Technical Assistance Consultant s Report. India: Capacity Development for India Infrastructure Finance Company Limited

Transcription

1 Technical Assistance Consultant s Report Project Number: July 2011 India: Capacity Development for India Infrastructure Finance Company Limited Prepared by CRISIL Risk and Infrastructure Solutions Limited 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-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Progress Report: Market Assessment 23 July 2011

3

4 Consultant Team Ajay Dwivedi Prasad Koparkar Amit Vora Mridul Muralidharan Karthik Krishnan Consultant Consultant Support Team Member Support Team Member Support Team Member [iii]

5 Abbreviations ADB ALM AMBAC CAGR CARE CCI CDO CRIS EAC ECB EPC EPFO FDI FGIC GDP ICDR IDFC IFCI IIDL IIFCL IPCL Asian Development Bank Asset-Liability Mismatch American Municipal Bond Assurance Corporation Compounded Annual Growth Rate Credit Analysis & Research Limited Cabinet Committee on Infrastructure Collateralized Debt Obligation CRISIL Risk and Infrastructure Solutions Limited Economic Advisory Council External Commercial Borrowings Engineering, Procurement & Construction E P F O Foreign Direct Investment Financial Guaranty Insurance Company Gross Domestic Product Incremental Credit-Deposit Ratio Infrastructure Development Finance Company Limited Industrial Finance Corporation of India India Infrastructure Developers Limited India Infrastructure Finance Company Limited Indian Petrochemicals Corporation Limited [iv]

6 IRDA LIC MBIA MRTS MSRDC NBFC NHAI NHDP NMDP PFC PPP PPPAC RBI REC RFP RFQ SAREFESI SPV VGF Insurance Regulatory and Development Authority Life Insurance Corporation Municipal Bond Insurance Association Mass Rapid Transit System Maharashtra State Road Development Corporation Non Banking Financial Company National Highways Authority of India National Highway Development Programme National Maritime Development Programme Power Finance Corporation Public Private Partnership PPP Approval Committee Reserve Bank of India Rural Electrification Corporation Request for Proposal Request for Qualification Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests Special Purpose Vehicle Viability Gap Funding [v]

7 Contents 1. Introduction About Asian Development Bank (ADB) About India Infrastructure Finance Company Limited (IIFCL) About CRISIL Risk and Infrastructure Solutions Limited (CRIS) Structure of the Report Investments in Infrastructure in India Recent Trends in Infrastructure Investments Outlook for Infrastructure Investments in the 12 th Five Year Plan Sector-wise outlook of some key sectors State of Infrastructure Financing In India Characteristics of infrastructure projects Risk in Infrastructure Projects Project Finance Characteristic of Infrastructure Lending Debt requirement for Infrastructure investments in 12 th Plan Sources of Debt Financing for Infrastructure Bank Lending Lending by Non-Banking Financial Companies (NBFCs) and other financial institutions Investments by insurance companies/pension funds External Commercial Borrowings Need to tap an alternative source of long-term funds for infrastructure the Bond Market Key Issues related to Bond Markets in India - Need for Credit Enhancement Key Issues related to the Indian Bond Market 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 Credit enhancement can help bridge the gap [b]

8 5. Options for Credit Enhancement Why Partial Credit Guarantee? Securitization of project cash flows Credit enhancement through asset and/or liability side tranching Multi-asset CDO Credit enhancement through diversification and additional collateral Escrow of project cash flows C project waterfall Credit Guarantee Credit Insurance Full credit guarantee v/s. Partial credit guarantee Features of Infrastructure projects that make PCG suitable The place of infrastructure assets in the economy Pricing of infrastructure services Recommended credit enhancement product for IIFCL Annexure 1 Risks under different Infrastructure Sectors Annexure 2 - Credit ratings of select infrastructure projects/spvs Annexure 3 Factors influencing Ratings of Infrastructure Projects Annexure 4 Top ten mobilizers of debt through private placement (April-December 2010) [c]

9 List of Tables Table 1: Comparison of infrastructure investments across Five Year Plans Increasing private share (R crore)... 4 Table 2: Country-wise comparison for investments in infrastructure... 5 Table 3: Investment during the 11th Five Year Plan (R crore)... 5 Table 4: Sector-wise investments in infrastructure during the 10th Plan and the 11 th Plan (R crore).. 6 Table 5: Debt requirement for infrastructure investments during the 12th Plan Table 6: Incremental flow of credit into infrastructure sector from various sources (R crore) Table 7: Incremental flow of bank credit to infrastructure (R crore) Table 8: Bank credit to infrastructure sector in relation to overall bank credit (R crore) Table 9: Incremental lending by NBFCs to infrastructure sector (R crore) Table 10: Disbursements by IIFCL to the infrastructure sector (first 9 months of financial year 2011) (R crore) Table 11: Incremental flow of credit from insurance companies into infrastructure and social sector (R crore) Table 12: Investments in infrastructure sector by insurance companies (R crore) Table 13: Incremental investments made by Employees' Provident Fund Organization (R crore) Table 14: Flow of ECBs to infrastructure sector (USD million) Table 15: Data for ECBs for infrastructure projects for the period Jan-Mar Table 16: Amount raised through private debt placement* (R crore) Table 17: Private bond market capitalization as a share of GDP Table 18: Summary of private placement issues by issuer type (Apr-Dec 2010) Table 19: Benefits/Drawbacks of credit guarantee Table 20: Typical Risks Common to All Sectors Table 21: Key Risks Unique to the Road Sector Table 22: Key Risks unique to the Ports Sector [d]

