Clearer path ahead

India’s new government has pledged to revive infrastructure investment, but much will depend on shifting the funding requirements beyond the capital-constrained banking sector.

Having set an ambitious target of mobilising US$1trn of infrastructure investment in 2012–17, India has been busy expanding its range of financing options in the last two years.

Among measures already taken to strengthen infrastructure financing are the establishment of Infrastructure Debt Funds (IDFs), credit enhancements of corporate bonds for infra projects, deepening of the local bond market, expansion of debt limits of foreign investors to buy long-term infra bonds and changes in the archaic Land Acquisition Act. However, these have not yielded desired results.

“Financing infrastructure has never been an issue in India. The key challenge is getting projects off the ground and implementing efficiently,” said Anita Nandi, chief representative of the City of London in India, citing key findings of the organisation’s in-house research paper that had inputs from market practitioners.

The entity provides local government and policing services for the financial and commercial heart of Britain.Development of the corporate bond market, infrastructure financing and international use of the rupee are some of the focus areas of the City of London in India.

“The new government has started rolling out a number of policies, which may improve the efficiency of the bureaucracy and strengthen the investment climate. However, lifting GDP growth to substantially higher levels would require large productivity gains through implementation of far-reaching reforms.”

“Investors are eager to invest in India, but are concerned that they don’t have a clear exit route. A faster and effective judicial system will definitely attract and retain investors” she said. “India must understand that foreign investors have options to invest their money elsewhere. India should make itself competitive for doing business on a global scale.”

Like many, Nandi expressed confidence in new Indian Prime Minister Narendra Modi, but insisted his government would need to show results sooner rather than later.

Since May, the pro-reform Modi government has introduced some key long-pending and crucial measures to boost infrastructure financing. These include introduction of senior bonds to promote long-term infra lending, investment trusts, real estate investment trusts and reduction of withholding tax on bond offerings.

The most crucial measure among all has been allowing Indian banks to issue onshore senior bonds as this provides access to a key source of long-term funding for the country’s lenders. These bonds will also help fix a key anomaly of the Indian banking sector- the huge asset-liability mismatch.

Fixing demand-supply imbalance

India’s mostly state-owned lenders have shied away from issuing senior bonds in the local market simply because the Banking Regulation Act of 1949 does not explicitly allow them to do so. Nevertheless, lenders supported the pick-up in infrastructure lending since 2002 with short-term deposits. Almost half of all-bank funding in India matures in one year or less.

As of May 30 2014, Indian banks had a combined infrastructure loan book of Rs8.57trn (US$140bn), according to Icra, the local associate of Moody’s. The infra lending of Indian banks registered compound annual growth rates of 25% in the last five years (2010–2014), Icra said.

The rating agency also estimates Rs2.7trn to Rs3.5trn (3%–4% of estimated deposits as on March 31 2015) of onshore senior bonds can be issued to fund infra and low-cost housing sectors. This issuance can increase significantly to Rs24trn to Rs29trn for a six-year period from 2015 to 2020, it says.

However, such a deluge of supply may not find adequate demand from local investors. As domestic investors like provident funds, insurance companies and pension funds can only buy around Rs1trn of such bonds, it is crucial that foreign insitutional investors also take a part of these sales. So far, the interest of the foreign investors in infra bonds have been muted.

The FII limit of US$51bn for corporate debt was only 47.54% used as of October 7 2014 as per data available on the National Securities Depository website.

Nevertheless, the government has made it enticing for issuers to sell the senior bonds and, as a result, fixed the supply side. As per RBI rules, the senior bonds must have a minimum tenor of seven years and are exempted from statutory requirements, such cash reserve ratio, statutory liquidity requirement or priority sector lending.

RBI rules provide that Indian banks should keep 4% of their deposits with the central bank as CRR. Banks also invest 22% of their deposits in government bonds as per the SLR requirements. These regulatory incentives bring savings of anywhere between 100bp and 200bp to banks on these bonds.

However, the regulatory incentives will be limited to one sixth of outstanding infrastructure and affordable housing loans for 2015 (to go up a sixth of eligible credit each year). This means senior bonds, which will not replace the existing loans, will be costlier to issue.

The unsecured senior bonds issues are also restricted from getting credit insurance, while banks have been barred from buying these bonds to prevent cross holdings.

Bridging the gap

With India desperate for economic growth, market experts feel the government may have to remove some of these restrictions to ensure financing for infrastructure is not hampered.

India’s June quarter GDP growth came in at 5.7%, the highest in 27 months. For FY15, the RBI expects Indian GDP growth in the 5%–6% range, though some investors, such as BlackRock, expect Indian GDP growth to accelerate to 7% next year, partially due to a revival of pending infrastructure projects.

The government also seems to be working towards this goal. From the current construction of 3km of road per day, the government aims to scale up to 30km a day come 2016. However, it remains a fact that there are Rs189trn (US$3.1trn) of infra projects still stuck due to regulatory hurdles.

