually 40% of the project cost) and the private contractor does his bit by putting up the rest and finishing the project. However, once the construction is complete, the contractor does not make money off of collecting toll. Instead, he transfers the assets over to NHAI.

So its incumbent on the government to pay the rest of the money once the project takes off. And the payments are dependent on the asset created, the performance of the developer, and a few other things. However, since the payouts usually last 15–20 years we need to find a way to determine what kind of money the government pays the contractor every 6 months.

And here’s the best way to think about this — So when the government pays the 40% upfront, it's promising to pay the 60% sometime in the future. It's money they owe the contractor. It's money borrowed. So when the repayments, are made, they'll have to pay the principal and the interest. The interest involves a fixed component (3%) and a variable component. The variable component is effectively the short term policy rates Andy Mukherjee was talking about. So if the RBI keeps cutting these short term rates, private contractors get less money per installment even if their roads are all nice and shiny. And this can’t bode well for them because they probably put up the 60% back in the day by borrowing from another bank. A bank that’s charging them long term interest rates that refuse to come down.

So effectively, if the long term rates don’t move alongside short term interest rates, you can get all sorts of problems. And now you know why.

Until next time…

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