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India
Financing Infrastructure : Addressing Constraints and Challenges

June 2006 Finance and Private Sector Development Unit South Asia Region

Contents
EXECUTIVE SUMMARY I. II. INTRODUCTION CONSTRAINTS TO INFRASTRUCTURE FINANCING 2.1 Financial Sector Related Constraints Constraints to equity and quasi-equity financing Restrictions on ECBs Limited use of takeout financing 9 21 25 25 25 29 30

An underdeveloped corporate bond market and the lack of longer term financing 30 Regulatory and institutional issues constraining higher participation of FIs and commercial banks 2.2 Fiscal Barriers to Private Financing of Infrastructure High customs duties on infrastructure equipment Section 10(23G) of the Income Tax Act Tax holidays under section 80IA Poor state government finances 2.3 Approvals, Red tape and Inadequate Administrative Capacity in Government Multiple clearances Lack of coordination between government ministries / departments Problems in contract negotiations and delays in the award of contracts Limited capacity within government to execute PPPs in infrastructure 2.4 Constraints Related to Poor Infrastructure Regulation and Related Risks and Uncertainties Sector specific issues: roads Sector-specific issues: power Sector-specific issues: ports, airports and railways The RBI and non-sector specific regulatory issues III CONCLUSIONS AND THE WAY FORWARD 3.1 Addressing Financial Sector and Related Regulatory Issues 36 41 42 42 43 43 43 43 44 44 44 45 45 46 48 48 51 51

INDIA Financing Infrastructure : Addressing Constraints and Challenges

Facilitating equity financing Encouraging the use of more innovative financing instruments like mezzanine and takeout financing Developing a longer term corporate bond market Encouraging participation by FIs in infrastructure financing 3.2 3.3 3.4 Fiscal measures that would support private financing of infrastructure and financial market innovation Streamlining Approvals, Cutting Down on Red Tape and Enhancing Infrastructure Regulation Stimulating Public Private PartnershipsBuilding Government Capacity

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BIBLIOGRAPHY ANNEXES: ANNEX A: INVESTMENT NEEDS FOR INFRASTRUCTURE, 2001-02 TO 2010-11 ANNEX B: CASE STUDY: TAKEOUT FINANCING ANNEX C : STATUS OF DEBT MARKET IN INDIA ANNEX D: USE OF FINANCIAL INSTRUMENTS TO INCREASE LIQUIDITY ANNEX E: PARTICIPATION BY FIs IN INFRASTRUCTURE PROJECTS ANNEX F: SECTOR SPECIFIC RECOMMENDATIONS TO IMPROVE THE REGULATORY ENVIRONMENT

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ACKNOWLEDGEMENTS
This report was prepared by a joint World Bank-IFC team led by Priya Basu (Lead Economist, Finance and Private Sector Development, South Asia Region, World Bank), and comprising Inderbir Dhingra and Varsha Marathe (Finance and Private Sector Development, South Asia Region, World Bank), and Shalabh Tandon and Mayank Choudhary (IFC). The report benefited from a background note on infrastructure financing gaps prepared by Omkar Goswami (CERG, India). The peer reviewers were Clive Harris (Energy and Infrastructure, South Asia Region, World Bank) and Stephan von Klaudy (Infrastructure Sector, World Bank). Allen Townsend (Energy and Infrastructure, South Asia Region), Alain Locussol (Water and Urban, South Asia Region) and Anita George (IFC) commented on an earlier draft. Heather Fernandes (Finance and Private Sector Development, South Asia Region, World Bank) designed the report and provided administrative support. This report was discussed with the Ministry of Finance, Government of India; while the report benefited greatly from comments provided by the Government of India, it does not necessarily bear their approval for all its contents, especially where the Bank has stated its judgments/opinions/policy recommendations.

INDIA Financing Infrastructure : Addressing Constraints and Challenges

ABBREVIATIONS AND ACRONYMS


AAI ADB AERA AGR ANDIMA APDRP BIS BOT BRO BSNL CAGR CBDT CDMA CFS Airports Authority of India Asian Development Bank Airport Economic Regulatory Authority Adjusted Gross Revenue Association of Open Market Institution Accelerated Power Development and Reform Program Bank for International Settlements Build Operate Transfer Border Roads Organization Bharat Sanchar Nigam Limited Compounded Annual Growth Rate Central Board of Direct Taxes Code Division Multiple Access Container Freight Stations GE GIC GQ GSM HSD HUDCO IATA ICD IDBI IDF IDFC IEBR IIBI IIG IIM ILD IL&FS IMC IMG IPP IR IRDA IRR ISP JNPT LIC M&A MAT MCA General Electric General Insurance Corporation Golden Quadrilateral Global System for Mobile Communications High Speed Diesel Housing and Urban Development Corporation International Air Transport Association Inland Container Depot Industrial Development Bank of India India Development Fund Infrastructure Development Finance Corporation (IDFC) Internal and Extra Budgetary Resources Industrial Investment Bank of India Limited Inter Institutional Group Indian Institute of Management International Long Distance Infrastructure Leasing and Financial Services Inter-Ministerial Committee Inter-Ministerial Group Independent Power Producer Indian Railways Insurance Regulatory and Development Authority Internal Rate of Return Internet Service Providers Jawaharlal Nehru Port Trust Life Insurance Corporation of India Mergers & Acquisitions Minimum Alternate Tax Model Concession Agreement

COD Commercial Operations Date CONCOR Container Corporation of India Limited CRF Central Road Fund CRR DDBDEA DFI DoT DRT ECB EGOM EPC EPF EXIM FDI FI GAIL GBS GDP Cash Reserve Ratio Deep Discount Bonds Department of Economic Affairs Development Finance Institution Department of Telecom Debt Recovery Tribunal External Commercial Borrowings Empowered Group of Ministers Engineering Procurement Construction Employees Provident Fund Export Import Bank of India Foreign Direct Investment Financial Institution Gas Authority of India Gross Budgetary Support Gross Domestic Product

MDR MEXDER MIBOR MoF MoU MoU MSEB MTNL NABARD NDS NDTL NEEPCO NHAI NHDP NHPC NIA NIC NLC NLD NPA NRVY NSC NSE NSICT NTP 99 NTPC OECD OIC OTC PFC PFI PGCIL

Major District Roads Mexican Derivatives Exchange Mumbai Inter Bank Rate Ministry of Finance Memorandum of Understanding Minutes of Usage Maharashtra State Electricity Board Mahanagar Telephone Nigam Limited National Bank for Agriculture and Rural Development Negotiated Dealing System Net Demand and Time Liabilities North Eastern Electric Power Corporation National Highways Authority of India National Highway Development Project National Hydro Electric Power Corporation New India Assurance Company National Insurance Company Neyveli Lignite Corporation National Long Distance Non-Performing Assets National Rail Vikas Yojana National Savings Certificate National Stock Exchange Nhava Sheva International Container Terminal New Telecom Policy 99 National Thermal Power Corporation Organization for Economic Cooperation and Development Oriental Insurance Company Over The Counter Power Finance Corporation Public Financial Institutions Power Grid Corporation of India

PLF PMGSY

Plant Load Factor

Pradhan Mantri Gram Sadak Yojana PMO Prime Ministers Office PPA Power Purchase Agreement PPF Public Provident Fund PPP Public-Private Partnership PRG Partial Risk Guarantee PSA Port of Singapore PWD Public Works Departments QIB Qualified Institutional Buyers RARSY Remote Area Rail Sampark Yojana RBI Reserve Bank of India ROSC Report on the Observance of Standards and Codes RTGS Real-time Gross Settlement SARFAESI Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest SBI State Bank of India SEBI Securities and Exchange Board of India SERC State Electricity Regulatory Commission SIDBI Small Industries Development Bank of India SLR Statutory Liquidity Ratio SND National Private Bond System SOE State Owned Enterprise SPV Special Purpose Vehicle TAMP Tariff Authority for Major Ports TDR Term Deposit Receipt TDSAT Telecom Dispute Settlement Appellate Tribunal TEU Twenty-foot Equivalent Units TIFI The Infrastructure Fund of India TRAI Telecom Regulatory Authority of India UII United India Assurance US GAAP US Generally Accepted Accounting Principles UTI Unit Trust of India

INDIA Financing Infrastructure : Addressing Constraints and Challenges

CURRENCY EQUIVALENTS
As of April 27, 2005, US$1 = Rs. 43.43 Rupees (Rs).

EXECUTIVE SUMMARY
It is well recognized that, with its present state of physical infrastructure, India will be hardpressed to sustain 7 percent plus annual GDP growth over the medium term. Be it in power, roads, ports, airports, water, railways, urban facilities or even telecoms, the countrys infrastructure needs are enormous. There is a massive and urgent need to increase investment in these sectors. In recent years, efforts have been made by the Government of India (GoI) to step-up investment in infrastructure, and particularly to catalyze greater private investment. In the Union Budget 2005, the Finance Minister reiterated the importance of infrastructure for rapid economic development and noted that, in the Governments view, the most glaring deficit in India is the infrastructure deficit. In this context, he proposed to continue (and enhance) budgetary support for investment in infrastructure, including through initiatives to catalyze greater private financing of infrastructure through a proposed viability gap fund (VGF) and a special purpose vehicle (SPV). Efforts have also been made, over the years, to strengthen the policy and regulatory framework underpinning some of the key infrastructure sectors, with notable success achieved in the telecommunications sector. The commitment to infrastructure has been further reiterated in the Union Budget 2006 recently, through increased budgetary allocations and reform initiatives for infrastructure sectors. But investment in infrastructure over the past decade has not lived up to expectations. The 1996 India Infrastructure Report projected the need for an increase in investment in infrastructure from levels of under 5 percent to about 8 percent of GDP by 2005/06. The same report targeted significant increases in both public and private spending on infrastructure including a doubling of private infrastructure spending to over 2 percent of GDP by the late 1990s, and then further increases. At the end of the 1990s, however, actual investment (public and private) in infrastructure1 remained at under 4 percent of GDP per annum. In 1999, public investment in infrastructure stood at 2.8 percent of GDP while private investment was just 0.9 percent of GDP2. Indeed, throughout the past decade, private investment in infrastructure has remained at well below the targeted 2 percent of GDP. Cross-country data shows that, even in countries which recorded impressive private investment in infrastructure in the 1990s, the figure was typically 4 percent to 6 percent of GDP. While it is true that even with good policies in place, private investment will not contribute the bulk of what is needed and public investment will retain its predominant role. However, there is room for PPPs to play a much greater role than before. Estimates suggest that over the last decade private investment has accounted for around 20% of total investment in infrastructure in developing countries. India can, of course, do
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In energy, transport, telecoms and water supply & sanitation. 2 The estimate for private investment in telecom used by us, from the World Banks WDI database, is lower than that cited by the Planning Commission. Nonetheless, even if one considers the private investment figure in the telecom sector as released by the Planning Commission for the Plan Period 1997-2002, total private investment in infrastructure as a percent of GDP in 1999 only increases marginally to 1 % of GDP from 0.9%.

INDIA Financing Infrastructure : Addressing Constraints and Challenges

much better. Since 1996 private investment in Chile has averaged 3-4% of GDP; in Brazil it has averaged 1.5% and in Colombia around 2-3% over the same time period. Over this period in China private investment has accounted for around 10% of total investment in the road program, compared to around 4% in India. International experience shows that there is no unique formula for facilitating PPPs in infrastructure. However some of the key ingredients of a successful PPP program are: clear and stable policy and legal frameworks for PPPs that have broad support; competent and enabled institutions that can identify which projects are best done as PPPs and whether they are priorities, and then procure and properly monitor them; efficient oversight and dispute resolution procedures; and of course, well developed financial markets, including long-term corporate bond market. This note, which was prepared in response to a specific request from GoIs Department of Economic Affairs (DEA), focuses primarily on financial sector related constraints to private investment in key infrastructure sectors in India, where the potential for greater private participation exists. It identifies key financial sector related constraints and suggests practical solutions for addressing them. However, since funding is inextricably linked to policy uncertainties, sector specific policy and regulatory issues, and procedural hassles faced by project developers, these constraintswhich are arguably the most binding at this stage in the development of Indian infrastructureare also examined in the note. It should be clarified at the outset that the analysis presented in this note will become
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particularly relevant as infrastructure policy and regulatory frameworks emerge and reforms advance; a better developed financial system can accelerate access to finance by infrastructure projects, while a less developed financial system is likely to slow down reform in infrastructure since it cannot as quickly respond to the changing financial requirements, in particular for long-term resources. Good examples in this context are South Africa and Chile, both of which were able to mobilize longterm (i.e. up to and over 20 years) local currency debt in form of bank loans and bonds, once they had designed toll road programs that generated projects with acceptable risk profiles. Other examples would be Malaysia and South Korea, or in Europe countries like Portugal, Spain and Greece that would not have been able to mobilize long-term resources for their private infrastructure programs as smoothly in the preEuro period. That finance will become an ever more important constraint for Indian infrastructure over the medium term is evident from calculations on financing gaps. According to the estimates of funding in the GoIs given for the Tenth and the Eleventh Five Year Plans, government finance consisting of gross budgetary support to the central plan, allocations to the states and internal and extra-budgetary resources of central State Owned Enterprises (SOEs) amounts to roughly Rs.13,601 billion for the main six infrastructure sectors3 over the period 2001-02 to 2010-11. This, of course, assumes that the government will be able to undertake fiscal adjustment. Even if one were to accept this assumption, India would still face a staggering financing gap of over Rs.5,500 billion for the decade ending 2010-11. By any canon, this is a huge difference between what the country needs and what the government can pay. Success in attracting private funding to help meet this gap will depend on Indias success in having regimes, systems and practices in place that consistently encourage

These comprise roads, power, telecommunications, railways, airports and ports.

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Executive Summary

private investment and public private partnerships (PPPs) in infrastructure. The note is organized as follows. Section I provides a brief introduction to the topic. Section II analyses the reasons why more private finance has not been forthcoming for the different infrastructure sectors. In doing so, it examines barriers posed by the absence of a sufficiently sophisticated financial sector, fiscal barriers, red tape and procedural inefficiencies that have contributed to project delays and discouraged private investors, and constraints arising from the absence of adequate infrastructure regulation that exacerbates risks and uncertainties for investors. Section III suggests practical ways to mitigate these constraints and policy reforms to facilitate more sustained private investment and PPPs in infrastructure.

financial institutions (FIs), and government agencies. Key constraints in the financial sector relate to the following: Raising adequate equity finance tends to be the most challenging aspect of infrastructure project financing, as equity typically shoulders the greatest level of operational, financial and market risk. However, at present, limited exit options for investors limits equity financing. Other constraints include a shallow capital market (albeit continuously improving), and weaknesses in corporate governance (primarily minority shareholder protection rights). Mezzanine financing, which is critical in funding infrastructure projects in developed countries, is also limited in India. The reasons for this are many, notably: (i) the lack of a sufficiently large and varied pool of infrastructure projects, which leads to a preference among funding institutions to opt for more straightforward loans (rather than hybrids); and (ii) interest rate caps on external commercial borrowing (ECBs), which prevent the pricing of different debt or quasi-equity instruments (like mezzanine financing) commensurately with the risks associated with them. Interest rate caps pose a constraint to attracting ECBs, but an even greater constraint in utilizing foreign currency loans is the lack of a sufficiently deep forwardsmarket in foreign exchange. Infrastructure projects require long tenor loans, and if financed through foreign currency borrowings these need to be adequately hedged against currency risks since few infrastructure projects have forex earnings to serve as a natural hedge. Inability to hedge long term currency risk in a market which is limited to one years forward cover poses a big challenge to the use of foreign currency loans in these projects.

