The policy rigmarole of core sector financing

NEW DELHI: The Reserve Bank has come under pressure to not only lend, but also give some equity support to the proposed overseas arm of government-owned infrastructure financing company IIFCL, as the government thinks this is in the interest of reducing the subsidiary’s cost of finance and thereby turning it into an effective player in its designated role of funding capital expenditure abroad of Indian infrastructure players.

The finance ministry has made a strong case for the central bank’ financing in the form of a mix of equity and loaning (refinancing) out of the large forex reserves it currently manages, so that the proposed externally focussed investment company would be strong by birth, government officials told ET.

The Budget 2007-08 mentioned only “loan” support by RBI, but later the finance ministry came to think that the subsidiary might not be playing a meaningful role unless its capital costs were brought down.

The RBI has initially been resistant to even lending to the company out of the forex reserves, thanks to its tenacity to avoid risks, but later agreed to the refinancing model, which requires the IIFCL arm to get funds from elsewhere to start with. (Under the refinancing model, RBI would later extend loans to the company equivalent to the amount of liability on its books).

In a meeting here last week, the RBI and the finance ministry discussed the legal aspects of the proposals (RBI Act doesn’t allow outright loaning to an entity like the proposed IIFCL arm), but the central bank is yet to give a formal commitment, government sources told ET.

It, however, agreed to finalise its views and communicate the same to the ministry soon. “As of now, it does not seem that the finance ministry would initiate an amendment to the RBI Act for this purpose,” said an informed source.

The finance ministry has suggested that either RBI should bolster the overseas company with equity-plus-refinance backing or give it outright loan so that its cost of capital would be competitive.

Earlier, the RBI had rejected another proposal for infrastructure financing out of forex reserves, requiring another IIFCL arm to provide credit wraps to infrastructure projects for a one-time upfront fee. Under the proposal, RBI would have to subscribe to the company’s long-term foreign currency bonds. The credit wrap proposal has already been put under the backburner and the finance ministry is now focussing on the plan to fund Indian infrastructure companies’ capital expenditure aboard through an IIFCL arm to be incorporated abroad.

As per the Budget, the loans by RBI to these two companies would be guaranteed by the government and the RBI would be assured of a return higher than the average rate of return on its incremental investment.

The Deepak Parekh committee has proposed the two models to reinforce infrastructure financing in India. Stressing the importance of not adding to already high rate of domestic monetary expansion and keeping in mind the real risk of disruptive reversals of capital flows,” the committee said the “challenge is to balance the objectives of RBI in its reserve management against the needs of the infrastructure sector.” The panel said the IIFCL arm could borrow a small fraction, say $10 billion, from the RBI and the loan could be benchmarked to 30-year US government bond.

The panel also said, “The company can provide support to Indian oil and gas companies to acquire assets overseas..” “The main risk of this model is that it would entail some loss of liquidity in the asset portfolio of the RBI and the funds set aside may not qualify as reserves. This risk would, however, be manageable since the corpus of the company is small in comparison to total reserves,” said the committee. Sources said the government and IIFCL are considering three countries - Singapore, UAE and Mauritius - to get the company incorporated. “Ease of operations, withholding tax rates and the tax treaties with the country concerned are the criteria,” an official said.

Meanwhile, the Parekh committee, in its final report, has proposed allowing banks to raise long-tenor gold deposits for funding infrastructure. Currently, gold consumption in India is predominantly as physical savings. Banks could issue fixed-tenure, long-term gold deposit certificates to convert these physical savings into financial savings. This would let households to hold their gold exposure in a form which does away with the need for physical holdings of gold. Banks, in turn, could hedge the risk of such gold liabilities in the forward or futures market to create financial liabilities for themselves, the committee said. These long-tenure liabilities could eventually be used for infrastructure financing.

It said since the gross domestic savings are to rise by 1% of GDP a year, to achieve the infrastructure spending target of 8% of GDP by 2011-12, half of the incremental domestic savings will have to be routed to the sector.
Lamenting the inadequacy of risk capital to support debt raising, despite the existence of a robust equity market, the panel underscored the need to develop the market for various other forms of risk capital such as mezzanine financing, subordinated debt and private equity. FDI flow should strengthen, too. The panel noted that India has large external debt capacity - it can borrow an additional $120 billion in the next five years and yet maintain external debt to GDP ratio at the current level of about 15% - and a third of this would mean covering 10% of the infra funding gap.

PSUs account for 40% of India’s infrastructure financing at present but several of the financially sound PSUs haven’t leveraged their strength to raise resources from market, according to the committee. The panel revised the infrastructure spending target for the Eleventh Plan from $320 billion (at 2005-06 prices) which is the government’s estimate, to $384 billion (or $475 billion at current prices), in view of the government’s under-estimation of required investments in residual sectors such as state highways, rural roads, urban infrastructure, pipelines, telecom and SEZs. This, according to the panel, entails a financing gap of $129 billion, going by the current level of infra spending as per cent of GDP.

While making proposals aimed at addressing the weakness of India’s financial system, the committee however also emphasised that howsoever the system is reshaped and improved, funding of infrastructure would remain below the required level unless “governance issues” (read liberal sectoral regulatory regimes and introduction of user charges) are addressed. The fiscal sops proposed by the committee for the sector have already been shot down by the revenue department.