A Deliberation on the Logic of Utilizing Forex Reserves as a Means for Infrastructure Financing in India!

The Planning Commission estimates that the investment in infrastructure needs to be around $320 billion during the 11th plan period.

The Deepak Parekh panel on infrastructure financing has projected an investment requirement of $475 billion at current prices, revised upwards from $384 billion at 2005-06 prices.

The Finance Minister P Chidambaram opines that India will have to increase investment in infrastructure to 8% of its GDP in the next five years from 4.6% currently, if the economy is to continue to grow at 9% a year.

The Problem: These statistics underscore the threat which the over-stretched infrastructure in India poses, to sustaining the impressive 9.4% growth India clocked in 2006-07. The infrastructural deficiencies have become even more visible due to an average of 8.6% growth in the past 4 years.

The Proposed Solution: Considering the dire need of long term funds for infrastructure financing and the exponential rise in foreign exchange reserves – which began a couple of years ago - the idea of using forex reserves for improving country's infrastructure was mooted by deputy chairman of Planning Commission Montek Singh Ahluwalia two years ago and later on by the Deepak Parekh committee. Before we delve further into the details of the proposed mechanism, let’s first take a look at why has there been a rise in the forex reserves and why is there a lack of long term funds in India.

Rise in Forex Reserves: During the past few years, India has attracted tremendous interest from foreign investors, resulting in huge dollar inflows and putting immense upward pressure on the domestic currency. The central bank in its bid to prevent a run away rise in the value of the rupee has been frequently intervening in the foreign exchange (forex) markets, in the process adding on to its forex reserves. This has led to reserves rising to a record $230 billion (approximately), currently.

Lack of Long-Term Funds: The long gestation periods of capital intensive infrastructure projects necessitates long-term debt funding. With short term deposits being the dominant source of funds for commercial banks in India, they are capable of providing funds only for the medium term of 4-6 years and not for the long term, as otherwise they run the risk of asset liability mismatch. Banks may also face interest rate risk if they lend for the long term. Floating interest rates cease to be an option as they would add to the already considerable project risks embedded anyway in long-gestation activity. The rather moribund state of the corporate debt market in India, incapable of providing long term funding also exacerbates the problems. Thus there is a real dearth of long-term funds in India.

The Funding Nuances: The FM in his budget speech for the current fiscal corroborated the suggestions of the Deepak Parekh committee by detailing the mechanism by which forex reserves would be channelized towards infrastructure financing. The FM said that the Deepak Parekh committee had proposed establishing two wholly-owned overseas subsidiaries of IIFCL. While one of these subsidiaries would borrow funds from RBI, to invest in highly rated collateral securities, and provide 'credit wrap' insurance to infrastructure projects in India for raising resources in international markets; The second SPV would borrow funds from RBI to invest in transnational projects undertaken on a PPP basis, or to co-finance the ECBs for projects undertaken by companies in India, solely for capital expenditure outside India. The government has assured a guaranteed return of more than 3.5% to the RBI on the dollar borrowing.

The MoF/RBI Face-off: While, RBI has rejected the proposal of forex reserves being used for the purposes of providing credit wrap insurance to infrastructure projects, the modalities of transferring $5 billion of forex reserves for the second SPV are being worked upon. The present state of the tussle between the finance ministry and the RBI over the transfer of these reserves, suggests that the finance ministry has asked RBI to subscribe to the bonds issued by the offshore subsidiary. The finance ministry had rejected the earlier RBI proposal to refinance the subsidiary as it would lead to an escalation in the borrowing costs. RBI had earlier cited section 17 of the RBI Act that mandates the investment of forex reserves in institutions specified in the Act. The finance ministry after having consulted the law ministry has ruled out the need for an amendment of the RBI Act. The ministry has taken refuge in clause 13 under section 17 of the Act that empowers the central bank to consider investment in “any other foreign institution as may be approved by the Central Board”.

Merits: Such a structure for infrastructure financing has some significant advantages. The cheap, long-term source of debt which such an SPV is capable of providing would give a fillip to infrastructure development in India. Also, as newly formed infrastructure companies normally get poor rating, this SPV can, by subscribing to the securities of such firms, ensure the availability of cheap, long term debt for them. The SPV could also indulge in take-out financing and thus adequately address the issue of commercial bank funding being available only for the medium term. This mechanism would have a neutral impact on the rupee since the forex provided by the RBI would be used to fund imports of capital equipment used in infrastructure projects. Such a mechanism would also ensure a better rate of return for the RBI on its forex holdings, though quantum of returns may not be the most dominant deciding factor for the RBI, with security and liquidity of forex reserves being of utmost concern.

Demerits: But the proposed mechanism of financing also lends itself to a few shortcomings. The condition of lending only for capital expenditure outside India makes this sort of a funding mechanism unavailable for infrastructure projects involving significant amounts of rupee expenditure. Thus while power projects may benefit immensely from this sort of financing, a road project may not.

The critiques of such means of infrastructure financing continue to insist that it is the lack of bankable projects which is primarily impeding infrastructure development in India. They claim that in the event of the SPV having to write off its loans which it provided to the non-bankable projects, it would not be able to service its bonds issued to the RBI and this would tantamount to financing through the budget deficit – an off budget deficit much like oil & fertilizer bonds. They opine that if projects were bankable in the first place there would be no need to adopt this funding mechanism.

