Section 5

Infrastructure Financing: Emerging Role of the Banking Sector

Dr.Sunando Roy1 Assistant Adviser Internal Debt Management Cell Reserve Bank of India,Mumbai [email protected] .

1

The author wishes to thank Prof.S.Sriraman,University of Mumbai for the benefit of discussions on a wide range of issues related to infrastructure. The usual disclaimer applies.

Infrastructure Financing: Emerging Role of the Banking Sector Dr.Sunando Roy2 Assistant Adviser Internal Debt Management Cell Reserve Bank of India,Mumbai [email protected] . There is a broad ranging consensus in emerging economies that the success of the reform process depended crucially on the ability to provide effective infrastructure which will lead to a faster growth in the private production of goods and services in the economy. The Indian economy and in other counties that underwent economic reforms also realised the importance of the financial system in the growth process, and also realised the importance of proper sequencing between the financial and real sectors. In order to move to a higher growth trajectory, two factors were significant: a) growth of infrastructure and (b) financial sector reform. Within the Indian financial sector, the importance of the commecial banking sector can hardly be overemphasized. The Commercial banks had access to about half of the savings of the nation. The assets created out of such a huge resource mobilisation effort have left an undeniable imprint on the growth process of the Indian economy. The role is even more important since the onset of the reform process with the lowering of government preemption of such investible resources. The scheduled commercial bank's contribution to the infrastructure sector has been rather low, owing to the long tem nature of such investments. Financial innovations since the onset of the reform process holds promise of a change towards a more active role of commercial banking in the infrastructure sector. The international experience also brings forth a large number of financial innovations in infrastructure financing. The present paper assesses the emerging role of commercial banks in infrastructure financing. The paper is divided into three parts. The first part discusses the role of commercial banks in Infrastructure financing in India. The second part of the paper addresses the threats to financial stability that arises on account of infrastructure financing by the banking sector. The final and concluding section discusses the emerging scenario and the road ahead for commercial banks in infrastructure financing. Section I Role of Commercial Banks in Infrastructure Financing - Indian Experience Over the last three decades since the nationalisation of major Indian Banks, the share of deposits in the national income of the country has grown steadily from 15.5 per cent to 2

The author wishes to thank Prof.S.Sriraman,University of Mumbai for the benefit of discussions on a wide range of issues related to infrastructure. The usual disclaimer applies.

54.1 per cent in March 2000. As a ratio of household financial savings in the country, the share of deposits stood at 41.8 per cent in 1998-99.

Table 1- Distribution of Household financial saving in india-1970-71 to 1998-99. Years Currency Deposits Shares Claims on Insurance Provident Gross and Governmen Funds and Pension Household Debentur t Funds Financial eSavings Res 1970-71 17.9 38.1 3.4 5.3 10.5 24.8 100.0 1975-76 6.8 42.0 0.8 17.8 8.4 24.2 100.0 1980-81 13.4 52.0 3.7 5.9 7.6 17.5 100.0 1985-86 8.7 46.9 7.8 13.4 7.1 16.2 100.0 1990-91 10.6 33.3 14.3 13.5 9.5 18.9 100.0 1992-93 8.2 42.5 17.2 4.9 8.8 18.4 100.0 1995-96 13.4 42.1 7.4 7.8 11.3 18.1 100.0 1998-99 10.1 41.8 2.5 12.3 10.5 22.7 100.0 Source: Percentages calculated on the basis of CSO data It can be seen from Table 1 that a major chunk of the financial saving is in the form of banking sector instruments, mainly in the form of deposits of various maturities. The banking sector is, thus, the major source of financial savings of the households in the country. While the deepening of financial markets has led to the emergence of a wide range of financial instruments, resulting in a fall of the share of bank deposits from 45.6 percent in the 1970s to 40.3 percent in the 1980s and further to 34.8 percent in the 1990s. This is attributable to a sharp rise in the share of long term contractual savings like insurance premium, pension funds and small savings certificates. Given the dimension of banking sector liabilities, it may be interesting to see how much is translated into assets that benefit the infrastructure sector. One needs to take a look at the nature of infrastructure financing done by the Indian Banks so far. The commercial banks has basically been averse to infrastructure financing due to the high credit risk associated with such high investment and low return of the sector. The infrastructure sector was served by the banking sector in the form of loans given to transport operators. A major part of such financing was in the form of priority sector credit, around 75 per cent in the mid nineties. Traditionally, the commercial banking sector’s involvement in transport sector financing has been almost exclusively limited to loans given to transport operators. Since the onset of the reform process and policy initiatives undertaken in the infrastructure sectors, this model is undergoing a transformation. In the new market oriented economic structures, the financial sector has launched several innovative products to finance infrastructure projects. The Financing of transport activities by commercial banks has historically been a small proportion of gross bank credit. The share of transport sector was 1.9 per cent of gross bank credit in 1975, rose steadily to 4.8 per cent in 1985. Thereafter, it declined steadily

