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June 21, 2018

Capital Markets|Development Strategy

Debt Markets for Development

By Nitin Desai


Policy makers are struggling with several problems that can be attributed to one core deficiency - the failure to develop a rational policy framework and an effective term finance system for long gestation infrastructure  projects. The rising problem of non-performing assets in banks, the stagnation in  investment intentions and the viability woes of the investors seduced by public private partnerships are linked to this key gap in capital markets.

Infrastructure projects pose a real challenge for immature capital markets. Their fund requirements are very large relative to the scale at which untied loanable funds are available. They operate in a heavily regulated environment in which their viability is hostage to political calculations rather than economic rationality  and on how well or badly other parts of the network, of which they are a part, operate.

In the pre-liberalisation era infrastructure funding depended on budgetary support and specialised term lending institutions that could mobilise semi-official finance. However a variety of pressures led to a shift towards public-private partnerships (PPP). The performance of the public sector entities involved in infrastructure development was widely criticised for cost and time overruns, corruption and poor financial performance.  At the same time budgetary resources came under pressure in the Centre and the States as ruling parties, facing increasing electoral competition, diverted resources to populist handouts. Political compulsions also led to irrational pricing policies that eroded the financial viability of these public sector infrastructure enterprises.

Under these pressures and the private sector bias implicit in the liberalisation process we launched a major drive to induct private investment and management into the infrastructure sector after 1991. Well over a thousand PPP projects have been launched mainly in roads, seaports, airports and power generation. But we did this without addressing the policy reforms, particularly in pricing, required to provide reasonable levels of commercial viability, while devolving most of the risk on the private investors and relying heavily on bank lending for the required debt finance.

In some instances, like seaports and international airports, with fewer political constraints,  the PPP initiative worked reasonably well. But in many others we have ended up with firms facing bankruptcy and banks being landed with burgeoning non-performing assets.

Indian banks entered the field of term financing in a big way in the post-liberalisation period. Their lending for infrastructure projects grew at an annual average rate of 42% between 1998 and 2015.  In absolute terms, outstanding bank credit for infrastructure increased from Rs.3 thousand crores or just 2% of gross credit to industry in March1998 to Rs.965 thousand crores, or 35% of gross credit to industry in March 2016. 

Infrastructure lending is not like traditional bank lending for working capital or the purchase of cars and houses, where the probity of the borrower and the adequacy of the collateral can be assessed at branch level. Infrastructure projects require funds that go well beyond branch level transactions. They involve judgements about sectoral risks, promoter probity and corporate governance. They are necessarily long term in nature.

Did our commercial banks have the competencies in project analysis and risk assessment required for this departure from traditional banking business? Did we professionalise governance in public sector banks and prevent interference by those close to the Government? Did the banks have a business plan for managing the higher risk of loan defaults?  The answer, regrettably, is clearly negative.

What can be done to get out of this mess? Some useful steps have been taken like stricter norms on the reporting of non-performing assets, pumping of fresh capital into public sector banks and the new provisions on insolvency that can force promoters  to surrender control of their companies. These measures can stem the rot; but they will not stop the problem from recurring.

We need to do more- re-examine our infrastructure development strategy, reform the governance and management of public sector banks and develop an effective market in corporate debt instruments in order to reduce dependence on bank finance.

Infrastructure development requires coherence in planning and coordinated implementation, particularly when network linkages are important. It needs pricing regimes that ensure viability. Depending heavily on PPP can fragment network planning and politicise pricing. China's spectacular infrastructure development did not rest on such partnerships. We need to take a fresh look at the balance between the private and public sector in infrastructure development.

Public sector banks need to be liberated from control by politicians. Privatisation is politically infeasible and may not be the answer given the deficiencies in private corporate governance. But an arms length relationship can begin by abolishing the Department of Financial Services and giving the RBI the same powers over public sector banks  as it has over private  banks.  Divest more to private investors, constitute boards from a roster of qualified professionals and allow long tenures for top managers and we will be half-way there.

But banks should not be our prime instrument for long term finance. Right now NPAs and vigilance pressures are already stopping them from advancing large project loans. In the long term we should develop an effective market in corporate debt so that the dependence on banks is reduced. In the developed economies the ratio between  debt and bank credit for long term finance is 85:15 while in India it is 20:80, far more skewed towards bank credit than in other emerging economies where it is around 55:45.

The corporate bond market has grown at about 22% a year over the past decade, mainly through private placements. But the secondary market is very weak and private debt assets tend to be illiquid. We need more A-rated securities to attract major institutional investors, a market for credit default swaps and interest rate futures to allow risk hedging and designated market makers for strengthening the secondary market in corporate debt.

We have taken firefighting measures to address the immediate challenges in the credit market.  We must now move to reforms  that will fireproof the system and prevent an NPA trauma  from occurring again.

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