KEY CONSTRAINTS TO PRIVATE FINANCING OF INFRASTRUCTURE


Financial sector constraints to private financing of infrastructure
Infrastructure projects are complex, capital intensive, long gestation projects that involve multiple and often unique risks to project financiers. Infrastructure projects are characterized by non-recourse or limited recourse financing, i.e., lenders can only be repaid from the revenues generated by the project. This limited recourse characteristic, and the scale and complexity of an infrastructure project makes financing a tough challenge, which is further compounded by two factors. First, a combination of high capital costs and low operating costs implies that initial financing costs are a very large proportion of the total costs. Second, infrastructure project financing calls for a complex and varied mix of financial and contractual arrangements amongst multiple parties including the project sponsors, commercial banks, domestic and international

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Underdeveloped debt markets are yet another key constraint to infrastructure financing, given that most infrastructure projects begin to generate profits in 10-15 years and require longer term debt. The lack of size and depth in Indias corporate bond market is associated partly with the lack of depth in the government bond market and the absence of a yield curve for government bonds which could serve as a benchmark for corporate bond. Beyond that, corporate debt markets are constrained by cumbersome primary issuance guidelines; inadequate credit information; inefficient clearing and settlement mechanisms; poor and lengthy enforcement laws relating to default proceedings; inefficiencies arising from weaknesses in regulation, including poor coordination among the various agencies involved in corporate debt market regulation; and the absence of long term investors. A host of regulatory and institutional problems facing financial institutions (FIs) constrain their participation in infrastructure projects. A fundamental factor limiting the participation of all types of FIs in infrastructure financing relates to regulatory uncertainty, which raises the risk-profile of infrastructure sectors, and makes FIs reluctant to finance infrastructure, particularly in the early stages, where project risks are concentrated. Restrictive government policies and regulatory guidelines have further constrained the participation of insurance companies and pension funds in infrastructure. For example, Insurance Regulatory and Development Authority (IRDA) requires insurance companies to invest in debt paper with a minimum credit rating of AA, which automatically excludes investment by insurance companies in debt paper of most private infrastructure sponsors. Insufficient knowledge and appraisal skills related to infrastructure projects also pose a constraint.

Fiscal barriers
An enabling fiscal environment is a prerequisite for attracting private sector players to inherently high risk ventures. There are some fiscal issuesparticularly in relation to Sections 10(23G) and Section 80IA of the Income Tax Actthat need to be ironed out in order to give further fillip to infrastructure sectors. Also, the fact that nearly all states suffer from serious fiscal imbalances and are ridden with huge debt obligations does not make them the most bankable business partners for the private sector.

Approvals, Red tape and Government Administrative Capacity


Infrastructure projects require multiple clearances at centre, state and local levels, resulting in serious delays. The time taken to obtain all the requisite approvals for an infrastructure project can vary between a low of 18 months to as much as four to five years. In spite of many states having introduced, on paper, single window clearance, the fact remains that when most projects apply for approvals at the state-level, these have to go through multiple clearances at various levels. Most infrastructure projects involve dealing with multiple ministries. One of the key reasons for projects not taking off at the prefinancing stage is that the actions and policies of different ministries are not coordinated and are often at variance with each other. Problems in contract negotiations and delays in the award of contracts are pervasive across all infrastructure sectors.

Limited capacity within government to execute PPPs in infrastructure


Both the central government and the states are aiming to use PPPs more extensively to help meet gaps in the provision of basic

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Executive Summary

services in the country. But PPPs represent a claim on public resources that needs to be understood and assessed. They are often complex transactions, needing a clear specification of the services to be provided and an understanding of the way risks are allocated between the public and private sector. Their long-term nature means that the government has to develop and manage a relationship with the private providers to overcome unexpected events that over time can disrupt even well-designed contracts. Financiers of these projects critically evaluate a project in terms of all design features mentioned above and hence the ability to conceptualize and structure a PPP from the governments side is a key variable in determining the viability of, and the willingness of FIs and banks to finance the project. The capacity to effectively conceptualize, procure and manage these PPPs is limited within the public sector both organizationally (legal frameworks, procurement guidelines etc) and at the individual level. Internationally, governments embarking on PPP programs have often developed new policy, legal and institutional frameworks, individual training and technical support to provide the required organizational and individual capacities. A similar comprehensive effort at building capacity to facilitate PPPs is needed by the central and state governments.

Authority of India (TRAI) has truly established itself as an efficient, fair, expeditious and independent regulator which is respected as a body for creating a level playing field and fostering the rapid growth of telecom in India. In sharp contrast, the regulatory environment in power leaves much to be desired; and as yet there is no independent regulatory institution in place for ports or airports.

INCREASING PRIVATE FINANCING OF INFRASTRUCTURE: THE WAY FORWARD


Addressing Financial Sector and Related Regulatory Issues
A deeper and more diversified financial sector could certainly help increase private participation in infrastructure. Developing local capital markets can play a critical role in facilitating private investment in infrastructure. Key priorities include: Facilitating equity financing Improving exit policies to make it easier for investors to exit. In this context, a key priority is for Reserve Bank of India (RBI) to introduce enabling regulations for the use of put options as an exit mechanism for investors in unlisted (privately held) companies. At present, the regulations do not allow financial investors to reach an upfront agreement with sponsors on the terms of a put option, if the sponsor company is unlisted. Greater comfort on exit would encourage financial investors to take equity in greenfield infrastructure projects by having some defined, low guaranteed returns. This practice is standard in many emerging markets, especially in Latin America. An additional and desirable outcome of this would be that with the entry of more financial investors in the equity market, it would broaden the investor base and with successful closing of projects it would increase investor confidence.

Deficiencies in Sector Policy and Regulatory Frameworks


There are also a number of sector specific policy and regulatory impediments, which vary considerably across sectors. In some, such as telecom, the obstacles and contradictions during the initial phase of the 1990s are things of the past. Through learning-by-doing, the Telecom Regulatory

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Other factors that would help increase equity investment in infrastructure projects include better corporate governance, with a particular focus on minority shareholder protection rights. Encouraging the use of more innovative financing instruments like mezzanine and takeout financing Removing interest rate caps on ECBs could encourage foreign investors to use instruments like mezzanine and take out financing for infrastructure investment: The Government should consider either removing the 350 basis point interest rate cap above LIBOR on infrastructure loans above 5 years, or, at the very least, double the cap to 700 basis points above LIBOR. In addition, tools for mitigating the risks involved for international lenders should be developed for example, Partial Risk Guarantees (PRGs) to hedge against political risk, and developing the swap market to mitigate foreign exchange risk. Developing a longer term corporate bond market A well developed government bond market is a critical prerequisite to the development of the corporate bond market. Hence, there is an urgent need to increase the depth and the breadth of the government bond market, through the following measures: To improve the breadth of the government bond market, the government should consider recalling the existing illiquid, infrequently traded bonds and re-issue liquid bonds. The existing regulation that requires institutional funds such as pension funds and insurance funds to hold till maturity all government securities should be removed and they should be allowed to actively trade in the market.

To bring in more retail investors to the government bond market there is a need to introduce an element of marketability and price discovery, which can only be brought in by making securities trading screen based and more transparent. Furthermore, the development of Indias corporate bond market would benefit from the following measures: Issuance and listing: The procedures for public issuance of debt need to be streamlined, drawing on lessons from countries like Korea, where regulatory approval takes just 5 days (against 21 days in India). To facilitate timely market access of corporate debt securities, a distinction between regulatory requirements that apply to the wholesale market (where qualified institutional investors are concerned) from those that apply to the retail market could be made to enable listing to be a straightforward exercise. Private debt placement guidelines also need to be made less restrictive. Extending shelf registration to all types of corporate issuers, would also facilitate quick, timely and cost-effective access of issuers to the markets. This is widely used in developed debt markets, such as the US and UK, Korea and Singapore. Better corporate credit information can play a critical role in corporate debt market development. More effort needs to be put into collecting and disseminating data on bond issues, size, coupon, latest credit rating, underlying corporate performance, information on secondary trading (particularly pre-trade information related to investors having access to best quotes) and default histories of companies. A centralized agency for this purpose would be a welcome step forward.

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Executive Summary

Better market infrastructure. Efficient trading and settlement systems are critical for providing an exit route for debt investments in infrastructure. India needs to upgrade its trading and settlement systems. Mechanisms that have been put in place in several Asian and Latin American markets, which have adopted sophisticated settlement systems and have also put in place mechanisms for recourse (through guarantee funds/ compensation funds) in settling transactions, could provide some useful lessons. New products. Government should encourage financial intermediaries to offer new product structures (e.g., credit enhancement, bond insurance) that enable sub-investment grade corporates/ municipalities to access financing. This could be achieved through initial guarantee or funding support to the financial intermediaries. RBI and Securities and Exchange Board Board of India (SEBI) should consider regulatory reforms that would help develop hedging tools for investors and traders: e.g., credit derivatives, bond futures and options. Increasing the appetite of long-term investors. Given the current stage of market development, where long term institutional investors are yet to develop, the banking system could play an important role in the development of the corporate debt market; regulatory caps on banks investments in corporate bonds could be relaxed (limited to 10 percent of their total non-SLR investments) as could the minimum rating requirement (minimum investment grade, i.e. AA and above). While not an immediate constraint, over the medium term, the debenture trustee system needs to be strengthened to encourage retail investment in infrastructure by providing protection from default by the company in payment of timely interest. Other measures also need to be taken to encourage

insurance companies and pension funds to step-up their investment in infrastructure projects. These are discussed below. Encouraging participation by FIs in infrastructure financing Investment policies and regulatory guidelines for insurance companies, pension funds, mutual funds, banks and other FIs need to be sufficiently flexible for these entities to choose an appropriate risk-return profile within fiduciary constraints. This will also help professionalize fund management. While it would not be appropriate or practical to introduce radical changes in investment guidelines at this stage, primarily because issues such as high rate of assured return, deficiencies in the accounting methodology, lack of skills in fund management need to be resolved first, there is certainly a need to deregulate these sources of long-term finance and formulate prudential norms for infrastructure related projects. The authorities should look at the existing investment norms prescribed for insurance, Employees Provident Fund (EPF) and Public Provident Fund (PPF) with a view to relaxing them so that these institutions can commit significantly larger amounts of long-term funds for infrastructure. In particular, investment guidelines for: insurance companies need to be modified to allow investment in instruments with a rating of less than AA. At present these investments are counted towards unapproved investments. This, in conjunction with development of credit enhancement products should enable insurance companies to invest in infrastructure projects; pension funds should be modified to allow them to invest in infrastructure projects, which have a guarantee from the central government or multilateral agencies. The cost

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of such funding will also be lower since these will not carry any currency risk. Going forward, with appropriate changes in the investment guidelines, three mechanisms could be used to channel pension funds in to infrastructure projects without distorting their risk-return profile. First, to initialize entry in to such projects at the lowest risk level, pension funds should be allowed to invest in projects where a multilateral agency or central government extends a guarantee on the minimum rate of return. The multilateral agency in turn could charge the project sponsor (such as National Highways Authority of India (NHAI)) a commercial fee to extend this guarantee. Second, pension funds should be permitted to deposit part of their funds with banks for long periods and ensure that the banks use them exclusively for infrastructure financing. Third, in the longer term, pension funds should be allowed to deploy funds in projects appraised by the allIndia FIs. There exists an urgent need for specialized infrastructure financing institutions such as Infrastructure Leasing and Financial Services (IL&FS) and Infrastructure Development Finance Corporation (IDFC) to participate at the design stage of a project. The backing of such institutions at an early stage would carry at least two advantages. First, it would make it easier for project developers to obtain finance from other sources. Second, it would provide the developer with the opportunity to use the expertise of such institutions in project designing and financial structuring. It must be noted, of course, that potential conflicts of interest could arise in instances where the specialized infrastructure financing institution provides advisory services for the project and also bids for the role of structuring the financing package. Such potential conflicts of interest would need to be handled carefully.

Project evaluation and fund management skills at banks and other FIs with long term funds (insurance companies and pension funds) need to be strengthened. In particular, insurance companies need to be encouraged to develop specialized appraisal skills in the infrastructure projects. Given the large corpus of funds available with these companies, going forward, they will need to become lead financiers in infrastructure projects. However, at present, they do not have the requisite appraisal skills to appropriately evaluate project viability. There is a need to create a debt recovery mechanism for pension and provident funds on the lines of the Debt Recovery Tribunal (DRT). While the need for such a tribunal is not felt at present due to the restricted investment profile, it will be critical if pension and provident funds are to have any significant exposure in the infrastructure sector. In order to provide an active incentive for banks to scale-up infrastructure financing, the RBI could consider classifying infrastructure as one of the priority sectors. Moreover, as far as banks are concerned, liabilities created by the sale of long term infrastructure bonds may be kept outside the purview of Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR). Fiscal measures that would support private financing of infrastructure and financial market innovation While it should be noted that fiscal concessions are not necessarily desirable, per se, they might help increase returns and hence, investment. In this context: The Ministry of Finance (MoF) could consider reducing the customs duty on capital goods and machinery that are critical for roads, ports, airports, power, railways,

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Executive Summary

telecommunication, oil and gas pipelines and supply and distribution of water. This fiscal incentive would significantly reduce the cost of many infrastructure projects. With respect to the fiscal concessions under section 80IA and 80IB, the government could consider extending the time horizon from the present 10+5 years (0 percent tax on the first, and 50 percent tax liabilities in the second period) to a 20 year time horizon where the project would be tax free for the first 10 years, pay a third of the tax liabilities in the next five and 50 percent of it in the final five. In addition, the government could also consider removing the provisions of Minimum Alternate Tax (MAT) for those infrastructure companies which are availing the benefits under sections 80IA and 80IB. Another alternative would be to remove sections 80IA and 80IB altogether and, instead, allow for unlimited carry-forward of losses. This would allow all infrastructure companies to set off the large losses in the initial years of operations against the profits of the later period and, in effect, create a more transparent fiscal incentive than 80IA or 80IB. The fiscal benefits given under section 10(23G) should be approved at one shot for the stipulated 10-year period, instead of the present practice of the companies or SPVs getting annual approval from the Central Board of Direct Taxes (CBDT). Moreover, the government should seriously consider eliminating the word wholly which prevents any infrastructure SPV from redeploying its investible surplus in another group infrastructure SPV and substituting it by substantially. The tax implications of this is minuscule compared to the operational flexibility that it will give to companies which have more than one infrastructure SPV. The concept of escalating section 10(23G) benefits to umbrella infrastructure companies should be investigated something that

could be possible if the word wholly is replaced by substantially. This will allow sponsors to consolidate their infrastructure SPVs under a single holding company, which will have the critical threshold to carry out a successful public offering. Such a mechanism will give sponsors and FIs an exit option from equity participation, which could be recycled for new projects. Also, the government ought to consider making the benefits of 10(23G) available to retail investors, who could then invest in dedicated infrastructure mutual funds which would use the finances so obtained to offer longer term credit facilities to infrastructure projects. Streamlining Approvals, Cutting Down on Red Tape and Enhancing Infrastructure Regulation Governments need to assure potential investors that there is an intention to lay out clear policy frameworks for each sector and reduce uncertainties arising out of policy implementations and arbitrary actions in contractual commitments of the governments. All infrastructure projects involve multiple clearances from different Ministries and Departments which contribute to significant delays. In order to mitigate this problem, the Government of India needs to set up sufficiently high-level Inter-Ministerial groups for roads, power, telecom, ports and airports. Ministries which are represented in each of these groups would vary according to the sector. It would be useful for these groups to be formed under the aegis of the Planning Commission, and for them to meet once every 45 or 60 days to discuss and resolve all outstanding Inter-Ministerial issues. In addition, each Ministry substantively dealing with infrastructure should adopt the practice introduced by the Ministry of Power by setting up Inter-Institutional Groups (IIG).