to below 2 per cent. This may be attributable to a wide range of financial products that were introduced following financial sector reforms. The major share of credit (70%) has been for a heavy commercial vehicles (trucks and buses), with intermediate Public Transport modes (Taxis and Autorikshaw) receiving about 13-14% of credit, non-mechanised (land) and water transport modes receiving about 7-8% each. Within the commercial Banking sectors, more than three-fourth of the loans to transport operators was provided by SBI and nationalized Banks. Foreign Banks Other Commercial Banks and Regional Rural Banks accounted for 3.11 per cent, 11.06 per cent and 7.76 per cent only. (Table 2) Table 2: Financing of Transport Operators by Scheduled Commercial Banks March 2000 Category SBI and Associates Nationalised Banks Foreign Banks Regional Rural Banks Other SCBs All SCBs

Amount (Rs.Cr) 1709.77 4594.88 250.72 626.82 893.04 8073.22

Per cent 21.18 56.92 3.11 7.76 11.06 100.00

Source : BSR Returns,March 2000, RBI.

The financial sector reform has led to an overall decline in interest rates over the entire spectrum of the yield curve. In that context, it may be pertinent to examine the interest rates on credit by commercial banks towards infrastructure financing. It may be observed from the following Table 3 that there has been a discernable shift towards higher interest rates. Loans sanctioned below 15 per cents interest rates declined from 63.3 per cent in 1991 to 48.1 per cent in 2000. In contrast, loans given at an interest rate of 15 per cent or more rose to 51.9 per cent in 200 as against 36.8 per cent in 1991.

Table 3: Percentage Distribution of Transport Credit by Interest Rate Range 1991 and 2001 Size of Credit

1991

2000

Less than 6% 6% - 10 % 10% - 12% 12% - 14% 14% - 15% 15% - 16% 16% - 17% 17% - 18%

1.5 0.3 1.3 44.1 16.1 15.9 12.4 3.2

0.0 5.9 0.6 31.1 10.49 14.57 16.66 8.1

18% - 20% 20% and above

4.8 0.5

9.93 2.69

TOTAL

100.0

100.0

Source : BSR,RBI,March,2000. The twin problems of reduced finance and higher interest rates may be attributed to the rising proportion of non- performing loans in this sector. The financing of transport operators by the banks takes place directly and indirectly. In the direct method, finance is provided directly to the operators. But an emerging route where banks conceived fewer risks was by lending to Non-Banking financial companies. (NBFCs) who, in turn, gave the finance to transport operators. As this is now included as part of the priority sector advances, there is merit in disbursement of loans through the NBFC route. It has been observed in the Indian context that NBFCs have done well in reducing the extent of non-performing loans in this sector through closer monitoring. The second and the emerging route of commercial bank financing of infrastructure is project finance. In recent years, several banks have started exploring possibilities of providing finance to infrastructure projects. It is well known that Banks are inherently constrained to provide long- term finance due to the relatively lower maturity structure of their liabilities. The ensuing liquidity risk may be lower with deep and liquid bond markets, but the market in India is yet to attain such depth. In such an event, banks are more likely to park these investments in Government securities market, which is risk free and where an active secondary market has emerged over the last five years with primary dealers playing active role as market makers. In order to promote and strengthen infrastructure financing in India, in April 1999, the Reserve Bank of India has issued operational guidelines for financing of infrastructure projects. Banks have been permitted to sanction term loans to technically feasible, financially viable and bankable projects undertaken by both the public and the private sector undertakings. Four broad modes of financing has been identified for this purpose: firstly, financing through funds raised by subordinated debt (Tier II capital) was permitted, second, banks were allowed to enter into Take out financing, an innovation that provide opportunities to the commercial banks to create long term assets from short term liabilities. The participation of a long term player is crucial in this deal. After a specified period of time, the long term asset is transferred to the books of this long term financial institution. The takeout structure is defined by a main document, the takeout financing agreement, which would be a tripartite agreement between the project company, bank and the term lending institutions. In India, take out financing is in its nascent stage. In September 1998, The Infrastructure Development Finance Company Ltd. (IDFC) entered into a Rs. 400 crore take-out financing agreements with the State Bank of India. The IDFC will provide liquidity support to SBI to the extent of Rs. 400 crore initially, which will go up to Rs. 5000 crores over the next five years. The structure will be applied to three projects- Bharati Telnet, Narmada bridge in Gujarat and Coimbatore bypass in Tamilnadu. In these projects , the debt fund will be provided by SBI for 5 years, at the end of which SBI has the option to continue or call back the principal. At that point IDFC will take out SBI for the principal amount of the loan. the project, companies, therefor will be able to get funds for a longer duration. Both IDFC