10 List of Figures Figure 1: Key Risks in Infrastructure Projects Figure 2: Key Risks in Infrastructure Projects across different stages in the Project Lifecycle Figure 3: Exposure of individual banks to the infrastructure sector Figure 3: Exposure of the banking system to some of the large business groups (R Figure 4: Asset-Liability Profile of Banking Sector Figure 5: Bond issuances by rating (% of issuance values) Figure 6: Securitization by banks Figure 7: CDO cash flow diagram Figure 8: Credit guarantee mechanism [e]

11

12 Asian Development Bank 1. Introduction India is one of the largest and one of the fastest growing economies in the world presently India was the tenth largest in the world by nominal GDP and the fourth largest in the world by purchasing power parity in 2010 (IMF); as per Quick Estimates released on 31st January 2011, India's growth in 2010 is estimated at 8.0 percent (2 nd largest amongst the top ten economies) and is expected to grow by 8.6 percent (2 nd largest amongst the top ten economies) in To sustain this growth, a significant growth in investment in infrastructure is widely believed to be a prerequisite. The infrastructure investment requirement is expected to grow from an actual of 5.08 percent of GDP in the 10 th Five Year Plan ended 2007 to an estimated 7.55 percent of GDP in the 11 th Five Year Plan ending 2012 to an expected 10 percent of GDP in the 12 th Five Year Plan ending The funding of infrastructure investment in India has predominantly been provided by the banking sector thus far. This has been possible because banks channel more than 50 percent of domestic savings in India and their exposure to Infrastructure assets has traditionally been low (6.8 percent of total assets in 2005). However, in view of the fast growing quantum of infrastructure investment demand, the fact that infrastructure investments have grown to account for about 14 percent of the asset book of the Indian banking sector in 2011, and the lengthening maturities of loans required by infrastructure projects, it is unlikely that the banking sector will be able to continue meet a majority of the borrowing requirements of infrastructure investment in India. Moreover, the growing share of -liability mismatch (ALM) risk for the Indian banking system. Further, some large and successful business groups in the infrastructure space in India are nearing group exposure limits with domestic banks. Therefore, looking for and finding sources of infrastructure finance, outside the traditional baking channel, I T T the non-sovereign bond market in India has been stubbornly tepid, in part because investment norms of most large bond investors (insurance and pension funds) have an investibility threshold of AA or higher. These thresholds shut out bond market access to most infrastructure assets, which tend be rated in the BBB category or around. The Economic Advisory Council to the Prime Minister (PM-EAC) has accordingly instructed India Infrastructure Finance Company Limited (IIFCL) to design a credit enhancement scheme which could be used to enhance the ratings of the infrastructure project bonds such that the projects are able to access finance from a larger number of institutional long-term investors such as insurance and pension funds. CRISIL Risk and Infrastructure Solutions Ltd. (CRIS) has been appointed for the purpose of designing such a scheme, establishing the economic cost of credit enhancement and creating a viable and 1 Planning Commission and IMF TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment [1]

13 Asian Development Bank sustainable economic model along with potential structures and pricing for providing credit enhancement on infrastructure bonds. The assignment is being undertaken under a Technical Assistance grant from the Asian Development Bank (ADB). 1.1 About Asian Development Bank (ADB) ADB is a regional development bank established to facilitate economic development of countries in Asia. India is a founding member of ADB and its fifth largest shareholder. Since the beginning of lending operations in 1986, ADB has approved 159 loans (sovereign and non-sovereign) amounting to USD billion. As of December 31, 2010, its portfolio included 67 ongoing sovereign loans amounting to USD 10.2 billion, with USD 3.7 billion going to transport, USD 1.3 billion to water supply and other municipal infrastructure and services, USD 2.5 billion to the energy sector, USD1.05 billion to the finance sector, and USD 0.2 billion to the agriculture and natural resources sector About India Infrastructure Finance Company Limited (IIFCL) IIFCL was established, under the Scheme for Financing Viable Infrastructure Projects (SIFTI), in January 2006 as a wholly owned Government of India company. IIFCL provides long term financial assistance to various viable infrastructure projects under the terms of the SIFTI. IIFCL had a capital of R billion and total loans outstanding of R billion as at March 31, 2010 ; corresponding previous year figures were R billion and R billion respectively. IIFCL disbursed loans aggregating R billion in the first 9 months of financial year 2011 and R billion in the previous twelve months of The borrowings of the company are backed by a sovereign guarantee About CRISIL Risk and Infrastructure Solutions Limited (CRIS) CRISIL Risk & Infrastructure Solutions Ltd. is a wholly owned subsidiary of CRISIL Limited I leading Ratings, Research Risk and Policy Advisory Company. It houses CRISIL Infrastructure Advisory, which is carrying out the present assignment. CRISIL Infrastructure Advisory represents the consulting business of CRISIL group. It provides consulting services to a range of players who are active in the infrastructure space - Governments, Multilaterals, Private Developers and investors. The service offering of CRISIL Infrastructure advisory spans the lifecycle of private sector participation in infrastructure development - shaping public policy and reforms, structuring bankable projects and running the bid process for the public sector, and providing transaction advisory services to the private sector [2] TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment

