Technical Assistance Consultant s Report. India: Preparing the Bond Guarantee Fund for India (Financed by the Japan Fund for Poverty Reduction)

Transcription

1 Technical Assistance Consultant s Report Project Number: August 2014 India: Preparing the Bond Guarantee Fund for India (Financed by the Japan Fund for Poverty Reduction) Prepared by CRISIL Risk and Infrastructure Solutions Limited Mumbai, India For Department of Financial Services, Ministry of Finance This consultant s report does not necessarily reflect the views of ADB or the Government concerned, and ADB and the Government cannot be held liable for its contents. (For project preparatory technical assistance: All the views expressed herein may not be incorporated into the proposed project s design.

2 CRISIL Risk and Infrastructure Solutions Limited Asian Development Bank TA-8279 IND: Preparing the Bond Guarantee Fund for India 1 Consulting Firm ( ) August 2014

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4 Abbreviations ADB AUM BGFI CAGR CDR COD CRIS CRISIL CRR CSO ECB EPF EPFO GCF GDP GFCF GIC GNPA HDFC HNI HPCL IDBI IDF IDFC IFC IFCI IIFCL IL&FS IRDA LIC MOSPI MSME NBFC NCD NHAI NHB Asian Development Bank Assets Under Management Bond Guarantee Fund for India Compounded Annual Growth Rate Corporate Debt Restructuring Commercial Operations Date CRISIL Risk and Infrastructure Solutions Credit Rating and Information Services India Ltd. Cash Reserve Ratio Central Statistics Office External Commercial Borrowings Employee Provident Fund Employees Provident Fund Organisation Gross Capital Formation Gross Domestic Product Gross Fixed Capital Formation General Insurance Corporation of India Gross Non-Performing Asset Housing Development and Finance Corporation High Net-Worth Individual Hindustan Petroleum Corporation Limited Industrial Development Bank of India Infrastructure Debt Fund Infrastructure Development & Finance Corporation International Finance Corporation Industrial Finance Corporation of India India Infrastructure Finance Company Ltd. Infrastructure Leasing & Financial Services Ltd. Insurance Regulatory and Development Authority Life Insurance Corporation of India Ministry of Statistics & Programme Implementation Micro, Small & Medium Enterprises Non-Banking Finance Company Non-Convertible Debenture National Highways Authority of India National Housing Bank TA-8279 IND: Preparing the Bond Guarantee Fund for India [iii]

5 NHDP NPS NTPC ONGC PCG PFC PFRDA PMI PMS PPP PSU RBI REC SARFAESI SBI SEB SEBI SIDBI SLR SPV USA USAID USD UTI WPI National Highways Development Project National Pension System National Thermal Power Corporation Oil and Natural Gas Corporation Partial Credit Guarantee Power Finance Corporation Pension Fund Regulatory and Development Authority Purchasing Managers Index Portfolio Management Services Public-Private Partnership Public Sector Undertaking/Utility Reserve Bank of India Rural Electrification Corporation The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 State Bank of India State Electricity Board Securities and Exchange Board of India Small Industries Development Bank of India Statutory Liquidity Ratio Special Purpose Vehicle United States of America United States Agency for International Development United States Dollar Unit Trust of India Wholesale Price Index [iv] TA-8279 IND: Preparing the Bond Guarantee Fund for India

6 Executive Summary The Bond Guarantee Fund for India (BGFI seeks to catalyze the nascent bond market BGFI is proposed to be a credit enhancement mechanism, giving guarantees to long-term bond issuances (by entities (private and public) in the infrastructure and non-infrastructure sectors) of issuers with credit rating less than AA (category); through this credit enhancement these bond issues would achieve a structured rating of AA or above and would therefore be able to attract bond market investors. CRISIL Infrastructure Advisory (CRIS) has been appointed by ADB to design such a fund ascertain the business case through market assessment, analyze the financial viability, develop the structure and frameworks and conduct road shows and seminars. A kick-off meeting with the Steering Committee was conducted on June 2, 2014 and subsequently the inception report was submitted on June 23, This report details out the first stage of the engagement i.e market assessment. Based on the analysis conducted investments required over a period of 10 years, supply of traditional sources of funds and their constraints it can be concluded that bond markets need to play a significant part to fund these investments. There is a huge pool of lower rated entities, rated lower than AA (and especially in the A and BBB categories) which are practically serviced only by banks today and which would benefit from the bond market and therefore a mechanism such as BGFI. Moreover all market participants, interacted with during the course of this stage, were positively disposed towards the overall concept of BGFI. A comprehensive market assessment exercise was undertaken to ascertain the business case for BGFI over a period of 10 years The exercise undertaken was two-fold: First, an analytical projection of investments and debt requirement (long term and for entities rated less than AA) for both infrastructure and non-infrastructure sectors for 10 years was done against which supply of debt from the existing sources of finance such as banks, NBFCs, ECBs, and bond investors was measured. The objective of this exercise was to arrive at the potential gap in debt financing. Second, extensive interactions were held with a cross-section of stakeholders (government/ministry departments, regulators, investors, bond issuers, investment banks and lenders) to gain perspectives on the overall concept and attractiveness of the same to them. Projected gap of ~INR 55 1 lakh crores in infrastructure and ~INR 35 lakh crores in noninfrastructure 1 10 million = 1 crores, 1 trillion = 1 lakh crores TA-8279 IND: Preparing the Bond Guarantee Fund for India [v]

7 Figure 1: Demand-supply assessment for long-term debt for ratings below AA (INR lakh crores) Source: CRIS analysis A vibrant bond market could address this gap but beset with several issues The Indian corporate bond market lacks depth amounting to only 15% of the GDP (the figures for the US and Singapore bond market are 126% and 47% respectively) in The market suffers from concentration issues with regards to the type of issuers and rating of issuers financial sector accounts for more than 70% of the issuances through private placement, the market is predominantly restricted to issuances rated AA and above. Moreover, bond investors are credit risk averse and prevented by regulations and / or internal investment policies from investing in issuances rated less than AA. Credit enhancement could help low rated issuers access the bond market existing mechanisms are nascent and cannot address the huge gap on their own Three such mechanisms are currently used for the infrastructure sector: Partial Credit Guarantee by India Infrastructure Finance Company Limited (IIFCL) and ADB The scheme was launched in Under the partial credit guarantee scheme, IIFCL, supported by ADB, provides partial credit guarantee to enhance the ratings of the bond issuances of projects (refinancing, commissioned projects). The scheme hasn t seen much traction yet. Two pilot transactions with GMR and L&T fell through due to the high interest regime then and therefore the minimal savings in cost that was on offer to the promoters. It is understood that 5-6 new proposals are being considered. Recent reports indicate that the initial fund to cater to the PCG scheme would be around INR 1500 crores (almost 50% is funded by ADB). This would be enough to generate a business of INR 6,000-9,000 crores. Infrastructure Debt Fund (IDF) Two types of IDFs are allowed, one structured as a nonbanking finance company (NBFC) and the other as a mutual fund (MF). o IDF-NBFCs Take-over or refinancing of loans of commissioned projects through a tripartite agreement between the IDF, the concessionaire and the project authority. Tripartite agreements for roads and ports are in place. There are two operational [vi] TA-8279 IND: Preparing the Bond Guarantee Fund for India

8 o IDFs, one promoted by ICICI and other by L&T. Interactions reveal that these funds are finding it tough to find adequate assets in the market; primary reason is that banks are not willing to sell off their assets after project commissioning as they believe that risks come down substantially after commissioning of projects. Discussions are also underway to do away with the tripartite agreement which could result in lower credit rating for the respective IDFs, impacting their ability to attract long term funds, as well as impacting their investments. IDF-MFs Three IDFs set up by IL&FS, IIFCL and SREI. Investment guidelines mandate them to invest at least 90% of AUM in infrastructure companies or infrastructure projects/spvs or bank loans in terms of completed and revenue generating projects or public finance institutions or infrastructure finance companies. Today while they are technically allowed to invest upto BBB, there are hardly any investments in less than AA credits. The appetite of these funds for investment directly in projects in the infrastructure sector is therefore questionable. Credit enhancement by banks The recent draft circular by RBI, which is open to public comments allows restricted credit enhancement (by 20%/2 notches whichever is lower) through provision of subordinate debt or a line of credit. Considering the fact that infrastructure sector projects in general are rated not above BBB/BB, would need a higher level of credit enhancement to take them to AA. Moreover, the current capital requirements as mandated by the circular are prohibitive. Therefore, in the present form this mechanism is not expected to be successful. Clearly the viability of most of these mechanisms is in question. Moreover, the large market gap cannot be addressed without new mechanisms being introduced. The RBI has recently issued a circular, following the announcement in the Union Budget , allowing banks to issue long-term infrastructure bonds which are exempted from Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) and Priority Sector Lending limits. This initiative would help the banks two-fold, i) manage their assets/liabilities better and ii) help the higher rated banks access cheaper sources of funds (due to the exemptions) and thereby become aggressive in pricing of loans (interactions reveal that AAA rated banks would probably enjoy pricing advantages to the tune of bps). However the initiative would do little to catalyze the bond market in terms of helping low rated entities access it. Tremendous opportunity for BGFI overall unanimous approval for such a mechanism, from all stakeholders A diverse set of stakeholders government/ministry departments, regulators, investors, issuers, lenders, and investment bankers were consulted with during this stage. All of them were well disposed towards such a concept and believed that such a mechanism could help kick-start the bond market in the country. Key issues were discussed and inputs were garnered from a wide cross-section of stakeholders on the following issues: Who will own this entity? Strong ownership is required to attain AAA rating. Majority government holding might create a moral hazard, while majority private sector holding might not promote acceptability in the market. A widely held structure, professionally run, with representation from both government and private sector could be explored along the lines of IDFC IDFC when set up had 35% government holding, 5% by IDBI, 40% by foreign investors and 20% by domestic institutions. Government holding ensured easy access to various stakeholders and forums within the government which helped in development of IDFC. TA-8279 IND: Preparing the Bond Guarantee Fund for India [vii]

9 How will the entity be capitalized? In addition to ownership, the entity should be sufficiently capitalized to attain AAA rating. The capital could be upfront through direct infusion or by means of callable capital. The government could also participate through a long-term subordinate debt case in point; the government has provided a 50-year subordinate debt to IDFC. What will be the legal structure of this entity? The entity is meant to be a pure guarantee company. Thus the operations of the entity do not strictly fall under the ambit of any of the current regulated structures in India. A potential option is as a bond insurance company (akin to a monoline insurer) under IRDA. Structuring the entity as a NBFC under RBI may also be explored but it may lead to issues pertaining to exposure limits which NBFCs are subjected to unless specific exemptions are obtained for the same. What will be the business model of this entity? o Products Partial credit guarantee as an instrument is still nascent in India. It might be prudent to employ a mix of full guarantees and partial guarantees to begin with to establish credibility and acceptability. o Rating enhancement To begin with BGFI could target entities rated A and BBB category, and enhance them to AA+/AAA. This would promote acceptability in the market. o Pricing Pricing might be critical to wean away borrowers from the bank loan market. Prominent bigger firms enjoy a long relationship with banks and therefore favourable interest rates. The prospective cost savings in the bond market might not be attractive enough to pull these firms away from their relationships. It would therefore be advisable to target smaller promoters, with good credit quality, but who do not enjoy favourable interest rates with the banks currently. This report establishes the need for a facility such as BGFI. The next stage of the engagement, which will be part of the interim report, will be to ascertain the financial viability of this facility as a standalone business. [viii] TA-8279 IND: Preparing the Bond Guarantee Fund for India

