Credit guarantees attract investments

Indian infrastructure financing has for long suffered from rating concerns, but recent changes to credit enhancement are helping to plug this gap, enabling investment by foreign insurance and pension companies, and stimulating project exports.

A small refinancing deal in October 2015, followed by a similar one in January 2016, has supplied a critical missing piece, without which Indian infrastructure financing had been stunted for years. If this elusive financial instrument is now consolidated, it will enable infrastructure projects to attract strategic overseas funding as well as make Indian project exports more competitive.

The first transaction, of October 2015, involves power generator ReNew Power Ventures on one side, and the government-owned India Infrastructure Finance Company Ltd (IIFCL) jointly with the Asian Development Bank (ADB) on the other side. In January 2016, another energy company, Hindustan Powerprojects, concluded a similar deal with the IIFCL-ADB combine. Both ReNew and Hindustan Powerprojects have substantial investments in renewable energy projects.[1][2]

Both companies were refinancing existing bank loans with fresh bond issues—ReNew with Rs 451 crores[3] and Hindustan Powerprojects with Rs 380 crores.[4] The bonds were initially rated lower but were able to improve to AA+ due to “credit enhancement” provided jointly by IIFCL-ADB.[5] This enabled the bond issuers to lower their interest costs and, importantly, attract infrastructure-friendly international investors who have stayed away from Indian infrastructure projects because of rating concerns. The IIFCL-ADB’s credit enhancement has made their participation possible.

Credit enhancements (or credit guarantees) resemble insurance policies: a credible financial institution guarantees (for a fee) a bond issuer’s repayments. Such an assurance helps bond issuers obtain a better credit rating. Participation by multilateral institutions—such as ADB’s involvement in IIFCL’s credit enhancement—provides an additional layer of comfort and improves the rating by multiple notches. IIFCL plans to engage with other multilateral institutions (such as the World Bank) for future credit enhancement deals.

This crucial instrument has strategic geo-economic consequences: it can attract long-term overseas financing into fund-starved infrastructure projects as well as sharpen the competitive edge of Indian project exports.

Credit enhancement makes bonds issued by infrastructure companies eligible for investment by overseas insurance companies and pension funds. Both are custodians of long-term funds and thus ideal investors for long-gestation infrastructure projects. This has another advantage: since they invest for the long term, they remain rooted during periods of volatility.

A geo-strategic tool

Most Indian infrastructure projects were unable to tap into the global pool of insurance and pension savings because of rating restrictions. Indian infrastructure projects—public-private partnerships or completely private-owned—are typically executed through a special purpose vehicle (SPV, a separate company set up only to execute the project), with no recourse to the private sector parent’s balance sheet. In short, in times of crisis or default, SPV investors cannot dip into the parent’s resources. With no previous revenue track record, no visible safety net, and an extended project gestation period, SPVs usually got the lowest rating in the investment grade scale.

This deterred insurance and pension funds from investing in such projects. These long-term investors have strict internal regulatory and risk-management parameters, which includes the lowest credit rating that can be allowed for fixed-income investment. In most cases, it is fixed at AA. Incidentally, even Indian pension funds can invest in infrastructure bonds with a minimum AA rating.[6]

There is another collateral benefit arising from the credit enhancement programme. Deprived of long-term financing, most Indian infrastructure projects became dependent on bank financing, which is short-term. This inherent maturity mismatch has affected bank balance sheets adversely and choked off funding for other projects. According to Reserve Bank of India (RBI) data for March 2016, 16.7% of infrastructure loans advanced by banks have turned non-performing.[7] Credit enhancement now allows projects to replace bank loans with cheaper bond proceeds before they turn sticky; this also frees up bank funds for other greenfield/brownfield projects.

The RBI has also allowed commercial banks to provide partial credit enhancement, subject to certain conditions[8] for infrastructure projects that want to refinance their existing bank loans through bonds with lower interest rates. The availability of this facility will again improve the credit rating of the bonds, allowing a wider segment of investors to invest.

Credit enhancements will have the greatest impact on the infrastructure sector where projects have stagnated for want of long-term financing. According to the erstwhile Planning Commission, India needs approximately $1 trillion during 2012-17 to fix its infrastructure deficit.[9] A large chunk of this will be in the form of debt. But given the banking sector’s concerns on maturity mismatches, this debt has to be sourced from long-term investors at home and abroad. Without the rating upgrade mechanism, this was not possible.

