When talking about the Indian economy, are we missing the big picture ?

Posted on September 24, 2017. Filed under: Uncategorized | Tags: , , , , , , , , , , , |

So the new government got into the office on the back of a pitch that was based on a lot of hope and promises, and while I have been personally quite supportive of the need for change. I have never been in any doubt that, the changes will require time and government will have to let down people. In a country like or anywhere else for that matter, a government gets elected mostly on perception built around the hype. Average people are simply unable to breakthrough each policies and make sense of it. A country like India needs a complete overhaul of its existing economic and financial infrastructure , and that requires a lot of re-wiring and also redesigning of the entire system. Any good reforms takes time, and a prudent policy is always, to not overload the system with Big Bang reforms, one after the other, the changes have to be incremental, but constant. A system overhaul takes time, and you can’t expect the system to start firing on all cylinders right away especially when you are creating more capacity in the old system.

But economic policies alone can’t re-wire the system, it also requires better execution. And if we are talking about creating growth then, there should be a realisation that, without the ability of funding, government policies on their own aren’t the magic fix. So I don’t care what economic policies the government can come up with, driving growth in a country like India , where almost 80- 90% financing is sourced from banks simply isn’t going to work, unless and until the banks are back in shape. The fact is, the bad loans problem hasn’t been fixed, and the lenders have been too slow to offload the garbage sitting in their living room, yes there are legislative policy changes and reforms to help the banks, but banks haven’t been proactive enough. And a lot has to do with the existing training as well as mindset of the executives within the current banking system. For example, based on my own experience, I have realised that a sizeable percentage of the senior bank executives in India aren’t willing to make tough decisions, because for them, as I understood it, it’s all about a peaceful retirement and self preservation. And the investigative agencies haven’t helped decision making process either. Also some of the rule changes don’t really help the banks clean up their balance sheet. The asset reconstruction companies or ARC as they are known in India are, like a time bomb waiting to explode . On practicality basis, there is almost zero value in the ARC structure.

Without recycling the rubbish, you can’t get rid of the stinky garbage, and monetise it. Many quality ideas are simply not getting funded in India, and young entrepreneurs who could drive growth are more or less shut out from funding. And the other real issue is that, like European banks, the Indian banks are also now scared to lend. The ex RBI governor did good talking and provided public opinion on almost everything, but failed to provide real solutions, and now he is busy promoting a book.

I would prefer a wholesale reform of the financial infrastructure of the Indian economy, where capital market becomes the largest source of capital and not the banks. The regulators also need to support the government by unburdening the system from socialistic era policies. Also the government needs to do more work and talk less, there is too much distraction. A lot of announcement, but not much is getting done. Media channels have an endless lineup of experts, who probably wake up everyday, ready to provide new round of expert opinion. And the quality of journalism is rubbish, where is a decent discussion on, what reforms need to be brought in, to help the nation grow? The issue is everyone is drinking from the same source, whether you are the federal or state government, central or state government owned companies, or the private sector. And unless there is new liquidity going into the banks, it’s going to be tough to fund growth.

Various state governments across India are struggling with a very bloated fiscal situation, and they also own companies that have not made money for a long period of time, so it doesn’t make any good business sense for these states, to continue to own unprofitable companies. And in most cases, these companies are competing with other unprofitable or distressed state owned companies across India. These companies were set up in various states across the country, to provide services to the citizens, and by design they were probably never pushed to make a profit. But the time has come for states across the country to find an exit, by either privatising the companies or merging them together with similar companies in other states, and then exiting it. This will also reduce the debt burden on the states.

Also to fund growth, I will encourage the government of India to put in $ 3 billion in equity and then raise additional $ 7 billion from local banks as well as international investors/ banks, to create a growth and investment fund. This fund could also be made tax exempt from withholding taxes for foreign investors, and let this fund buy new loans from the banks, the fund could then repackage the loans in an asset backed security ( ABS) as a way to refinance itself. The fund could also provide working capital loan indirectly to the SMEs through the banks, and let the originator banks hold just 10% of the new loan on their books. RBI could also buy some of these securities from the secondary market to improve the liquidity and pricing. Also Emerging market focused fixed income investors could buy into these securities, and will be exempt from any withholding taxes. I am not a great fan of using pure debt to finance infrastructure, I would rather first raise equity to fund the infrastructure, and then give equity investors an exit by issuing the debt. If you look at it from pure risk perspective, the equity investors are in fact protected from the completion of the underlying asset, and that’s why you need a strong construction company to provide completion and construction risk coverage. So once the asset is built, equity investors will have their value protected, and the return will come from issuing the debt at a premium. There is a natural cycle, and any insurance cover to protect your investment in infrastructure asset will not work, if you simply buy a credit protection. I prefer a equity – debt- equity – exit cycle , which is based on water cycle of cloud – liquid water- ice – water – cloud. That’s the best value preservation model.

