Infrastructure Financing – Opportunities & Challenges

Introduction

Complex, capital intensive, long gestation periods that involve multiple and often unique risks to project financiers are some of the typical characteristics of an Infrastructure project.

Infrastructure projects are further characterized by non-recourse or limited recourse financing, i.e., lenders can only be repaid from the revenues generated by the project. Infrastructure projects are also exposed to several forms of risks like operational risk, completion risk, market risk, infrastructure risk, funding and legal risks. Infrastructure Projects have unique forms of risks due to the public interest nature of the projects. These typical characteristics of Infrastructure projects make Infrastructure Financing a tough challenge.

Government budgetary support and internal resources of public sector infrastructure   companies have been the main source of Infrastructure financing for a long period of time. However in the span of last few years private sector has emerged as key cog in the wheel of Infrastructure Financing. However the regulatory policies limit the capacity of the banks and FI’s in meeting the requirements of Infrastructure sector.

RBI Norms for Banks and FI’s for Lending to Infrastructure Sector
Single Company	Group
20% of the capital funds for Infrastructure Projects #	50% of the capital funds for infrastructure projects $
# 25% with board’s approval	$ 55% with board’s approval
Capital Funds Include Tier I and II capital

Constraints are more than one and are not just regulatory in nature. However the biggest hurdle Infrastructure financing is faced with are financial sector constraints.

a.       Equity and Quasi Equity Financing constraints 
b.      Restriction on ECBs 
c.       Limited use of Takeout Financing 
d.      Underdeveloped Bond Market and Lack of Long Term Financing

a. Equity and Quasi Equity Financing Constraints:

Raising adequate equity finance tends to be the most challenging aspect of infrastructure project financing, as equity typically carries the greatest level of operational, financial and market risk. Equity financing offers limited exit options at present which limits equity financing. Other constraints include a shallow capital market (albeit continuously improving), and weaknesses in corporate governance (primarily minority shareholder protection rights).

 Mezzanine finance, which is a hybrid of debt and equity, is a debt capital with fixed payment or repayment requirements, but with the right to convert to an equity interest in a company is critical in funding infrastructure projects in developed countries, but is also limited in India. The basic reason for this is:

(i)                 The lack of a sufficiently large and varied pool of infrastructure projects, which leads to a preference among funding institutions to opt for more straightforward loans (rather than hybrids)

(ii)               Interest rate caps on external commercial borrowing (ECBs), which prevent the precise pricing of different debt or quasi-equity instruments (like mezzanine financing)

b. Restriction on ECBs

New ECB guidelines encourage use of infrastructure financing. Despite this external funds are significantly low compared to the needs and the reason for this is the interest rate cap on ECBs (Libor+350 for loans more than 5 years). These caps do not seem commensurate to the risk of infrastructure projects. This also has implication on mezzanine financing as indicated earlier.

Constraint in utilizing foreign currency loans is the lack of a sufficiently deep forwards market in foreign exchange. Infrastructure projects require long tenor loans, and if financed through foreign currency borrowings these need to be adequately hedged against currency risks since few infrastructure projects have FOREX earnings to serve as a natural hedge. Inability to hedge long term currency risk in a market which is limited to one year’s forward cover poses a big challenge to the use of foreign currency loans in these projects.

c. Limited Take-Out Financing


In take-out financing, banks provide long-term infrastructure loans, featuring the loan being extinguished from the books of the financing bank within a pre-fixed period by another institution, say in seven or eight years of a loan with a tenor of 15 years to mitigate the possibility of an asset-liability mismatch.

Source: Economic Times, 24^th August 2011

Though takeout financing is not very common, it can give a fillip to infrastructure financing by addressing both the unwillingness and the lack of experience of institutional investors to participate in infrastructure financing. The main factors limiting the use of takeout financing include the following:

First, the presence of excess liquidity in the system reduces the need for banks to quickly circulate their funds, and hence, the appetites for innovative instruments like takeout financing. With limited number of ‘bankable’ projects in the fray and no liquidity crunch, banks have no inclination to sell out these good assets from their portfolio.

Second, high stamp duties reduce the attractiveness of takeout financing and securitization. Excessive rates of stamp duties in some states have stymied the growth in innovative financial instruments such as take-out financing and also securitization

RBI is now unwilling to allow banks to raise bonds to fund infrastructure. It has also not revised group exposure norms or individual borrowing limit. Breaching lending norms would result in constraints on prudential exposure norms. All these factors could boost demand for takeout financing. However, there are sceptics who say that it will be tough for infrastructure finance companies to promote take-out financing in a big way as infrastructure lending by banks has started picking up only in the last two three years. Many banks have not exhausted their infrastructure exposure limit. So there is a limited scope to take out big sums now. It will take some more time for recently funded projects to be eligible for takeout financing.

d. Underdeveloped Bond Market and Lack of Long Term Financing

Issues pertaining to development of government securities market, lack of market infrastructure and innovations in the corporate debt market are the basic reasons for the underdeveloped bond market in India.

Limited size of government securities and their trading activity has meant that there is no reliable benchmark yield curve. This is one of the key issues associated with development of government securities. This implies there is a need for the benchmark yield curve for government bonds. Absence of the same has been responsible for the poor development of the bond markets.

Similarly burdensome primary issuance guidelines have affected trading by being responsible for higher costs for raising debt, regulatory compliances’ costs, advertising expenses and intermediation costs to brokers and underwriters. This Market infrastructure also is inefficient in information dissemination leading to information asymmetry, and is also responsible for inefficient clearing and settlement mechanisms. These issues are of extreme importance as they are responsible for making markets illiquid. 

In order to give a fillip to the infrastructure financing, India needs to adopt ‘market finance’

approach instead of the prevalent ‘contract finance’ approach. This can be achieved through Privatization and securitization .Private ownership of public investment projects will support a more efficient and successful infrastructure development in the country. Therefore it is imperative to explore the opportunities for securitization for improving the financing for the Indian infrastructure sector.

Submitted By:

Gunjan Sheth

Snehal Punjani

1st Prize winners of Article writing Competition, held across B-Schools

Name of the Institute:

Narsee Monjee Institute of Management Studies & MBA-Core