An Overview of Infrastructure Financing in India and Future Options

November 17, 2007

Rajiv Lall, Ritu Anand and Nirmal Mohanty Infrastructure Development Finance Company

Think Infrastructure. Think IDFC.

Introduction
Economic (9% growth per annum) Indias medium-term ambition Political (Inclusive growth) Infrastructure has a significant role to realize both. Government envisages a rise in infra spending from 5.6 % of GDP in 2006/07 to 9.2% in 2011/12 to enable 9 % GDP growth in XI Plan. Two sets of issues are impeding investment in infrastructure: - Sector governance (brief discussion) - Financing system (focus of discussion) Inability to meet the specific requirements of infrastructure projects

To support accelerated investment in infrastructure, sector governance must change.

Two characteristics of recent approach to infrastructure investment Declining dependence on budgetary resources Increasing reliance on private participation Challenges for sector governance emerge from: reduced budgetary support User charge financed strategy needs to assure investors of adequate payment security (over a long period) and consumers of competitive tariff Higher private participation Level playing field, greater consistency and predictability of `rules of game and public consultations But political economy is inhibiting such change in governance Govt unwilling to give up its role as provider and regulator, although it is creating facilitating frameworks; for example: Newly created state-owned power utilities are acting as extension of Government `Open access is provided by Electricity Act, but States have been reluctant to phase it in Investment will be impeded if governance response is not appropriate
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GCF in infrastructure: bottom-up estimates by PC

(At 2006-07 prices) Year 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 Total (XI Plan) 2006/07 prices Current prices Eleventh Plan Period GDP at market prices ($ billion) 1,006 1,097 1,196 1,303 1,420 1,548 Rate of growth of GDP (%) 9 9 9 9 9 9 Bottom-up GCF in infra (as % of GDP) 5.6 6.0 6.5 7.2 8.1 9.2 GCF in infra (US $ billion) 495 585 56 65 77 94 115 143 Central (% of GDP) 2.6 2.7 2.9 3.1 3.4 State (% of GDP) 1.7 1.9 2.2 2.5 3.0 Private (% of GDP) 1.7 1.9 2.1 2.5 2.8

Financing pattern projected by the PC for XI Plan

(At current prices; $ billion) Projected investment Center States Private Total projected investment

Budgetary resources 57 122 0 179

Internal resources/ equity 52 17 52 122

Debt 122 40 122 284

231 180 174 585

It has been assumed that budgetary resources would be directed largely towards rural infrastructure and north-east, leaving little room for funding other infrastructure projects

Who is financing and how, now (2006/07)? Also, PCs projection for 2011/12 at current prices.
2006/07 % of GDP Central Government and its enterprises State Govts and their enterprises Private sector Total Government borrowing Internal Resources/ equity Private sector Public sector Debt (required) Domestic bank credit NBFCs Insurance companies ECBs Debt shortfall 2.1 2.3 1.2 5.6 2.4 1.2 0.4 0.8 2.0 0.8 0.6 0.2 0.4 0 USD (bn) 21 23 12 56 24 12 4 8 20 8 6 2 4 0 # @ $ 2011/12 % of GDP 3.4 3.0 2.8 9.2 2.8 1.9 0.8 1.1 4.5 2.0 1.1 0.2 0.5 0.5 USD (bn) 67 59 55 181 56 39 17 22 87 40 (32%) 22 (37%) 5 (16 %) 9 (16 %) 11
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According to PC, unfinanced gap is $11billion for 2011/12 and $ 45 billion for XI plan.

What would this entail?

The recent trend of fiscal correction must continue Higher populist spending can come only at the cost of infrastructure investment in rural areas or economically depressed areas Intermediation of domestic savings must be accelerated Bulk of incremental savings must go to infrastructure There are limits to bank exposure and by implication NBFCs exposure,to infrastructure A fairly large part of private corporate savings must go to infrastructure There are indications of equity shortfall for private sector If domestic savings cannot be adequately mobilized for infrastructure sector, additional access to foreign savings must be resorted to But, can we?