10 Contents 1. Introduction Market estimation Classification of infrastructure and non-infrastructure sectors Structure of the report Overview of the Indian Economy Macroeconomic overview Sectoral trends Key indicators and outlook Infrastructure sector indicators Macroeconomic outlook Investments in India and Debt Requirement Methodology to forecast investments and estimate debt requirement Recent trends in investments Investment in infrastructure sector Investment in non-infrastructure sector Financial Sector in India and Debt Supply Overview of the Indian financial sector Sources of debt financing and estimation of debt supply Banks Non-banking finance companies (NBFCs) External commercial borrowings (ECBs) Insurance sector Other suppliers of debt Gap assessment Infrastructure sector Non-infrastructure sector Sensitivity analysis Adjustment for credit ratings bracket Adjustment to investment by insurance sector in less than AA Adjustment to investment by EPFO, pension funds in less than AA Adjustment to long-term tenure of credit provided by banks Requirement of Bond Market in India [ix]

11 5.1 Key Issues with the bond market in India Lack of depth in corporate bond market in India Low credit rating for infrastructure projects Absence of bond Market for low rated paper Low risk appetite of investors and regulatory restrictions Limited secondary market activity Lack of awareness and information Credit enhancement can help bridge the gap Sectors that can potentially tap the bond market through credit enhancement Infrastructure Non-infrastructure Existing credit enhancement mechanisms in India Partial Credit Guarantee Scheme (PCG) Infrastructure Debt Fund (IDF) Credit enhancement by banks Initial Thoughts on Bond Guarantee Fund for India and Next Steps Stakeholder s initial inputs on BGFI Next steps Annexure 1 Stakeholder meetings [x]

12 List of Tables Table 1: Classification of infrastructure and non-infrastructure sectors... 3 Table 2: Growth in GDP of India at constant prices ( prices (percent))... 4 Table 3: Sectoral share in GDP (%)... 5 Table 4: Global Competitiveness Report - Ranking for Infrastructure... 6 Table 5: Contribution of investment to GDP in percentage terms (at current market prices)... 8 Table 6: Comparison of infrastructure investments across Five Year Plans Planning Commission (INR crores)... 9 Table 7: Planning Commission estimates for private corporate sector debt requirement in the infrastructure sector during 12 th Five Year Plan (INR crores) Table 8: Forecast for investment and debt requirement in infrastructure sector (INR crores) Table 9: Investments in non-infrastructure sectors Table 10: Estimated Private Debt Requirement in non-infrastructure sector Table 11: Outstanding credit by scheduled commercial banks in India (INR crores) Table 12: Incremental flow of bank credit to infrastructure (INR crores) Table 13: Outstanding bank credit to non-infrastructure sector (INR crores) Table 14: Overall and incremental credit by scheduled commercial banks Table 15: Forecast of debt supply from banks to infrastructure sector (INR crores) Table 16: Forecast of debt supply from banks to non-infrastructure sector (INR crores) Table 17: Loans and advances by NBFCs (INR crores) Table 18: Loans and advances by NBFC-IFCs (INR crores) Table 19: Forecast of debt supply from NBFC-IFCs to infrastructure sector (INR crores) Table 20: Total ECB Inflow (INR crores) Table 21: Flow of ECBs to infrastructure sector (INR crores) Table 22: Data for ECBs to non-infrastructure sector for the period January-April Table 23: Forecast of debt supply through ECBs to infrastructure sector (INR crores) Table 24: Forecast of debt supply through ECBs to non-infrastructure sector (INR crores) Table 25: Incremental flow of credit from insurance companies into infrastructure sector (INR crores) Table 26: Investments in infrastructure sector by life insurance companies (INR crores) Table 27: Forecast of debt supply from insurance companies to infrastructure sector (INR crores) Table 28: Forecast of debt supply from insurance companies to non-infrastructure sector (INR crores) [xi]

13 Table 29: EPFO corpus (INR crores) Table 30: EPFO portfolio managers Table 31: Corporate Bonds Investment Pattern EPFO (INR crores as of September 2013) Table 32: Corpus size and investment pattern NPS (INR crores) Table 33: Estimated debt supply NPS (INR crores) Table 34: Estimated Debt Supply - Mutual Funds Table 35: Historical debt supply from multilateral/bilateral Institutions Table 36: Estimated Debt Supply from Multilateral/Bilateral Institutions Table 37: Gap assessment for infrastructure sector (INR crores) Table 38: Gap assessment for non-infrastructure sector (INR crores) Table 39: Adjustment to credit ratings bracket Table 40: Sensitivity - insurance sector Supply Increase Table 41: Sensitivity - Pension funds sector supply increase Table 42: Sensitivity - Long term debt to Infrastructure from Banks Table 43: Sensitivity - Long term debt to Non-Infrastructure from Banks Table 44: Past PCG transactions in India Table 45: List of stakeholders met [xii]

14 List of Figures Figure 1: Demand-supply assessment for long-term debt for ratings below AA (INR lakh crores)... vi Figure 2: Approach and methodology for market assessment... 2 Figure 3: Sector-wise growth rate of GDP... 5 Figure 4: Methodology to estimate debt requirement... 8 Figure 5: Investment in Infrastructure (% of GDP) for other emerging economies Figure 6: Mode of financing of infrastructure investments Figure 7: Corporate bonds outstanding as a percentage of GDP, 2013 Replaced China with Thailand Figure 8: Methodology adopted for estimating debt supply from banks Figure 9: Banking sector GNPA and RA (%) Figure 10: Exposure of the banking system to some of the large business groups (INR 000 crores). 22 Figure 11: Methodology adopted for estimating debt supply from NBFCs Figure 12: Methodology adopted for estimating debt supply from ECBs Figure 13: Methodology adopted for estimating debt supply from insurance companies Figure 14: Issuances by issuer type (INR crores) Figure 15: Sectoral share in primary market issues Figure 16: Amount raised through private debt placement (INR crores) Figure 17: Issuances by issuer type (INR crores) Figure 18: Long-term instruments rated below AA in infrastructure sectors (INR crores) Figure 19: Bond issuances by rating (% of issuance values) Figure 20: 10-year spreads data for AA, A and BBB category bonds in India [xiii]

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16 1. Introduction The Ministry of Finance (MOF) has requested the Asian Development Bank (ADB) to examine the modalities, scope and potential for the establishment of the Bond Guarantee Fund for India (BGFI) that supports the development of the local currency bond market to meet India s infrastructure and non-infrastructure financing requirements. CRISIL Infrastructure Advisory (CRIS) has been appointed for designing such a fund. The assignment is being undertaken under a technical assistance grant from ADB and under the aegis of the MOF. The MOF has constituted a Steering Committee to oversee the progress of this assignment comprising representatives from Department of Financial Services (DFS) Chairperson, Department of Economic Affairs (DEA) Observer, Insurance Regulatory and Development Authority (IRDA), Pension Fund Regulatory and Development Authority (PFRDA), Reserve Bank of India (RBI), and Securities and Exchange Board of India (SEBI). The first meeting with the Steering Committee was held on June 2, 2014 wherein CRIS presented the objectives of the study and detailed work programme approach and methodology, work plan and deliverables schedule. Thereafter, a detailed Inception Report was submitted by CRIS on June 23, 2014 presenting the afore-mentioned details. This document market assessment report forms the second deliverable of this study. It is advised that this report is read post reading of the inception report. 1.1 Market estimation BGFI is proposed to be a credit enhancement mechanism, giving guarantees to long-term bond issuances (by entities (private and public) in the infrastructure and non-infrastructure sectors) with credit rating less than AA (category); through this credit enhancement these bond issues would achieve a structured rating of AA or above and would therefore be able to attract bond market investors. With this background, this report strives to estimate a market/ a business case for BGFI. The estimation is structured in the following broad manner for both the infrastructure and noninfrastructure sectors. TA-8279 IND: Preparing the Bond Guarantee Fund for India [1]

17 Figure 2: Approach and methodology for market assessment Forecast investments/fixed capital formation (for 10 years from to ) by entities (public and private) and estimate the demand for debt Forecast supply of debt (for the same time period) from the existing traditional sources of finance banks (also accounting for the recent initiative to allow them to issue long-term infrastructure bonds), non-banking finance companies (NBFCs), external commercial borrowings (ECBs) amongst others Estimate if there is a gap between demand and supply Conduct a broad analysis of the possible addressable gap by some of the recently announced mechanisms such as partial credit guarantee (PCG), Infrastructure Debt Fund (IDF) and other credit enhancement mechanisms Estimate a possible market for BGFI. The existing bank loan ratings will also be analysed to assess the quantum of long-term bank loans required for entities rated less than AA. The detailed methodology is given in pertinent sections from Chapter 3. The analysis is based on primary and secondary research including interactions with seasoned internal as well as external stakeholders Classification of infrastructure and non-infrastructure sectors For the estimation of investment requirements and supply, all economic sectors have been divided into two main sectors, namely, infrastructure and non-infrastructure. This division is based on the [2] TA-8279 IND: Preparing the Bond Guarantee Fund for India

18 definition of infrastructure sectors as specified by RBI 2 as well as the sectors considered under capital formation in the National Account Statistics prepared by the Ministry of Statistics and Programme Implementation (MOSPI) 3. The following table presents the sub-sectors considered as part of infrastructure and noninfrastructure sectors. Table 1: Classification of infrastructure and non-infrastructure sectors Sector Infrastructure Non-Infrastructure Sub-sectors Mining & Quarrying Electricity, gas & water supply, Construction Transport, Storage & Communication Agriculture, forestry & fishing, Manufacturing (Both registered & unregistered) Trade, hotels and restaurants Financial, insurance, real estate & business services, Community, social & personal services Source: RBI, MOSPI 1.2 Structure of the report The purpose of this report is to assess the business potential/estimate the market size for BGFI. The report is structured as follows: Chapter 1 (this chapter) provides an introduction to this report and puts forth the structure of the report. Chapter 2 provides a brief overview on the Indian economy and outlook. Chapter 3 looks at historical trends and estimates of future investments in the infrastructure and non-infrastructure sectors in India; following which an estimate of debt to fund these investments is arrived at. Chapter 4 gives an overview of the current sources of financing in India, the key constraints and issues in present financing sources. This chapter also estimates the likely debt supply from these sources in the future and the resulting gap between debt demand and supply. Chapter 5 establishes the importance of the bond market and the key issues facing the bond market in India today. The chapter also touches upon why credit enhancement would be important to catalyze the bond market and also looks at the existing credit enhancement mechanisms in the country. Chapter 6 establishes the need for Bond Guarantee Fund in India and presents the initial thoughts on some of the key issues (highlighted in the inception report) and summarizes discussions with stakeholders on these issues. This chapter also presents the next steps on this engagement. 2 Circular RBI/ /378 dated November 25, TA-8279 IND: Preparing the Bond Guarantee Fund for India [3]

19 2. Overview of the Indian Economy 2.1 Macroeconomic overview The Indian economy grew at a fast clip of over 9% for three successive years before it slowed down due to the global financial crisis in It however recovered strongly and posted almost equivalent pre-crisis growth figures in the two subsequent years. In recent times, the economy has suffered a slowdown, witnessing its lowest growth rate in A combination of domestic factors, borne out of weak policy decisions, such as high inflation, weak currency, and drop in foreign investment coupled with global stress factors such as the sovereign debt crisis in the Euro-zone that unfolded in (and the subsequent recession in the Euro-area) were primary reasons for the slow growth. Table 2: Growth in GDP of India at constant prices ( prices (percent)) Source: CSO Release May 30, 2014, RBI, EAC to PM, Ministry of Finance; May 31, 2014 The economy began to show signs of recovery in , with the second quarter of recording a growth of 4.8%. This follows a growth rate of 4.4% in the first quarter which was the lowest growth recorded in 16 quarters. The external sector witnessed a turnaround after the first quarter of , the year ending with a current account deficit of 1.7% of GDP as against 4.7 per cent in Improvement has also been observed on the fiscal front, with the fiscal deficit declining from 5.7% of GDP in to 4.9% in and 4.5% in Other indications of recovery are the moderation on year-on-year WPI inflation to 6.0% in vis-à-vis 8.9% in and 7.4% in , accelerated growth in agriculture and a mild recovery in manufacturing Sectoral trends In the last decade, the biggest contributors to the economy growth were the services and industry sectors. As seen in the subsequent graph, between and when the annual growth rate of GDP was over 9 per cent, the performance of these two sectors was particularly strong. The slowdown witnessed in the following years, however, was broad-based across all sectors. The agriculture sector witnessed a steady decline in growth rate from 7.9 per cent in to 3.6% in and further to 1.9 per cent in Within the industry sector, mining and manufacturing sectors have decelerated significantly over the period and Growth in services which had averaged 10 per cent for six years, reduced to 8.2 per cent and 7.1% in and respectively. Within the services sector, transport (particularly railways) and communications, as well as banking and insurance, slowed in vis-à-vis In , the agriculture and allied sectors achieved a growth of 4.7% due to favourable monsoons, while business services also witnessed recovery due to moderate revival in the global economy. [4] TA-8279 IND: Preparing the Bond Guarantee Fund for India