and SBI will participate in the credit risk for the principal and the interest respectively. The takeout financing fee will be around 0.25 to0.5 of the liquidity support given. This apart, banks were also allowed to provide project finance directly, based on the viability of such projects. Banks can also subscribe to infrastructure bonds raised by project promoters or financial institutions like ICICI, IDBI etc. It is expected that these efforts will yield results and banks can be more proactive in infrastructure financing in the near future. International experience with project financing reveals that banks have performed as active conduits of savings mobilization for infrastructure projects. Let us give a few illustrative examples from emerging economies in Asia.The Asian experiment with privatisation of highways began in the mid-eighties in Malaysia and Thailand. While the North South Expressway of Malaysia depended heavily on Government guarantees and financial support, in the case of urban Toll Roads in Thailand, Thai banks contributed to the success of the project. In the case of the Indonesian toll roads, the development banks provided significant part of the finance for such projects (Mody,1996,1997).

Section II Infrastructure Financing and Banking Sector Stability Infrastructure finance by the Banking sector has come out of its traditional mould in recent years. Banks are exploring the possibilities of introducing new financial innovations with a view to finance infrastructure projects. While this is desirable from the growth perspective, the extent of risks associated with such financing needs to be carefully explored as defaults by the project promoters can have significant impact on the stability of the banking system. In the Indian context, the need for stability in the financial system can hardly be overemphasised (Patra and Roy, 2000). In the specific case of infrastructure financing, banks have to exercise caution in several respects. First, banks must realise the importance of proper risk assessment of projects even when such project are backed by state government guarantees and letters of comfort. (Thorat and Roy,2000) This is due to the poor state of finances of State Governments who are already burdened with high fiscal deficits. Any default or delay in honouring guarantees may have serious implications for the financing institutions. The possibility of contagion also cannot be ruled out in an integrated market. Secondly, Banks should properly assess the risks associated with projects financed by them through the private placement route. The Private placements market, which has in recent years completely overshadowed the public issues, has started showing signs of vulnerability. Unless Banks are cautious, and properly evaluate the risks, the threat to financial stability remains a major concern. In this context, Banks should develop its expertise in internal rating of projects. This should supplement and validate the external ratings, if any provided by the promoter.

At the same time, international experience has shown that participation in a Quasi-Blind Pool can be an effective risk management mechanism. In such a pool, developers, contractors and investors involved with the project contributes financial resources. This reduces the default risk (World Bank,1994). Fifth, the Banks must be aware that the cushion of collateral based funding may not be available for many infrastructure projects. For instance, in Highway financing, the physical asset, land, does not belong to the SPV but to the Government and the Banks cannot mortgage such assets. The issue of regulation is also crucial. Policy reforms should be pursued in such a manner so that legal reform.investment policy and tariff regime is synchronised and does not contradict each other. Institution of an appropriate regulatory framework is crucial to the success of infrastructure financing and contributes to financial stability.

Section III Concluding Remarks The paper attempted to explore the limited engagement of commercial banks with infrastructure financing in India. With the help of available statistical evidence, it is observed that over the years, the Banking sector's involvement in infrastructure finance was in the form of support to individual transport operators, mainly in the form of priority sector credit. The paper finds that while transport credit has shrinked over the last decade as a proportion of gross bank credit, the cost of credit has gone up. The non-performing asset in this sector is an indicator of risk in transport operator financing in India. Recognition of indirect financing to NBFCs who onlend such resources to transport operators is an effective mechanism in mitigating the credit risk. The more recent incursions of the Banking sector in project financing are desirable from the viewpoint of greater resource mobilisation in Infrastructure. Evaluating the recent developments in project financing in India, the paper addresses the potential threats posed by such financing to the banking sector. The paper stresses the need for the institution of effective internal rating system in banks and asks Banks to exercise caution while investing in the private placements market. An effective regulatory regime with coordinated legal, investment and tariff policy is also advocated. Reference Mody,A(1997): " Infrastructure Strategies in East Asia , EDI, World Bank. Patra,M.D. and Sunando Roy (2000); "Financial Stability-A Survey of the Indian Experience", Reserve Bank of India Occasional Papers, January. Reserve Bank of India , Basic Statistical Returns, Various Years. Reserve Bank of India, Master Circular on Priority Sector Lending,2000. Sriraman,S and A.Bagchi ( 1997) : Financing Transport Infrastructure and Services in India, Asian Transport Journal,May.

Thorat,U and Sunando Roy, "Contingent Liabilities at the State Level-The Indian Experience", World Bank Fiscal Conference, New Delhi,2000. World Bank (1994) Infrastructure for Development, World Development Report, World Bank. World Bank(1990) Financial Systems and Development, World Bank. .