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

These would consist of the infrastructure developers and senior representatives from banks and FIs. Under the leadership of the Secretary of the concerned Ministry, the IIGs would meet once a month to discuss the progress of specific infrastructure projects and to resolve any outstanding issues or disputes between the developers and various funding agencies. This experiment has been very successful in the case of Power and should be replicated in other key Ministries. Infrastructure is an urgent national priority. To give it the importance it deserves, there has to be a clear signal that the ownership lies at the highest level of government. Therefore, it would be advisable for the Prime Ministers office (PMO) to have a dedicated infrastructure secretariat which would not only monitor the status of projects in different sectors but also convene quarterly meetings between the Prime Minister and those of his cabinet colleagues in charge of infrastructure ministries. This secretariat could ensure consistency in policy formulation and implementation for various infrastructure sectors, and would liaise with various government agencies to present a single window clearance to the private sector. This act alone would demonstrate the governments focused commitment to infrastructure. The government has constituted a Committee on Infrastructure chaired by the Prime Minister. This Committee has a secretariat in the Planning Commission. This committee does focus on policy direction for improving infrastructure in the country and is aimed at ensuring inter-ministerial coordination on infrastructure issues. However, there is also a need for a more operational role for a secretariat as suggested above. Develop a policy and regulatory framework for sectors where no framework has been articulated (airports, railways) and establish independent regulators.

Stimulating Public Private Partnerships Building Government Capacity There is a need to encourage entry of the private sector in infrastructure development through viable PPP projects, and it is a fact that private investors in infrastructure look for stable and friendly sector-specific policies. Developing domestic capabilities to manage, participate in and finance private infrastructure projects is important to broaden the constituency of PPPs, enlarge the pool of funding, and mitigate foreign exchange risk. In industrialized countries, and increasingly in more mature reformed developing countries, one of the largest sources of financing for investment is the utilitys own cash flow. But additional funding will have to come from domestic capital markets and from pension funds/ insurance companies. This will require a strong macroeconomic framework and a solid financial infrastructure, as well as attractive investment opportunities as detailed in the earlier sections. To encourage PPPs, the Government of India has announced that it will provide viability gap financing for selected infrastructure projects which are socially and economically necessary but carry either high risk or inadequate Internal Rate of Return (IRR) to be fully funded by the private sector. According to the policy, up to 40 percent of the financing needs of such projects could be met through VGFs. This is a step in the right direction and could help to hasten the financial closure of many infrastructure projects. For instance, the 22.5 km long Trans-Harbor Bridge that is proposed for Mumbai and costing over $1 billion is not feasible without at least 30 percent viability gap funding. So too is the case for almost all major bridges as well as large sections of Indias national and state highways. Assuming that the viability gap funding policy is credible, its success will require, among other things, strengthening the institutional capacity of government to manage, participate in, and monitor PPPs.

18

Executive Summary

Capacities for identifying, procuring and managing PPPs could be strengthened in India so that they can make a larger contribution to meeting basic infrastructure needs. The steps that the Centre could take to achieve this are: Issuing a policy statement on the use of PPPs, including rationale and benefits expected; The creation of a national level PPP unit for information dissemination and guidance functions, plus transactions advisory support to central agencies and ministries in their PPP programs; Setting up a project preparation fund for identifying and procuring PPPs; and Setting up a fund to partly cover the cost of government participation under PPPs. In addition, if there is to be an increase in the usage of PPPs, the Centre would have to work to strengthen oversight of their fiscal costs and assist state governments in doing the same. The investment needs for infrastructure are enormous. India faces a very large financing gap which needs to be bridged by domestic as well as foreign private sector investments. Success in attracting private funding to infrastructure will depend partly on Indias ability to develop a more sophisticated financial sector, requiring reforms that facilitate the use of diverse financial instruments by investors, and address the current barriers to increased participation by both sponsors and financial institutions. But securing increased private funding for infrastructure will also require reforms to address the more binding constraints, related to the policy and regulatory environment. In the foreseeable future, Government will remain the key investor in critical infrastructure sectors, although PPPs could

help reduce some of the funding pressure on Government. The Governments ability to finance infrastructure will, of course, depend crucially on the success with which it is able to progressively reduce the fiscal deficit to make available public funds for infrastructure investment. Three caveats First, while the focus of this note is on identifying and addressing constraints to private financing of infrastructure, it is important to recognize upfront that private investment can, at best, provide a partial solution to meeting Indias immediate infrastructure investment needs. In areas such as rural roads, rural electrification, rural water supply and sanitation, the government will likely have to play a significant financing role in the foreseeable future. Second, while the primary concern of this note is to examine financial sector related factors that may constrain private investment in infrastructure, as noted, funding issues are closely linked to sector policy and regulatory frameworks. These latter issues are also examined in the note. Third, while this note focuses mainly on supply side constraints, clearly, the demand side also matters. Indeed, many financiers argue that, while they do have the resources, appetite and instruments to fund infrastructure, the problem lies in the absence of financially viable bankable projects with acceptable risk profiles. They argue that, if bankable projects existed, the funding could be made available. This links back to issues related to the policy and regulatory environment in which infrastructure project developers and financiers in India have to operate.
I

19

I. INTRODUCTION
It is well recognized that, with its present state of physical infrastructure, India will be hardpressed to sustain 7 percent plus annual GDP growth over the medium term. Be it in power, roads, ports, airports, water, railways, urban facilities or even telecoms, the countrys infrastructure needs are enormous. There is a massive and urgent need to increase investment in these sectors. In recent years, efforts have been made by the Government of India (GoI) to step-up investment in infrastructure, and particularly to catalyze greater private investment. In the Union Budget 2005, the Finance Minister reiterated the importance of infrastructure for rapid economic development and noted that, in the Governments view, the most glaring deficit in India is the infrastructure deficit. In this context, he proposed to continue (and enhance) budgetary support for investment in infrastructure, including through initiatives to catalyze greater private financing of infrastructure through a proposed viability gap fund (VGF) and a special purpose vehicle (SPV), discussed later in this note. Efforts have also been made, over the years, to strengthen the policy and regulatory framework underpinning some of the key infrastructure sectors, with notable success achieved in the telecommunications sector. But investment in infrastructure over the past decade has not lived up to expectations. The 1996 India Infrastructure Report projected the need for an increase in investment in infrastructure from levels of under 5 percent to about 8 percent of GDP by 2005/06. The same report targeted significant increases in both public and private spending on infrastructure

Figure 1: Investment in infrastructure in India

Figure 2: Private Investment in Infrastructure in India

* In energy, transport, telecoms and water supply & sanitation. Source: World Bank WDI Database.

* In energy, transport, telecoms and water supply & sanitation. Source: World Bank WDI Database.

21

INDIA Financing Infrastructure : Addressing Constraints and Challenges

Figure 3: International trends in private investment in infrastructure

* In energy, transport, telecoms and water supply & sanitation. Source: World Bank WDI Database.

including a doubling of private infrastructure spending to over 2 percent of GDP by the late 1990s, and then further increases. At the end of the 1990s, however, actual investment (public and private) in infrastructure4 remained at under 4 percent of GDP per annum (Figure 1). In 1999, public investment in infrastructure stood at 2.8 percent of GDP while private investment was just 0.9 percent of GDP5. Indeed, throughout the past decade, private investment in infrastructure has remained at well below the targeted 2 percent of GDP. (Figure 2). Cross-country data shows that, even in countries which recorded impressive private investment in infrastructure in the 1990s, the figure was typically between 4 percent to 6 percent of GDP.6 (Figure 3). Contrasting this against Indias
4 5

performance suggests that there is considerable scope for higher private investment in infrastructure in India in the future, at least in sectors such as telecom, ports, airports and urban power and urban water. In response to a specific request from GoIs Department of Economic Affairs (DEA), this note focuses primarily on financial sector related constraints to private investment in key infrastructure sectors in India, where the potential for greater private participation exists. It identifies key financial sector related constraints and suggests practical solutions for addressing these constraints. However, since funding is inextricably linked to sector specific policy uncertainties, regulatory issues, and procedural hassles faced by project developers,

In energy, transport, telecoms and water supply & sanitation. The estimate for private investment in telecom used by us, from the World Banks WDI database, is lower than that cited by the Planning Commission. Nonetheless, even if one considers the private investment figure in the telecom sector as released by the Planning Commission for the Plan Period 1997-2002, total private investment in infrastructure as a percent of GDP in 1999 only increases marginally to 1 % of GDP from 0.9%. 6 In the Philippines, private investment in infrastructure reached over 12 percent of GDP in 1997, driven mainly by the privatization of the water utility in Manila and a few large Independent Power Projects in the same year. Since the late 1990s, however, private investment in infrastructure has tapered across countries. In East Asian countries, it declined after the financial crisis that took hold in 1997, and in Argentina, it declined in the aftermath of the crisis in 2001.

22

Introduction

these set of constraintswhich are arguably the most binding constraints at this stage in the development of Indian infrastructureare also examined in the note.

regulatory frameworks, and procedural delays. Third, while this note focuses mainly on supply side constraints, clearly, the demand side also matters. Indeed, many financiers argue that, while they do have the resources, appetite and instruments to fund infrastructure, the problem lies in the absence of financially viable bankable projects with acceptable risk profiles. They argue that, if bankable projects existed, the funding could be made available. This links back to issues related to the policy and regulatory environment in which infrastructure project developers and financiers in India have to operate. It should be noted, though, that while there may be a theoretical surfeit of funds for infrastructure at present, this will most likely not be the case over the medium to longer-term. According to the estimates of funding given for the Tenth and the Eleventh Five Year Plans, government finance consisting of gross budgetary support to the central plan, allocations to the states and internal and extra-budgetary resources of central State Owned Enterprises (SOEs) amounts to roughly Rs.13,601 billion for the main six infrastructure sectors8 over the period 2001-02 to 2010-11. This, of course, assumes that the government will be able to undertake fiscal adjustment. Even if one were to accept this assumption, India would still face a staggering financing gap of over Rs.5,500 billion for the decade ending 2010-11. (See Annex A for details of this calculation). By any canon, this is a huge difference between what the country needs and what the government can pay. And it will have to be met by private sector financing. Success in attracting private funding to infrastructure will depend on Indias success in having regimes, systems and practices in place that consistently encourage private investment and public private partnerships (PPPs) in infrastructure.

Three caveats
First, while the focus of this note is on identifying and addressing constraints to private financing of infrastructure, it is important to recognize upfront that private investment can, at best, provide a partial solution to meeting Indias immediate infrastructure investment needs. In areas such as rural roads, rural electrification, rural water supply and sanitation, the government will likely have to play a significant financing role in the foreseeable future. Second, while the primary concern of this note is to examine financial sector related factors that may constrain private investment in infrastructure, as noted above, funding issues are closely linked to sector policy and regulatory frameworks. These latter issues are also examined in the note. In the power sector, for example, 70 percent of the corpus of the Inter Institutional Group (IIG) set-up for this sector remained unutilized as of November 2004. In the roads sector, no significant projects have been offered by National Highways Authority of India (NHAI) for over one year7 leading to a situation of over-syndication by banks in the projects on offer. In October 2004, State Bank of India (SBI) signed a Memorandum of Understanding (MoU) with Life Insurance Corporation of India (LIC) under which it was expected that SBI would evaluate projects and provide short term (up to five years) funding, while LIC would take on the long-term risk. However, to date, not a single private or public-private project has been financed under the MoU. Project developers argue that this has much to do with policy flipflopping, ambiguities in sector policy and
7 8

Very recently NHAI has offered 37 projects in the road sector. These comprise roads, power, telecommunications, railways, airports and ports.

23

INDIA Financing Infrastructure : Addressing Constraints and Challenges

The rest of this note is organized as follows. Section II analyses the reasons why more private finance has not been forthcoming for the different infrastructure sectors. In doing so, it examines barriers posed by the absence of a sufficiently sophisticated financial sector, fiscal barriers, red tape and procedural inefficiencies that have contributed to project delays and

discouraged private investors, and constraints arising from the absence of adequate infrastructure regulation that exacerbates risks and uncertainties for investors. Section III suggests practical ways to mitigate these constraints and policy reforms to facilitate more sustained private investment and PPPs in infrastructure.

24

II. CONSTRAINTS TO INFRASTRUCTURE FINANCING


2.1 Financial Sector Related Constraints
Infrastructure projects are complex, capital intensive, long gestation projects that involve multiple and often unique risks to project financiers. (See Box 1). Infrastructure projects are characterized by non-recourse or limited recourse financing, i.e., lenders can only be repaid from the revenues generated by the project. This limited recourse characteristic, and the scale and complexity of an infrastructure project makes financing a tough challenge. This challenge is further compounded by two factors. First, a combination of high capital costs and low operating costs implies that initial financing costs are a very large proportion of the total costs. Second, infrastructure project financing calls for a complex and varied mix of financial and contractual arrangements amongst multiple parties including the project sponsors, commercial banks, domestic and international financial institutions (FIs), and government agencies. In India, as in many other countries, the early phase of private financing of infrastructure has shown a predominance of sponsor equity. But the ability of sponsors to raise equity from the primary market remains limited. First, infrastructure companies or project sponsors typically have much higher gearing than other corporates, which makes them unattractive candidates in the securities market. Second, not only are the projects operationally complex but also, they involve complexities in terms of contracts, legal structures, right of first charge on assets etc. Consequently, investors, especially retail investors, find it difficult to understand the true risks involved and are wary of investing in such issues. In the longer-term, equity finance from financial investors including private equity funds such as venture capital funds and other institutional investors, such as dedicated infrastructure funds sponsored by a consortium of insurance companies, pension funds, Government sponsored funds, commercial banks, development banks, private fund managers and other privately-held companies -- can prove to be critical. This is particularly true in situations where the sponsors equity is consumed at the early stages of projects, and not recycled quickly enough due to lack of refinancing options. However, at present, equity financing by financial investors is constrained by the following factors: Limited exit options constrain equity participation. Financial investors have a welldefined investment horizon and usually divest in a pre-determined span of time9. They usually

Constraints to equity and quasi-equity financing


Equity financing
Raising adequate equity finance tends to be the most challenging aspect of infrastructure project financing, as equity typically shoulders the greatest level of operational, financial and market risk. Equity can be provided by project sponsors (those who have an operational interest in the contract) or financial investors (those who have only an investment interest).
9

For example funds like AIG Asian Infrastructure Fund (Asia I, $1.08 billion); AIG Asian Infrastructure Fund II ($1.67 billion); AIG-GE Capital Latin American Infrastructure Fund ($1.01 billion); AIG Emerging Europe Infrastructure Fund

25

INDIA Financing Infrastructure : Addressing Constraints and Challenges

prefer to determine the terms of the exit on an upfront basis. The best route for financial investors to exit from an infrastructure project is to sell their stake to the sponsors, through a put option, which involves an upfront agreement between the financial investor and sponsor, including agreement on the minimum price at which the financial investor could sell the equity stake to the sponsor at a future date. However, in India, the regulations do not allow such agreements to be reached upfront between financial investors and sponsors of an unlisted company. For one thing, the approval to exercise the put has to be obtained from the Reserve Bank of India (RBI) at the time of the exercise, and cannot be obtained up-front. For another, put option agreements with sponsors of unlisted companies cannot guarantee a minimum price on the sale of shares to the sponsors. The sale price in such transactions is subject to pricing requirements of the RBI, which requires an independent valuation to determine a fair price for the shares at the time the option is exercised. This leaves a lot of uncertainty in the minds of investors and prevents them from negotiating a floor to their return and ensuring a suitable exit prior to investing. Additional constraints to equity investment include a shallow capital market (albeit continuously improving), and corporate governance issues (primarily minority shareholder protection rights). Some of the issues that impinge on the broader issues on minority shareholder rights relate to (a) adequate recording of ownership rights: Mandatory disclosure on shareholder ownership is limited to only the shareholders name which usually is not sufficiently unique; (b) transparency in disclosures related to capital structures and arrangements: Such transparency would enable

certain shareholders to obtain a degree of control disproportionate to their equity ownership. While there is a trend towards more transparent share ownership, the classification does not give a fully transparent picture of control due to the prevalence of complex cross-holdings across family or business groups; and (c) Misuse of corporate assets and abuse in related party transactions remain problems. It is not always easy to identify related parties or assess the fairness of a transfer price. More specifically, there are atypical corporate governance issues with respect to protection of minority shareholder rights in infrastructure projects. Often infrastructure project developers are construction companies, equipment suppliers or infrastructure services companies. For example: Road projects are being developed by construction companies Ports and airports are being developed by construction companies, equipment suppliers, user companies, port management companies etc. Power projects are developed by construction companies and equipment suppliers Return on equity for these companies on their investment in infrastructure projects comes not only from the returns generated by the project, but also from the additional business generated from the project. For example: Construction company undertaking the Engineering-Procurement-Construction (EPC) contract for the construction of a road, port, airport, power project. Equipment supplier supplying equipment to the port, airport, power project.