20 Figure 3: Sector-wise growth rate of GDP 14% 10% 12% 10% 12.2% 10.3% 10.0% 10.5% 10.1% 10.3% 10.0% 10.5% 9.8% 9.2% 9% 8% 7% 8% 6% 4% 4.2% 5.8% 7.9% 5.0% 3.5% 8.2% 7.1% 7.2% 4.7% 6% 5% 4% 3% 2% 0% 1.4% 1.3% 0.8% 0.1% 0.6% Agriculture & Allied Industry Services GDP 2% 1% 0% Source: Planning Commission The share of the agriculture and allied sectors in GDP has been consistently declining while the shares of services and industry sectors have witnessed a rising trend. Between and , the share of the agriculture and allied sectors in GDP declined by 9.3 percentage points, while that of industry and services increased by 0.5 and 8.8 percentage points respectively. Table 3: Sectoral share in GDP (%) Sector (P) Agriculture & allied Industry Services Source: National Accounts Statistics, CSO. (P) Provisional 2.2 Key indicators and outlook The World Economic Forum s Global Competitiveness Report ranks India 60 th out of 140 countries on the global competitiveness index. Other emerging economies, such as Brazil, China, and Sri Lanka are ranked higher than India. In terms of basic requirements such as institutions, infrastructure, macroeconomic environment, health, and primary education, India is ranked 96 th. Inadequate infrastructure has been cited as the most problematic factor for doing business in India Infrastructure sector indicators The overall status of the infrastructure sector in India is currently bleak. The Global Competitiveness Report ranks India 85 th out of 140 economies in terms of infrastructure, scoring 3.7/7.0 in the TA-8279 IND: Preparing the Bond Guarantee Fund for India [5]

21 global competitiveness index. Other emerging economies, such as China, Brazil, and Sri Lanka are ranked higher and boast of better basic infrastructure, as shown in the table below. Table 4: Global Competitiveness Report - Ranking for Infrastructure Country Rank Global Competitiveness Index Score (Out of 7) Hong Kong Singapore USA China Brazil Sri Lanka India Pakistan Source: Global Competitiveness Report , World Economic Forum Further, India is ranked 84 th in terms of road infrastructure, 19 th in terms of railroad, 70 th in terms of port infrastructure, 61 st in terms of quality of air transport infrastructure and 111 th in terms of electricity supply. Time overruns in the implementation of projects continue to be one of the main reasons for underachievement in many infrastructure sectors. According to the Ministry of Statistics and Programme Implementation (MOSPI) Flash Report for February 2014, of the 239 central-sector infrastructure projects costing INR 1000 crores and above, 99 are delayed with respect to the latest schedule and 11 have reported additional delays with respect to the date of completion reported in the previous month. Delays in land acquisition, municipal permission, supply of materials, award of work, operational issues, etc. continue to drag down the implementation of these projects and hinder efficient capital expenditure. Further, infrastructure projects are also subject to financing constraints since they are typically complex, are highly capital-intensive, and have long gestation periods. Infrastructure projects are characterized by non-recourse or limited recourse financing. Initial financing requirements form a large proportion of the total cost of the project, owing to the high capital requirements. In India, the sector is over-dependent on banks for its financing due to the absence of other alternative sources of long-term finance. Banks have been increasingly facing stress due to overexposure to the sector and increasing asset-liability mismatches. Resolving bottlenecks in infrastructure investments and associated financing issues is the need of the hour Macroeconomic outlook With the appointment of a new government which is widely touted to be progressive, the economy is expected to regain lost ground and move upwards. This growth is based on the expectations of modest revival in the global economy, improved balance of payments situations and better performance of the manufacturing sector, which registered a growth of only 2% per annum in the last two years. [6] TA-8279 IND: Preparing the Bond Guarantee Fund for India

22 Global economic activity is expected to strengthen in the current year on the back of some recovery in advanced economies. The World Bank has predicted a growth rate of above 1% for the Euro area as against the contraction witnessed in 2012 and The growth outlook for emerging Asian economies is generally benign with some grappling with inflation, structural bottlenecks, and external imbalances. The Union Budget has announced steps to raise private consumption growth as well as push growth in the manufacturing and construction/infrastructure sectors. While these steps would help in industrial recovery, weaker monsoons are likely to adversely impact growth in the short term. The Economic Survey of India (July, 2014) has predicted a growth rate of GDP at constant prices in the range of % in for the economy. This assumes the revival of growth in the industrial sector witnessed in April 2014 to continue for the rest of the year, the generally benign outlook on oil prices and the absence of pronounced destabilizing shocks. However, as per our estimates, it is expected that GDP will grow at a lower growth rate of 5.5% in the short term, given the likely deficit in monsoons in that could affect agriculture production. TA-8279 IND: Preparing the Bond Guarantee Fund for India [7]

23 3. Investments in India and Debt Requirement 3.1 Methodology to forecast investments and estimate debt requirement Debt requirement has been estimated separately for both infrastructure and non-infrastructure sectors in the future, based on the likely economic growth and fixed capital formation. The flowchart in the following figure gives a snapshot of the methodology utilized for estimating this requirement. Figure 4: Methodology to estimate debt requirement Source: CRIS analysis Detailed analysis and assumptions are present in the Excel document accompanying this report. 3.2 Recent trends in investments It is an understood fact that there is a positive correlation between the general overall growth in the economy and the investment rate. The investment rate (investment to GDP ratio) in India averaged 25% from to Between and , the rate of investment averaged 35.4 per cent, reaching the peak of 38.1 per cent in The rate of gross fixed capital formation, which accounts for the bulk of total investment, increased significantly from , peaked in , and generally declined thereafter. As per the provisional estimates for released by the CSO, the ratio of fixed capital formation to GDP in was 2.1 percentage points lower than in Table 5: Contribution of investment to GDP in percentage terms (at current market prices) Particulars to to to [8] TA-8279 IND: Preparing the Bond Guarantee Fund for India

24 Particulars to to to Total Investment Gross Fixed Capital Formation Public Sector NA Private Corporate Sector Household Sector NA Source: CSO Release May 30, 2014, RBI, EAC to PM, Ministry of Finance; May 31, 2014, NA-Not Available As can be seen from the previous table, the private sector (comprising private corporate sector and household sector) is the major source of investment in the country. Increase in investment by the private corporate sector explained the bulk of the increase in overall investment during the upswing phase between and NA Investment in infrastructure sector Investment in infrastructure sector Planning Commission estimates Investments in the infrastructure sector in India over the period (10 th & 11 th Five Year Plans) were to the tune of INR 32.6 lakh crores. A comparison between the actual investments in infrastructure during the 10 th and 11 th Five Year Plans and the projected investments during the 12 th Five Year Plan as given by the Planning Commission are given in the table below. Table 6: Comparison of infrastructure investments across Five Year Plans Planning Commission (INR crores) Particulars 10th Five Year Plan ( ) - Actual 11th Five Year Plan ( ) - Actual 12th Five Year Plan ( ) Projected GDP at market prices 1,65,98,847 3,36,04,450 6,81,63,208 Total investment 8,37,159 24,24,277 55,74,663 Total investment as percentage of GDP 5.04% 7.21% 8.18% Public investment 6,51,136 15,36,773 28,90,823 Private corporate sector investment Percentage share of private corporate sector investment in total investment 1,86,023 8,87,504 26,83,840 22% 37% 48% Source: Planning Commission The total investment in infrastructure, as a percentage of GDP, is projected to increase from around 5.08% during the 10 th Five Year Plan to 8.18% by the end of 12 th Five Year Plan. Percentage share of TA-8279 IND: Preparing the Bond Guarantee Fund for India [9]

25 private investment in the total investment is projected to increase from 25% during the 10 th Plan to 48% by the end of the 12 th Plan. The Union Budget has announced a slew of measures to boost infrastructure investments mainstreaming Public-Private Partnerships (PPPs) through the creation of 3P India, focusing on increasing investments in infrastructure through various projects and increasing funding to the sector amongst others; these measures are expected to boost the pace of growth in the infrastructure sector. Overall spending on infrastructure is budgeted to rise 24% over last fiscal to INR 2.1 lakh crores. While the budget provisions are positive, addressing on-the-ground issues like land acquisition, environmental clearances, inflation, and uncertainties in regulations etc. is key to reinvigorate the sector. Keeping these teething issues in mind it is believed that the total investment in infrastructure as a percentage of GDP might just fall short of the Planning Commission estimates for the 12 th Plan period, falling to an average of 7.3% of GDP for the same period. Contribution by private corporate sector in the overall investment has been growing year on year. While a slowdown in investment was seen in recent years, with the focus of the new government on increasing private sector participation it is expected that their contribution to investments would increase further Outlook on investments in key infrastructure segments In the following sub-section, details on investments in some of the key infrastructure segments are provided Power/Electricity The capacity-addition target for the 12 th Plan period is estimated at 88,537 MW, comprising 26,182 MW in the central sector, 15,530 MW in the state sector, and 46,825 MW in the private sector. In , a record capacity addition of 20,622.8 MW (20,121.8 MW in thermal and 501 MW in hydro) was achieved, as against the set target of 17,956.3 MW. The capacity addition target for the year was 18,432.3 MW. The government has also recently undertaken initiatives for augmenting power generation in India changes in the mega power policy for provisional mega power certified projects (February 2014), allocation of new coal blocks to NTPC, Independent Coal Regulatory Bill, automatic approval for foreign direct investment etc. It is expected that another 37,000 MW of capacity will be added by , out of which around 82% will be based on coal. Private sector is expected account for around 54% of the capacity additions Roads It is expected that roads and highways would see an investment of about INR 6.3 lakh crores between and Of this amount, the share of national highways would be 43%, followed by state roads and rural roads at 30% and 27%, respectively. Going forward, it is expected that the highway projects under the National Highways Development Programme (NHDP) would pick up, with the main focus on Phase III, Phase IV and Phase V projects. A total length of 21,787 km has been completed till March 2014 under various phases of the NHDP. The Union Budget has announced the provision of INR 14,400 crores towards Pradhan Mantri Gram Sadak Yojana Scheme and INR crores for national highways and state roads. Further, it has set aside INR 500 crores to initiate work on expressways. [10] TA-8279 IND: Preparing the Bond Guarantee Fund for India