14 Asian Development Bank CRISIL Infrastructure Advisory has played a key role in the development of the power, ports, airports and urban infrastructure sectors in India. It has also provided its services in large markets in Africa, Middle-East and South-East Asia. 1.4 Structure of the Report The report is divided into four chapters: Chapter 1 provides a brief overview on the scale of investments in infrastructure in India in the recent past and an outlook for the future. Chapter 2 gives an overview of the current sources of financing in India, the key constraints and issues in present financing and establishes the need to attract alternative sources to bank funding, such as the bond market, to meet the infrastructure investment requirement. Chapter 3 looks at the reasons behind the undeveloped bond market in India and how credit enhancement could help deepen the same. Chapter 4 looks at the various options for credit enhancement that are available and establishes why partial credit guarantee is the most suitable option to achieve the objectives of a credit enhancement scheme for IIFCL. TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment [3]

15 Asian Development Bank 2. Investments in Infrastructure in India World-class infrastructure is a must for a growing economy. Investments in infrastructure have been growing over the past decade in India, and are envisaged to contribute almost 10 percent to the national GDP, from the current levels of 7-8 percent. The government has taken several steps to catalyze investments in infrastructure, including encouraging private sector participation through PPP. 2.1 Recent Trends in Infrastructure Investments Investments in the infrastructure sector in India over the period (10 th Five Year Plan ( ) and the first two years of the 11 th Five Year Plan ( )) were to the tune of R 15.7 lakh crore. A comparison between the actual investments in infrastructure during the 10 th Five Year Plan and the projected investments during the 11 th and 12 th Five Year Plans are given in the table below. Table 1: Comparison of infrastructure investments across Five Year Plans Increasing private share (R crore) Particulars 10 th Five Year Plan ( ) - Actual 11 th Five Year Plan ( ) - Projected 12 th Five Year Plan ( ) Projected GDP at market prices 1,78,40,877 2,71,91,700 4,11,90,064 Public Investment 6,80,855 13,11,293 20,49,620 Private Investment 2,25,220 7,42,912 20,49,620 Percentage share of private investment in total investment 25% 36% 50% Total Investment 9,06,074 20,54,205 40,99,240 Total Investment as percentage of GDP 5.08% 7.55% 9.95% Source: Planning Commission The total investment in infrastructure, as a percentage of GDP, is projected to increase from around 5.08 percent during the 10 th Five Year Plan to 9.95 percent by the end of 12 th Five Year Plan. Percentage share of private investment in the total investment is projected to increase from 25 percent during the 10 th Plan to 50 percent by the end of the 12 th Plan. In comparison to other countries as provided in Table 2, while it appears that the figure (for investment in infrastructure as a percentage of GDP) for India is much higher, this needs to be seen in context of the condition of infrastructure in India as against these other countries. To enable such a comparison, Table 2 W E F in these countries. These sc I lowest, thus necessitating substantially more investments in infrastructure development. [4] TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment

16 Asian Development Bank Table 2: Country-wise comparison for investments in infrastructure Country Investment in infrastructure as a percentage of GDP WEF score on overall infrastructure (Scale of 7) China India Russia Mexico Indonesia Brazil United States Source: Various, World Economic Forum It was projected towards the end of the 10 th Plan that infrastructure investments of R 20.6 lakh crore, more than double the 10 th Plan figure, would be needed during the 11 th Five Year Plan ( ) to sustain the growing economy. The table below gives the actual figures of investment during the first two years of the plan and the revised projections for the remaining years. Investment, as percentage of GDP, is expected to slowly increase from 7.18 percent (as assessed for ) to 8.37 percent in the last year of the plan. Table 3: Investment during the 11th Five Year Plan (R crore) Actual Actual Projected Projected Projected Total 11 th Plan GDP at market prices 47,17,187 50,03,545 53,63,800 57,92,904 63,14,265 2,71,91,700 Public Investment 1,99,539 2,38,054 2,62,963 2,90,832 3,19,904 13,11,293 Private Investment 1,04,268 1,21,138 1,39,866 1,69,227 2,08,413 7,42,912 Total Investment 3,03,807 3,59,192 4,02,829 4,60,059 5,28,316 20,54,205 Total Investment as percentage of GDP GDP growth rates for , and have been assumed as 7.2%, 8% and 9% respectively; Source: Planning Commission A mid-term appraisal was undertaken recently (report published in 2011) by the Planning Commission to assess the investments in infrastructure during the first two years of the 11 th Plan and to revise the projections. Though the sum of the revised projections was almost equal to that of the original projections, there was a decrease in the projections of some of the sectors. This was mainly due to lesser than expected investments in such sectors during the first two years of the 11 th Plan. The sector-wise TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment [5]