Separately, Crisil Risk and Infrastructure Solutions Ltd and ADB have jointly recommended, in a technical assistance report[10] for India’s finance ministry, the creation of a separate bond guarantee fund. This fund’s shareholding pattern and capital structure should be designed with a AAA rating in mind.

A follow-up to their suggestion looks likely: the government-owned Life Insurance Corporation of India (LIC), India’s largest insurer, is planning to create a separate finance company that will provide credit enhancement to infrastructure bonds;[11]

Other kinds of credit guarantees are also falling into place. Project exporters have been able to lower their borrowing costs and improve their competitive appeal with credit guarantees from agencies like ECGC Ltd. Project exports by Indian public sector engineering companies are often guided by India’s geo-strategic considerations. Over time, many private Indian engineering companies have also started focusing on project exports as a revenue source. But since many of these projects were located in risky jurisdictions (for example, in parts of Africa), bank credit for executing these long-term overseas projects became expensive. Such guarantees therefore go a long way in easing such exports.

Exim Bank too has announced12 that it will focus on financing Indian project exports over the next three years. According to Exim Bank, Indian companies have a competitive advantage in project exports over some of their global competitors, such as China. This comes from years of executing large projects in developing and poor countries, which have demanding working conditions, which include rough terrain and fickle political climates.

Clearly a single critical financial instrument—credit enhancement—has the capacity to attract overseas investments as well as propel India’s strategic exports.

This feature was exclusively written for Gateway House: Indian Council on Global Relations. You can also read it here.

Reference

[1] Homepage, ReNew Power, <http://renewpower.in/>

[2] Homepage, Hindustan Powerprojects, <http://www.hindustanpowerprojects.com/>

[3] Sen, Amiti, ‘IIFCL Launches Renew Wind Energy’s Rs 451-crore “credit-enhanced” infra bonds’, The Hindu Businessline, 23 September 2015, <http://bit.ly/29DSsPs>

[4] Hindustan Powerprojects, ‘Clean Energy Arm of Hindustan Power first to place credit enhanced infrastructure bond’, Hindustan Powerprojects Blog, 5 January 2016, <http://bit.ly/29Di3XH>

[5] Schemes/Products, India Infrastructure Finance Company Ltd, Regular Credit Enhancement Scheme of IIFCL, <http://www.iifcl.co.in/Content/ceps.aspx>

[6] Pension Fund Regulatory and Development Authority, ‘Investment Guidelines for NPS Schemes’, Circular No PFRDA/2015/16/PFM/7, 3 June 2015, <http://www.pfrda.org.in//MyAuth/Admin/showimg.cshtml?ID=705>

[7] Reserve Bank of India, ‘Chart 2.9: Stressed advances ratios of major sub-sectors within industry,’, Financial Stability Report, Issue No 13, June 2016, p 24, <https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/0FSR2316BB76DB39BF964542B9D1EBE2CBC273E7.PDF>

[8] Reserve Bank of India, ‘Partial Credit Enhancement to Corporate Bonds (Notification to all scheduled commercial banks)’, RBI/2015-16/183, DBR.BP.BC.No. 40 /21.04.142/2015-16, September 24, 2015, <https://rbidocs.rbi.org.in/rdocs/notification/PDFs/P183165FFAB186FE4825A0FAD0E95739436F.PDF>

[9] Planning Commission, ‘Twelfth Five Year Plan (2012-17): Faster, More Inclusive and Sustainable Growth’, Vol. I, Sage Publications India, (2013), p. 18. <http://planningcommission.gov.in/plans/planrel/12thplan/pdf/12fyp_vol1.pdf>

[10] CRISIL Risk and Infrastructure Solutions Ltd and Asian Development Bank, ‘India: Preparing the Bond Guarantee Fund for India; Technical Assistance Consultant’s Report; Project Number: 44447’, Asian Development Bank, August 2014, <http://www.adb.org/sites/default/files/project-document/152971/44447-012-tacr-02.pdf>

[11] Laskar, Anirudh, ‘LIC-led NBFC may offer up to Rs1 trillion credit guarantee’,Mint, July 1, 2016, http://bit.ly/29wm5mX

[12] S, Arun, ‘Exim Bank’s African credit to boost service exports’, The Hindu, 12 June, 2016, <http://www.thehindu.com/business/Economy/exim-banks-african-credit-to-boost-services-exports/article8721312.ece>

The Legacy: Raghuram Rajan is leaving the battlefield just when he was getting the better of his rivals

India’s debonair central banker, Raghuram Rajan, leaves behind many broken hearts and disappointed souls. Chronicles of his legacy will list many achievements, but will also note that he left the battlefield just when he was getting the better of his rivals; what’s surprising is that the commander-in-chief agreed to his pre-mature withdrawal even though the general’s strategies could be seen bearing fruit.