26 Railways The Indian Railways is currently working at close to 100% capacity utilization, highlighting the need to augment its freight-carrying capacity in the near future. Keeping these constraints in mind, policies have been developed to focus on the creation of additional capacity, modernization of the existing network, improvement in asset utilization and productivity, and modernization of rolling stock and maintenance practices to bring about overall improvement in the quality of railway services, while augmenting profitability and internal resource generation. The 12th Five Year Plan envisages an investment of over INR 5 lakh crores in Railways. It also envisages a larger role for PPP in projects like high-speed rail corridors and direct freight corridors for effective project execution. The Union Budget plans to introduce a bullet train on the Mumbai-Ahmedabad route and create a diamond quadrilateral for high-speed trains. It further provides for permitting foreign direct investment in railway projects Ports Over INR 55,000 crores has been invested in the ports sector, in the last five years. More than 80% of these investments are estimated to have been made by the private sector, majority towards non-major ports, whereas public sector contribution in the investments has remained limited to maintenance of draft and building of allied infrastructure like roads at major ports. Going forward, it is expected that close to INR 60,000 crores will be invested in the ports sector in the coming years. Based on the present status of ongoing/announced projects, it is likely that a higher proportion of these investments would flow towards projects at major ports Debt requirement in infrastructure sector Planning Commission estimates For the 12 th Five Year Plan, the Planning Commission has estimated an overall debt requirement of INR lakh crores in the infrastructure sector, based on the assumption that 50% of the total investment requirements are likely to be met by debt sources. The year-wise split for projected debt requirement is presented in the table below. Table 7: Planning Commission estimates for private corporate sector debt requirement in the infrastructure sector during 12 th Five Year Plan (INR crores) Particulars Total Twelfth Plan Total projected investment Debt requirement for private corporate sector 7,51,012 8,87,454 10,61,316 12,85,573 15,89,308 55,74,663 2,05,318 2,63,723 3,38,413 4,47,172 6,03,923 18,58,549 Source: Planning Commission CRIS projections for investment and debt requirement in infrastructure sector Forecast for overall investment in infrastructure sectors As previously mentioned it is estimated that the overall investment in infrastructure for the 12 th Five Year Plan might just fall short of the Planning Commission estimates, achieving an average of 7.2% of GDP. Considering the positive steps taken by the new government, we have assumed that the TA-8279 IND: Preparing the Bond Guarantee Fund for India [11]

27 investments in infrastructure will grow in steps to average around 8.05% of GDP in the 10 years between and This estimate is in line with the trends observed in emerging economies such as Indonesia, South Africa, China and Mexico. As seen in following figure, forecasted investments for developing countries are in the range of 7-8% in the short term. Figure 5: Investment in Infrastructure (% of GDP) for other emerging economies F Indonesia Mexico South Africa China Source: Various Contribution by private corporate sector in overall forecasted investment In emerging economies such as South Africa and Indonesia, private sector contribution to the infrastructure sector has escalated from 20-30% in the previous decade to over 50% currently. Private investment in infrastructure in South Africa is currently over 60% while Indonesia is poised to witness a 70% share in private investments in A similar trend has been witnessed in developed countries, such as Canada, Australia, USA and Britain, where public sector investment in infrastructure has gradually declined. Also, the role of governments in infrastructure provision has generally shifted in the recent decades, with governments reducing their role in economic management that was previously conducted through their ownership of infrastructure. Currently, private infrastructure investment in the USA is five times larger than the total non-defence government investment while in the UK, it contributes to over 80% of the total infrastructure investments. Hence, it is expected that a similar trend of rising private sector investments in infrastructure will be observed in the Indian economy. This is further backed by an increasing focus of the new government to involve private corporate sector in infrastructure investments through PPP initiatives. It is estimated that their contribution will touch 54% in the 12 th Five Year Plan. While it is expected that this figure could be as high as 80% in the next 10 years, a more conservative estimate of 70% in the 10 years between and has been considered in our analysis. The remaining share in infrastructure investments has been allocated to public sector undertakings. Total debt requirements of this sector have been estimated by removing the extent of budgetary support in the form of grants. Budgetary support to the infrastructure sector has remained constant over the past 3 five year plans, at 2.2%. [12] TA-8279 IND: Preparing the Bond Guarantee Fund for India

28 Forecast for debt requirement in infrastructure sector adjusted for tenure and rating Considering the long-term nature of these investments it is estimated that they will be funded by longterm debt this is assumed at current levels of 70% 4 of overall investments. Moreover, it is assumed that 85% 5 of this total debt requirement would pertain to entities rated less than AA category for the private sector and 30% 6 for the public sector. Table 8: Forecast for investment and debt requirement in infrastructure sector (INR crores) Particulars to to Total projected investment 71,45, ,50,732 (% of GDP) 7.70% 8.40% Contribution by private corporate sector 48,35,005 96,25,512 (% of projected investment) 67% 70% Contribution by PSUs 2,74,939 5,02,744 Debt requirement Long term and by entities rated less than AA 29,34,565 58,32,756 Source: CRIS analysis Investment in non-infrastructure sector Investments in the non-infrastructure sectors have grown at a CAGR of 18% in the last decade. The manufacturing and business services segments (real estate) constitute dominate investments in the non-infrastructure sector, constituting approximately 70% of the total investments. Estimated investment in the non-infrastructure sectors over the 11 th & 12 th Five Year Plans and its split between the public and private sectors has been highlighted in the table below. The private corporate sector has contributed 29% of investments during the 11 th Five Year Plan. Following the decline in overall investments due to the economic slowdown, this share is expected to fall to an average of 25% in the 12 th Five Year Plan. Table 9: Investments in non-infrastructure sectors Particulars 11th Five Year Plan ( ) - Actual 12th Five Year Plan ( ) Estimated 4 Arrived at after Prowess analysis of outstanding liabilities of entities in the infrastructure sector 5 Arrived at after Prowess analysis of outstanding credit rating data 6 Arrived at after Prowess analysis of outstanding credit rating data TA-8279 IND: Preparing the Bond Guarantee Fund for India [13]

29 Particulars 11th Five Year Plan ( ) - Actual 12th Five Year Plan ( ) Estimated Total Investment 46,93,693 1,07,86,678 Public Investment 6,87,272 15,78,372 Private Corporate Sector Investment Percentage share of private corporate investment in total investment 13,62,532 27,21,235 29% 25% Source: Ministry of Statistics and Programme Implementation, Govt. of India, All figures in INR crores Outlook on investments in non-infrastructure sectors Going forward, it is expected that the manufacturing sector will continue to constitute for a majority of total investments among non-infrastructure sectors Manufacturing The manufacturing sector GDP declined by 0.7% in due to the deceleration in investment particularly by the private corporate sector during and , a trend that appears to be following trends in overall investments. Several other domestic and external factors such as higher interest, infrastructure bottlenecks, inflationary pressure leading to rising input costs, and drop in domestic and exports demand, have together contributed to the recent slowdown in the manufacturing sector. Hence, it seems highly unlikely that projected 12 th Five Year Plan growth targets of 10% for the manufacturing sector will be met in the near term. However, the manufacturing sector has recently shown signs of recovery, with overall activity expanding for the fifth consecutive month in March 2014 and the latest export figures being the highest since April The HSBC India Manufacturing Purchasing Managers Index (PMI) increased marginally from 51.3 in April to 51.4 in May, This further indicates some improvement in manufacturing activities and domestic and exports orders. Hence, with improvement expected in the overall macroeconomic and policy environment, manufacturing industry is expected to revive and witness higher growth and investments in the next two to five years Real estate The growth of the real estate sector is reinforced by the massive growth expected in the Indian real estate market, which is recognized as one of the fastest growing markets in the world. As per CII, the market is expected to reach a size of approximately INR 1.5 lakh crores by 2020, from its current size of INR 24,000 crores. This robust growth of the sector is a result of growing demand for retail and office space along with residential properties, especially in the country s seven major cities Delhi- NCR, Mumbai, Bengaluru, Chennai, Pune, Hyderabad and Kolkata. This sector is also supported by a favourable policy environment with a provision of 100% FDI and ease in obtaining housing finance. Benefitting from the growth in the real estate market, ancillary real estate services such as property management companies are poised for growth in the short and long term. [14] TA-8279 IND: Preparing the Bond Guarantee Fund for India

30 CRIS projections for investment and debt requirement in non-infrastructure sectors Forecast for total private corporate investment As per our estimates, private corporate investment in both infrastructure and non-infrastructure sectors has historically grown from 5.3% in to 10% currently. Following these trends, private corporate investment is expected to increase in the future, given the limited investment ability of the public sector due to the fiscal deficit target and an overall impetus to privatization in the economy. Hence, private corporate gross fixed capital formation as a percentage of GDP is expected to rise by another five percentage points over the next year, rising to 15% in Forecast for total private corporate investment in the non-infrastructure sector The estimates for private corporate investment in the non-infrastructure sector have been arrived at by calculating the balancing figure for overall private corporate investment. It has been assumed that the balance of private corporate investments to infrastructure sector will be invested in the noninfrastructure sector Forecast for debt requirement in infrastructure sector adjusted for tenure and rating It is expected that these investments for fixed capital formation will be funded by long-term debt this is assumed at current levels of 60% 7 of overall investments. Moreover, it is assumed that 52% 8 of this total debt requirement would pertain to entities rated less than AA category in the private sector and 15% 9 in the public sector. Table 10: Estimated Private Debt Requirement in non-infrastructure sector Particulars to to Investment by Private Corporate Sector 61,94, ,87,733 Investment by PSUs 25,63,457 53,69,724 Debt requirement Long term and by entities rated less than AA 21,63,424 46,29,048 Source: CRIS analysis 7 Arrived at after Prowess analysis of outstanding liabilities of entities in the non-infrastructure sector 8 Arrived at after Prowess analysis of outstanding credit rating data 9 Arrived at after Prowess analysis of outstanding credit rating data TA-8279 IND: Preparing the Bond Guarantee Fund for India [15]

31 4. Financial Sector in India and Debt Supply 4.1 Overview of the Indian financial sector India has one of the better financial market systems in the world. The World Economic Forum s Global Competitiveness Report ranks India 45 th out of 128 countries in availability of financial services and 38 th in both ease of access to loans and affordability of financial services, outperforming most of its peers in the BRICS quintet such as Brazil, China, and Russia. However, there exists a lack of long-term finance for long gestation products, especially physical infrastructure, which forces commercial banks to excessively stretch their asset liability mismatch since they mostly hold short-term liabilities. This is a unique model when compared to other countries where such long-term infrastructure finance is driven by the development finance institutions or more pertinently, the corporate bond market. Figure 6: Mode of financing of infrastructure investments Source: CRIS analysis The bond market in India is very small in comparison to not only developed markets, but also some of the emerging market economies in Asia such as Malaysia, Thailand and Singapore. As seen in the following graph outstanding corporate bonds are close to 125% of GDP in US where the corporate debt market is most developed; around 78% in Hong Kong and close to 20% in Thailand. In comparison, size of outstanding corporate bonds as a percentage of GDP in India is around 15%. [16] TA-8279 IND: Preparing the Bond Guarantee Fund for India

32 Figure 7: Corporate bonds outstanding as a percentage of GDP, 2013 Replaced China with Thailand 126% 78% 47% 20% 15% Thailand Hong Kong Singapore USA India Source: Deutsche Bank Research, World Bank, Prime Database. *Data is for Sources of debt financing and estimation of debt supply As mentioned earlier, historically, debt financing in India has been the stronghold of commercial banks. Other key sources of debt financing are NBFCs, ECBs, bond investors such as insurance companies, mutual funds, pension funds and provident funds amongst others. This section elucidates the debt supply characteristics of each of these sources, and their historical contribution and likely contribution to both infrastructure and non-infrastructure sectors in the future Banks Figure 8: Methodology adopted for estimating debt supply from banks Source: CRIS analysis Banks as financial intermediaries collect deposits from public and channel these deposits into lending activities. Historically, bank credit has constituted a significant portion of the total debt supply to infrastructure and non-infrastructure sectors. Outstanding non-food credit disbursed by banks has grown at a CAGR of 22.9% over the past decade; however, in the backdrop of general economic slowdown, the sector has witnessed a slowdown in recent years. TA-8279 IND: Preparing the Bond Guarantee Fund for India [17]