17 Asian Development Bank actual investments during the 10 th Plan and the projected investments for the 11 th Plan are given below. Table 4: Sector-wise investments in infrastructure during the 10th Plan and the 11 th Plan (R crore) Sector 10 th Plan 11 th Plan Actual Investments Projected Investments Electricity (incl. non conventional energy) 3,40,237 6,58,630 Roads & bridges 1,27,107 2,78,658 Telecommunications 1,01,889 3,45,134 Railways (incl. MRTS) 1,02,091 2,00,802 Irrigation (incl. watershed) 1,06,743 2,46,234 Water supply & sanitation 60,108 1,11,689 Ports (incl. Inland waterways) 22,997 40,647 Airports 6,893 36,138 Storage 5,643 8,966 Oil & gas pipelines 32,367 1,27,306 Total 9,06,074 20,54,205 Planning Commission 2.2 Outlook for Infrastructure Investments in the 12 th Five Year Plan Investment in infrastructure is expected to reach the USD 1 trillion mark in the 12 th Five Year Plan ( ), contributing almost 10 percent of the GDP. This is almost double the estimated investment during the 11 th Five Year Plan and almost five times the investment undertaken during the 10 th Plan. In the following sub-section, details on investments in some of the key infrastructure segments are provided Sector-wise outlook of some key sectors Power/Electricity I s risen significantly over the past few years from 7 percent in to the current 10.8 percent. This is mainly on account of the sharp growth in consumption from the industrial sector. In order to meet the growing deficit, the government has initiated processes such as setting up of Ultra Mega Power Plants (UMPPs) along with transmission and distribution through the Revised Accelerated Power Development and Reforms Programme and the Rajiv Gandhi Grameen Vidyutikaran Yojana. It is expected that around 100 GW of capacities will be added during [6] TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment

18 Asian Development Bank the 12 th Five Year Plan. Further, the private sector is expected to account for a significant portion of the investments in projects adding 55 GW of capacity. This sizeable capacity addition is expected to translate to an investment potential of nearly R 15 lakh crore, with generation (both utilities and captives) contributing significantly. Roads It is expected that roads and highways would see an investment of about R 6.3 lakh crore over the next five years. Of this amount, the share of national highways would be 43 percent, followed by state roads and rural roads at 30 percent and 27 percent, respectively. Going forward, it is expected that the highway projects under the National Highway Development Programme (NHDP) would pick up, with the main focus on Phase III, Phase IV and Phase V projects. The government has outlined a new expressway programme, which involves building 18,637 km of greenfield national expressways by This programme will be implemented in three phases, involving four-laned and six-laned expressways. Stretches for different phases have been identified based on the traffic density on nearby stretches, economic activity in surrounding areas and the financial viability. However, issues like MCA, bidding process, land acquisition, setting up of an expressway authority and competing roads are still being addressed. This would delay implementation of the programme. However, some traction is expected to be seen from , with about 1,000 km expected to be completed by at an estimated cost of R 20,300 crores. Railways The Indian Railways is currently working at close to 100 percent capacity utilization, highlighting the need to augment its freight-carrying capacity in the near future. Investment in railways, over the next few years, is expected to be more than double the actual investments during the 10 th Plan. Government of India released Vision 2020 for the Indian railways listing out specific targets in terms of capacity creation and network expansion in order to leapfrog the Railways to a higher growth trajectory. It also envisages a larger role for PPP in projects like high-speed rail corridors and direct freight corridors for effective project execution. As per Vision 2020, about R lakh crore is required for capacity augmentation, upgrading and modernization of railways in the next 10 years. Ports The ports in India are currently operating at high utilization levels of more than 90 percent. Significant investment is required to ease congestion at the ports and handle the increasing traffic. Under the National Maritime Development Programme (NMDP) launched in 2005, a total of 276 projects requiring an investment of R 55,804 crore were identified for upgradation at the major ports in India. However, only one-fifth of these projects have been completed thus far. The government has proposed a new programme, the Maritime Vision , to replace NMDP. The new programme also covers the non-major ports and the shipping sector. It is expected that Indian ports would see investments of over R 1 lakh crore over the next five years, of which 80 percent is expected to be contributed by the private sector. TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment [7]