($550 million); AIG African Infrastructure Fund ($407.6 million) and IDB Infrastructure Fund (approx.$1 billion) have a typical time horizon of 5 to 10 years to divest all funds. The recently initiated The Infrastructure Fund of India (TIFI)an Asian Development Bank (ADB) and AMP Capital Investors ventureis expected to have a life of 7 years.

26

Constraints to Infrastructure Financing

Management company managing the port or airport operations. User companies using the facility. For these companies, revenues from these activities exceed the returns provided by equity. Many times, this is their primary motivation for venturing into infrastructure projects, rather than the returns provided by the project itself. For a financial investor, the only return on equity is provided by the revenues generated by the project. Therefore, there is a severe conflict of interest between the project developer and the financial investor. A project developer may act in a way which maximizes his return from the secondary activities, at the cost of project revenues. The financial investor, who is in a minority position in such projects, loses out in such situations. To improve corporate governance, and to protect minority shareholders rights infrastructure projects must go for competitive bidding for the EPC contracts, equipment supply contract, management contract and user contracts. The project promoters may participate in such bidding processes, but must emerge a winner from such a process to obtain the contract for providing such services.

the balance sheet of a company, it is treated like quasi-equity, which makes it easier to increase the component of the usual bank or financial institution loans. Also, since subordinated debt is not a loan, FIs do not insist on escrow backing for such funding. Mezzanine finance is typically found with venture capital companies and/or alternative lending institutions seeking a higher rate of return. Unfortunately, there is no infrastructure funding entity that has actively explored mezzanine financing in India in any sizeable amounts. The reasons for this include the following: First, an impediment to the use of mezzanine financing is the lack of a sufficiently large and varied pool of infrastructure projects. When projects and financiers are few and far between, and when modern infrastructure financing is in its nascent stages, there is a preference for funding institutions to opt for more straightforward loans than hybrids. Second, interest rate caps on external commercial borrowing (ECBs) constrain the use of mezzanine financing by foreign investors. The interest rate caps make no provision for pricing different debt or quasi-equity instruments commensurately with the risks associated with them. Third, regulatory norms and premium pricing are also factors that weigh against mezzanine financing. The norms for provisioning against Non-Performing Assets (NPA) do not make a distinction between senior debt and subordinated debt; the latter deserves more liberal treatment given its quasi-equity nature. Also, sponsors with projects that are at the margin in terms of profitability find the premium demanded for subordinated debt over senior debt by a host of risk-averse lenders far too excessiveenough to turn a potentially profitable venture into an unviable one. As the situation stands today, most domestic lenders (banks and FIs) prefer to provide senior debt to bankable projects with a lower

Limited mezzanine financing


In the developed world, many infrastructure projects are part-funded through mezzanine finance, which is a hybrid of debt and equity. Mezzanine finance is debt capital with fixed payment or repayment requirements, but with the right to convert to an equity interest in a company. An example of this type of financing is the convertible unsecured loan which is a loan that pays fixed interest but gives its holder the right to convert it into equity sometime in the future. Mezzanine is generally subordinated debt. It carries two advantages: first, it attracts investors by offering a rate of return which is higher than that of senior debt and second, on

27

INDIA Financing Infrastructure : Addressing Constraints and Challenges

Box 1: Risks Presenting Unique Challenges to Infrastructure Project Financiers Key risks relate to recovery in infrastructure projects which arise out of wrong revenue forecasts, inability of government entities to levy appropriate user charges, and the arbitrary actions of state governments as consumers. Recent experiences suggest that there are at least seven different types of risks which characterize most infrastructure projects: (i) Public risks, involving political, administrative, legal, regulatory, and dispute resolution and enforcement mechanisms; (ii) Economic and financial risks, i.e. those dealing with interest rates, currency risks, and other macroeconomic factors; (iii) Market risks, which concern traffic, revenue and business model forecasts; (iv) Construction risks, or the problems associated with timely completion and force majeure; (v) Operating and maintenance risks; (vi) Environment risks; and (vii) The risk of public unacceptability of project features, such as levels of tariffs, the inability of government entities to levy appropriate user charges and the arbitrary actions of state governments as consumers. India has been fortunate in the last half decade to be relatively immune to interest rate, currency and other macroeconomic risks. But it has faced all other risks listed above in some measure. Attracting private financing in infrastructure will require a facilitating environment that addresses these various unique risks. Three types of market risks that pose a unique challenge to infrastructure project financiers are particularly worth noting: *

Wrong traffic projections. For the PPP projects in roads, most traffic projections made by the best of independent consultants have been way off the mark, and all they need are small revenue fluctuations to bring about sharp declines to their Internal Rate of Returns (IRRs) For instance, in case of the Delhi-Noida Flyover, traffic was initially overestimated to the tune of 50 percent. To be fair, over estimating traffic and revenue is a global phenomenon. For instance, the traffic on the toll highway between Mexico City and Acapulco via Cuernavaca was so grossly over estimated and actual traffic flow was so much less that the Build-Operate-Transfer (BOT) project ran on severe losses for almost a decade, and needed to be renegotiated twice over. The risk of over-estimated traffic projections becomes extremely relevant in the case of the BOT contracts, where the private developer has to bear the traffic risk, and even more so in greenfield toll roads that compete with existing free routes. In case of expansion and upgradation projects obviously the traffic projections are relatively easier to forecast, but then it is not obvious that in these cases the private contractor needs to bear the traffic risk (as in the annuity projects in India where the private party does not bear any traffic risk). If traffic projections for roads are difficult, those for ports, especially green-fields, are virtually impossible to estimate. While initial over estimation tends to get dampened with experience, it still leads to an unintended harmful consequence. Lenders get over-cautious about all traffic projections and almost instinctively evaluate all projects by cutting down the revenue figures. This immediately increases project risk, reduces IRR and often makes the cost of funding so high as to scuttle the project. Collection risks. The flow of funds for infrastructure projects is critically dependent on the credibility and certainty of future revenue streams which, given the existing uncertainties in collection, remains suspect. In roads, power and water, the inability of the government to apply and recover appropriate user charges from users seriously hampers the viability of projects.10 In roads, such problems occur even in instances where the traffic is more or less correctly projected. They relate to cases where, because of political clout, consumers simply refuse to pay the appropriate charges. Such cases have been known to have occurred in toll roads, for example the Coimbatore Bypass project in Tamilnadu. They also occur quite frequently in the power sector with both State Electricity Boards (SEBs) and some sections of final consumers consistently refusing to pay their dues. Arbitrary reneging of contracts. The power sector in India has been plagued by this problem the Maharashtra State Electricity Board (MSEB) terminating its Power Purchase Agreement (PPA) with Dabhol, followed by similar terminations in Andhra Pradesh and Karnataka. In Tamil Nadu, although no PPA has been terminated so far, the authorities frequently threaten to do so whenever independent power producers try to press for payments. This arbitrary termination risk is extremely severe in India, especially given the precarious financial situation of most SEBs. The problem gets accentuated because most state governments guarantees are not financially credible.
* Regulatory and other risks are discussed later in the note.
10

For example, having a parallel un-tolled road with a toll road as in the case of Mumbai-Pune Highway.

28

Constraints to Infrastructure Financing

return rather than risk large quantities of funds to earn a couple of hundred basis points higher.

Restrictions on ECBs
Given the risk aversion and/or relative inexperience of many financial intermediaries in India in the area of infrastructure financing, external financial resources (ECBs, mezzanine, equity, etc.) can potentially play an important role in meeting funding gaps. Recent amendments to government policy on ECBs provide for greater flexibility regarding infrastructure related projects. Revised ECB guidelines now allow (i) companies to access ECB for undertaking infrastructure investment activity in India, (ii) borrowings under the approval route by FIs dealing exclusively with infrastructure. The maximum amount of ECB that can be raised by Indian companies under the automatic route in any financial year was increased to $500 million, with minimum average maturity of three years for loans up to $20 million, and of five years for loans above $20 million. Of late, there has been a growth of ECB (through the approvals route) for infrastructure, from $270 million in 2001-02 to nearly $1.9 billion in 2003-4. (Table 1). Despite the welcome increase in ECB for infrastructure, the fact still remains that external funds are significantly inadequate compared to the needs. This may be attributed to the following:

One concern raised by investors is the interest rate cap on ECBs. According to the ECB guidelines, interest rates are capped at Libor+200 basis points for loans with an average maturity of 3-5 years, and at Libor+350 basis points for loans with an average maturity of more than five years. It has been argued that, while these caps may be adequate for normal industrial projects, they are too low to attract funds for riskier infrastructure projects. They limit the compensation which lenders can receive for longer tenors or higher credit risk and, in effect, reduce the availability of long term loan funds for infrastructure where the credit needs are typically for longer durations and where the risk profiles often require pricing at spreads higher than those allowed by the ECB caps. This has implications for mezzanine financing (discussed above). An even greater constraint in utilizing foreign currency loans is the lack of a sufficiently deep forwards-market in foreign exchange. Infrastructure projects require long tenor loans, and if financed through foreign currency borrowings these need to be adequately hedged against currency risks since few infrastructure projects have forex earnings to serve as a natural hedge. Inability to hedge long term currency risk in a market which is limited to one years forward cover poses a big challenge to the use of foreign currency loans in these projects.

Table 1: ECB approvals for infrastructure, 2001-02 to 2003-04 In USD million 2001-02 Power Telecom Roads Total 270 0 0 270 2002-03 375 341 829 1,545 2003-04 700 1,166 0 1,866 2001-02 13 0 0 13 In Rs. Billion 2002-03 18 17 40 75 2003-04 32 54 0 86

Note: Exchange rates are Rs.46.7, Rs.48.4 and Rs.46.0 per USD for 2001-02, 2002-03 and 2003-04 respectively. Source: Economic Survey 2003-04

29

INDIA Financing Infrastructure : Addressing Constraints and Challenges

Limited use of takeout financing


Commercial bank funding of infrastructure projects runs the risk of asset-liability mismatch. An innovative method is to encourage the use of take-out finance. Here, a bank which is funding an infrastructure project gets into an arrangement with a financial institution, where the institution commits to buying the banks loans after a certain period. There are two versions to this arrangement: unconditional and conditional take-out finance. The unconditional version involves full or partial credit risk with the institution agreeing to take over the finance from the original lender.11 Under conditional take-out finance, the institution commits to taking over the finance from the lending institution only if it is satisfied with certain stipulated conditions. Hence, it is only unconditional takeout financing that helps bank resolve the asset-liability mismatch since under the conditional takeout financing model, the long-term risk still remains on the books of the banks until the take out actually happens12. Take-out financing is ideally suited for annuity and BOT type road and housing projects. While there are some recent examples of institutions like IDFC and Housing and Urban Development Corporation (HUDCO) trying takeout financing as a method, this has not found much favor in India. (See Annex B for a case study on takeout financing). While unconditional takeout financing is not very common, it can give a fillip to infrastructure financing by addressing both the unwillingness and the lack of experience of institutional investors to participate in infrastructure financing. The main factors limiting the use of takeout financing include the following: First, the presence of excess liquidity in the system reduces the need for banks to quickly
11

circulate their funds, and hence, the appetite for instruments like takeout financing. With limited number of bankable projects in the fray and no liquidity crunch, banks have no inclination to sell out these good assets from their portfolio. Second, high stamp duties reduce the attractiveness of takeout financing and securitization. Being a state government subject, stamp duties vary considerably across the country. Excessive rates of stamp duties in some states have stymied the growth in innovative financial instruments such as take-out financing and also securitization. In the light of the differential duties across states in India, the infrastructure SPV for securitization could be registered in the state with the lowest stamp duty. However, the fact remains that it results in higher transaction costs and inconvenience in domiciling the entity based on this criteria, despite having all business interests elsewhere. Furthermore, since these duties are charged ad valorem they inflict a high cost for projects that involve high value securities or large asset transactions.

An underdeveloped corporate bond market and the lack of longer term financing
Most infrastructure projects fructify into profit making entities 10 to 15 years after the initial investment and hence require longer tenor financing (with long drawn out repayments) to ensure financial viability of the project. The availability of a developed bond market is an important backbone to project financing for infrastructure as it increases the prospects for project finance banks to eventually off-load their assets, and for project companies to lock in fixed

In such a case the credit facility extended to the borrower is reflected on the books of the original lender till it is taken over. The institution agreeing to take over shows this obligation as a contingent liability till it actually takes over with full or partial credit risk as agreed upon. 12 Here, the assets on the books of the original lender carry 100 percent risk weight as the take over is not automatic.

30

Constraints to Infrastructure Financing

interest rates at lower margin when the project has stabilized after a few years of operation13. Moreover, functional bond markets are important for funding existing infrastructure utilities/companies, as well as certain types of projects with no or low construction risk and an established revenue pattern. Unfortunately, India still does not have a wide or deep enough corporate bond market for such paper. According to the estimates of the Bank for International Settlement (BIS), the size of Indias corporate bond market was 0.3 percent of nominal GDP in December 2003much lower than that of Malaysia (43.3 percent) or South Korea (27.7 percent). Trading on the Indian corporate bond market is limited. For instance, in the long-term debenture market (10 years or more), of the 70 or so issues available for trading, including those of banks and FIs, 41 issues have not been traded even once since their issuance. The rest are sporadically tradedfrom once a month to once a year. Listed SOE bonds a major part of corporate debt paper are traded on the Wholesale Debt Market (WDM) of the National Stock Exchange (NSE). However, trading in the private corporate sector bond market is insignificant, and most of the issuance is currently on a private placement basis.

Table 2: Interest rates on various savings instruments Saving Instrument Postal Savings National Saving Scheme EPF PPF G-Sec T-bill Rates (%) 6.25-7.5 8.5 9.5 8.0 4.69-5.73 4.36-4.37

Note: Rates for 1 to 5 years duration except EPF; as of Dec 2004 Source : Reserve Bank of India, State Bank of India, National Stock Exchange and Department of Posts

and innovations in the corporate debt market and regulatory issues:

I. Outstanding issues in the development of the government securities market


Absence of a benchmark yield curve for government bonds. While the government has issued long term securities, the relatively small average size of each benchmark securities issuance14 coupled with limited trading activity has meant that there is really no risk-free benchmark reference rate to peg the longer tenor section of the yield curve.15 To create a reliable government bond benchmark yield curve, the size of each benchmark security needs to be sufficiently large, usually a significant multiple of the average transaction size. Starting in 2003, the RBI has made efforts to consolidate issuances with the aim of concentrating liquidity in a small number of benchmark issues. However, more active steps need to be taken for consolidation. (See Annex C). The government debt market is wholesale in nature; the limited trading that does

What explains the underdeveloped nature of Indias corporate bond market?