33 Sectoral deployment of credit by all commercial banks in India for the past four years is presented in the table below. Table 11: Outstanding credit by scheduled commercial banks in India (INR crores) Particulars Average Share (%) Non-food credit bank 36,87,087 43,71,400 49,64,200 55,66, % Agriculture 4,83,466 5,48,400 5,89,900 6,69,438 12% Industry 16,13,184 19,37,400 22,30,200 25,22,876 45% Of which infrastructure 5,21,400 6,29,990 7,29,721 8,39,780 15% Services 8,90,781 10,16,600 11,48,600 13,37,033 24% Personal loans 6,99,657 7,87,300 9,00,900 10,36,661 18% Source: RBI Sectoral shares in the credit flow have generally remained stable with the industry being the dominant sector accounting for around 45 per cent of the total credit disbursed by the banks Sectoral deployment of credit to infrastructure sector Historically, banks have accounted for the largest share of infrastructure investments. However, with the recent slump in economic growth and rising issues in the infrastructure sector, growth of bank credit to the infrastructure sector has slowed down. Incremental bank credit to infrastructure as a percentage of incremental overall bank credit to infrastructure has decreased from 25% in to 18% currently. As seen in the following table, incremental credit to the infrastructure sector witnessed a slight decline in Table 12: Incremental flow of bank credit to infrastructure (INR crores) Particulars Overall Infrastructure 64,658 1,09,895 1,41,513 1,08,591 99,730 1,10,059 Power 29,380 63,394 81,355 63,507 84,923 72,497 Roads 12,530 26,509 19,000 19,998 20,371 26,087 Telecom 12,283 9,036 41, ,230 2,628 Others 10,679 10,956 5,307 22, ,846 Source: RBI Banks have witnessed a particularly high increase in non-performing (NPAs) for infrastructure sector with NPAs as a percentage of credit advanced increasing from 3.23% as of March 2011 to 8.22% as [18] TA-8279 IND: Preparing the Bond Guarantee Fund for India

34 of March As of March 31, 2014, banks had restructured INR 50,239 crores of infrastructure loans 21% of the total loans recast in the last fiscal year under the corporate debt restructuring (CDR) mechanism Sectoral deployment of credit to non-infrastructure sector As is the case of the infrastructure sector, banks have historically provided majority of total credit to the non-infrastructure sector. Incremental non-food gross credit to non-infrastructure sectors has increased at a CAGR of 14% in the past decade. The manufacturing sector and it sub-segments constitute a major portion of credit flow in the noninfrastructure sector. In view of the ongoing industrial slow down, various segments of this sector have witnessed moderation in credit flow from banks in the recent years. The outstanding credit to manufacturing sector and its sub-segments is provided in the table below. Table 13: Outstanding bank credit to non-infrastructure sector (INR crores) Industry Food Processing 76,646 90,622 1,09,200 1,33,879 1,66,577 Textiles 1,21,375 1,46,103 1,59,414 1,83,536 2,03,998 Wood, Paper, Leather Products 29,677 33,657 38,758 44,609 52,756 Petroleum, Coal Products & Nuclear Fuels 78,579 50,990 61,175 64,327 63,488 Chemicals & Chemical Products 85,713 1,08,852 1,26,993 1,59,244 1,67,670 Rubber, Plastic & their Products 15,617 25,908 29,904 31,217 36,822 Glass & Glassware 4,831 5,478 6,269 7,448 8,711 Cement & Cement Products 24,722 29,615 36,910 45,858 54,116 Basic Metal & Metal Product 1,62,929 2,14,448 2,61,809 3,14,116 3,61,969 All Engineering 73,821 93,322 1,13,010 1,28,447 1,45,573 Vehicles, Vehicle Parts & Transport Equipment 38,780 45,793 51,781 58,863 67,738 Gems & Jewellery 31,751 40,012 51,326 61,144 71,968 Other Industries 1,24,821 1,36,046 1,79,724 1,80,968 1,84,970 Industries Total 8,69,262 10,20,846 12,26,273 14,13,656 15,86,356 Year on Year Growth 17% 20% 15% 12% Source: RBI As seen in the table, individual sector-level credit absorption in petroleum, chemicals and chemical products, basic metals, transport, and all engineering sectors showed lower growth in gross bank credit flow during as compared to the previous years, mainly due to the slowdown in these sectors. TA-8279 IND: Preparing the Bond Guarantee Fund for India [19]

35 Challenges faced by banks Increasing stressed assets Asset quality in the banking system has deteriorated in the post-crisis years with the growth in stressed assets outpacing credit growth in the banking system in recent years. In 2013 itself, growth in stressed assets increased by 40.2% against a credit growth of 15.1%. Amongst banks groups, public sector banks (PSBs) had the highest level of stress in terms of NPAs and restructured advances (RAs). Figure 9: Banking sector GNPA and RA (%) GNPA + RA% GNPA% NNPA% Source: ASSOCHAM India, PwC India Growing NPAs in banks RBI in its Financial Stability Report, June 2014 has identified five sectors infrastructure, iron and steel, textiles, aviation, and mining as the stressed sectors. The share of these five stressed subsectors to the total advances of SCBs is around 24%. PSBs have high exposures to the industry sector in general and to such stressed sectors in particular. Increase in NPAs of banks is mainly accounted for by switchover to system-based identification of NPAs by PSBs, slowdown of economic growth, and aggressive lending by banks in the past, especially during times of high growth Asset-Liability mismatches Growing divergence in the tenors of loans and deposits has resulted in rising asset-liability mismatches in the Indian banking system. Majority of the funds with Indian banks are savings bank deposits and term deposits, essentially short term, with tenures of six months to five years. These deposits are increasingly being used to finance long-term lending, having tenures of 10 to 15 years. Also, as per RBI data, it is seen that banks, especially those in the public sector, have experienced a shift in their deposits towards the shorter end of the maturity spectrum, while loans and investments have moved towards the longer term. Deposits maturing within one year for government banks increased to almost 50% of the total deposits in 2014, up from 33% in 2002 while the cumulative gap to fund one-year deposits increased to 15.7% of assets at end-march 2014 from below 4% in This gap increases the likelihood of a liquidity risk wherein there exists a shortage of ready collateral that could be used to repo with RBI in case of a liquidity squeeze. [20] TA-8279 IND: Preparing the Bond Guarantee Fund for India

36 For many government banks, funding gaps are unsustainable in the long term since long-term loan products are likely to maintain their share in banks loan portfolios, particularly as an economic revival may require continued bank funding for longer tenor loans, especially in the infrastructure sector. With this background, RBI recently issued guidelines 10 to banks specifying operational norms for flexible structuring and refinancing of new project loans for the infrastructure sector as well as allowing banks to issue long-term infrastructure bonds. Key aspects of these guidelines include the following: No CRR/SLR requirement on the issue of such bonds. Also exemption from priority sector lending targets. Bonds to be denominated in INR with a minimum maturity of seven years. Around 16% of the existing book (less amortization during FY 2015) as well as incremental disbursements to long-term projects in infrastructure sub-sectors and affordable housing eligible to be funded out of these bonds. Bonds may be issued with fixed/floating rate of interest. Raising such long-term resources is expected to help banks address their asset-liability mismatches Sectoral exposure There is a significant dependence on the bank loan market for funding the infrastructure sector. The infrastructure portfolio of banks has been the fastest growing segment (31.2% CAGR from to ) and its share to total loans is the highest across all sectors. Infrastructure bank loans as a percentage of total bank loans have increased from 9% in to 15% in Though RBI does not mandate a sectoral exposure limit, banks tend to fix their internal exposure limits so that exposures are evenly spread across sectors and the risk of over-exposure to a single sector is minimized. Banks typically have an internal sectoral exposure limit of around 15%. As can be seen from the table below, the banking system has reached this limit for the infrastructure sector. Table 14: Overall and incremental credit by scheduled commercial banks Particulars Bank credit- Overall (A) Bank credit- Infrastructure (B) % of infrastructure lending (B/A) Incremental bank credit- Overall (C) Incremental bank credit- 22,04,802 26,01,823 30,40,007 36,67,354 42,89,744 48,69,600 2,05,334 2,69,992 3,79,887 5,21,400 6,30,000 7,29, % 10.4% 12.5% 14.2% 14.7% 15.0% 4,09,444 3,97,021 4,38,184 6,27,347 6,22,390 5,79,856 62,346 64,658 1,09,895 1,41,513 1,08,600 99, RBI/ /127 Issue of long term bonds by banks Financing of infrastructure and affordable housing TA-8279 IND: Preparing the Bond Guarantee Fund for India [21]

37 Particulars Infrastructure (D) % of incremental lending to infrastructure sector (D/C) 15.2% 16.3% 25.1% 22.6% 17.4% 17.2% Source: RBI Group exposure In addition to sectoral limits, banks also face the risk of reaching limits pertaining to group exposure. RBI mandates the exposure ceiling limit at 40% of the capital funds in case of a borrower group. This figure can go up by another 10% in case additional exposure is on account of extension of credit to infrastructure projects. A further 5% exposure (for a total exposure of 55%) is allowed subject to the borrower consenting to the banks making appropriate disclosures in their annual reports. The capital funds for the purpose comprise Tier-I and Tier-II capital as defined under capital adequacy standards. The following figure shows the exposure of the banking system to some of the large business groups, as on March Though it is not evident whether the banking system as a whole is reaching its group exposure limits or not, there s a possibility that individual banks, with which such groups foster long-term relationships, face the risk of reaching such limits. In such a scenario, these groups would experience challenges in obtaining bank funding and would welcome viable alternative sources of funding. Figure 10: Exposure of the banking system to some of the large business groups (INR 000 crores) Reliance Industries Essar Group Jaypee Group Tata Group* Source: Annual reports, *Tata Group exposure as in 2010 [22] TA-8279 IND: Preparing the Bond Guarantee Fund for India

38 CRIS projections for debt supply by banks Infrastructure sector Banks are expected to benefit from the recent guidelines issued by RBI allowing banks to issue longterm bonds to finance infrastructure and affordable housing. Interactions with stakeholders reveal that this initiative would help banks decrease their effective cost of borrowing by bps thereby translating into a pricing advantage. While this is assumed to increase the overall flow of bank credit to infrastructure sector, as well as augment the existing supply of high rated bonds in the market, this initiative will not help solve the underlying issues of the bond market. For estimating debt supply to the infrastructure, we expect gross bank credit to infrastructure as a percentage of the overall non-food bank credit to increase steadily from the current 15% to 20% in the next 10 years; while the overall gross non-food bank credit grows at a CAGR of around 16%. As per RBI data, 28% of the total outstanding debt is long-term in nature or greater than 3 years. While information specific to infrastructure is not published, interactions with stakeholders reveal that this figure could be higher by 5 percentage points for infrastructure. We have therefore assumed 33% of the total debt in infrastructure to be long-term in nature. With the likelihood of high dependency on banks for long-term loans to continue due to the economic revival, this share is unlikely to reduce in the future. A further analysis of credit ratings of companies operating in the infrastructure space revealed that 38% (by value) of the total long-term bank borrowings are rated below the AA grade. This ratio has also been assumed to remain constant in the future. This is a conservative assumption since most of the highly rated issuers would already be having access to bank loans and the increase in the borrower base of banks in future is predominantly expected to be from relatively lower rated entities. The following table provides our estimates for long-term debt supply to the infrastructure sector (for credit ratings less than AA) from banks. Table 15: Forecast of debt supply from banks to infrastructure sector (INR crores) Particulars to to Gross credit 88,54,421 2,14,17,328 Gross credit Long term and for entities rated less than AA Incremental credit Long term and for entities rated less than AA 11,10,344 26,85,733 1,79,864 4,33,445 Source: CRIS analysis Non-infrastructure sector The Union Budget has announced steps such as extended excise duty cuts in auto, and a thrust to expansion of labour intensive sectors such as textiles, tourism, food processing, and small and medium enterprises; the manufacturing sector is expected to revive in the medium term. In order to estimate the supply of debt to non-infrastructure sectors in the future, credit inflow to the infrastructure sector along with credit disbursed to personal loans historically has been removed from forecasted total non-food gross credit. Further, based on historical data pertaining to long term loans in the non-infrastructure sector, it has been calculated that 28% of total loans disbursed to this sector TA-8279 IND: Preparing the Bond Guarantee Fund for India [23]