19 Asian Development Bank Airports Investments in airport infrastructure have gained prominence over the last few years with the growth in passenger and cargo traffic. It is expected that around R 25,000 crore will be invested in upgrading infrastructure at metro airports and constructing greenfield airports. Work is currently underway at the airports in Mumbai, Delhi, Chennai and Kolkata along with modernization of infrastructure at 35 non-metro airports. Metros In lieu of the rapid urbanization of India, the demand for urban mass transportation systems is rapidly increasing. In order to meet this increasing demand, Government of India has introduced a number of metro rail projects to improve connectivity within cities. Metro projects have already been initiated in Delhi, Kolkata, Bangalore, Chennai, Hyderabad and Mumbai and is now being proposed for cities such as Pune, Jaipur, Lucknow, Ludhiana, Kanpur, Ahmedabad, Kochi, Indore and Chanidgarh. The total investment requirements for such metro projects would be around R 2,00,000 crore. [8] TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment

20

21

22

23

24

25

26

27

28

29

30

31

32

33

34 Asian Development Bank 4. Key Issues related to Bond Markets in India - Need for Credit Enhancement Infrastructure projects are typically run by SPVs and their financing is characterized by non-recourse or limited recourse lending. Since the risks are high at the project inception stage, infrastructure projects get an initial low credit rating (BBB). Unlike in most developed markets, BBB rated papers do not have a market in India and, therefore, do not find takers among insurance companies and pension funds. Credit enhancement (from a higher-rated third party) could help increase the rating of such projects to a level comfortable with long-term investors 4.1 Key Issues related to the Indian Bond Market Lack of depth in corporate bond market in India The corporate bond market in India, unlike in the US and the rest of the developed world, is still at its infancy (albeit growing) in terms of market participation and efficient price discovery. The mobilization through debt on private placement basis, over the last few years is given in the table below. Table 16: Amount raised through private debt placement* (R crore) Apr 2010-Dec ,847 93,855 1,15,423 1,74,327 1,89,478 1,44,693 *-Private debt placement is done by financial institutions and corporations; Source: PRIME database In India, private bond market capitalization is only around percent of the GDP. Comparable figures for other countries are given in the table below. Table 17: Private bond market capitalization as a share of GDP Country Private bond market capitalization United States % Republic of Korea 58.81% Japan 38.79% China 24.46% Brazil 16.92% Thailand 16.00% South Africa 15.96% United Kingdom 15.84% Russia 2.87% TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment [23]

35 Asian Development Bank Country Private bond market capitalization India % Figures in %; Source: World Bank, 2007 As previously stated, the first nine months of the fiscal year 2011 witnessed a mobilization through debt (bonds) on private placement basis of R 1.4 lakh crore. The summary by type of issuer is given in the table below. Table 18: Summary of private placement issues by issuer type (Apr-Dec 2010) Issuer type Issue amount (R crore) Percentage All-India financial institutions & banks/subsidiaries 87, State financial institutions 1, Public sector undertakings 11, State level undertakings 1, Private sector 43, Total 1,44, Source: PRIME database Thus, corporate bond markets in India remain undeveloped in scale in comparison with corporate bond markets in other developing and developed countries. Several efforts are being undertaken to study this market and develop it, as it presents an attractive source of funds for a country which is hugely dependent on banks for financing needs 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 in the BBB category. Annexure 2 gives the details of a sample set of entities in the infrastructure sector rated in the recent past. It is seen that, 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 (almost 50 percent of the sample) are unable to mobilize such amounts of debt. In this context it is pertinent to understand the factors responsible for infrastructure projects being rated below AA. The framework of most of the rating agencies for assessing credit quality covers four broad areas: Business Risk Financial Risk Management Risk and Project risk. [24] TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment

36 Asian Development Bank The difference in the perceived risk by rating agencies between strong corporate entities (with rating of A and above) and infrastructure projects is more pronounced in the case of the business risk and financial risk parameters. This has been paraphrased C I IL T Infrastructure Sector: Its Unique Rating Drivers in Annexure Absence of Bond Market for Low Rated Paper Unlike in rest of the world, BBB rated papers do not have a market in India. As can be seen from the I AA- majority being AAA-rated government securities. Figure 6: Bond issuances by rating (% of issuance values) AAA AA A BBB 3% 4% 3% 8% 8% 20% 15% 24% 21% 20% 78% 81% 71% 70% 72% * *Data till December 2010; Source: Prime Database Low risk appetite of investors and regulatory restrictions Investors such as insurance, pension and provident funds in India hold large volumes of long-term funds. But they have had limited presence in financing infrastructure projects in the private sector. IRDA regulations mandate life insurance companies to invest a minimum of 15 percent of controlled fund in the infrastructure and social sector. For non-life/general insurance companies this figure is 10 percent. Life insurance companies which are dominated by public life insurance companies like LIC have not been able to satisfy this limit, and most of their investments in infrastructure sector have been in infrastructure created by public sector and almost none in private sector. This is because of a high degree of risk averseness. Current regulations also prevent insurance companies and pension funds from investing in debt securities rated below AA. While there is a provision for investment in A+ securities with special approval from the investment committee, insurance companies and pension funds do not invest in securities rated below AA. Since most of the infrastructure projects are implemented through the SPV route, they are unable to get AA or higher rating at the pre-commissioning stage. TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment [25]