Equally perplexing will be the choice of his replacement.

Both the government and Rajan personally have been advocates of an alternative global financial architecture. He has also been proposing for a while that it was time for a new Bretton Woods mechanism. And Rajan had taken the battle to the enemy camp. At the April 2016 spring meetings of the International Monetary Fund and the World Bank, Rajan observed how deeply multilateral financial institutions were in thrall of western economic orthodoxies. He even wryly remarked how ideas from emerging economies were dismissed as “crankiness.”

He was prescient about the trans-Atlantic financial crisis. He took on former US Federal Reserve chairman Ben Bernanke when US domestic monetary policy spilled over into the global economy and led to severe volatility in emerging markets. He is unlikely to have fond memories of the period: he had to douse this particular fire soon after his appointment in Sept. 2013.

So, here is question number one: Will his successor have the same zeal about promoting an alternative global financial architecture that is sensitive to emerging economy needs and is not partisan about any particular economic ideology?

Rajan also quits before another crusade could be brought to its logical end. He’s been battening down the hatches that allowed a cosy nexus between large corporate borrowers, bankers, politicians, and bureaucrats, to bleed public sector banks through questionable debt write-offs. Rajan had taken a large broom to bank balance sheets and forced them to take drastic action against defaulters.

Many large—and over-stretched—corporate borrowers have been carping about Rajan’s reluctance to reduce interest rates, which, when lowered, would have certainly helped moderate their interest burden. These same corporates also turned into quack economists on the matter of interest rates: in their collective view, only lower interest rates could bring back high rates of economic growth. This view is oblivious to the fact that the low interest rates in the US, or negative rates in Europe and Japan, have failed to promote any economic growth.

Time for question number two: Will Rajan’s successor have the stomach (or benign sanction from the government) to continue with the clean-up act? Or to hold rates steady when required?

So, what does Rajan’s legacy look like? Apart from the well-documented success in fending off volatility from the US Fed’s tapering in 2013, his tenure will be remembered for three systemic changes he fostered.

One will be the differentiated banking landscape that he designed and left behind. As RBI governor, he grandfathered the emergence of a new breed of universal, small, and payments banks. He was in the process of adding two more categories—custodian banks and wholesale (or long-term) financing banks—to the mix. We will now have to wait and see if his successor has the same enthusiasm for a differentiated banking model.

These new categories come in addition to existing myriad forms of cooperative banks, regional rural banks, local area banks, public sector scheduled commercial banks, State Bank of India group of scheduled commercial banks, old-generation private sector banks, new-generation private sector banks, and foreign banks.

Restive signs mark the payments banks space—three companies which received in-principle approval to launch payments banks (Cholamandalam, Tech Mahindra, and Dilip Shanghvi of Sun Pharma) returned their licences stating that the project was not economically feasible. Undeniably, and in true RBI style, the initial architecture is anti-profit and has flaws in it.

The second marquee item is his strict action against non-performing assets (NPAs) that continue to impair bank balance-sheets. This was viewed as his struggle to end Indian-style crony capitalism: large volumes of loans remain unpaid every year and yet defaulting borrowers manage to get fresh loans unfailingly with some help from politicians, bureaucrats, and complicit bankers.

The staggering amount of NPAs is a direct drain on taxpayers, since loss to state-owned bank balance sheets must be compensated with fresh equity infusion by the largest shareholder—government— every year.

Finally, the outgoing governor will be remembered for installing a new monetary policy framework, which uses inflation-targeting as its driving philosophy. It also includes a monetary policy committee comprising three government representatives and three central bankers, with the RBI governor getting the casting vote. This new structure overhauls the old belief that the economy’s fiscal (the government) and monetary policy (central bank) sides should remain out of each other’s hair.

While the government has been uncomfortable with Rajan’s public comments about governance and broader political economy trends—saying that central bankers should not interfere with the fiscal side—it has not shown the same restraint when trying to influence monetary policy.

It will have to be seen how future central bankers and monetary historians view Rajan’s acquiescence to large government presence in monetary policy making.

The article first appeared in www.qz.com/india and can also be read here.

When Harry Met Keynes

The financial crisis of 2007-08 has sparked a renewed interest in the Bretton Woods compact, which created a "prosperous" world for about 20-30 years. Academics across the world have been wondering whether the world needs a new agreement and new institutions to meet the demands of a new economic order. The perception is that the 44-nation Bretton Woods discussions, which gave birth to the multilateral institutions World Bank and the International Monetary Fund, were held in a generally conducive and collegial atmosphere. This is not true. A new book on the Bretton Woods discussions -- The Battle of Bretton Woods by Benn Steil --  shows how the talks were held in a generally combative atmosphere.