The idea that you can protect your asset for its entire life cycle carrying just debt is completely absurd, and it simply doesn’t work, any debt, if not managed well tends to have the natural tendency to end up spiralling into an unsustainable burden. And, if there was no refinancing then, most debt will not be repaid. You can repay debt from cash flow, but refinancing still remains the most frequently used tool. So we need to link the cycle especially for infrastructure assets. The issue with an infrastructure asset also is the permanent loss of value, and this is when the asset becomes redundant for a number of reasons, but if as an investor, you haven’t recovered money during the cash flow generation lifespan or lifecycle of the asset then, you are looking at a permanent loss of capital.







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Infrastructure Financing: Tapping into a diversified Funding Pool

Posted on January 16, 2012. Filed under: Uncategorized | Tags: , , , , , , , , , , , , , |

As a key asset infrastructure is one of the most important driving force of an economy and has a direct impact on the overall growth and development story of the country. Infrastructure assets support a wide range of systems in both public and private sectors without which the industrial society of today simply won’t function or be as efficient. Generally developed world tends to have better infrastructure than emerging economies but having said that the overall spending on infrastructure in GDP terms by developed economies have been declining recently whereas the emerging world has increased its overall spending on infrastructure. In a fast growing economy you would expect the demand for infrastructure assets to increase immensely year-on-year and the opposite is true for a slow growth economic environment.

 So the state of a country’s economy certainly plays an important role in infrastructural needs of that nation. Infrastructure assets should always be forwarding looking because the rapid growth in population and economy especially in emerging countries will put strain on the existing infrastructure creating bottlenecks relatively quickly but at the same time parts of the countries experiencing lower or minimal growth may create a situation of overcapacity.

 Conceiving a smart and forward looking infrastructure asset and supporting it with the right capital is always critical.In the past federal, state, local tax bases other funding sources have been used to pay for vital infrastructure projects across the world. We have seen the business model for developing and funding infrastructure assets evolve in the last decade where a number of high profile infrastructure assets were built and paid for through Public Private Partnership or Initiative ( PPP or PPI). Although a number of high profile PPP projects have failed this model of developing and financing infrastructure projects is still considered one of the best way to pay for it.

 While emerging economies have the need to keep building vital infrastructure to support their growth and improve the living standards of its citizens, the developed nations especially the US are sitting on an aging infrastructure that needs to be updated. All this requires capital and with the ongoing financial CRISIS it is getting harder to source funding for infrastructure assets as banks are still struggling to fix their balance sheet. Also the asset-liability (ALM) mismatch is one of the major defects in the traditional business model followed by banks today which makes it tougher for them to commit more resources towards financing infrastructure projects. Most infrastructure projects require long term capital commitments ranging from 7 to 20 or more whereas banks own source of capital ( i.e. deposits) tend to be of much shorter tenure ranging between 1 to 5 years or less. There are also regulatory issues including of the overall exposure to the sector and the credit risk rating of the asset which limits the ability of traditional banks to commit capital. Alternate source of capital providers including of hedge funds dedicated to investing in infrastructure sector as an asset class tend to prefer investing in liquid assets and in most cases their exposure to the sector is limited to owning stocks or debts of listed utilities, toll road operators, constructions companies, ports operators among others.

 There is a strong need to diversify the source of capital base by making infrastructure an appealing asset class to a wide range of investors especially when governments including of developed as well the developing world are targeting infrastructure spending. Recently the ministry of finance of India announced an initiative called Infrastructure debt fund as to way to attract capital into the sector. This is a step in the right direction but having said that the proposal doesn’t address the core issue facing prospective investors when looking at infrastructure financing opportunities. The government of India is targeting an investment of over US$ 1 trillion ( around 10% of GDP) on infrastructure in its 12th five year growth plan for the country and the expectation is that the private sector’s share will be 50%. It is no doubt a highly ambitious plan and through Infrastructure debt fund the government’s objective is to facilitate the flow of capital from public and private sectors as well as foreign investors into infrastructure projects in India. The government figures suggest that there is a funding gap of over US$ 135 billion and this is based on the assumptions that there will be as much as 50% budgetary support for the planned investment in its recently announced 12th five year plan and the policy & regulatory reforms will mobilize over US $174 billions. Looking at the state of infrastructure in India and the balance sheet strength of the local banks it is safe to say that in reality the funding gap may be much higher than government’s expectation.