37 Asian Development Bank 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. 4.2 Credit enhancement can help bridge the gap Credit enhancement is a reassurance given by a third party to the lender that it would honour the I above, the aim of credit enhancement would be to increase the rating of a typical BBB infrastructure project to a level (such as AA) that investors such as insurance companies and pension funds would be more comfortable with. Infrastructure projects would have typically taken long-term debt from commercial banks at the precommissioning stage. A credit enhancement scheme could look at refinancing the bank debt at a lower rate post commissioning of the project. Such a scheme, in addition to opening up alternative sources for infrastructure finance, would also deepen the fledgling Indian bond market. [26] TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment

38 Asian Development Bank 5. Options for Credit Enhancement Why Partial Credit Guarantee? The objective of credit enhancement in the present context is to improve the credit rating of an infrastructure project such that the project may access the bond market and attract long-term investors such as insurance and pension funds (AA rating as per current regulations).this section assesses various options for credit enhancement to identify the most suitable option. 5.1 Securitization of project cash flows Credit enhancement through asset and/or liability side tranching Securitization is the process of conversion of existing assets or future cash flows into marketable securities. In other words, securitization deals with the conversion of assets which are nonmarketable into marketable ones. The securitization market in India has been in existence since the 1990s, maturing significantly post 2002, with the enactment of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests (SAREFESI) Act. This Act governs the securitizations originated by RBI-regulated entities like banks, financial institutions (FIs) and non-banking financial companies (NBFCs). In 2006, the RBI issued further guidelines for securitization of standard assets by banks, FIs and NBFCs. A securitization transaction typically comprises the following steps: a) Creation of a Special Purpose Vehicle (SPV) b) Sale of financial assets by the holder (for instance, a bank) to the SPV c) Issuance of securities by SPV to investors In view of the increasing credit growth and lack of funds to service it, securitization could act as an avenue for lenders to free up blocked assets. For instance, banks could securitize the loans that they have given out and use the resultant money brought in to give out more credit. A simple diagrammatic representation of how banks securitize their loans is given below. TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment [27]

39 Asian Development Bank Figure 7: Securitization by banks Source: Wikipedia Securitization could also help borrowers refinance their existing loans. For instance, a port developer could sell the entire or part of the future cash flows of the port project (cash flows arising from handling of cargo) in the form of securities to raise money. These securities would typically be divided into tranches. Every tranche would have a different degree of risk exposure as well as credit protection than another, such that the senior-most tranche will have first claim to the project cash flows over the next senior-most tranche. Therefore the senior-most securities are typically regarded as credit enhanced (and thereby receive a higher credit rating than the tranches below it). The money received from this securitization agreement can be used to refinance existing loans. Also, a bankruptcy remote structure is created through securitization. In other words, if the issuer (port developer in this case) becomes bankrupt, the investors will still have first charge over the cash flows. There have been instances of securitization of project cash flows in India. A couple of examples are given below 6 : In 2004, the Maharashtra State Road Development Corporation (MSRDC) executed a securitization deal for the Mumbai-Pune Expressway project. In that transaction, it raised R 1,348 crore through securitization, of which R 918 crore was provided up-front to the project. The MSRDC invited bids from private companies for a period of 15 years for securitizing the future cash inflows from the expressway and the 111 km stretch of NH4 that 6 [28] TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment

40 Asian Development Bank T M DC P I developing, constructing and initially operating a high risk project and turning its revenue stream over at a price to free-up its investments for subsequent projects. The money received through the securitization was used to pay back some of the debt obligations of MSRDC for the Mumbai-Pune Expressway. MSRDC has also securitized various flyovers in Mumbai for R 428 crore and the Thane-Ghodbunder road for R 140 crore. Larsen & Toubro (L&T) raised Rs 409 crore from banks, foreign investors and mutual funds to finance the construction of a 2x45 MW gas turbine-based, captive co-generation power plant at the Gandhar complex in Gujarat. The power project was to be leased to Indian Petrochemicals Corporation Limited (IPCL). L&T structured a SPV company, called India Infrastructure Developers Ltd (IIDL) for the implementation of this power project. L&T was to act as the EPC contractor to IIDL which was to own the power plant and lease it to IPCL. The lease rentals, receivable by IIDL from IPCL, were securitized to raise funds for the construction of the power plant. Securitization typically entails a complex structure with various stakeholders and arrangements involved. Moreover, with regards to credit enhancement to improve the rating for infrastructure projects, a bankruptcy remote structure would be difficult. 5.2 Multi-asset CDO Credit enhancement through diversification and additional collateral Collateralized Debt Obligations (CDOs), a complex form of securitization, differs from the plainvanilla securitization structure explained above by the very fact that it is a type of asset-backed security backed by a pool of various assets like bonds, loans and other assets. CDOs might vary in structure and underlying assets. To create a CDO, the following steps are taken: a) A special purpose vehicle (SPV) is created to acquire a portfolio of assets. Common underlying assets include mortgage backed securities and corporate loans. b) The SPV issues bonds to investors in exchange for money which is used to buy the assets. The bonds issued are of different types, having different risk characteristics, called tranches. Senior tranches have first right to the cash flows followed by mezzanine and junior tranches. Therefore senior-most tranches have a higher credit rating. A diagrammatic representation of a CDO cash flow diagram is given below. TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment [29]

41 Asian Development Bank Figure 8: CDO cash flow diagram Source: Wikipedia In the 2000s, CDOs emerged as the fastest growing sector of the asset-backed securities market, reflecting an increasing appeal for a large set of asset managers and investors. CDO issuance reached its peak in 2007 amounting to almost USD 180 billion. The monoline insurers also got involved with writing credit default swaps on mortgage-backed CDOs. CDOs played a pivotal role in financing the housing bubble that peaked in the US around 2007 and the housing bust resulting in sub-prime crisis thereafter. Credit rating agencies, which had assigned safe ratings to most CDOs, were criticized for not being able to adequately account for the risks associated with such structured finance products. The complexity of this structure and recent experience with it in USA makes it unsuitable to kickstart this product in India 5.3 Escrow of project cash flows Credit support through a watertight enforcement of the project waterfall In an escrow mechanism, future cash flows or revenues of a project are aggregated in a separate escrow account. This amount is then used for servicing the obligations of the borrower, including debt service, before releasing it for further utilization. Such a mechanism reassures the lenders and ensures a proper utilization of the cash flows. For instance, in the model concession agreement for private sector projects in major ports, it is stipulated that the concessionaire or the project developer will maintain an escrow account with a bank approved by the lenders and enter into an agreement with such bank to ensure all proceeds for financing the project and all revenues and other receipts arising from the project and under any agreements, received by the concessionaire are deposited into such an escrow account. The [30] TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment

42 Asian Development Bank concession agreement also lists down the order of priority for withdrawals and appropriations during the concession period, as given below: a) for all taxes due and payable by the concessionaire; b) towards payment of license fee; c) all construction/implementation expenses relating to the project/project facilities and services, subject to limits if any set out under the financing documents; d) all expenses relating to operations and management of the project/project facilities and services, subject to limits if any set out under the financing documents; e) towards its debt service obligations under the financing documents; f) towards payment of royalty and other sums payable to the concessioning authority and liquidated damages, if any; g) towards any reserve requirements in accordance with the financing documents; The concessionaire is allowed to withdraw any sums outstanding in escrow account, only after all the aforesaid payments due have been made, every quarter. As is evident, this mechanism is already adopted for certain infrastructure projects and it essentially works as a credit support mechanism. It does not completely address the inherent risk of default and hence ratings for such projects are not higher. 5.4 Credit Guarantee Credit guarantee represents a promise of full and timely debt service payment. The credit risk profile of the guarantor is stronger than the borrower, which results in enhancing the ratings of the borrower. A depiction of the credit guarantee mechanism is given below. Figure 9: Credit guarantee mechanism Credit Insurance Credit insurance is a type of guarantee mechanism where insurance providers typically provide guarantees to bonds issued by companies, to enhance the credit rating of the issuer. For example in the US, monoline insurance companies provide insurance to municipal bonds or munis. Municipal TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment [31]

