‘Patient Capital’ For Infra Projects May Be More Willing With Low-Cost Forex Hedging Options

Prime Minister Narendra Modi is expected to meet 15 major global fund houses shortly in order to tap patient capital for India’s massive infrastructure programmes. According to Tarun Bajaj, economic affairs secretary, these fund houses are seeking good assets and moderate returns.

Among other things, the government is also trying to get Indian bonds into global indices. Once this happens, foreign funds will be able to invest in government bonds, increasing the country’s access to resources at lower costs.

A simple point to make here is that any spike in investment should, ideally, be equity led. Deepening the bond markets is good in itself, but in the long run it only worsens India’s debt profile and makes government finances vulnerable to global swings in investor moods.

If one were to look at the underlying risks as viewed from a foreign investors’ perspective, the primary risk may be seem to be project viability. But what may additionally deter investors is the exchange rate risk. If the currency is going to depreciate 5 to 7 per cent annually, sometime faster and sometimes slower, hedging that risk eats away the bulk of the margins from a project, even if it ultimately yields positive returns.

This implies that apart from offering sound assets and reasonable yields, what may tilt the balance may be low-cost hedging options. This is what Raghuram Rajan did in 2013, when the rupee was careening downwards. He offered a risk-free hedge for three years to raise debt through the banking system and got rewarded in spades.

But giving low-risk or risk-free returns on debt is counter-productive. It effectively gives the investor a free ride at our expense.

This time, we should shift the focus away from giving low-cost hedging options on debt, and tilt it towards equity.

Let’s assume we are selling a toll road to a US pension fund for steady returns. If a fund wants to make, say, a $10 billion investment in toll roads, there is no reason why we should not offer three-year (subsidised) exchange rate hedging options for half the amount of equity brought in, with the hedging costs being aligned to market rates every three years as the project starts generating greater cash flows over the concession period.

A part of the debt raised (preferably in rupees) can also be hedged, but it is the equity part that must be privileged. In short, if $5 billion of the $10 billion investment is hedged, it would imply that if the fund wants to sell out after, say, five years of the concession period, it would get half its money back in dollars at a pre-fixed exchange rate, with the other half being bought at the market exchange rate.

This may not be the best way to design an exchange rate hedge, but one needs to agree with the principle of it: the exchange rate hedge must be for patient capital, mostly equity. This may reassure investors over the next decade till they become more comfortable with the Indian economy and its innate potential. After that, they may not need the crutches of subsidised exchange cover.

Giving low-cost hedging options may be a good starting idea for priming the pump of patient capital. It is worth a try.