The lack of size and depth in Indias corporate bond market may be attributed to three broad sets of issues viz., development of government securities market, lack of market infrastructure
13

Internationally, the contributions of bonds to total project debt financing has been growing at a slow pace and at present bonds represent around 20 % of international project financing with the rest coming from syndicated loans mainly from banks. 14 While the size of the gross borrowing requirement is large, the markets absorptive capacity is small and this puts constraints on the size of individual issues leading to a number of small issuances of benchmark securities. This in turn affects liquidity of the benchmark securities. 15 Recently, the NSE in its WDM segment has come up with an innovative formula to devise a 20-year yield curve. While it functions as the only quasi-reference rate for long term corporate paper, it has not sufficed to trigger a more active bond market for long tenor debt securities.

31

INDIA Financing Infrastructure : Addressing Constraints and Challenges

take place is done bilaterally over the telephone through brokers,16 or on the Negotiated Dealing System (NDS). This results in a non-transparent market with poor-price discovery where only the parties to trade have information about the trade. The lack of trading in the government debt market may be attributed to two other factors. First, institutional investors such as pension funds and insurance companies are mandated to hold Government securities until maturity, thus hindering active trading. Second, retail investors prefer to invest in instruments such as postal savings and provident funds where returns are artificially pegged at much higher rates (see Table 2), than to invest in the debt market, especially given the lack of awareness on the risk-return profile of the Government securities and the relatively higher cost of trading in the retail segment of Government securities.

II. Market infrastructure issues and lack of innovative instruments in the corporate debt market
Cumbersome primary issuance guidelines for corporate issuers have further constrained the development of the corporate bond market. Raising debt through a public issuance in India entails high costs, associated with regulatory compliance, advertising, and intermediation costs to brokers and underwriters, and is a lengthy process - the minimum timeframe for clearance of offer documents by the regulator is 21 days. By comparison, approval by the regulator takes just 5 days in Korea (for secured and guaranteed bonds).

Each country has particular features which cause the costs of issuing securities to differ. The cost of raising US $ 100 million through a plain vanilla domestic bond issuance expressed as a percentage of issue size is 2.40, 2.74 and 1.18 per cent for Brazil, Chile, and Mexico respectively17. Anecdotal evidence suggests that public issuance costs in India for a similar issuance size could vary between 4-6 percent which typically covers costs related to fees for rating, listing, trusteeship, R&T Agent, arranger fees and stamp duty. On the other hand, the private placement market in India offers competitive rates and quick access to the market as there is relatively less regulatory compliance. Hence, this segment which is less transparent accounts for over 90 percent of debt placement in India18. Recent guidelines that require compulsory listing of all privately placed debt on the stock exchange and detailed listing agreements with the exchange have greatly increased the disclosure requirements and costs for private placement, thereby affecting first-time issuers who wish to tap the market. Also, shelf registration19, which facilitates frequent and quick issuance of debt securities, is available in India only to specially designated Public Financial Institutions (PFIs) and not to all corporate issuers. Inadequate corporate credit information. Investors lack sufficient, timely and reliable information on bonds. Data on bond issues, size, coupon, latest credit rating, underlying corporate performance, information on secondary trading (particularly pre-trade information related to investors having access to best quotes) and

16 NSE does provide a platform for trading, but it is mainly used for reporting deals which have been executed and thus it remains a negotiated market. 17 Source: Zervos, 2004; The Transactions Costs of Primary Market Issuance: The Case of Brazil, Chile, and Mexico, The World Bank. 18 In most jurisdictions, while extensive disclosure guidelines tend to apply to public issuances, private placements are usually exempt from such stringent rules. In the US, many issuers prefer to use Rule 144A for placing securities privately to qualified institutional buyers which exempts them from registration, detailed disclosures and costs related to preparing financial statements according to US General Accepted Accounting Principle (GAAP). 19 Shelf-registration in India is allowed through an umbrella prospectus, whereby a company files one consolidated offer document with the securities market regulator for the entire amount it proposes to raise over the next 12 months allowing the company to make more than one offering within the stipulated period.

32

Constraints to Infrastructure Financing

default histories of companies are sparsely available, and are not available from one source. No one knows exactly how much debt is outstanding on any given date. This has muddied the corporate debt market and created barriers to active trading and pricing. Lack of market infrastructure. Inefficient clearing and settlement mechanisms (currently most trades in the secondary debt market are settled bilaterally by the trading parties outside the clearing and settlement system run by the stock exchanges) and poor and lengthy enforcement laws relating to default proceedings make the corporate debt markets even more illiquid. The reforms undertaken by several East Asian and Latin American countries to improve market infrastructure related to clearing and settlement systems could provide some useful lessons (See Box 2). Skewed interest rates. Many companies with

AAA (i.e., investment grade) ratings offer lower coupons than the sovereign rate on instruments such as Public Provident Fund (PPF) or National Saving Certificates (NSCs). (Table 2). Individual investors, therefore, have almost no interest in the primary as well as secondary corporate coupon debts, unless these are accompanied by some significant fiscal concessions resulting in net higher return compared to sovereign or quasi-sovereign instruments. Lack of innovative instruments such as third-party credit enhancement and hedging tools for investors and traders to mitigate credit risk and interest rate risk. Third party credit enhancement or the provision of credit guarantee (also known as bond insurance) by a third party for issuers with noninvestment grade rating provides an important avenue for these lower rated issuers to tap the market20. From the point of view of the issuer, credit guarantee would help lower

Box 2: Reforms in clearing and settlement systems in East Asia and Latin America regions Robust clearing and settlement systems are a crucial element to bond market development because they help enhance the efficiency of bond trading and reduce their associated risks. In addition, bond market liquidity is closely linked to the reliability of bond clearing and settlement systems. Investors will only trade bonds if they are confident of the settlement of their trades. A key measure to improve market infrastructure would be to establish a clearing system for corporate debt, wherein settlement is guaranteed. To date, many countries in East Asia have adopted electronic trading and real-time gross settlement (RTGS) and delivery versus payment (DvP) clearing and settlement systems on a transaction by transaction basis. In Latin America, Mexican authorities have also paid attention to the market infrastructure, improving custody and clearing and settlement arrangements and adopting a RTGS. These improvements to the basic infrastructure, together with the development of a peso yield curve, help to explain the rapid growth of the local interest rate derivatives market on the Mexican Derivatives Exchange (MEXDER), which allows local participants to hedge interest rate risk (see Glaessner 2003). In terms of volume of derivatives contracts, MEXDER has become one of the most active exchanges worldwide in short-term interest rates futures trading. In Brazil the Association of Open Market Institution (ANDIMA) became the prime mover behind the establishment and running of the national clearing, settlement and registration systems for corporate bonds in Brazil. The importance of the National Private Bond System (SND) in Brazil is such that it has been reported that most corporate bond issues are registered with the SND even when there is no legal obligation to do so. Registration with the SND is said to lend more credibility and transparency to the bond issue. The SND is responsible for the registration and settlement of most corporate bonds in Brazil.
Source: IOSCO, 2002 and World Bank
20

Having said that, while credit insurance is important for the overall bond market, it is acknowledged that credit insurance for infrastructure financing has been more difficult and has been used in a few developing countries (such as in Chile for the toll road program) and often times in conjunction with official insurers such as MIGA or Inter-American Development Bank.

33

INDIA Financing Infrastructure : Addressing Constraints and Challenges

funding costs as well as broaden market access and the investor base 21. From the investors perspective, credit guarantee provides additional comfort or protection against default risk and can also contribute towards enhancing liquidity in the secondary market. Further, with a credit enhanced rating, many issuances are able to qualify under the guidelines of pension and insurance funds and of other conservative investors Credit guarantees play an important role in enhancing financial intermediation by bridging the gap between the borrowers especially those with inadequate credit ratings and certain investors who would only be allowed or interested in investing in bonds with higher credit rating. Currently, there are no institutions that provide such credit guarantee products in India. In more developed markets, credit guarantee services tend to be provided by specialized credit guarantee companies. For example in the US, credit guarantee facilities are mainly provided by four major credit guarantee companies called the monolines and the credit guarantee market has been recording a substantial growth in the US and to a smaller extent in Europe in the last two decades. In India third party credit enhancement has not developed due to lower maturity of the market, lack of market intermediaries such as the monoline insurers which have deep financial ability and risk capital to provide such services and lack of reliable credit default histories (which is at a very nascent stage of development in India today) needed to appropriately price credit guarantee products. Even if a lower-rated borrower uses this product, it would not be economical for it to do so unless the savings resulting from reduced interest cost exceed the
21

cost of guarantee. There have been very limited instances of credit-enhancement for bond issuances in India, mainly in municipal financing with multilateral (USAID, World Bank) funding. Development of financial instruments such as credit derivatives and interest rate hedging tools to increase liquidity in the secondary markets is constrained either by the absence of enabling guidelines from RBI in the case of credit derivatives or by an absence of a suitable money market index for the interest rate swap market to develop (although indications are that this is now beginning to develop). A comparison with other developing countries with regard to the availability of such instruments is provided in Annex D.

III. Regulatory issues


Overlap in regulation of the debt markets. The existence of regulatory barriers arising from capital/financial markets could be explained in part due to regulatory overlaps in the debt markets and in part due to the fact that bond markets are difficult to develop and creating the right regulatory and market conditions for an efficient bond market is a gradual process22. In the debt markets, Ministry of Finance (MoF), RBI and Securities and Exchange Board of India (SEBI) all have regulatory and supervisory roles that are not sufficiently delineated. As investment banker to GoI, the RBI oversees the Government debt market, and conducts primary issuance for the Governments debt requirements in the domestic bond markets. RBI is also responsible for regulation and policy for over-the-counter (OTC) financial derivatives and spot markets for government bonds. In addition, RBI regulates the

The issuer enhances its creditworthiness by purchasing credit guarantee and receives the credit rating, usually AAA, of the credit guarantee company. Unless the savings resulting from the reduced interest costs exceed the cost of the guarantee, this form of credit enhancement is not useful for the issuer. 22 There are certain pre-conditions that need to be in place in order to have a well functioning debt market such as macroeconomic stability and credibility, benchmark issues, taxation issues, regulatory guidelines and legal infrastructure, efficient money markets, bankruptcy laws, proper accounting, auditing and disclosure rules which are being introduced gradually in the Indian debt market.

34

Constraints to Infrastructure Financing

largest of investors and issuers in the bond markets viz. the banks and financial institutions. On the corporate debt market, SEBI is responsible for regulating and supervising primary offerings of securities (equity and debt instruments) by companies that are listed, or to be listed on an exchange as well as secondary trading, clearing and settlement of all instruments (including financial derivatives) traded on stock exchanges. The overlap in regulation and different focus of each authority tends to inhibit coordination between the regulators leading to impediments in development of new products and innovation in the design of debt markets which could lead to more efficient and safer issuance, trading, clearing and settlement mechanisms.

As markets develop and mutual funds evolve, bond funds are likely to hold a variety of instruments as is the case with income funds in mature markets, SEBI will clearly have jurisdiction over such bond funds. To the extent that corporate bond issuers interface with entities such as banks for arrangements such as trusteeship and guarantees of payments, the recording of such arrangements on banks books would require RBI oversight. In this context, the establishment of good mechanisms for regulatory information sharing and coordination are important. Such overlaps and jurisdiction issues will increase as financial markets become more complex and open, thereby increasing the challenge of regulating and supervising them. A few examples of this overlap which result in

Box 3: Examples of regulatory overlap in the debt market The exchange-traded secondary debt market in India is one such area of overlap, particularly for on-exchange government securities. The National Stock Exchange offers a trade reporting system for government securities (permission to offer this facility is granted by both RBI and SEBI) which allows a network of brokers to interface between banks and other institutional investors trading in government securities. Setting up of a parallel electronic negotiated dealing system (NDS) in 2002, owned and maintained by the RBI (which is the market regulator of the dealing system as well, a situation which could result in conflict of interest) has resulted in duplication of infrastructure and fragmentation of the market for government securities as the NDS is restricted to those entities which hold current accounts and securities with RBI (banks, primary dealers, Financial Institutions etc). Currently, market participants like brokers, provident funds, etc., who play an active role on NSEs Wholesale Debt Segment are not part of this system. This results in fragmentation and inefficient price discovery.

Legality of OTC Derivatives Following amendments to Securities Contracts (Regulation) Act, 1956, interest rate derivatives were introduced in 1999. Banks could undertake plain vanilla Forward Rate Agreements and Interest Rate Swap contracts for their own balance sheet management and also for market making purposes, provided they ensure adequate infrastructure, risk management systems and internal control systems. Over the last three years the volume in the OTC market has grown noticeably with the outstanding notional amount at around Rs. 6.4 trillion23. There is a proposal to amend the Securities Contracts (Regulation) Act, 1956 to make only those derivatives contracts that are executed on exchanges legal and valid. This market would then come under the purview of SEBI as SEBIs oversight extends over the exchange traded market. RBIs stand on this issue is that while exchange traded derivatives have their own role to play in the debt market by their very nature exchange traded derivatives have to be standardized products. On the other hand, OTC derivatives can be customized to the requirements of trading entities. Thus, both OTC and exchange traded derivatives are essential for market development. Therefore, RBI is proposing amendments to this law to make contracts, of the class and nature as notified by RBI, legally valid, even if they are not traded on any recognized stock exchange. Market participants believe that this is an extension of the earlier regulatory turf issue that emerged during the introduction of exchange traded interest rate derivatives which have not taken off since introduction.
23

Participation in the markets continues to remain limited mainly to select foreign and private sector banks and Primary Dealers

35

INDIA Financing Infrastructure : Addressing Constraints and Challenges

diffusing regulatory authority and uncertainty for market participants are provided in Box 3. Absence of long term investors has constrained the development of the long-term bond markets. With the exception of LIC, insurance companies, pension and provident funds, which should be active investors in long-term corporate debt paper, rarely invest in paper with a maturity longer than 5-7 years.24 This has much to do with the investment guidelines for these funds, which tend to be restrictive. Equally, it has much to do with their incentive structure. Most (if not all) of them do not have the incentive to earn abovemarket returns. The lack of incentives to earn high returns results in conservative investment behavior and stringent internal investment policies. Most funds (especially in the public sector) are managed by administrators rather than fund managers and have a buy-and-hold philosophy, which discourages secondary market trading. This could change in the future, once these funds start offering market-linked schemes and compete with each other for subscriptions. (These issues are discussed in more detail in Box 3). Regulatory treatment of bonds vis--vis loans. Another important class of investors, banks, are also constrained from participating actively in the corporate bond markets due to regulatory requirements that discriminate between the treatment accorded to investment by banks in corporate bonds, which require a higher risk
24

weight, than loans to corporates. Further, RBIs recent guidelines restrict banks investment in unlisted non-SLR securities25 to 10 percent and require minimum investment grade rating, thereby keeping out banks from investing in bonds of lower rated corporates (this would affect infrastructure companies as these would typically be lower rated corporates given the inherent riskiness of the sector).