43 Asian Development Bank bonds are securities issued by cities, states or countries to finance the infrastructure-related developments. Monoline insurance developed in the 1970s when the municipal bond market, which was more or less considered immune to default till then, suffered a series of catastrophes. The first was when New York stood on the edge of bankruptcy and the second when the Washington Public Power Supply system defaulted on revenue bonds worth USD 2 billion associated with a nuclear reactor. A number of bond insurance companies were developed to offer insurance to the muni bond market. The first monoline insurance provider, American Municipal Bond Assurance Corporation (AMBAC) was formed in Others like Municipal Bond Insurance Association (MBIA) and Financial Guaranty Insurance Company (FGIC) followed soon after. These companies sought to provide regional public administrations access to cheaper funding and were initially rated AAA. By the late 1990s, around 50 percent of the municipal bonds were insured. As the derivatives market began to rise through the 1990s, monoline insurers began to get involved in derivatives based on sub-prime mortgages otherwise known as mortgage-based Collaterized Debt O CDO T F G P C D which insured part of certain CDOs. When the sub-prime mortgage market collapsed in 2007, the monoline industry was gravely affected. Monoline insurance companies which had enjoyed AAA rating status till then were subsequently downgraded. This triggered a simultaneous downgrade of hundreds of thousands of B -insured bonds. Such a market has not developed in India for project finance. There are presently no providers of such insurance products in India Full credit guarantee v/s. Partial credit guarantee As mentioned earlier, infrastructure projects/spvs are typically assigned a lower than investmentgrade credit rating. In a credit guarantee scheme, the borrower (project SPV) would issue bonds which would be guaranteed by a third-party guarantor (having a higher credit rating). Investors (like insurance companies having access to long-term funds) would invest in these project bonds, thereby providing the necessary funds for the project. The amo 100 percent of the debt service payment (full credit guarantee) or a percentage of this payment (partial credit guarantee). Benefits/drawbacks of this credit enhancement product, to the various stakeholders involved, for both the full credit guarantee and partial credit guarantee scenarios are given below. [32] TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment

44 Asian Development Bank Table 19: Benefits/Drawbacks of credit guarantee Issuers Investors Guarantors Full Guarantee Benefits - Full guarantee helps in achieving a higher rating (typically the rating of the guarantor) - Wider market acceptance - Relatively simple and easy to structure Drawbacks - Even though it results in a lower coupon, the credit enhancement cost is higher Benefits - Simple to understand and widely used - Investors do not have any exposure to underlying asset risk Drawbacks - Presents lower yield due to lower risk Benefits - Simple and conventional - Higher guarantee fee Drawbacks - Since it is a full guarantee, the guarantor will have to bear all the risks Partial Guarantee Benefits - Net savings in credit enhancement cost (partially offset by higher coupon) - Deepens the bond market over the longer term - Supports a higher extent of bond issues Drawbacks - Structuring is not as simple as a full guarantee Benefits - Gives a better yield to the investors due to comparatively higher risk - B rating Benefits - Since guarantor covers only part of the debt service payment, there is better sharing of risk - More efficient use of capital can provide enhancement to larger amount of bonds with given capital Source: CRISIL Infrastructure Advisory While, a full credit guarantee would typically increase the rating to AAA (assuming the guarantor is AAA rated), it would be at a much higher cost vis-à-vis a partial guarantee. Since a AA/AA+ rating would suffice for potential bond investors in India and since the success of such a scheme will be based on the cost savings accruing to project developers, a partial credit guarantee would suffice and would be more suitable. TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment [33]

45 Asian Development Bank 5.5 Features of Infrastructure projects that make PCG suitable The place of infrastructure assets in the economy Infrastructure, though difficult to define, can be said to refer to shared facilitators of economic activity or those objects whose shared use helps people provide goods and services to each other. Infrastructure assets have traditionally been understood to include transport infrastructure (roads, airports, ports etc.), energy infrastructure (power generation, power and fuel transmission, power distribution), water infrastructure (dams, canals, sewerage systems, flood control systems etc.), solid waste infrastructure (land-fills, incinerators, recycling etc.), communications infrastructure (postal services, telecom services etc.), social infrastructure (education, healthcare etc.) and other such utilities. Interestingly, though infrastructure assets/services initially start out as facilitators of economic activity, their permeation in society soon makes them a prerequisite for economic activity, witness wired energy, piped water, school education etc. Further, once the use of these assets/services is established in society, they have no substitutes over fairly long periods of time Pricing of infrastructure services As facilitators of economic value creation, infrastructure assets support a diverse set of economic value chains. Each value chain has a different ability to pay for the use of the infrastructure asset that is its facilitator. The government, in its role as an enabler of economic activity by the populace seeks to ensure that infrastructure use is priced at a level where it remains within the paying capacity of as large a part of the population as possible. Consequently, perhaps, governments have fiscal capacity is no longer able to support the infrastructure needs of growing economic activity. Presently, while the private sector is required to have a growing presence in the ownership and operation of infrastructure assets, government continues to have an interest in their orderly provision and pricing. Therefore, private presence in infrastructure is typically facilitated by regulatory constraints placed on the supply of these assets/services in lieu of regulated pricing flexibility. Following from the above, it may be concluded that infrastructure assets have: 1. a necessary place in all economic activity in the geography 2. no substitutes over long time periods 3. a large set of users who are engaged in a diverse economic activities 4. a regulated pricing regime Due to 1, 2 and 3 above, infrastructure assets have very low demand risk. Once they are put in place, they can generate cash with very little inputs by way of management efforts, especially in relation to industrial assets where cash flows are critically dependent on management skills to maintain the business proposition. Th makes their cash flows more predictable than industrial assets. [34] TA-7030 (IND): Capacity Development for India Infrastructure Finance Company Limited Market Assessment