39 are of a maturity greater than three years. Since characteristics of debt required within the sub-sectors of the non-infrastructure segment vary greatly, this share has been assumed to remain constant throughout the duration of the forecast. A detailed analysis of credit ratings of companies operating in the manufacturing and services sector revealed that approximately 47% (by value) of the long term instruments are rated below AA grade. Based on the assumption that this share will continue to hold going forward, we have estimated a total debt supply to the non-infrastructure sector. Table 16: Forecast of debt supply from banks to non-infrastructure sector (INR crores) Particulars to to Gross credit 266,94, ,60,306 Gross credit Long term and for entities rated less than AA Incremental credit Long term and for entities rated less than AA 7,02,600 74,30,176 4,87,091 10,34,419 Source: CRIS analysis Non-banking finance companies (NBFCs) Figure 11: Methodology adopted for estimating debt supply from NBFCs Source: CRIS analysis NBFCs as a whole accounted for 13% of financial assets as on March 31, With the growing importance assigned to financial inclusion, NBFCs have been regarded as important financial intermediaries particularly for the small-scale and retail sectors. The following table depicts total loans and advances by two broad categories of NBFCs, namely deposit taking NBFCs (NBFC-D) and nondeposit taking NBFCs (NBFC-ND). Table 17: Loans and advances by NBFCs (INR crores) Total Loans & Advances NBFC-D 71,119 77,901 84,100 91,800 [24] TA-8279 IND: Preparing the Bond Guarantee Fund for India

40 Total Loans & Advances NBFC-ND-SI* 3,48,517 4,58,173 6,14,300 7,49,700 Total 4,19,636 5,36,074 6,98,400 8,41,500 Incremental 75,070 1,16,438 1,62,326 1,43,100 *-Total credit from NBFC-ND is believed to be minimal. Source: RBI Deployment of credit to infrastructure sector NBFCs focused on infrastructure or Infrastructure Finance Companies (NBFC-IFCs) form an important source of infrastructure debt financing. The table below gives the summary of loans and advances to the infrastructure sector by a few leading NBFC-IFCs. Table 18: Loans and advances by NBFC-IFCs (INR crores) Total Loans & Advances Power Finance Corporation Ltd. (PFC) Rural Electrification Corporation Ltd. (REC) Infrastructure Development Finance Company Ltd. (IDFC) Industrial Finance Corporation of India (IFCI) SREI Infrastructure Finance Ltd. L&T Infrastructure Finance Company Ltd ,178 1,00,054 1,30,372 1,60,623 66,089 81,744 1,01,412 1,27,208 21,008 25,098 37,780 47,785 9,488 12,064 16,513 15,524 1,198 3,565 4,988 8,828 2,260 4,261 6,578 9,957 Tata Capital Limited 2,157 2,859 4,273 5,830 Total 1,60,926 2,08,274 2,71,601 3,45,863 Incremental 30,101 47,348 63,328 74,262 Source: Annual Reports The NBFC-IFCs have funded INR 5.5 lakh crores of infrastructure loans as of December 31, 2013 and are expected to contribute another INR 3.1 lakh crores over the 12 th Plan during FY However, current challenges in the operating environment have partly reduced the risk appetite of such NBFC- IFCs. While lack of long term funds was always a challenge for NBFC-IFCs (barring public sector TA-8279 IND: Preparing the Bond Guarantee Fund for India [25]

41 NBFC-IFCs), large level of vulnerable accounts, increase in interest costs as well as rupee depreciation pose additional challenges for NBFC-IFCs Deployment of credit to non-infrastructure sector NBFC-IFCs are also present in construction equipment finance. They have gained market share at the expense of banks through focused lending, higher penetration and increased resource raising ability Challenges faced by NBFCs Asset Quality of NBFC-IFCs Similar to banks, gross NPAs of NBFC-IFCs witnessed a rising trend, increasing to 1.7% as of December 2013, from 1.5% as of March Further, the underlying stress on the infrastructure loans portfolio was clearly evident from the fact that the NBFC-IFCs restructured loans as a proportion of advances stood at 17% as of March Within NBFC-IFCs, restructuring of two state electricity boards (SEBs) across PFC and REC accounted for about 3/4 th of the total restructured book of the NBFC-IFCs. However, it is expected that certain policy level changes in the recent past such as restructuring of short-term liabilities of state distribution companies (discoms), pass through of imported coal cost in case of domestic coal based power projects and deferment of premium payable to NHAI in case of road projects could improve the liquidity profile of some players active in the segment and in turn could reduce portfolio vulnerability for the NBFC-IFCs CRIS projections for debt supply by NBFCs Infrastructure sector NBFC-IFCs will continue to remain a major source of financing to the infrastructure sector. However, it is to be noted that IDFC, one of the largest private sector NBFC-IFCs has been recently awarded a bank license. Interactions reveal that it is expected to commence its banking operations in 18 months. Moreover, growth of credit by NBFC-IFCs will be dependent on its continued access to bank finance/long-term funds and resolution of issues in the infrastructure sector, in general. Based on secondary research and interactions, it is assumed that incremental credit by NBFC-IFCs will grow between 16-20%; of which 70% is assumed to be long-term in nature. Prowess analysis reveals that 80% of this long-term debt is extended to entities with credit rating less than AA. Based on these assumptions, debt supply to the infrastructure sector has been estimated. Table 19: Forecast of debt supply from NBFC-IFCs to infrastructure sector (INR crores) Particulars to to Gross credit 49,93,248 1,15,63,757 Incremental Long term and for entities rated less than AA 3,37,373 7,17,677 [26] TA-8279 IND: Preparing the Bond Guarantee Fund for India

42 Non-infrastructure sector It is likely that credit to the non-infrastructure sector will be extended by NBFC-IFCs. RBI guidelines for NBFC-IFCs mandate a minimum of 75% of total assets to be invested in the infrastructure sector. The remaining 25% can be invested in the non-infrastructure sector. An analysis of current financials of NBFC-IFCs revealed that on an average, 75% of total assets of these NBFCs is invested in the infrastructure sector, while the remaining pertains to long term loans of the non-infrastructure sector. Incremental estimates have been provided in table 9 below. In case of other NBFCs which are not NBFC-IFCs, their exposure to the private corporate sector is at a minimum. Moreover, the tenure of such credit is typically less than 3 years. Therefore they have not been considered in the analysis. Table 9: Forecast of debt supply from NBFC-IFCs to non-infrastructure sector (INR crores) Particulars to to Gross credit to non-infrastructure sector 12,48,312 28,90,939 Incremental Long term and for entities rated less than AA to noninfrastructure sector by NBFC-IFCs 98,400 2,09,322 Source: CRIS Analysis External commercial borrowings (ECBs) Figure 12: Methodology adopted for estimating debt supply from ECBs Source: CRIS Analysis In recent times, the government has undertaken several initiatives to encourage ECBs to finance both infrastructure and non-infrastructure sectors. The important steps taken to liberalize the ECB policy include: Relaxing ECB norms for firms in manufacturing, hospitals, infrastructure, hotels, and software sector to raise foreign capital from foreign/indirect equity holders without RBI s approval. TA-8279 IND: Preparing the Bond Guarantee Fund for India [27]

43 Enhancing the limit for refinancing INR loans through ECBs from 25% to 40% for Indian companies in the power sector Allowing ECB for capital expenditure on the maintenance and operation of toll systems for roads and highways so long as they are a part of the original project subject to certain conditions, and also for low cost housing projects. Reducing the withholding tax from 20% to 5% for a period of three years (July June 2015) on interest payments on ECBs Introducing a new ECB scheme of USD 10 billion for companies in the manufacturing and infrastructure sectors Permitting the Small Industries Development Bank of India (SIDBI) as an eligible borrower for accessing ECB for on-lending to the MSME sector subject to certain conditions Permitting the National Housing Bank (NHB)/ housing finance companies to avail themselves of ECBs for financing prospective owners of low cost / affordable housing units In light of the boosts provided to ECBs, the overall inflow has increased at a CAGR of over 23.6% in the past 5 years. The following table depicts the total inflow of ECBs during this period. Table 20: Total ECB Inflow (INR crores) Particulars Gross inflow 2,87,320 3,32,412 4,02,579 5,02,972 6,70,956 Incremental - 45,091 70,167 1,00,393 1,67,983 Source: RBI Flow of ECBs to infrastructure sector ECBs have traditionally not been a significant source of funding. However since , IFCs are permitted to source funds through ECBs under the automatic route. As per the data available with RBI, the table below gives the flow of ECBs to infrastructure in the past few years. Table 21: Flow of ECBs to infrastructure sector (INR crores) Particulars Incremental 25,937 25,258 25,258 46,799 Source: RBI Flow of ECBs to non-infrastructure sector Similar to ECB inflow to the infrastructure sector, historical trends in ECB inflow to non-infrastructure sectors has displayed an arbitrary trend. The table below gives the details of some of the companies in the non-infrastructure sector that have borrowed overseas in the first three months of the calendar year Table 22: Data for ECBs to non-infrastructure sector for the period January-April 2014 Borrower Amount (USD) Sector [28] TA-8279 IND: Preparing the Bond Guarantee Fund for India

44 Borrower Amount (USD) Sector Pran Beverages (India) Private Limited Parag Milk Foods Private Limited 4,000,000 Food & Beverages 4,530,000 Food & Beverages Honda Cars India Limited 20,000,000 Automobile Manufacturing General Motors India Private Limited 244,498,778 Automobile Manufacturing Ford India Private Limited 113,756,890 Automobile Manufacturing Aurobindo Pharma Limited 30,000,000 Pharmaceuticals Source: RBI CRIS projections for debt supply through ECBs Infrastructure sector With recent changes made in the policy regime relaxing norms for ECB to the infrastructure sector, it is likely that ECB inflow will form an important component of debt funding to the sector in the future. For the purpose of forecast, it has been assumed that the total inflow of ECBs will continue to grow as it has been in the past decade, at a CAGR of 16% in the long term. Inflow to the infrastructure sector is assumed to continue at a historical median of 20% of the overall ECB inflow. Historical analysis reveals that 93% of these borrowings are long term in nature. This is assumed to be the case going forward. Also, it is assumed that 58% of ECBs would be raised by entities rated less than AA 11. Based on these assumptions a total debt supply through ECBs is arrived at. Table 23: Forecast of debt supply through ECBs to infrastructure sector (INR crores) Particulars to to Incremental Long term and for entities rated less than AA 2,78,615 5,78,112 Source: CRIS analysis Non-infrastructure sector Going forward, it is expected that out of the total ECB inflow in the economy, the remainder after ECB inflow to the infrastructure sector will flow into the non-infrastructure sectors. Also, it is assumed that 34% 12 of ECBs would be raised by entities rated less than AA. 11 Prowess analysis of all entities in infrastructure sector 12 Prowess analysis of all entities in non-infrastructure sector TA-8279 IND: Preparing the Bond Guarantee Fund for India [29]

45 Table 24: Forecast of debt supply through ECBs to non-infrastructure sector (INR crores) Particulars to to Incremental Long term and for entities rated less than AA 3,91,282 8,09,931 Source: CRIS analysis Insurance sector Figure 13: Methodology adopted for estimating debt supply from insurance companies Source: CRIS Analysis Since the liberalization of the insurance sector in 2000, the number of participants in the industry has gone up from 7 insurers (including the Life Insurance Corporation of India [LIC]), 4 public-sector general insurers, 1 specialized insurer, and the General Insurance Corporation (GIC) as the national re-insurer in 2000, to 53 insurers as on March 31, 2014 operating in the life, non-life, and re-insurance segments. The Union Budget has proposed to increase the foreign direct investment limit to 49% from the current level of 26% in the insurance sector. This is expected to give a boost to the insurance industry by bringing in more foreign capital thus helping companies expand their operations at a rapid pace. With new guidelines for the life insurance segments issued in January 2014, as many as 500 new insurance schemes are lined up to hit the market in The total accumulated assets under management of the insurance sector have increased at a CAGR of 19.5% between and , with the life insurance segment contributing the majority (over 90% incrementally). As on March 31, 2013, this amount was over INR 18 lakh crores. However, the insurance sector being essentially risk-averse in nature from an investment perspective, a significant proportion of this AUM has historically been invested in central and state government securities, the share being 57% and 40% in the life and non-life segments respectively. Insurance companies with their large corpus of long-term funds are an ideal source of funds for the infrastructure sector. However in India, this segment has not played a significant role in financing infrastructure projects. In terms of the infrastructure sector investments made by insurance companies (both life and nonlife), at the end of 2013, LIC had the largest share at around 76%. The following table highlights the investments made by the insurance companies in the infrastructure sector over the last few years. [30] TA-8279 IND: Preparing the Bond Guarantee Fund for India