Regulatory and institutional issues constraining higher participation of FIs and commercial banks
It is widely accepted that insurance companies and pension funds are ideal candidates for supplying long tenor financing given the longtenor nature (15 years or more) of their liabilities. But with a few notable exceptions, in recent times, most insurance companies and pension funds have not focused on funding infrastructure. Commercial banks have also had little appetite for infrastructure financing26, although recent years have witnessed an increase in their lending to infrastructure. (See Annex E for a detailed analysis of participation by FIs in infrastructure projects). The Industrial Development Bank of India (IDBI)s27 report on the sanctions and disbursements of FIs reveals that the total loans sanctioned by these institutions towards infrastructure in the first three years of the period 2001-02 to 2010-11

Retail participation in the secondary corporate debt market is insignificant and has fallen from 1.74 per cent in 199596 to 0.03 per cent in 2000-01. 25 Non-SLR securities typically comprise of securities issued by corporates, banks, FIs and State and Central Government sponsored institutions, SPVs etc. These securities are not considered as eligible securities for the purpose of SLR requirements of banks and financial institutions. 26 In part, this stems from asset liability mismatches on account of the difference in tenor between the banks liabilities and the tenor of advances needed for infrastructure financing. For instance, while infrastructure lending has an average tenor of 7-10 years, the average maturity period of 58 percent of deposits of scheduled commercial banks in India was under two years as of March 2003. In absence of take-out or mezzanine finance mechanisms, it is difficult beyond a point for banks to manage longer tenor assets with shorter-tenor liabilities. 27 The Industrial Development Bank of India (IDBI)s annually prepares a report of the sanctions and disbursements of FIs, including towards the infrastructure sectors. The list of institutions included in this report are IDBI, IFCI, ICICI Bank, IIBI, IDFC and SIDBI (which are classified as all-India development banks), specialized FIs such as the Exim Bank and NABARD, and investment institutions i.e. LIC, GIC, NIC, NIA, OIC, UII and UTI.

36

Constraints to Infrastructure Financing

Box 4: International Experience of Channeling Local Financing through Developing Local Capital Markets There are four channels through which local financing capabilities are being developed internationally: First, through issuance of equity on the local stock market by companies already engaged in providing infrastructure services. Telecom companies have been active issuers of equity in several countries (including Thailand and Argentina) and have played an important role in raising the capitalization of their emerging markets. Second, through private equity placements with individual project companies by institutional investors such as insurance companies and pension funds. This type of equity participation is more common with Greenfield projects that are financed on a limited recourse basis. The capital markets payoff emerges from the experience that institutional investors acquire through becoming more active investors in the real sector (in many countries, insurance and pension funds have mainly bought government securities). Pension and insurance firms in Chile, Malaysia and Philippines are now becoming active investors through their involvement in infrastructure projects. Third, through debt financing provided by local commercial banks and development FIs. These institutions can be privately, publicly (government) or jointly owned. Most projects have a local currency financing requirement and where possible local banks can contribute to development of the overall debt package. In many countries, local banks have limited experience with providing structured project financing debt, and participating in a large deal can enhance their risk appraisal capabilities. Fourth, debt finance obtained through locally-issued bonds by infrastructure companies. Bond issues are more common from established companies (such as those operating in telecoms) because bond purchasers tend to be risk averse. However, examples of pre-completion bond financing are starting to emerge in Chile and Malaysia. Each of these four channels provide a capital market impact that can be beneficial for a countrys mobilization capability, but the strongest impact occurs when project financing occurs through equity listing or a domestic bond issue. In addition, the state of a countrys capital markets may affect financing strategies. For instance, bond issuances can sometimes be made pre-construction, but not on the local market, if the legal and regulatory framework which governs capital market transactions is weak or if the domestic securities market is small. In India, a key legal weakness of the corporate bond market is the payoffs obtained by bondholders in the event of default. In industrial countries, an extensive bankruptcy code exists, with well functioning institutions. When a firm fails to pay out cashflows on time, the management team of the firm is displaced, the firm is sold off, and the residual value is given to the bondholders. Such processes do not exist in India. Bondholders have to plan for near-zero recovery, in the event of default. The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 has made some progress on rapid repossession of collateral for secured credit. However, this is a narrow concept which does not address the deeper issues of the bankruptcy code. In a modern setting, bond issuance should be a senior claim on the cashflows of the firm, and not associated with specific assets. One of the key weaknesses of SARFAESI is that it is focused on the interests of institutional bondholders. It does not adequately address the claims of individual bondholders. Differences in the capabilities of local bond market explain why Malaysia was able to finance a power project through a bond issuance whereas a Philippines power project required an international bond offering. Countries that promote the growth of their capital markets will find it easier to finance infrastructure investments.
Source: IFC: Lessons of Experience in Financing Private Infrastructure, September 1996

has been Rs.460.6 billion, or a mere 8.3 percent of our estimated aggregate financing gap of Rs.5,542 billion. At this rate, the total sanctions

for infrastructure projected forward for the decade 2001-02 to 2010-11 turns out to be a little more than Rs.1,500 billion, or 28 percent of

37

INDIA Financing Infrastructure : Addressing Constraints and Challenges

the aggregate finance gap. Clearly, these FIs have a long way to go. Moreover, while sanctions have been low compared to the financing gaps in infrastructure, disbursements have been lower still. For the three years ending 2003-04, total disbursement of the FIs has be Rs.287.6 billion, which translates to 5.2 percent of the finance gap for 2001-02 to 2010-11. Among the various term-lending institutions, LIC (the largest insurance company in India that is also state-owned) has emerged as the biggest player, with its disbursements for infrastructure projects exceeding the combined disbursements of IDBI, IFCI, IDFC, IIBI and SIDBI. However, most of the involvement of the state-owned insurance companies, including LIC, is in infrastructure projects of the central and state governments SOEs backed by government guarantees. These are often not based on credibility or the detailed economics of the project. In fact, in the past, state governments have raised funds from the insurance SOEs ostensibly for financing infrastructure, which have then been diverted to the states consolidated finances. Commercial banks have only been marginal players in terms of their share of infrastructure financing in the recent past, though this segment has registered strong growth in the last two years. Within the sectors, FIs have a much higher appetite to lend for power projects than others. Power generation accounts for 62 percent of the value of infrastructure loans sanctioned and 55 percent of disbursals. Telecommunication comes second, accounting for 20 percent of total infrastructure sanctions, and 24 percent of disbursals.

increases the risk-aversion of FIs towards infrastructure financing. Even in cases where projects are being regulated through contracts, the inability to enforce the contract conditions and threat (and actual experience) of reopening of these contracts by government, greatly increases the risk profile of the projects (a discussion on regulatory constraints in different sectors is presented later in this note Section 2.4). The risk-aversion of FIs in financing infrastructure projects further manifests itself in their reluctance to enter projects at the early stages, where project risks are concentrated. One of the main reasons cited for viable projects not reaching financial closure quickly enough has been the lack of financial support at the initial stage of a projects life cycle. Commercial banks, of course, rarely take equity positions in infrastructure projects. Unfortunately, even the specialized infrastructure financing companies, such as Infrastructure Leasing and Financial Services Ltd. (IL&FS) and Infrastructure Development Finance Company (IDFC), have preferred to enter projects only after the Commercial Operations Date (COD) phase. Critics point out that the rationale for setting up these specialized institutions was precisely to take initial equity positions in these ventures, and provide the confidence necessary to attract further capital into the project.

Restrictive government policies and regulatory guidelines


Restrictive government policies and regulatory guidelines have further constrained the ability of insurance companies and pension funds to participate in infrastructure financing. (See Box 5). For commercial banks, while RBI regulations do not pose serious constraints for banks to increase their exposure to infrastructure sectors, the flexibility of banks to become more active in this segment is constrained by RBIs regulations that

The role of regulatory uncertainty and risk in limiting FI participation


A fundamental factor limiting the participation of all types of FIs in infrastructure financing relates to regulatory uncertainty, which raises the risk-profile of infrastructure sectors, and

38

Constraints to Infrastructure Financing

Box 5: Restrictive Investment Policies and Guidelines for Insurance and Pensions The investment guidelines of insurance companies specified by IRDA require them to invest not less than 15 percent of their investments in infrastructure and social sectors. It is understood that most of the investments by insurance companies in infrastructure are made to State-owned specialized FIs such as National Thermal Power Corporation (NTPC), Power Finance Corporation (PFC) (which have a AAA rating) as also to housing sector which qualifies under infrastructure investments. This clearly indicates the low risk-taking outlook of the insurance companies. The guidelines also lay down a minimum credit rating of AA for investments in debt paper which would automatically exclude investment by insurance companies in debt paper of private infrastructure sponsors. Investment guidelines for life insurance companies S.No Type of Investment i) ii) iii) Government Securities Government Securities or other approved securities (including (I) above) Approved Investments as specified a) Infrastructure and Social SectorNot less than b) Others to be governed by specified Exposure/ Prudential Norms iv) Other than in Approved Investments to be governed by specified Exposure/ Prudential Norms 15% Not exceeding 20% Not exceeding 15% Percentage 25%, Not less than 50%,

Source : Insurance Regulatory and Development Authority (IRDA)

Investment guideline for non-life insurance companiesS.NoType of InvestmentPercentage i) ii) Central Government Securities being not less than State Government securities and other Guaranteed securities including (i) above being not less than 20% 30% 5%

iii) Housing and Loans to State Government for Housing and Fire Fighting equipment, being not less than iv) Investments in Approved Investments as specified in Schedule II a) Infrastructure and Social SectorNot less than b) Others to be governed by specified Exposure/ Prudential Norms v) Other than in Approved Investments to be governed by specified Exposure/ Prudential Norms

10% Not exceeding 30% Not exceeding 25%

Source: Insurance Regulatory and Development Authority (IRDA)

Pension and provident funds, both Employees Provident Fund (EPF) and PPF, are also repositories of large amount of long-term finance. However, as a legacy of government regulations, pension funds remain a notionally funded scheme. For one, almost 72 percent of the fund exists in the form of special deposits with the central government. Under the existing stipulations, these funds cannot be drawn out for deployment in other avenues and, thus, remain a black-hole. For another, a significant portion of the remaining funds are deployed in government securities, which, too, remain locked in for two reasons. First, once a government security is subscribed, regulations mandate that they be held till maturity. Second, investment guidelines also mandate that interest received from government securities be re-invested in those securities itself. The investment profile of pension funds are highly regulated with a massive bias towards government securities. This precludes the largest source of long-term funds from bridging the financing gap in infrastructure. A survey of pension fund investment guidelines of some of the Latin American countries suggest that while significant

39

INDIA Financing Infrastructure : Addressing Constraints and Challenges

exposure to government debt is stipulated there is considerable freedom for these funds to invest in a mix of financial instruments with varying risk-return profiles. Since the early eighties, pension funds have become important players in capital markets of many Latin American countries due to radical reforms to the social security systems. However, Pension funds are subject to quantitative restrictions including list of authorized assets, diversification rules, conflicts of interest regulation, valuation rules etc. Investment guidelines for pension funds Investment Pattern i) Central Govt. Securities; and/or units of Mutual Funds which have been set up as dedicated funds for investment in Government securities and which have been approved by SEBI a) Govt. Securities; created and issued by any State Government; and/or units of such Mutual Funds which have been set up as dedicated funds for investment in Govt. Securities and which have been approved by Securities and Exchange Board of India (SEBI) b) Any other negotiable securities the principal whereof and interest thereon is fully and unconditionally guaranteed by the Central Govt. or any State Government iii) a) Bonds/Securities of PFIs, Public sector companies including public sector banks b) Short duration Term Deposit Receipt(TDR) issued by public sector banks iv) to be invested in any of the above three categories decided by their trustees v) The trust, subject to their assessment of risk-return prospects, may invest up to 1/3rd of (iv) above, in private sector bonds/securities, which have an investment grade rating from at least two credit rating agencies. 30% Percentage amount to be investment

25%

ii)

15%

15% 30%

Source:EPFO guidelines

Maximum exposure to an asset for pension funds in Latin American countries Argentina Government Debt Time Deposit Bonds Stocks Mortgage Bonds Foreign Investment Close-End Investment Funds Futures and Exchange Risk Coverage 28% 28% 35% 28% 10% 14% 2% Chile 50% 50% 45% 37% 50% 12% 5% 9% Colombia 50% 50% 20% 30% 30% 10% Peru 50%40% 30% 49% 35% 40% 10% 15% 10% Uruguay 60% 30% 15% 25% 20% Nil Nil Nil 15% Nil India 55%* 30%**

Source: Organization for Economic Cooperation and Development (OECD)

*which could go to a maximum of 85 percent due to a discretionary component of 30 percent with the trustees **Bonds/Securities of PFIs, Public sector companies including public sector banks and short term deposits with banks

40

Constraints to Infrastructure Financing

prevent banks from participating in the credit derivatives markets. This precludes banks from taking on higher credit risk with the option of hedging these risks to the extent needed through these products. Furthermore, the skewed incentive systems of the larger (publicly owned) FIs, that have traditionally operated in an uncompetitive environment, have led to conservative internal investment guidelines of FIs, giving little space for investment in areas like infrastructure, that are perceived as risky. Until recently, in the absence of competition, the investment departments of these institutions merely functioned as administrators of funds, without any significant performance pressures on returns. Any shortfall on guaranteed returns to pension and insurance plans were expected to be met through government support. But this is changing as competition increases.

sectors. Consequently, entities that have access to large amounts of relatively cheap depositors funds shy away from infrastructure investment, unless proposals are appraised by specialized FIs like IDFC. Banks lack the incentive and the wherewithal to shore-up their appraisal skills. Additionally, the existing employees incentive structure in the public sector, including promotion and rotation policies, of public sector banks, makes it difficult for these banks to develop and/ or leverage on such a skill-set.

Lack of a reliable interest-rate benchmark


One of the standard practices in international project finance is to use a reliable and generally accepted interest rate benchmark (e.g. LIBOR) as a backbone for longer-term floating rate commitments which are periodically rolled over. In India, the Mumbai Inter Bank Rate (MIBOR) has been in existence for sometime now but has not yet attained the reliability and acceptance to serve as a benchmark for such project finance syndications. The absence of such a benchmark would limit flexibility and would reduce the incentive for FIs and banks to participate and thus the probability of success of syndications for infrastructure finance.

Insufficient knowledge and appraisal skills


Insufficient knowledge and appraisal skills related to infrastructure projects is another constraint, increasing the risk perception of insurance and pension funds towards infrastructure projects. The banking sector, too, lacks the specialization and experience to appraise the risks and returns associated with large and complex infrastructure projects. Commercial banks have generally focused on working capital finance, trade funding and bill discounting and, therefore, have not developed sufficient expertise to appraise complex and risky infrastructure projects with long gestation periods.28 Though, in recent times the State Bank of India (SBI) has developed relatively strong skills in project evaluation and infrastructure project advisory, most banks know little about the
28

2.2 Fiscal Barriers to Private Financing of Infrastructure


An enabling fiscal environment is a pre-requisite for attracting private sector players to inherently high risk ventures. The GoI has introduced tax concessions, and these have helped. GoI has also introduced VGF for infrastructure projects that are being operationalised currently. While tax concessions are not necessarily desirable per se, they help increase returns and hence in certain situations can help stimulate private investment.

This has been a handicap in project risk management, which covers the entire gamut of exposure i.e. engineering, construction, start-up and operations. To evaluate and mitigate such risks requires comprehensive due diligence, including a rigorous analysis of the assumptions underpinning the financial model which majority of the banks are ill-equipped to handle.

41

INDIA Financing Infrastructure : Addressing Constraints and Challenges

In this context, there are some fiscal issues that need to be ironed out in order to give further fillip to infrastructure sectors. Some of these are identified below.

which has on several occasions led to delays in getting the concessions. Second, there is an issue of escalation. In essence, if the surplus of an infrastructure SPV that falls under section 10(23G)is reinvested in another infrastructure SPV both of which belong to the same umbrella company could the latter also obtain the fiscal benefits under this provision? As of now, the opinion runs counter to this. According to this view, an enterprise qualifies for the benefits under section 10(23G) if it is wholly engaged in the business of developing, maintaining and operating any infrastructure facilities. The catch lies in the word wholly. This apparently precludes any infrastructure enterprise to invest or lend its investible surplus in another infrastructure entity for that would be an act of financing, and not amount to developing, maintaining or operating of infrastructure. So, if an infrastructure enterprise lends a part of its surplus, it ceases to be a company wholly engaged in infrastructure and, instead, becomes also a lending or investing entity. Thus, according to this interpretation, it will not get the benefits of section 10(23G). This is a very linguistic and extremely legalistic interpretation of the provision. Suppose a bank or financial institution lends to an infrastructure company X, which in turn reinvests a part of the surplus in another group infrastructure company Y only for the purpose of financing an infrastructure project. Clearly, in terms of transactions, this is more efficacious than Y again needing to approach a bank or FI for the additional amount of funding. In principle, therefore, the benefits of section 10(23G) should flow to company Y, provided that it is also a pure infrastructure company as defined under the section. This problem can be resolved by either eliminating the word wholly or substituting it with substantially.