Continued fiscal correction is critical.

(as % of GDP) FRBM targets 2005/06 Consolidated (Centre plus States) Revenue Deficit Fiscal deficit Capital exp + Net lending Of which: on infra 2.7 6.6 3.9 2.0 2.1 6.4 4.3 2.3 1.2 5.6 4.4 2.3 0 6 6 0 6 6 2.7 0 6 6 2.8 0 6 6 2.9 2006/07 (RE) 2007/08 (BE) (2008/09) 2009/10 20010/1 1 2011/1 2

The rest of capital expenditure is on defense (0.9% of GDP), housing, education, health and family welfare etc. If fiscal correction ceases or reverses, capital expenditure on infrastructure would suffer, unless non-infra capital expenditure is squeezed. Financing through larger borrowing would crowd out private investment.
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But, maintaining the same pace of fiscal improvement as in recent past will be difficult
Actual fiscal consolidation has been overstated because of higher off-budget spending Oil and food bonds, fertilizer subsidy and losses of state utilities amount to about 2 percent of GDP. There are additional risks to future fiscal consolidation Recommendations of the Sixth Pay Commission About half of fiscal deterioration between 1996/97 to 2001/02 can be attributed to the Fifth Pay Commission (revenue deficit from 3.5 % to 7 % of GDP and consolidated fiscal deficit from 6.3 % to 9.9 %) Special economic zone Proliferation of SEZs would lead to significant revenue loss due to tax holidays 395 have already been formally approved Economy may slow down Most of the recent improvement in fiscal performance is due to revenue growth Populist spending may rise due to upcoming election

Availability of domestic savings is not an issue.

Actual 87/88 Gross Domestic Savings of which Household sector Financial savings Physical savings Private Corporate sector Public sector 16 8 8 2 3 21 11 11 5 -1 22 12 11 8 2 23 12 11 9 2 23 12 11 9 3 24 13 11 11 4 20 99/00 25 05/06 32 06/07 34 Projected 07/08 11/12 35 39

GDS has been accelerating and the trend is likely to continue, but the critical assumption in this projection is that the entire incremental savings will be financial.
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Even with such assumption, intermediation of GDS will be a challenge.

Intermediation efforts (Percent of GDP) 2006/07 20011/12

Total infrastructure spending Gross domestic savings o/w financial savings

5.6 30.0 23.0

9.2 39.0 28.0

Memo items o/w ratio to be directed to infrastructure (%) 24.3 32.8

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Especially, when bulk of long-term household savings are appropriated by the Government

Household Financial Savings (% of GDP)

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And when bulk of incremental savings must go to infrastructure

(% of GDP) 2006-07 Infrastructure spending Private infrastructure spending Gross domestic (financial) savings 5.6 1.2 23 2007-08 6.0 1.7 24 2008-09 6.5 1.9 25 2009-10 7.2 2.1 26 2010-11 8.1 2.5 27 2011-12 9.2 2.8 28

Incremental infra spending Incremental private spending Incremental financial savings

0.4 0.5 1.0

0.5 0.2 1.0

0.7 0.2 1.0

0.9 0.4 1.0

1.0 0.3 1.0

% share of infrastructure in incremental financial savings % share of private infrastructure spending in incremental financial savings

40

50

70

90

100

50

20

20

40

30

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Commercial banks credit to infrastructure has been growing rapidly

Rs billion 1,600 1,400 1,200 1,000 800 600 400 200 0 2001 2002 Infrastructure 2003 Pow er 2004 2005 2006 Roads and ports 2007

Telecommunications

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But, can commercial banks meet the challenge in the medium term?
To attain the XI plan infra target set by the PC:
(at end of period) Rs. Billion 2000/01 2006/07 2011/12 CAGR (%) 2001/02 to 2006/07 25 2006/07 to 2011/12 25 (assumed)