46 Table 25: Incremental flow of credit from insurance companies into infrastructure sector (INR crores) Particulars LIC 16,925 1,500 4,041 17,467 Other Life Insurers 2,075 2,005 4,098 4,090 Non-Life Insurers 1,393 1, ,428 Total 20,394 5,349 8,398 24,986 Source: IRDA Annual Reports Challenges faced by the insurance sector As per the norms set by the Insurance Regulatory and Development Authority (IRDA), insurance funds are mandated to invest a minimum of 15% of their controlled fund in the infrastructure sector in projects with a minimum rating of AA. However, it is seen that most insurance funds (especially ones pertaining to life insurance) are unable to adhere to this limit due to non-availability of sufficiently rated projects for their investments. This is primarily due to the fact that infrastructure projects typically get a low credit rating at the inception. The following table gives the comparison between the mandated level of investments and the actual investments in the infrastructure sector, by insurance funds, across the years. Table 26: Investments in infrastructure sector by life insurance companies (INR crores) Particulars Life Insurance Controlled Fund Mandated limit of investment in infrastructure (not less than 15% of controlled fund) Actual Investment in Infrastructure 6,29,650 7,31,290 8,32,074 9,74,620 11,19,999 94,447 1,09,693 1,24,811 1,46,193 1,68,000 66,673 85,674 89,180 97,319 1,18,877 Source: IRDA Annual Reports As can be seen from the above table, investments by public life insurance companies, especially LIC (which has the largest controlled fund amongst all insurance companies) in the infrastructure sector is much lesser than the mandated limits thereby depicting potential to tap these funds for the infrastructure sector. TA-8279 IND: Preparing the Bond Guarantee Fund for India [31]

47 CRIS projections for debt supply from the insurance sector Given the promising growth prospects of the insurance industry, the premium as a percentage of GDP is expected to grow from 3.9% currently, to close to 10% in This robust growth is backed by the significant rise in the young working population of the country, wherein a large portion currently remains uninsured, especially in Tier 2 and Tier 3 cities. The Planning Commission has estimated that total assets under management of the insurance sector in India are likely to grow at an annual rate of 5%. The share of incremental premium that is invested - assets under management is currently 43% and is expected to grow to a maximum share of 75% in the next decade. Further, in line with current trends, it is expected that a majority of this investment (93%) will be sourced from the Life insurance sector, of which 6% will be invested in the infrastructure sector. Currently, the non-life segment, also invests close to 6% in the infrastructure sector Infrastructure sector An analysis of public disclosures released by major players in the life insurance sector revealed that 43% of investments are in non-government securities. Of the total infrastructure investments by life insurance companies, 81% are investment in debt securities (83% of which are long term and in 10% of entities which are rated less than AA). Similarly, of the total infrastructure investments of non-life sector, 95% is invested in debt securities, of which 49% are long term in nature and another 9% are in investments rated below AA. Assuming the current trends to follow, the debt supply from insurance companies to infrastructure sector is given in the following table. Table 27: Forecast of debt supply from insurance companies to infrastructure sector (INR crores) Particulars to to Incremental Long term and for entities rated less than AA 14,095 41,982 Source: CRIS analysis Non-infrastructure sector Similarly for investments by life insurance companies in non-infrastructure sector, 51% are investment in debt securities (83% of which are long term and in 10% of entities which are rated less than AA). The non-life segment invests 60% of its AUM in non-government securities, out of which 20% is invested in the debt for the non-infrastructure segment. (49% of which are long term and 9% are invested in entities rated below AA). Considering the current trends to follow, debt supply from insurance companies to non-infrastructure sector is given in the following table. Table 28: Forecast of debt supply from insurance companies to non-infrastructure sector (INR crores) Particulars to to Incremental Long term 52,113 1,55,222 [32] TA-8279 IND: Preparing the Bond Guarantee Fund for India

48 Particulars to to and for entities rated less than AA Source: CRIS analysis Other suppliers of debt Employees' Provident Fund Organization (EPFO) The current retirement funds corpus in India consists of the Employees Provident Fund Organisation (EPFO), the National Pension System (NPS), private pension funds and the public provident fund. Within this corpus, EPFO accounts for the largest share over 45% in The total corpus under EPFO has grown at a CAGR of 18% historically in the last decade. Table 29: EPFO corpus (INR crores) Particulars Provident Fund 1,68,281 2,01,064 2,37, 324 2,77,649 Pension Fund 1,23,790 1,42,050 1,61,780 1,83,405 Unit-Linked Insurance Fund 8,588 9,604 10,770 12,090 Total 3,00,659 3,52,718 4,09,874 4,73,145 Source: EPFO Annual Reports Currently, four portfolio managers manage the funds independently for the EPFO under portfolio management services (PMS), in accordance with the investment pattern specified by the Ministry of Labour & Employment and the guidelines issued by the Central Board of Trustees, EPFO from time to time. The following table gives the details of the allocation of funds amongst these portfolio managers. Table 30: EPFO portfolio managers Fund Manager Fund allocation (%) State Bank of India 35% ICICI Securities Primary Dealership Ltd 25% HSBC Asset Management Limited 20% Reliance Capital Asset Management Limited 20% Source: EPFO In line with the investment guidelines notified by the Ministry of Labour & Employment 13, over 40% of the total investments by EPFO have been undertaken in central and state government securities. While the investment guidelines allow investment upto 55% of the corpus in investment grade (BBB and above) debt securities/bonds issued by corporate entities, in practice negligible investment has 13 Notification dated November 21, 2013 TA-8279 IND: Preparing the Bond Guarantee Fund for India [33]

49 been undertaken in long-term corporate bonds with less than AA grade, as seen in table 31. This is because of the following reasons/internal guidelines Limited exposure allowance to lower rated issuances Exposure to private sector maintained at less than 10% Exposure linked to net worth of issuing entity Hence, even though it is expected that the EPFO corpus will continue to grow, it is highly unlikely that there will be any significant investment in long-term corporate bonds (rated less than AA). Table 31: Corporate Bonds Investment Pattern EPFO (INR crores as of September 2013) Credit Rating EPFO Provident Fund EPFO Pension Fund EPFO Insurance AA ( AA & AA+) 15,494 4, AAA (AAA & AAA(SO) ) 74,893 41,703 2,050 FD & Others 16,509 6, Total Corporate Bonds 1,06,896 52,161 2,611 Source: EPFO Similar to the investment pattern of EPFO, other pension funds refrain from investments in less than AA rated bonds. The NPS and its investment pattern have been discussed below National Pension System (NPS) The NPS is a defined-contribution-based pension system launched by the Government of India/PFRDA with effect from January 1, Since April 1, 2008, the pension contributions of Central Government employees covered by the NPS are being invested by eight professional pension fund managers in line with the investment guidelines of the government applicable to non-government provident funds set by PFRDA. The total corpus size under NPS is estimated to be around INR 50,000 crores currently. Analysis of funds held by each of the eight fund managers and their associated investments reveal that less than 4% of investments are undertaken in instruments holding a less than AA grade. Table 32: Corpus size and investment pattern NPS (INR crores) Fund Manager Corpus Size Investment in AA or above rated instruments UTI -November 13 4, , SBI - May 14 7, , LIC Pension Fund - May 14 4, , Reliance Pension Fund - June Kotak Pension Fund - June ICICI Pension Fund - June HDFC Pension Fund June DsP Black Rock Pension Fund [34] TA-8279 IND: Preparing the Bond Guarantee Fund for India

50 Fund Manager June 14 Source: Annual Reports Corpus Size Investment in AA or above rated instruments Industry reports expect a 15% CAGR for the NPS corpus, growing to a size of INR 1.88 lakh crores by While investment guidelines by PFRDA 14 are fairly liberal allowing for investment in debt securities, we expect the investment to follow trends similar to those witnessed in recent years. Hence, the total debt supply from the NPS to the infrastructure and non-infrastructure sectors, for long-term instruments rated less than AA, in the next decade, is expected to be negligible. The total estimated supply to the infrastructure and non-infrastructure sectors is provided in following table. Table 33: Estimated debt supply NPS (INR crores) Particulars to to Incremental Long term and for entities rated less than AA (Infrastructure Sector) Incremental Long term and for entities rated less than AA (Non-Infrastructure Sector) Source: CRIS analysis Mutual funds Assets under the management of the mutual funds industry have grown at a CAGR of 19% from to , amounting to INR 8.3 lakh crores in March Despite a sizeable corpus, the total investment of the mutual funds industry into the infrastructure sector, as a percentage of AUM in the form of NCDs and bonds, has remained less than 10% 15. Further, investment in less than AA rated papers of this sector has historically remained below 6% 10. Similarly, investment in the noninfrastructure sector in less than AA rated instruments, calculated as the balance after deducting investments in the infrastructure sector, is also minimal. Only 7% 10 of the AUM has historically been invested in papers rated below AA grade. The primary reason for low levels of investment in the infrastructure sector is the highly short term investment nature of the mutual funds industry. Investments in less than AA rated papers are further limited by the internal investment guidelines within the mutual funds industry. Though SEBI allows investment by mutual funds in unrated and below AA rated instruments, detailed parameters for these investments have to be approved by the Board of the Asset Management Company and Trustees. Investment policies at AMCs are typically highly restrictive with regard to investments in below AA rated instruments. 14 PFRDA/2014/02/PFM/1 dated January 29 th AMFI Annual Reports TA-8279 IND: Preparing the Bond Guarantee Fund for India [35]

51 Thus, assuming that the current scenario continues to hold in the future, investments from the mutual funds industry are expected to remain minimal in the future. Our estimates have been provided in table 34. Table 34: Estimated Debt Supply - Mutual Funds Particulars to to Incremental Long term and for entities rated less than AA (Infrastructure Sector) Incremental Long term and for entities rated less than AA (Non-Infrastructure Sector) ,522 8,288 Source: CRIS analysis Multilateral/bilateral institutions In the past 5-6 years, multilateral and bilateral institutions have increasingly contributed towards investment in the Indian economy. As seen in table 35, total borrowings from multilateral and bilateral institutions have increased from INR 11,010 crores in to INR 49,953 crores in Table 35: Historical debt supply from multilateral/bilateral Institutions Particulars Private Sector borrowing from Multilaterals Financial Institutions. Borrowing from Multilaterals Private Sector borrowing from Bilaterals Financial institutions Borrowing from Bilaterals Total Borrowings 11,010 19,233 23,221 29,633 41,360 49,953 Source: RBI Going forward, it is expected that borrowings will continue to grow at their historical CAGR of 9%. Based on the overall trends in debt supply in the infrastructure sector, it is expected that 45-50% of incremental borrowings will be invested in the infrastructure sector, whereas the remaining will be invested in the non-infrastructure sector. Further, assuming a debt and tenure adjustment similar to that of ECBs, we have the following estimates. [36] TA-8279 IND: Preparing the Bond Guarantee Fund for India