High customs duties on infrastructure equipment


While there are import duty concessions available to imports used for infrastructure development, such as in the case of mega power projects, certain telecom equipment etc., these are largely selective in nature. For instance, while equipment for mega-power projects can be imported against zero or low duties, the same facility is not available for capital goods used in roads. It has been suggested that the government create a master list of all key capital goods and machinery used for roads, power, ports, airports, telecom and water supply and distribution, and make these available at zero duty. In large measure, this is what China has done in the recent past, which has significantly reduced its cost of setting up infrastructure.

Section 10(23G) of the Income Tax Act


This clause exempts tax on income from dividends, interest and long term capital gains from any investment made in an enterprise engaged in the business of developing, maintaining and operating an infrastructure facility and has been of great help in facilitating infrastructure investments. However, three issues still cause problems. First, the borrowing infrastructure company needs to get annual approval and certification of its infrastructure status from the Central Board of Direct Taxes (CBDT) before the lender can claim the fiscal benefits under this section. The process is not automatic and often takes considerable time

42

Constraints to Infrastructure Financing

Third, the benefits of section 10(23G) do not flow down to retail investors. Had that been possible, the tax benefits of this provision could have been leveraged to create more dedicated infrastructure mutual funds where the retail investors would have been additionally attracted by the tax incentive.

business partners for private participation in infrastructure.

sector

2.3 Approvals, Red tape and Inadequate Administrative Capacity in Government


Almost all infrastructure projects in India suffer from unacceptable delays. Some of these relate to inadequate regulatory frameworks. However, much of it has to do with cascading level of inefficiencies across virtually all approving agencies. Given below are some of these barriers.

Tax holidays under section 80IA


Section 80IA of the Income Tax Act relates to infrastructure projects and provides for 100 percent tax deduction on profits for 10 years and 50 percent for the next five. There are two issues with this seemingly beneficial provision. First, most infrastructure projects, especially those in roads, power and ports, take up to 7-8 years before starting to show profits. Therefore, providing for a 100 percent tax holiday over the first 10 years does not actually amount to a serious fiscal incentive. Second, even this limited fiscal incentive is overridden by the Minimum Alternate Tax (MAT), which is levied at 7.5 percent on book profits. Consequently, the fiscal benefits from section 80IA get significantly diluted at the ground level.

Multiple clearances
Infrastructure projects require multiple clearances at centre, state and local levels. This is a time consuming process not only due to the sheer number of approvals but also because clearances are sequential, and not concurrent.29 According to most developers and financiers, the time taken to obtain all the requisite approvals for an infrastructure project can vary between a low of 18 months to as much as four to five years. For example, it took more than two years for the Gujarat Pipavav port project to receive the necessary clearances after achieving financial closure on the project. Delays like these in getting government approvals, places India very unfavorably compared to China and SouthEast Asia. In spite of the theoretical concept of a single window clearance in many states, when most projects apply for approvals at the state-level, these have to go through multiple clearances from local panchayats, municipalities, forest, environment board etc which cause huge delays in completion. In many cases, the concession agreement entered into by individual departments do not have pre-approved clearances from the Finance Department, leading to further delays.

Poor state government finances


Nearly all states suffer from serious fiscal imbalances and are ridden with huge debt obligations. The debt to GDP ratio of states has increased by over 7 percent in the last five years to 29.1 percent (31 March 2004). In 2003-04 interest payments on debt accounted for over 25 percent of revenue receipts. Apart from the increasing level of debt, the outstanding guarantees of state governments have also recorded a sharp increase from 4.4 percent of GDP in March 1996 to 7.5 percent of GDP, or Rs.1,842 billion. Clearly, in such a situation, states are not the most bankable
29

For example, when Sify was setting up internet cafes in different states, it involved over 50 different clearances!

43

INDIA Financing Infrastructure : Addressing Constraints and Challenges

Lack of coordination between government ministries / departments


Most infrastructure projects involve dealing with multiple ministries. One of the key reasons for projects not taking off at the pre-financing stage is that the actions and policies of different ministries are not coordinated and are often at variance with each other. This is particularly true for the power sector, where even if the developer obtains the requisite permission for setting-up of a generation facility, he finds it difficult to start operations because of lack of clearance for fuel supply, which involves some two other ministries. Similar problems exist regarding the Ministry of Environment. There are no IIGs except in power. The recently set up IIG for power has proved to be an effective way to expedite PPP investments in the sector. Such groups have not been formed for other sectors, and their absence has impeded the developers ability to achieve financial closure and complete the necessary formalities on time.

efficient organization like the NHAI is now causing delays. To give an example, the bids for the first lot of NHDP III projects were received in March 2004; not one of these has been awarded till date.

Limited capacity within government to execute PPPs in infrastructure


Both the central government and the states are aiming to use PPPs more intensively to help meet gaps in the provision of basic services in the country. These PPPs can help meet the infrastructure gap in India, but are not a panacea. They represent a claim on public resources that needs to be understood and assessed. They are often complex transactions, needing a clear specification of the services to be provided and an understanding of the way risks are allocated between the public and private sector. Their long-term nature means that the government has to develop and manage a relationship with the private providers to overcome unexpected events that over time can disrupt even well-designed contracts. Financiers of these projects critically evaluate a project in terms of all design features mentioned above and hence the ability to conceptualize and structure a PPP from the governments side is a key variable in determining the viability of, and the willingness of FIs and banks to finance the project. The capacity to effectively conceptualize, procure and manage these PPPs is very limited within the public sector both organizationally (legal frameworks, procures, guidelines etc) and at the individual level. Internationally, governments embarking on PPP programs have often developed new policy, legal and institutional frameworks, individual training and

Problems in contract negotiations and delays in the award of contracts


This is pervasive across all infrastructure sectors. For instance, it took Kakinada port four years to achieve financial closure. In the power sector, four gas-based power projects 30, which had achieved financial closure in early 2004 with an investment of over Rs.50 billion, are today on the verge of closing down due to flawed fuel supply contracts. While the gas supplier Gas Authority of India Limited (GAIL) has said that it has no gas to offer to these plants, project sponsors find it impossible to penalize GAIL due to one-sided fuel supply contract31 that they were forced into. Even a well run, relatively
30 31

The projects were sponsored by Ispat group, GVK industries, GMR group and EPS Oakwell Power. Interestingly, the supply agreement had a clause which stated that the power company had to pay for the gas on offer even if it did not need it but did not have a clause to penalize GAIL in case of supply default.

44

Constraints to Infrastructure Financing

technical support to provide the required organizational and individual capacities. A similar comprehensive effort at building capacity to facilitate PPPs is needed by the central and state governments.32.

2.4 Constraints Related to Poor Infrastructure Regulation and Related Risks and Uncertainties
Regulatory impediments vary considerably across sectors. In some, such as telecom, the obstacles and contradictions during the initial phase of the 1990s are things of the past. Through learningby-doing, the Telecom Regulatory Authority of India (TRAI) has truly established itself as an efficient, fair, expeditious and independent regulator which is respected as a body for creating a level playing field and fostering the rapid growth of telecom in India. In sharp contrast, the regulatory environment in power leaves much to be desired; and as yet there is no independent regulatory institution in place for ports or airports. To understand the extent of regulatory barriers, therefore, one needs to analyze the different sectors. Below is a brief discussion of some of the relevant regulatory issues across the different sectors.

experiences, the NHAI has stabilized a robust Model Concession Agreement (MCA) for its BOT as well as annuity projects. Standard bidding documents have also been prepared for the Pradhan Mantri Gram Sadak Yojana (PMGSY) contracts. Till now, there have been no major cases of the government reneging on BOT or annuity agreements, which has served to maintain and enhance the credibility of these contracts something that is lacking in the power sector. Moreover, there has been a clear financial commitment on the part of the Government of India in the form of setting-up a long-term ringfenced source of finance, namely the Central Road Fund (CRF) 33 . Not only does it secure significant long-term funds but it also helps project executing agencies such as NHAI to use it as quasi-equity to leverage market borrowings. Despite its successes, there are some regulatory issues that need to be addressed. The major one relates to the small size of NHAI projects. The average size of PPP projects (BOT, annuity and through pure contracting SPVs) is 44.6 km; that of BOT projects is 50.4 km; and of annuity-based projects is 59.4 km. This piece-meal approach adopted by NHAI towards awarding contracts has three negative consequences. First, it encourages the entry of smaller players with limited technical and financial abilities in the bidding process often leading to as many as 30 bids in response to

Sector specific issues: roads


By and large, the National Highways Development Program under NHDP has been a success. There has been significant learning by both government and the private sector. Through wide-spread consultation and its own
32

For a detailed discussion on this issue please see India: Building capacity for Public Private Partnerships, World Bank, May 2005. 33 Under the Central Road Fund Act, 2001, a Rs.1 per litre cess is charged on petrol and high speed diesel (HSD), which is estimated to yield Rs.15 billion from petrol Rs.45 billion from HSD. The cess on HSD has been increased to Rs.1.50 from 1 March 2003. Proceeds of the cess levied is first credited to the Consolidated Fund of India and thereafter credited to the Central Road Fund from time to time after deducting the expenses of collection. The cess is apportioned as follows: (i) 50 percent of the cess on HSD is for the development of rural roads; and (ii) the balance 50 percent cess on HSD and the entire cess on petrol in the following manner: 57.5 percent for the development and maintenance of national highways; 12.5 percent for the construction of roads either under or over the railways and erection of safety works at unmanned rail-road crossings; and 30 percent on development and maintenance of roads other than national highways, i.e. state highways.

45

INDIA Financing Infrastructure : Addressing Constraints and Challenges

a single tender floated by NHAI. Though this could be construed as healthy competition, it has sometimes resulted in the selection of firms with unrealistically low bids, who later have not been able to deliver.34 Second, smaller projects inflict higher per unit capital costs to the contractors. As the size of the project increases the per unit cost of mobilizing requisite physical and financial capital goes down more than proportionally. Scaling-up project sizes will incentivize bigger domestic and foreign players to make competitive bids and also make it economic for them to source the requisite capital in a timely manner. Third, small project sizes have discouraged large players, who can access both capital and expertise and deploy these more effectively than fragmented operators. Diseconomies of scale have also prevented more widespread use of annuity and BOT. Although the thrust of the NHAIs NHDP program is to encourage private sector involvement in road creation, operation and maintenance, in reality more than 80 percent of the Golden Quadrilateral (GQ) has been completed through EPC contracts, i.e. civil works implemented through contracts on a cash payment basis. Till date, only 9 BOT and 8 Annuity based schemes have materialized under GQ program, and none in the NS-EW project. The other regulatory issue relates to the CRF. Although the CRF is ring-fenced in the technical sense of the word, the timing and quantum of allocations to the CRF from the Consolidated Fund of India are still dependent upon the central government. For a program as important as improvement and modernization of roads, it is more advisable to have a statutorily independent body administering the CRF.
34

Sector-specific issues: power


More than any other, the power sector suffers from a wholly inadequate and non-credible regulatory regime at both the central and state government levels. Given below are some key deficiencies: State Electricity Regulatory Commissions (SERCs) do not act in a predictable and consistent manner in most states. The SEBs have been unbundled into three distinct entities (generation, transmission and distribution). Also in theory, with the enactment of the Electricity Act, 2003, these entities are supposed to be monitored and regulated by independent SERCs. However, in practice, no investor can be sure if the regulator will adjust prices, or when, or the extent to which non-action (or injurious action) will be defended on the grounds that social factors (especially, affordability) need to be taken into account. Unpredictable behavior of the SERCs relates in large part to their lack of autonomy and the fact that they are under pressure from many directions. Most, if not all, SERC members in any state are former employees of the SEBs that they are now expected to regulate. Moreover, the funding of SERCs comes from the state government. Consequently, the stage gets set for serious regulatory capture by both the state government and its SEB. In most cases, SERCs are weakened from inception, which allows large state utilities to remain unresponsive to their regulations. It should be pointed out however, that the above-mentioned issues stem predominantly from a fundamental structural flaw in the current operational and regulatory structure of the power sector. Since the reforms in the sector have progressed only to the extent of

Till date, at least 8 foreign firms and 9 Indian firms have been declared as non- performing and blacklisted. Two contracts, one on NH-2 (Delhi-Kolkata) and one on NH-5 (Chennai-Kolkata) have also been terminated.

46

Constraints to Infrastructure Financing

unbundling and establishing regulatory bodies without actually changing ownership, the effectiveness of the regulator to regulate the utility (which is another arm of the government) is obviously limited. The policy maker, the regulator and the utility are all different parts of the government. In this scenario, at the very least, there needs to be operational autonomy for the utilities and functional and financial autonomy for the SERCs. Access charges. The Electricity Act, 2003, which is supposed to be adopted by all states, provides for non-discriminatory open access to transmission and distribution lines. There are serious regulatory concerns about stateowned transmission companies stifling competition by levying prohibitively high access charges between private sector generating companies and end-consumers. This has often been cited as one of the major regulatory risks that could prevent an active private sector market for the wheeling of power. Credibility of fuel supply agreements. Every power generation project is based upon fuel supply agreements be it for coal or gas. Unfortunately, neither source of fuel falls within the domain of the Ministry of Power, and there have been serious delays in power projects because the promised fuel supply agreement has not materialized. Moreover, fuel that is promised to be supplied often does not arrive on time. In September 2004, one of the bigger units of NTPC had to be shut down for five and a half days because of coal shortages. The shortage of gas has also been quite severe in the past, which has adversely affected the Plant Load Factor (PLF) of many plants. For example, it is estimated that around 1,600 MW of gas-based power capacity in the private sector is not being made operational on account of fuel shortage. The Ministry of Power estimates that but for the fuel

shortages, the growth in actual generation for the first nine months of FY06 would have been five percentage points higher. Fuel supply poses serious concern with new plants, which even after achieving financial closure are not able to move on to the construction phase because of their inability to garner requisite fuel supply. State government guarantees. Some observers believe that guarantees could play an important role in catalyzing private investment in the power sector. Unfortunately, the financial credibility of most state government guarantees is clearly suspect in light of the weak fiscal position of states. By March 2004, outstanding guarantees of all state governments were as high as Rs.1,842 billion or 7.5 percent of GDP. In addition to this, the estimated commercial losses of the SEBs in 2005-06 were approximately Rs.226 billion (excluding subsidies). Such financial penury does not augur well for PPPs in power. Other observers, however, argue that in states where the fiscal situation is relatively better, state government guarantees in fact create the wrong incentives. In Rajasthan, for example, the states transmission company can borrow (essentially, to cover losses in the distribution sector) from commercial banks and issue bonds at surprisingly good interest rates, despite annual financial losses of over Rs.2000 crore, as long as it has a state guarantee. Its ability to borrow at tenors of up to 15 years may be a factor in delaying more fundamental reform of pricing and creates an uneven playing field against private operators who do not enjoy similar government guarantees. States reneging on escrows as well as PPAs. Initially, private power generating entities required SEBs to create escrow accounts so as to ring fence the revenues payable to them. However, in many cases, such escrows have

47

INDIA Financing Infrastructure : Addressing Constraints and Challenges

not worked out because these did not address the basic problem of inadequate revenue streams for the SEBs. An even more serious issue is the prevalence of cases where SEBs have unilaterally reneged on contractually obligated PPAs. The most widely reported case is the MSEB vis--vis the Dabhol project. In addition, there have been PPA reneging and termination in Karnataka and Andhra Pradesh and Tamil Nadu. Slow operationalization of the Electricity Act, 2003. Without doubt, the Electricity Act, 2003, is good in theory. The key features of the Act are: Easing of requirements for private entry into generation. De-licensing of generation (thermal) and freeing captive power plants from control of SEBs. Opening of transmission and distribution to private participation. Allowing for multiple distribution licences. Non-discriminatory open access to transmission lines. A new power tariff framework based on competitive bidding Mandating universal metering and punishments for electricity theft. Mandating setting-up of SERCs in all states. However, progress by states to frame the rules to operationalize the Act has been slow and patchy35. Consequently, it does not serve as a guidepost for structuring projects and making investment decisions.