My review of the book was carried by Business Standard (http://goo.gl/s758Q). Here it is:

In a rare photo op, the heads of the World Bank and the United Nations flew to violence-scarred East Africa recently. There was nothing spectacular about this visit - it showcased two ageing international bureaucrats posing together and providing sound bites about how their respective institutions were willing to work together to bring peace to this war-ravaged region, also known as the Great Lakes region. It could well be a convergence of coincidences: both dignitaries happened to be there at the right time, and both were born in Korea.

But there was another bit of detail that made this visit interesting and historic: this was probably the first time these two multilateral institutions were actually seen working together and promising to enhance this co-operation in future. Though they had made similar noises in the past, they unfailingly broke their promises. Both institutions, with unwieldy and terribly insular bureaucracies, have been distrustful of each other.

The genesis of this strife and suspicion towards each other can be found in the circumstances surrounding the birth of the World Bank along with its sister institution, the International Monetary Fund (IMF). Both these multilateral agencies were the outcome of a post-Depression meeting comprising 44 nations in a small New Hampshire town called Bretton Woods. The meeting, which was held in Mount Washington Hotel, was aimed at creating a lasting post-war global economic compact - an agreement that would lay down the long-term blueprint for global economic prosperity.

In reality, the conclave turned out to be a contest between two powers: the United Kingdom, a waning imperial power keen to reverse its ebbing national self-esteem; and the United States of America, the global superpower eager to leave its imprint on the global economy.

At first sight, the dice seemed loaded in favour of the UK team, which included the first celebrity economist of modern times, John Maynard Keynes. His formidable reputation, his distaste for intellectual lightweights, his irascible temper, and his sharp tongue gave the British side a psychological advantage. Keynes had been planning to create an international currency union, which would launch its own international currency - "bancor", an alternative to the all-powerful dollar - and lend to indebted countries such as Britain.

But the American side had a surprise: Harry Dexter White, a dogged and industrious bureaucrat who enjoyed the confidence of Henry Morgenthau Jr, then Treasury secretary. White, a Harvard-trained economist, had been hatching a plan to create an international stabilisation fund. This fund would not only lend dollars to debtor countries, but also stabilise currency movements across the world by convincing countries to peg their currencies to the dollar and, in turn, peg the dollar to a fixed gold price.

When Keynes' and White's plans collided at Bretton Woods, the result was the birth of the IMF. History shows that the discussions took place in a collegial atmosphere, but author Benn Steil's latest version injects an undercurrent of understated hostility, marked by a sparring match between two monumental intellects, and egos.

Differences even crept up as to where to locate the IMF - Keynes felt New York (in close proximity to the UN's Economic and Social Council) was ideal, but his suggestion was railroaded by the US' preference for Washington, DC. The dividing lines were also quite pronounced about the IMF's future role.

A book that describes in detail such a conference, its leading characters, and changing moods and directions is usually as dull as dishwater. There are quotes from agendas, memos, official correspondence, file notings, research papers and personal letters. What saves the day, or adds colour, is the insight into the character of White, whose personal papers were made public only recently. He was believed to be a Russian spy and was accused of passing on the details of the Treasury department's plans and former US president Franklin Roosevelt's thoughts to his contacts in the Russian embassy. Mr Steil has refrained, sensibly, from dwelling too much on Keynes' homosexuality and its presumed impact on policy making, as some right-wing historians have tried vainly in the past.

The book's over-reliance on minutiae can be crushing, but given the renewed interest in economic history - especially the Great Depression and the creation of the Bretton Woods institutions - Benn Steil cannot be faulted for his timing.

THE BATTLE OF BRETTON WOODS
John Maynard Keynes, Harry Dexter White, and the Making of a New World Order
Benn Steil
Princeton University Press
449 pages; $29.95

Agriculture, The Engine Of Growth

The structural deficiency of the agricultural economy as a whole and the slipover impact from the rise of crude prices on fertiliser prices as well as on transport costs for ferrying food items need to be tackled urgently

THE meeting of heads of state from G-8 and eight other economically important nations (which included Indian Prime Minister Manmohan Singh) in Japan this week got headlines in the Indian media for all the wrong reasons. While the PM’s presence there provided the focal point of all political action in Delhi, the conclave wound up on Wednesday without reaching any meaningful action plan on the two most contentious issues: combating climate change and controlling global inflation caused by rising food and fuel prices. Preoccupied as he might be with all the political drama, Manmohan Singh should also be worried about food security. Especially, since Maharashtra faces a drought-like situation this year.

