What are the lessons from around the globe that can help India in financing its infrastructure pipeline efficiently?
In an effort to revive economic growth, the Union Government recently announced a Rs 102 lakh Crore five-year infrastructure investment plan. This has naturally raised questions about the source of its financing. In a series of three articles, I examine the challenges associated with its financing and the design of an appropriate financing institution.
Before diving into the financing challenges, it may be useful to categorise the infrastructure sector from a financing perspective. Importantly, there is no single infrastructure asset category. The risk-return profiles vary widely not only across sectors, but even within too – eg. electricity generation and distribution, or water treatment and distribution.
They also vary based on the stage of the project, construction and operation, and across locations. Some are commercially viable. Some can be made commercially viable using public finance or enabling policies, many cannot be done so. Some face risks, some uncertainties, and some both. Complicating matters, with the evolution of the market, these profiles vary.
It may, therefore, be useful to divide infrastructure into four illustrative categories depending on their commercial viability. Certain sectors, Category I, can recover their construction and operation costs through tariffs or user-fees and therefore are commercially viable. They include telecommunications, power generation and transmission, gas transmission and distribution, high traffic roads and railway corridors, major airports and port terminals, and sometimes bulk water supply.
Certain other types, or Category II, can be made commercially viable if a part of the capital expenditure is excluded or covered otherwise. They include sectors like many road stretches and metro-rail projects on high-density routes, or the smaller airports. Or those in general which require large capital expenditures, but which are not offset by the long-term revenues.
They can be made commercially viable if a part of the capital expenditure is subsidised, in the form of concessions and transfers directly made to the project asset or in the form of viability gap funding during the bidding process. The former includes the transfer of land parcels to a metro-railway project to generate additional real estate-based revenue streams. The latter include viability gap funding of airlines as part of the UDAAN program to service remote regions.
Then there are the Category III projects, which involve assets which can theoretically become commercially viable, and some of them are so in some developed countries. However, especially, but not only, in developing countries, but they also suffer from both construction and operational uncertainties. Urban infrastructure – water and sewerage, solid waste management, and mass transit – and power distribution are good examples of such assets. In these, for example, contracted tariff increases often get embroiled in the local political economy and come to naught. Investors hesitate to invest without significant risk mitigation.
All the remaining infrastructure assets, which are not commercial in nature, are best financed by governments. Social infrastructure works like schools, hospitals, irrigation etc., belong to this category. In such projects, private participation, if at all, comes through service concessions for specific activities like facilities management.
The World Bank’s Public-Private Partnership (PPP) Database of private participation in infrastructure in low and middle-income countries informs that Category I and II projects made up 87.1% of all PPP projects in the 1995-2019 period. In contrast, urban infrastructure, made up just 6.3%. The corresponding Indian figures are 96% and 1.1%. In fact, power generation, national highways, and telecoms formed over 90% of the $265.8 bn worth PPP projects in India over the 1990-2018 period. Add in airports and ports, and the rest all put together is rounding error. Incidentally, this categorisation neatly coincides with an index of maturity and investment attractiveness of different infrastructure asset categories developed by the rating agency CRISIL.
The important takeaway is that while some infrastructure sectors are commercially viable, some others can be made so. In any case, there is no alternative to public finance for a large segment of infrastructure. It is, therefore, encouraging that public finance is expected to cover 78% of the cost of the new infrastructure plan.
What’s the role of public policy in financing infrastructure?
There are four potential sources of finance – three domestic (government, private corporate, and private household savings) and foreign. The domestic private capital, which has to do the heavy lifting, is determined by the available investible long-term savings from households and corporates. Foreign capital is limited by the level of the country’s sustainable external balance. The envelope of finance available for infrastructure is therefore limited. In simple terms, capital mobilisation has hard accounting constraints.
India’s gross domestic savings (GDS) for 2017-18 stood 30.5% of the GDP. Of this, government savings formed 1.7% of the GDP, private corporate 11.6%, and private household 17.2%. However, of the private household savings, physical assets like gold, silver, land etc formed 10.6% of the GDP, leaving financial savings at just 6.6% of the GDP. Adding everything up, the total financial savings available for the economy in 2017-18 was no more than 19.9% of the GDP. Here too bank deposits, which are unsuited for long-term investments like infrastructure, formed nearly half the aggregate financial savings.