But is the use of forex reserves for infrastructure financing the best solution? There isn’t an iota of doubt that we are not making the best use of our reserves currently. We also continue to hold reserves, far in excess of what we really need, but simply allocating a mere $5 billion towards infrastructure financing will not suffice. $5 billion is a miniscule 1.56% of the amount of investment in infrastructure needed, even by the most conservative estimates. Will we continue to use more of our forex reserves, as and when the current amount of $5 billion gets exhausted? And what if certain unfortunate macro-economic factors, force rapid depletion of our forex reserves? Can we risk depending primarily on forex reserves to fund our infrastructure development?

Other Alternatives: There are numerous other options which the government can explore to expedite delivery of capital for the long term to fund infrastructure development. Firstly, there is a pressing need to expedite disbursal of funds already sanctioned by the IIFCL. On similar lines, it is essential that government speeds up fund disbursal under the viability gap funding scheme. Secondly, there is an urgent need to deepen and widen the currently lackluster corporate debt market in India. Relaxing the SLR requirements, which could result in the non-SLR securities becoming more attractive and more liquid, is just one of the measures which could help liven up the market. The Deepak Parekh committee has also suggested the use of CDO’s as a means of infrastructure financing. But CDO’s too require a thriving and deep, secondary debt market. It is also imperative that the track record of project implementation improves as this would lead to greater availability of foreign funds, though this would raise the concerns of exchange rate management for the RBI. Certain sections also feel that the government intervention in pricing of infrastructure services is keeping large amounts of private capital in abeyance. Thus reduction of such pricing controls would make available larger amounts of domestic funds for infrastructure development. Adequate policy and regulatory changes much be affected, to ensure that funds from the insurance sector flow towards financing of Indian infrastructure, as there is a considerable match between the gestation periods of infrastructure projects and the payback obligations of insurance firms.

Govt holding in Indian PSU banks!

IBA recently made a representation to the government proposing consolidation of public sector banks as well as dilution of government holding to below 51%. Reduction of government holding to 26% or even 33% it was suggested, would allow the government to be the single largest shareholder though it may lose the right of appointment, which shall rest with the RBI thereafter. Also since RBI rules do not permit any bank to hold more than 5% equity in another, government control would be ensured.

As an alternative, mechanisms such as "Free Carry Equity" or maybe even the "Golden Share" concept maybe used to ensure government control in these banks. The implementation of these mechanisms, if accepted, would require substantial overhaul of rules & regualtions governing the banking sector.

The issue of government stake in PSU's assumes immense significance as the current regulations restricting the government holding in these institutions from falling below 51%, are seriously denting the ability of these banks to raise capital. Inability to raise capital is adversely impacting the expansion plans of these banks, who shall also have to be mindful of the Basel II norms which kick in from March'08 for all those banks with international presence. Also since most banks today have insurance subsidiaries which are in need of immense capital infusion (the 26% cap on foreign holding adding to the woes of the local partners who have to bring in the rest 74%), there is an urgent need to address the way in which they can raise fresh capital.

Thus relaxation of capital raising norms in a manner which takes care of the interests of all the stake holders is an imperative. While stringent regulations resulting in healthy financial institutions is the need of the hour for an economy like India which is on a growth trajectory, the regulators also must ensure that the regulations dont end up being an impediment in the growth path of these institutions.

Offseting Carbon Footprint in India!!!! Bah...!

Recently came across this article in Mint which mentioned of a start up by the name of carbonyatra.com which intends to sell carbon offsets to individuals. The proceeds of the reduction certificates bought from this company will be used to invest in jatropha plantations in Uttarakhand, resulting in a plant in the name of the buyer of the offset. Interesting?

http://www.livemint.com/2007/08/28235844/Save-the-earth-online-offset.html

Well I dont think so!

The company it seems intends to blend capitalistic motives with social ones by capitalising on the guilt we face by driving fuel guzzling vehicles or sitting down in air conditioned buildings day in and day out! But what guilt.....in a country where people dont care to keep the roads clean, have no civic sense, blame the Mumbai Municipal Corporation for flooding every year even whilst they make little effort to dispose of garbage at the place and in the manner its supposed to be disposed - I doubt that such an initiative can work.

Also the business model reminds me of those numerous timber plantation companies that came up in mid 90's and duped unsuspecting investors.....the likes of Golden Forest etc.......individuals who have been even remotely associated with such incidents may like to entirely refrain from this scheme.

The article suggests that it will cost approx Rs5,500 for a family that uses 850kWh of electricity a month and drives 2 medium sized petrol cars, to offset their carbon emissions for a year. Though this seems like a rather miniscule amount when compared to the amount asked for similar schemes in Europe.....yet the ignorance of we Indians when it comes to global warming and the initiatives being taken to contain the effect.....may become a roadblock. Also a vast majority of Indians may not be able to afford this annual expense of Rs5,500.

Thus though the idea is noble....its effectiveness in the Indian context remains doubtful!