 In the developed world, UK chancellor has earmarked over GBP 30 billion in infrastructure spending in his speech delivered to the British parliament in November of 2011. The UK treasury is hoping that two-thirds of its earmarked for infrastructure investments will come from the National Association of Pension Funds and the Pension Protection Fund. It is also seeking investments in infrastructure from insurance companies and from China. The United States will need to spend over $2.2 trillion on updating and developing infrastructure assets across the country over a period of five years to meet the current needs and around $1.1 trillion of the overall spending would be new. This is according to the American Society of Civil Engineers (ASCE), and while private sector is expected to make its contribution most of the heavy spending will have to come from the government as evident from the previous spending on infrastructure in the US. The Congressional Budget Office figures suggests that the federal government, state and local governments spent over US$ 312 billion in 2004 on just water and transport infrastructure in the United states with very little contribution from the private sector.

 The current state of the global economy makes it extremely difficult for infrastructure projects to get funded. In markets like China banks are over exposed to the sector by lending to local government financial vehicles (LGFV) and most local governments are sitting on bad projects that aren’t making money and have also created overcapacity. There is also a lack of an efficient and developed secondary market for infrastructure loans in emerging market economies especially in countries like India, making it difficult for both public and private sector banks to refinance their loan books and in most cases the banks are as the end users of credit by holding the asset on their balance sheet until maturity   therefore becoming super exposed to the sector and minimizing their ability to grant more loans. Also Indian banks have recently been running a daily deficit of over INR 1trillion per day for the past few months causing a systemic liquidity deficit in the banking system further limiting their ability to commit more capital to the sector.

 Considering the above, Infrastructure debt fund (IDF) initiative of the ministry of finance of India does sound like an idea whose time has time come as it proposes to offer banks a platform to help refinance their existing loan book and by means of credit enhancement also be able to tap into low cost long term funding sources including of Insurance and pension funds. Having said that Indian banks will be competing for capital with their peers and there are no guarantees that foreign pension and insurance funds will pick Indian infrastructure assets over others. Money has no nationality and most investors will need to understand the structure better before committing capital. According to the public information released by the ministry of finance of India, the proposed IDFs will either be formatted as a mutual fund or a non bank financial company under modus operandi set out by the regulatory agencies including of SEBI and RBI.

 Although the case for IDFs has merit going forward the structure will have to evolve incorporating the realities of the market. Besides IDFs other plausible long term, simpler and sustainable solution will be for banks to set up their own independent infrastructure investment companies or in a consortium with credit guarantee agencies, construction & development companies, Institutional investors, regional development banks, multilateral agencies, utilities among others. As the promoter of the “ Infra Investment Company(IIC)” banks will inject their existing infrastructure assets and loan books along with the cash flows ( from the projects) into the balance sheet of the company and other founding partners will provide seed capital (in cash equity) of around 10% to 15% of the assets held by the company in order to secure a strong rating and valuation. The Infra Investment company(IIC) will have fixed and guaranteed revenue stream coming from existing infrastructure assets it owns and it will be relatively easier for such a company to secure a credit loss insurance cover on its pool of revenues further protecting its cash flow.

To access a diversified pool of investor base the “IIC” could do dual listing in local and foreign markets, issue bonds in local as well as foreign currency supported by its balance sheet and the strength of its credit rating. It can also act as a platform to deliver infrastructure related credit and assets to end users including of pension and insurance funds. Also through the “IIC” institutional investors such as pension and insurance funds could commit new capital into the sector removing the need for them to hire a fund or portfolio manager to manage their investment in the infrastructure sector across various asset class.

 Infrastructure assets are a vital support pillar of any economy and though some investors may consider the sector boring, good Infrastructure investments does create a positive cycle of growth, providing essential networks and services, stimulating economic growth and improving the standard of living for current and future generations. Also the investment in the sector tends to be less volatile than any other publicly traded securities.

 Although the Infra structure Investment company may not address all the existing issues in the sector but by adopting a flexible strategy the “IIC” should be able to tap into a wide range of funding pool including of retail equity investors, institutional investors, sector focused investors among others. It provides an opportunity to Investors who in principle do like infrastructure but are reluctant to buy into it because of the lack of liquidity that comes with it.

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