“India need to streamline its labour laws, land acquisition process, instilling transparency and accountability are critical to deliver results,” said Nandi of City of London. “Simple and consistent regulations are needed.”

The absence of a bankruptcy regime and a faster judicial system has been a big hurdle in attracting foreign investors to the sector.

“Challenges [to dispute resolution] still exist, but the government is moving towards resolving them,” said Saugata Bhattacharaya, senior vice president (Business and Economic Research), Axis Bank. He pointed out that the bankruptcy law was part of the suggestions of the Financial Sector Legislative Reforms Commission and the Indian Finance Code.

“There are plans to set up special courts for faster resolution of disputes,” he said.

Foreign investors have been also looking forward to transparent tax laws, uniform know-your-customer rules, single-window clearances for financial investments, among other things.

“The new government has started rolling out a number of policies, which may improve the efficiency of the bureaucracy and strengthen the investment climate. However, lifting GDP growth to substantially higher levels would require large productivity gains through implementation of far-reaching reforms by the central and state governments related to governance and product and labour markets, as well as reduction of infrastructure bottlenecks,” Fitch said in a report released on October 1.

“Potential for change is substantial, as India ranks the lowest of all BBB– rated sovereigns on the World Bank’s Ease of Doing Business indicators and its governance indicators compare unfavourably with peers,” the rating agency noted.

Modi, in his recent foreign visits, has been very aggressive in seeking long-term investments for India. Japan, for instance, has promised to invest US$35bn over the next five years for developmental projects, while pension funds from the US and Canada are also keen to invest invest in infra projects and the planned smart cities.

Bankers said interest of foreign investors bode well for local capital markets and would ensure smoother take-off of financing tools, such as the IDFs, and the newer-infrastructure investment trusts and REITs.

IDFs have been in the making for the last two years, but, so far, only two have raised funds from the local bond markets.

The first was India Infradebt with a Rs3bn dual-tranche offering in May, split into tranches of five and 10 years at coupons of 9.70%. The second was L&T Infra Debt Fund with an IDF bond sale of Rs2.5bn also in May. The issue featured a five-year tranche paying 9.60% coupon, as well as seven- and 10-year pieces at coupons of 9.70%.

The transactions reflect growing investor interest in Indian infrastructure financing. Taxation rules have also been eased to make IDFs more attractive to offshore funds.

Besides these, projects bonds and credit enhancement of local bonds was one area that bankers said could help push infra financing, especially refinancing of bank loans with bonds. However, not much progress has been made on this front yet.

In May, the RBI unveiled draft rules on the use of credit enhancements to support infrastructure-related bonds, but the central bank requirements are very restrictive.

The draft rules limit banks from providing full guarantees and impose a high capital charge for any credit wrap. Lenders are also barred from investing in bonds for which they provide credit support.

The RBI said its measures were designed to help more infrastructure projects come to the capital markets, where long-term financings better matched the needs of investors, such as insurers and pension funds.

The stringent requirements, however, underline the RBI’s determination to limit a build-up in contingent liabilities in the banking system, barely a month after it banned Indian banks from issuing overseas guarantees to help refinance rupee loans.

The draft rules issued on May 20 allow banks to support bond sales from an infrastructure company in one of only two ways: with either a subordinated loan or a non-fund based facility to support the most senior portion of the bond.

The subordinated loan or non-fund based facility should not exceed 20% of the bond it guarantees and should not raise the rating of the security more than two notches.

Even as bankers expect the central bank to loosen these credit-wrap rules, they feel the municipal bond market is another avenue of funding that needs to be pushed to support infrastructure financing.

In the Union Budget for 2014, the government hiked the corpus of the pooled municipal debt obligation facility, or PMDOF, to Rs500bn from Rs50bn.

This tenfold increase in the PMDOF’s corpus is seen invigorating the domestic municipal bond market as the funds will be used for credit enhancement, according to bankers.

IL&FS along with other sponsors, including IDBI, IIFCL, Canara Bank and other state-owned lenders, set up the PMDOF in 2006. At present, 16 sponsors fund this facility, which meets the funding requirements for urbanisation.

The facility was to be available only until October 2015, though the government has extended it for five years to March 2019.

Bankers also said innovative debt instruments for rupee denominated convertible bonds or optionally convertible debentures could also be used by creating a single regulatory clearing window. Such instruments can help in resolving mezzanine debt funding needs for infra projects.

Even securitisation as a financing tool is underutilised in India. “If banks are given more flexibility in churning their infrastructure loan portfolios, we can easily get over the problem of sector exposure issues,” said a Delhi-based DCM banker.

Multi-asset collatorised debt obligations, or CDOs, can be allowed to get assets off-balance sheet. ICICI Bank and Citibank have tried these structured in the past in India, but new securitisation rules and unclear accounting norms have curbed these transactions.

As infrastructure financing is a long-term play, key investors like pension and insurance companies should also be freed from high-rating caps of their investors so that they can invest instruments funding infra projects. These investors usually do not invest in anything rated below AA+. Most Infrastructure debt instruments in India are rated AA or lower.