Total credit outstanding Of which: Outstanding credit to industrial sector Outstanding credit to infrastructure sector

5114

19289

58865

2188 113

6973 1430

18086 6305

21 53

21 (assumed) 34 (required)

Memo items: Outstanding credit to infrastructure as a % of: Credit to industrial sector Total credit 5.2 2.2 20.5 7.4 (required) 34.8 10.7

Note that not all commercial banks finance infrastructure; for those that do, the ratios are even higher 15

Significant share of private sector retained earnings would have to be directed into infrastructure
(% of GDP)
2006-07 Private sector equity requirement Private corporate savings o/w savings of private industrial sector % share of equity requirement to total corporate savings 4.4 % share of equity requirements to corporate savings in industrial sector 5.6 6.0 6.3 6.6 7.7 0.4 9 2007-08 0.5 9 2008-09 0.6 10 2009-10 0.6 10 2010-11 0.7 11 2011-12 0.8 11

3.5

4.0

11.0

21.0

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Faster development of corporate bond market is unavoidable

There are limits to banks exposure to infrastructure NBFCs exposure to infrastructure is limited by banks growth potential A banks exposure to a single NBFC should not exceed 5 % of banks net worth and banks exposure to all NBFCs should be less than 40 % of banks net worth NBFCs can and do have access to mutual funds, but such access is typically limited MFs generally prefer short-term bonds and are extremely coupon sensitive Insurance companies typically prefer public sector NBFCs All these imply that corporate bond market will have to be the mainstay of infrastructure development Will be a source of long-term funds, allowing insurance companies, pension funds to play a bigger role Developing a vibrant corporate bond market will take a few years What do we do in the mean time?

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As concerns for external viability subside, ECBs have begun to pick up

$ Billion 25 ECB flow s in India

20

15

10

0 1990/91 -5 Gross Repayment Net 1992/93 1994/95 1996/97 1998/99 2000/01 2002/03 2004/05 2006/07

%
50 40 30 20 10 0 1990-91 1992-93 1994-95 26 36

External debt/ GDP

35

33

30

26

23

23

23

21

22

21

20

17

16

15

16

1996-97

1998-99

2000-01

2002.-03

2004-05

2006-07

Long-term debt to GDP

Short-term debt to GDP

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ECB was the biggest contributor to net capital flows in 2006/07

INDIA'S Summary Balance of Payments (US $billion) 2005/06 2006/07 Current Account (net) -9.2 -9.6 Capital Account (net) : 24.2 46.2 of which: Foreign Direct Investment 4.7 8.4 Portfolio Investment 12.5 7.1 External Commercial Borrowing 2.7 16.1 Short-term Trade Credit 1.7 3.3 External Assistance 1.7 1.8 NRI Deposits 2.8 3.9 Addition to Reserves 15.1 36.6

Change -0.4 22.0 3.7 -5.4 13.4 1.6 0.1 1.1 21.5

Source: RBI's "Macroeconomic and Monetary Developments, First Quarter, 2007/8, July 2007

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ECB restrictions are impeding infrastructure investment

To reduce complications in macro management, Government has attempted to slow down ECB flows by Setting a very low limit ($ 20 mn) for domestic expenditure; prior RBI approval Infrastructure generally has a low import intensity All-in-cost ceiling has been reduced by 50-100 basis points Makes it difficult to raise senior, subordinate debt, mezzanine financing, as the maximum permissible return is not considered enough to match risk ECB is not allowed for integrated township Need for prioritization has been recognized, but not implemented Because of a lurking fear of arbitrage opportunities Should ECBs into infra surge, there would be concerns about exchange risk One option is to facilitate risk participation in infrastructure projects by foreign investors, which would create contingent liability for the latter This could be accommodated within the overall limit for ECBs May not solve the funding problem, but will help distribute risk more widely

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