Further, in recent years, India’s GDS have been falling and its share of investible savings is smaller compared to the East Asian economies. In its high growth years, and even now, China had sustained 40-50 per cent GDS and could, therefore, afford gross fixed capital formation rates of 45-50 per cent. Further, they all had a far greater share of investible household savings. And industrial policy played a very active role in this intermediation.
Also, as an asset category, infrastructure is considered a stable but low-return investment, thereby lowering its attractiveness. On a global perspective, the median Net Internal Rates of Return (IRR) on all private capital has ranged from 8-12% over the 2007-15 period. Over a ten and five-year horizons to September 2018, infrastructure funds have delivered an average IRR of less than 6% and 8% respectively, both being the lowest among all private capital investment categories. Therefore, only a small share of investors have the risk appetite and returns expectations which match that of infrastructure.
Given all this and the diversity within infrastructure sector itself, there is an important distinction to be made between the use of public policy to efficiently leverage the available long-term private capital to invest in infrastructure and its use to expand the envelope of available long-term private capital to invest in infrastructure. In mainstream debates, it is often assumed that public policy can expand the envelope of available infrastructure finance. However, in reality, the envelope public policy can meaningfully expand is the supply of projects which can be made attractive enough for the available capital. Expanding the envelope of available capital itself requires boosting the country’s GDS.
Further, given the variations in the nature of infrastructure segments, the role of government too varies widely. In Category I projects, it is more about efficient crowding-in of the infrastructure itself than of capital. In others like Category II and III projects, and greenfield assets generally, governments may have a primary financing role to de-risk to crowd-in private capital.
Finally, the use of foreign capital faces a currency mismatch problem. Infrastructure projects have local currency expenditures and revenues and are risky and low return investments. If we add up the country risk, higher inflation rate, and likely currency depreciation, the asset has to generate a very high rate of return to justify foreign capital financing.
The main sources of infrastructure finance in India today are domestic banks and capital markets, and foreign investors. The total infrastructure sector credit outstanding from banks, the primary source, as on March 29, 2019, was INR 10,559.21 bn (USD 148 bn), and the total incremental bank credit to the infrastructure sector for the year 2018-19 was INR 1649.84 bn (USD 23 bn). Further, infrastructure sector formed 36.6% of the total credit outstanding of the scheduled commercial banks to industry, and 12.2% of the total non-food bank credit outstanding, both being at the regulatory limits of exposure.
In response to the limitations of bank finance, experts posit capital markets as an alternative and lament their under-developed state. But the global experience, especially outside the United States, shows that domestic banks loans, often syndicated, have been the primary source of infrastructure financing. Bonds have formed less than 10%, with the vast majority concentrated in the United States. Annual total infrastructure bonds issuances domestically for all emerging economies, excluding China, have been less than $10 bn in recent years. In fact, infrastructure bonds form a very small proportion of the total bond markets.
What about foreign capital? Consultants and opinion-makers estimate a large volume of foreign capital available for infrastructure investments. But this is deceptive and becomes vanishingly small when examined closely.
As on September 2018, the private capital dry powder, or funds available to invest, for infrastructure was $189 bn from out of $2.2 trillion across all sectors. Only a tiny proportion of this targets India. For example, of the $132 bn infrastructure-focused dry powder available at end-2017, just $17 bn was focused on Asia. Among those in the market raising capital as on October 2018, just 15 funds raising $9 bn were primarily focused on Asia. And within Asia too, India competes with Japan, China and the other East Asian economies. Further, most of this capital is towards Category I projects, in particular, renewables, and on brownfield assets. Taking all this into account, the likely available India-bound infrastructure-focused private capital annually would be no more than a few billion dollars.
As India explores various alternatives for financing infrastructure, it would do well to keep in mind the global experience of public finance and domestic bank loans being the major contributors. While alternative sources like bonds and foreign capital are useful complements, we need to be realistic with our expectations for them. This also underscores the importance of boosting domestic savings and immediate restoration of the banks’ balance sheets.
Gulzar Natarajan is an IAS Officer. Views expressed are personal.