The greatest disappointment of the G-8 meeting, however, seemed to be the failure of global leaders to come up with a concrete plan to tackle the food crisis. News agency Reuters filed this report: “The G-8 leaders also acknowledged the economic threat from surging oil and food prices…but came up with no fresh initiatives to tackle what they said were complex problems requiring long-term solutions.” What’s strange is the absence of any acknowledgement from the G-8 leaders that the major reason for the rise in food prices is increasing bio-fuels production in the US and, to some extent, in Europe. The rich countries made no promises to remedy this structural issue, which promises to pull another 100 million people below the poverty line this year, but shifted the responsibility to other big emerging countries. Reuters also filed this report: “The G-8…called for countries with sufficient food stocks to make available a part of their surplus for countries in need.”

The World Bank says this upfront in a position paper (Rising Food Prices — Policy Options and World Bank Response): “Concern over oil prices, energy security and climate change have prompted governments to take a more proactive stance towards encouraging production and use of bio-fuels. The has led to increased demand for bio-fuel raw materials, such as wheat, soy, maize and palm oil, and increased competition for cropland…Other developments, such as drought in Australia and poor crops in the EU and Ukraine in 2006 and 2007, were largely offset by good crops and increased exports in other countries and would not, on their own, have had a significant impact on prices. Only a relatively small share of the increase in food production prices (around 15%) is due directly to higher energy and fertiliser costs.” On a more pessimistic note, the World Bank’s note prepared for the G-8 meeting — Double Jeopardy: Responding to High Food and Fuel Prices — states clearly that food prices are likely to remain above the 2004 levels till at least 2015.

All this raises worries about India’s food situation, particularly since repeated studies have shown that any rise in food prices, rather than fuel prices, is seen to have a greater impact on the common man’s inflationary expectations. This assumes greater importance in the case of the urban poor and the rural landless workers, where food has the lion’s share of the total consumption basket, compared to fuel which is either subsidised or almost free. What is likely to exacerbate the situation is the structural deficiency of the agricultural economy as a whole and the slip-over impact from the rise of crude prices on both fertiliser prices as well as on transport costs for ferrying food items from production centres to consumption hubs. Here are some of the urgent issues that need tackling immediately.

THE first anomaly lies at the macro level. Over 60% of the country’s population is today dependent on agriculture, which contributes to only 20% of GDP. This translates into low income per rural family, which then makes most of them vulnerable to debt traps and pushes them into distress every time there is an exogenous shock. The need is to wean away part of each family into skills-based training, without necessarily alienating the entire family from its agricultural roots. The solution is not to provide them with only urban-based jobs, but to create a talent pool for rural industry, whether it is manufacturing or services-based. Such an industrial base, through linkages, has the potential of bringing about qualitative changes in agriculture as well.

• As a result of so many people depending on agriculture for income, land holdings are exceedingly fragmented, leading to falling crop productivity. According to official statistics, close to 60% of all land holdings in the country are marginal holdings (where land ownership is less than 1 hectare). Consequently, the average size of operational holdings is not even half a hectare, or about 1 acre. Average foodgrain yields, therefore, have been almost stagnant.

• Diversion of crop land into non-agricultural use is growing and could be another cause for worry in the long run. New ways should be found of converting non-agricultural land into agricultural land (without actually reducing the forest cover) and employing technology to increase the productivity of these tracts. Antiquated legislation regulating sale and purchase of agricultural land also needs to be updated, with adequate safeguards, to allow for consolidation of farmland.

• A solution for improving the income and the yields would be to introduce contract farming in a big way. This allows a large corporate to tie up with a large number of farmers with contiguous plots. Both win: while the farmer does not lose his homestead and is assured of an income at the end of the harvest, the corporate is ensured a steady supply of output, which takes some of the uncertainties out of his supply chain.

• Finally, the government has no choice but to rise above petty vote-bank politics and take a hard look at all the handouts (such as loan waivers or cheap credit) and the subsidy structure. According to the World Development Report, 2008, 75% of India’s agricultural budget is spent on such private goods, instead of investing in public goods (such as rural roads, or increasing outlays for agricultural R&D).

In short, agriculture has the potential to become the engine for future growth in the economy, but only if the right cards are played now.

Published as an Op-Ed in The Economic Times (July 11, 2008)