52 Table 36: Estimated Debt Supply from Multilateral/Bilateral Institutions Particulars to to Incremental Long term and for entities rated less than AA (Infrastructure Sector) Incremental Long term and for entities rated less than AA (Non-Infrastructure Sector) 15,162 23,120 8,927 13,612 Source: CRIS analysis 4.3 Gap assessment Having analyzed the total requirement/supply of long-term debt for entities rated less than AA, we arrive at a gap assessment as given in the subsequent sections Infrastructure sector Table 37: Gap assessment for infrastructure sector (INR crores) Particulars to to Total debt requirement 29,34,565 58,32,756 Total debt supply 10,31,890 22,23,067 Banks 1,79,864 4,33,445 NBFCs 3,37,372 7,17,677 ECBs 4,84,548 10,05,412 Insurance companies 14,094 41,982 Mutual Funds Multi-lats/Bi-lats 15,162 23,120 Pension Funds Gap 19,02,675 36,09,689 TA-8279 IND: Preparing the Bond Guarantee Fund for India [37]

53 4.3.2 Non-infrastructure sector Table 38: Gap assessment for non-infrastructure sector (INR crores) Particulars to to Total debt requirement 21,63,424 46,29,048 Total debt supply 10,29,199 22,09,521 Banks 4,87,091 10,34,419 NBFCs 98,400 2,09,322 ECBs 3,91,282 8,09,931 Insurance companies 52,113 1,55,222 Mutual Funds 5,522 8,288 Multi-lats/Bi-lats 8,927 13,612 Pension Funds Gap 11,34,225 24,19,526 Source: CRIS Analysis 4.4 Sensitivity analysis Adjustment for credit ratings bracket While BGFI would target instruments with credit ratings below AA grade, it would be prudent to begin with providing credit enhancement to instruments rated in the A and BBB categories. In case this bracket of ratings is assessed for estimating the demand and supply, the gap changes in the manner presented in the table below. Table 39: Adjustment to credit ratings bracket Particulars to to Less than AA A and BBB Less than AA A and BBB Infrastructure Gap Non- Infrastructure Gap 19,02,675 8,12,013 36,09,689 15,05,666 11,34,225 9,35,723 24,19,526 19,94,226 Source: CRIS Analysis [38] TA-8279 IND: Preparing the Bond Guarantee Fund for India

54 4.4.2 Adjustment to investment by insurance sector in less than AA The insurance sector s contribution towards debt supply is currently minimal. However, this contribution depends excessively on the regulatory environment of the sector. In a scenario where investments from the insurance sector towards debt supply to instruments rated below AA grade increase, fall in the overall gaps are observed, as shown in the following table. Table 40: Sensitivity - insurance sector Supply Increase Infrastructure Gap Non-Infrastructure Gap Additional % to to to to % 19,02,675 36,09,689 11,34,225 24,19,526 3% 19,02,508 36,09,068 11,33,959 23,74,309 5% 19,02,399 36,08,654 11,33,779 23,44,165 7% 19,02,290 36,08,240 11,33,598 23,14,020 10% 19,02,128 36,07,219 11,33,324 22,68,804 Source: CRIS Analysis Adjustment to investment by EPFO, pension funds in less than AA Despite a large corpus size, investments from the pension sector, i.e. from EPFO, private pension funds and NPS have remained insignificant in the past. Assuming a change in scenario wherein investments from this sector increase in less than AA, the following decline in overall gaps is observed. Table 41: Sensitivity - Pension funds sector supply increase Infrastructure Gap Non-Infrastructure Gap Additional % to to to to % 19,02,675 36,09,689 11,34,225 24,19,526 3% 18,98,557 36,09, ,657 24,18,990 5% 18,95,810 36,08,815 11,08,279 24,18,628 7% 18,93,062 36,08,465 10,97,900 24,18,265 TA-8279 IND: Preparing the Bond Guarantee Fund for India [39]

55 Infrastructure Gap Non-Infrastructure Gap 10% 18,88,938 36,07,941 10,82,332 24,17,714 Source: CRIS Analysis Adjustment to long-term tenure of credit provided by banks Currently, for the infrastructure sector, we have assumed 33% of total outstanding debt to be longterm in nature (greater than 3 years). However, since this figure is simply an extrapolation of residual maturity data published by RBI, there exist reasons to believe that this share may, in reality, be higher than 33%. In this case, the estimated gap in the infrastructure sector is subject to change in the following manner. Table 42: Sensitivity - Long term debt to Infrastructure from Banks Infrastructure Gap % of long term outstanding debt to to % 19,02,675 36,09,689 43% 18,47,729 34,77,664 53% 17,92,808 33,45,676 63% 17,37,908 32,13,723 73% 16,83,030 30,81,802 83% 16,28,170 29,49,909 Source: CRIS Analysis Similarly, for the non-infrastructure sector, in case this share is higher than the 28% assumed, the estimated gap changes in the following manner. Table 43: Sensitivity - Long term debt to Non-Infrastructure from Banks Non-Infrastructure Gap % of long term outstanding debt to to % 11,34,225 24,19,526 38% 9,60,240 20,50,043 [40] TA-8279 IND: Preparing the Bond Guarantee Fund for India

56 Non-Infrastructure Gap 48% 7,86,259 16,80,566 58% 6,12,280 13,11,095 68% 4,38,304 9,41,629 78% 2,64,329 5,72,166 Source: CRIS Analysis TA-8279 IND: Preparing the Bond Guarantee Fund for India [41]

57 5. Requirement of Bond Market in India As analysed in the earlier sections, the traditional sources of finance will not be sufficient to meet investments and therefrom arise debt requirements for the future. The banking sector which has been the mainstay for debt financing is increasingly facing stress. Therefore, it is imperative that alternative financing channels be developed in a systematic manner to supplement traditional bank credit. A well-functioning corporate debt market could play a critical role by supplementing the banking system to meet the requirements of the corporate sector for long-term capital investment and asset creation. Bond finance differs from conventional bank finance in certain aspects. These are discussed below Fixed v/s. Floating rate Bond finance typically comprises a fixed coupon rate while banks loans usually have a floating interest rate, linked to the interest rate cycle. By taking on a fixed interest rate, the borrower would be able to better forecast fixed cash flows. The choice of entering into a floating rate or fixed rate debt arrangement essentially depends on market timing and risk appetite of borrower/investor. For instance, if the interest rates are expected to increase over a certain time period, it might be more beneficial for the project to enter into a debt arrangement/refinanced existing debt arrangement through a fixed coupon bond. Longer maturity period The investment appetite for investors on the asset site depends on the profile of their liability side. The liability tenure of bond investors such as insurance funds and pension funds is much longer than that of banks. Therefore, these bond investors would have the appetite to invest in long-term projects. In general, bonds have a maturity period longer than bank loans. Exit Option Banks typically have prepayment penalty clauses written into the loan agreements, while in bond finance theoretically there is no such penalty. For instance, if the borrower wishes to close out an existing loan by prepaying it a penalty (to the extent prepaid) will be levied. Borrowers can provide an option of exiting bonds to investors by listing them in the exchanges. Bonds may also have a put option, where the investor is allowed to sell the bonds based on certain conditions back to the borrower. Similarly call options in bonds enable borrowers to buy back the bonds from investors. Negative Cost of Carry Bond funds have to be drawn in one go while bank funds can be drawn in tranches. Drawing in tranches reduces the negative carry. High Transaction Cost The transaction costs associated with issue of bonds (rating of bond, listing on exchange etc.) would be higher than those for bank financing (as a percentage) for a higher quantum. But the amount would be minimal and therefore would not be a significant factor affecting the choice of one financing arrangement over the other. Pricing Mechanism [42] TA-8279 IND: Preparing the Bond Guarantee Fund for India

58 Yields on bond issuances are typically set at a spread over and above the traded government security bond issuances. Banks set their lending rates at a spread over and above the base rate. The base rate accounts for cost of deposits, cost of maintaining CRR and SLR and overheads. Recovery mechanism While banks have the SARFAESI Act (The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002) to resort to non-judicial recovery mechanisms, bond investors do not have any such measures. 5.1 Key Issues with the bond market in India As stated earlier, the size of the corporate bond market in India is small in comparison to other emerging economies. The public sector dominates the issuances in the corporate bond market segment in the form of banks, public sector oil companies or government-sponsored financial institutions. Figure 14: Issuances by issuer type (INR crores) 400, , ,000 Private Sector 250, , , ,000 State Level Undertakings Public Sector Undertakings State Financial Institutions 50, All India Financial Institutions & Banks /subsidiaries Source: Prime Database, CRISIL Research Share of issuances in the infrastructure sector (for instance power generation, oil drilling, telecom and roads), has been volatile and was lower in as compared to the previous years. Further, the share of issuances in the manufacturing sector has traditionally remained low at about 4%. Figure 15: Sectoral share in primary market issues Industry/Sector Finance Banking) (including 70.2% 71.0% 77.1% 69.6% 71.5% Infrastructure 16.2% 15.1% 15.2% 16.2% 12.5% TA-8279 IND: Preparing the Bond Guarantee Fund for India [43]

59 Industry/Sector Manufacturing 5.7% 8.2% 2.8% 4.0% 4.1% Others 7.9% 5.7% 5.0% 10.2% 11.8% Source: Prime Database, CRISIL Research Key issues of the bond market are highlighted below in the following sub-sections Lack of depth in corporate bond market in India Corporate bond markets in India remain undeveloped in comparison with corporate bond markets in other developing and developed countries. The mobilization through debt on private placement basis, over the last few years is given in the table below. Figure 16: Amount raised through private debt placement (INR crores) ,74,327 1,89,640 1,98,555 2,58,869 3,52,169 2,70,946 Source: Prime Database, CRISIL Research The summary by type of issuer is given in the table below. Figure 17: Issuances by issuer type (INR crores) Issuer Type All India Financial Institutions & Banks /subsidiaries 1,44,926 State Financial Institutions 1,482 Public Sector Undertakings 31,248 State Level Undertakings 3,686 Private Sector 89,603 Source: Prime Database, CRISIL Research Low credit rating for infrastructure projects Infrastructure projects present multiple risks to project financiers. These projects are typically characterized by non-recourse or limited recourse financing. The risks, especially credit risk, are high at the project inception stage, due to which these projects typically get a low credit rating and are likely to be not higher than the BBB or A category. An analysis of infrastructure companies covered by the Prowess database reveals that 79% of long-term instruments of the infrastructure sector are rated below AA. Figure 18: Long-term instruments rated below AA in infrastructure sectors (INR crores) Infrastructure sub-sectors Total Rated Credit Long Term Long Term Rated Below AA Construction 41,59,467 45% 90% [44] TA-8279 IND: Preparing the Bond Guarantee Fund for India

60 Infrastructure sub-sectors Total Rated Credit Long Term Long Term Rated Below AA Electricity 22,12,809 77% 98% Mining 3,68,728 36% 48% Source: Prowess Further, it is typically the AAA rated entities like the Public Sector Utilities (PSUs) which are able to mobilize high amount of debts in the market, while the entities rated BBB and below are unable to mobilize such amounts of debt Absence of bond Market for low rated paper Unlike in the rest of the world, BBB-rated papers do not have a market in India. As can be seen from the following figure, over 90% of the bond issuances in India have a rating of AA or above, with the majority being AAA-rated securities. Figure 19: Bond issuances by rating (% of issuance values) 0% 1% 1% 0% 2% 8% 8% 5% 5% 5% 21% 23% 19% 28% 23% 70% 69% 76% 66% 71% FY10 FY11 FY12 FY13 FY14 AAA AA A BBB Source: Prime Database, CRISIL Research Low risk appetite of investors and regulatory restrictions Several regulatory restrictions and internal guidelines curtail investments of institutional investors in the corporate bond markets. Current regulations prevent insurance companies and pension funds from investing in debt securities rated below AA. While there is a provision for investment in A+ security with special approval from the investment committee, insurance companies and pension funds typically do not invest in securities rated below AA. Internationally, insurance companies do invest in paper rated below AA. In UK, for instance, BBB- is the cut-off for investment by insurance or pension funds. For the insurance sector, IRDA mandates that total investment in central government securities, state government securities and other approved securities will not be less than 50% taken together. Regulations further mandate life insurance companies to invest a minimum of 15% of their controlled TA-8279 IND: Preparing the Bond Guarantee Fund for India [45]