Sector-specific issues: ports, airports36 and railways


None of these sectors have independent regulators in place. While there is a Tariff Authority for Major Ports (TAMP) which regulates and supervises tariffs of private sector service providers, it is not a regulator in the wider sense of the term. Airports have yet to have an independent regulator, although this was an important recommendation of the Naresh Chandra Committee. Indian Railways has refused to have one despite the recommendation of the Rakesh Mohan Expert Group. In railways, the lack of a regulator has allowed the Container Corporation of India (CONCOR), a subsidiary of Indian Railways, to exercise complete monopoly rights of managing and linking up inland container depots (ICDs) with container freight stations (CFSs) at ports, to the detriment of port-side container terminals although this monopoly is now being ended by allowing private sector to offer linkages to ICDs. The lack of independent regulators in these critical sectors creates problems for future deregulation, and fails to provide comfort to potential investors in terms of predictability and stability.

The RBI and non-sector specific regulatory issues


There are three regulatory barriers that have been mentioned by infrastructure players acrossthe-board, all of which have to do with RBI regulations. Should infrastructure finance be treated as priority sector lending? At present, the RBI rules state that 40 percent of a domestic scheduled commercial banks loans and advances (and 32 percent of a foreign banks) should be directed to the so-called priority

35

Of the reforms mentioned under the Electricity Act, SERCs have been set up in almost all states (though their operational success varies vastly) and the Tariff Policy has been announced and expected to be implemented shortly. 36 The GoI is at present discussing the AERA (Airport Economic Regulatory Authority) Bill.

48

Constraints to Infrastructure Financing

sectors, which comprise agriculture, small scale industries, khadi and village industries and a classified list of other small scale businesses. Infrastructure sectors such as those examined in this note fall outside the definition of priority sector. It has been argued by several banks that, given the critical importance of infrastructure, it too should be considered as a priority sector. Should there be Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) requirements on infrastructure bonds? At present, scheduled commercial banks are required to maintain with RBI on a fortnightly basis an average cash balance or CRR amounting to 3.5 percent of the total of the Net Demand and Time Liabilities (NDTL) in India. SLR is peculiar to India, which mandates that scheduled commercial banks must keep 25 percent of their total demand and time liabilities in India in cash, gold or approved government securities. The reason

for both is to maintain a safe liquidity in banking system, although the SLR requirement makes it easier for the central government to pre-empt depositors funds. It has been suggested by many banks that since 15-20 year AAA rated infrastructure bonds are of long maturity and carry no short term liquidity risks, liabilities on account of the sale of such instruments should be considered outside the purview of SLR and CRR. Should there be interest caps on ECBs for infrastructure loans? As mentioned earlier, long gestation infrastructure ECBs may not be readily forthcoming in a regulatory regime that imposes a cap of LIBOR plus 350 basis points. It has been suggested by several infrastructure players that for infrastructure loans above five years maturity, there should either be no cap on interest rate or, at the very least, the cap should be doubled to 700 basis points above LIBOR.

49

III CONCLUSIONS AND THE WAY FORWARD


The analysis in the preceding section clearly suggests that while a number of financial sector related constraints need to be addressed to facilitate greater private financing of infrastructure, it will not suffice to reform the financial sector alone without paying adequate heed to other aspects of infrastructure. Indeed, it would be fair to say that, without reforming the regulatory regime, central and state finances, the fiscal situation and without altering a political economy that looks askance at economically viable user charges, mere reforms in the financial sector will not lead to an upsurge in infrastructure activities. Therefore, while the recommendations outlined below address the financial sector and financing instruments, they also focus on other key issues which have a direct bearing on infrastructure investments.37 investors, which include dedicated infrastructure funds sponsored by a consortium of insurance companies, pension funds, Government sponsored funds, commercial banks, development banks, private fund managers and other privately-held companies is essential for increasing private investment in infrastructure. The priorities are to: Improve exit policies to make it easier for investors to exit. In this context, a key priority is for RBI to introduce enabling regulations for the use of put options as an exit mechanism for investors in unlisted (privately held) companies. At present, the regulations do not allow financial investors to reach an upfront agreement with sponsors on the terms of a put option, if the sponsor company is unlisted. Greater comfort on exit would encourage financial investors to take equity in greenfield infrastructure projects by having some defined, low guaranteed returns. This practice is standard in many emerging markets, especially in Latin America. An additional, and desirable, outcome of this would be that with the entry of more financial investors in the equity market, it would broaden the investor base and with successful closing of projects it would increase investor confidence. Other factors that would help increase equity investment in infrastructure projects include better corporate governance, with a particular focus on minority shareholder protection rights.38

3.1 Addressing Financial Sector and Related Regulatory Issues


A deeper and more diversified financial sector could certainly help increase private participation in infrastructure. Developing local capital markets can play a critical role in facilitating private investment in infrastructure. (See Box 4). Key priorities include:

Facilitating equity financing


In the longer-term, equity finance from financial investors including private equity funds such as venture capital funds and other institutional
37 38

Telecom is a success story in all aspects and there are no recommendations for this sector. The legal framework and stock exchange rules should provide for full disclosure of shareholder agreements that could have an impact on how the company is governed or how other shareholders may be treated. For example, agreements include understandings with respect to the exercise of voting rights, puts and calls, rights of first refusal, and powers of certain shareholders to nominate corporate officers. Detailed policy recommendations are available in the Corporate Governance ROSC for India (Report on the Observance of Standards and Codes). The ROSC report can be accessed at http://www.worldbank.org/ifa/rosc_cg-ind.pdf. The Bank is working in close cooperation with the Ministry of Company Affairs to address several of the issues raised in the ROSC assessment.

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

Encouraging the use of more innovative financing instruments like mezzanine and takeout financing
Removing interest rate caps on ECBs could encourage foreign investors to use instruments like mezzanine and take out financing for infrastructure investment: The Government should consider either removing the 350 basis point interest rate cap above LIBOR on infrastructure loans above 5 years, or, at the very least, double the cap to 700 basis points above LIBOR. In addition, tools for mitigating the risks involved for international lenders should be developed for example, Partial Risk Guarantees (PRGs) to hedge against political risk, and developing the swap market to mitigate foreign exchange risk. Extending fiscal concessions, such as those under section 10(23G) to venture capital and private equity funds that invest in infrastructure, could also help encourage mezzanine financing. Rationalization of stamp duties would facilitate the use of takeout financing and securitization in states where these duties remain high. High stamp duties levied at ad valorem rates are barriers to securitization as well as take-out financing. Given that stamp duties are state subjects, the Central Government can, at best, play a persuasive and demonstrative role. While it is desirable to waive stamp duties for transactions relating to infrastructure projects, this may not be possible because these duties often form a sizable part of a states revenues. An alternative is to: (i) reduce the duties to a uniform low rate across all states, and (ii) charge a lump-sum specific duty for transactions beyond a certain threshold. Inadequate takeout financing can affect

annuity and BOT projects in roads, in power as well as in ports.

Developing a longer term corporate bond market


A well developed government bond market is a critical prerequisite to the development of the corporate bond market. Hence, there is an urgent need to increase the depth and the breadth of the government bond market, through the following measures: To improve the breadth of the government bond market, the government should consider recalling the existing illiquid, infrequently traded bonds and re-issue liquid bonds. The existing regulation that requires institutional funds such as pension funds and insurance funds to hold till maturity all government securities should be removed and they should be allowed to actively trade in the market. To bring in more retail investors to the government bond market there is a need to introduce an element of marketability and price discovery, which can only be brought in by making securities trading screen based and more transparent. Furthermore, the development of Indias corporate bond market would benefit from the following measures: Issuance and listing: The procedures for public issuance of debt need to be streamlined, drawing on lessons from countries like Korea, where regulatory approval takes just 5 days (against 21 days in India). To facilitate timely market access of corporate debt securities, a distinction between regulatory requirements that apply to the wholesale market (where qualified institutional investors are concerned) from those that apply to the retail market could

52

Conclusions and the Way Forward

be made 39 to enable listing to be a straightforward exercise. Private debt placement guidelines also need to be made less restrictive. Extending shelf registration to all types of corporate issuers, would also facilitate quick, timely and cost-effective access of issuers to the markets. This is widely used in developed debt markets, such as the US and UK, Korea and Singapore. Better corporate credit information can play a critical role in corporate debt market development. More effort needs to be put into collecting and disseminating data on bond issues, size, coupon, latest credit rating, underlying corporate performance, information on secondary trading (particularly pre-trade information related to investors having access to best quotes) and default histories of companies. A centralized agency for this purpose would be a welcome step forward. Better market infrastructure. Efficient trading and settlement systems are critical for providing an exit route for debt investments in infrastructure. India needs to upgrade its trading and settlement systems. Mechanisms that have been put in place in several Asian and Latin American markets, which have adopted sophisticated settlement systems and have also put in place mechanisms for recourse (through guarantee funds/ compensation funds) in settling transactions, as discussed in Box 2 could offer some useful lessons. New products. Government should encourage financial intermediaries to offer new product structures (e.g., credit enhancement, bond insurance) that enable
39

sub-investment grade corporates/ municipalities to access financing. This could be achieved through initial guarantee or funding support to the financial intermediaries. RBI and SEBI should consider regulatory reforms that would help develop hedging tools for investors and traders: e.g., credit derivatives, bond futures and options. Increasing the appetite of long-term investors. Given the current stage of market development, where long term institutional investors are yet to develop, the banking system could play an important role in the development of the corporate debt market; regulatory caps on banks investments in corporate bonds could be relaxed (limited to 10 percent of their total non-SLR investments) as could the minimum rating requirement (minimum investment grade, i.e. AA and above). While not an immediate constraint, over the medium term, the debenture trustee system needs to be strengthened to encourage retail investment in infrastructure by providing protection from default by the company in payment of timely interest.40 Other measures also need to be taken to encourage insurance companies and pension funds to step-up their investment in infrastructure projects. These are discussed below.

Encouraging participation by FIs in infrastructure financing


Investment policies and regulatory guidelines for insurance companies, pension funds, mutual funds, banks and other FIs need to be sufficiently flexible for these entities to choose an appropriate risk-return profile within fiduciary

For example, regulators could consider an extension of shelf registrations of prospectuses to all companies that offer debt instruments to Qualified Institutional Buyers (QIBs) rather than only to PFIs. Alternatively it could adopt similar practices to those found in the Eurobond market, where issuers who tap the market frequently, are permitted to use a short form listing agreement, and are given regulatory approval as a condition to an offer closing with the consequence that an issue can be launched more easily with the documentation and approvals to follow. 40 The debenture trustee has a fiduciary responsibility to protect the interest of the debenture holder and is expected to enforce security in the event of default by the issuer company to the bond holders.

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

constraints. This will also help professionalize fund management. While it would not be appropriate or practical to introduce radical changes in investment guidelines at this stage, primarily because issues such as high rate of assured return, deficiencies in the accounting methodology, lack of skills in fund management need to be resolved first, there is certainly a need to deregulate these sources of long-term finance and formulate prudential norms for infrastructure related projects. The authorities should look at the existing investment norms prescribed for insurance, EPF and PPF with a view to relaxing them so that these institutions can commit significantly larger amounts of long-term funds for infrastructure. The investment guidelines for insurance companies need to be modified to allow investment in instruments with a rating of less than AA. At present these investments are counted towards unapproved investments. This, in conjunction with development of credit enhancement products should enable insurance companies to invest in infrastructure projects. Investment guidelines for pension funds should be modified to allow them to invest in infrastructure projects, which have a guarantee from the central government or multilateral agencies. The cost of such funding will also be lower since these will not carry any currency risk. Going forward, with appropriate changes in the investment guidelines, three mechanisms could be used to channel pension funds in to infrastructure projects without distorting their risk-return profile. First, to initialize entry in to such projects at the lowest risk level, pension funds should be allowed to invest in projects where a multilateral agency or central government extends a guarantee on the minimum rate of return. The multilateral agency in turn could charge the project

sponsor (such as NHAI) a commercial fee to extend this guarantee. Second, pension funds should be permitted to deposit part of their funds with banks for long periods and ensure that the banks use them exclusively for infrastructure financing. Third, in the longer term, pension funds should be allowed to deploy funds in projects appraised by the all-India FIs. There exists an urgent need for specialized infrastructure financing institutions such as IL&FS and IDFC to participate at the design stage of a project. The backing of such institutions at an early stage would carry at least two advantages. First, it would make it easier for project developers to obtain finance from other sources. Second, it would provide the developer with the opportunity to use the expertise of such institutions in project designing and financial structuring. It must be noted, of course, that potential conflicts of interest could arise in instances where the specialized infrastructure financing institution provides advisory services for the project and also bids for the role of structuring the financing package. Such potential conflicts of interest would need to be handled carefully. Project evaluation and fund management skills at banks and other FIs with long term funds (insurance companies and pension funds) need to be strengthened. In particular, insurance companies need to be encouraged to develop specialized appraisal skills in the infrastructure projects. Given the large corpus of funds available with these companies, going forward, they will need to become lead financiers in infrastructure projects. However, at present, they do not have the requisite appraisal skills to appropriately evaluate project viability. There is a need to create a debt recovery mechanism for pension and provident fund

54

Conclusions and the Way Forward

on the lines of the Debt Recovery Tribunal (DRT)41. While the need for such a tribunal is not felt at present due to the restricted investment profile, it will be critical if pension and provident funds are to have any significant exposure in the infrastructure sector. In order to provide an active incentive for banks to scale-up infrastructure financing, the RBI could consider classifying infrastructure as one of the priority sectors. Moreover, as far as banks are concerned, liabilities created by the sale of long term infrastructure bonds may be kept outside the purview of SLR and CRR.

In addition the government could also consider removing the provisions of MAT for those infrastructure companies which are availing the benefits under sections 80IA and 80IB. Another alternative would be to remove sections 80IA and 80IB altogether and, instead, allow for unlimited carry-forward of losses. This would allow all infrastructure companies to set off the large losses in the initial years of operations against the profits of the later period and, in effect, create a more transparent fiscal incentive than 80IA or 80IB. The fiscal benefits given under section 10(23G) should be approved at one shot for the stipulated 10-year period, instead of the present practice of the companies or SPVs getting annual approval from the CBDT. Moreover, the government should seriously consider eliminating the word wholly which prevents any infrastructure SPV from redeploying its investible surplus in another group infrastructure SPV and substituting it by substantially. The tax implications of this is minuscule compared to the operational flexibility that it will give to companies which have more than one infrastructure SPV. The concept of escalating section 10(23G) benefits to umbrella infrastructure companies should be investigated something that could be possible if the word wholly is replaced by substantially. This will allow sponsors to consolidate their infrastructure SPVs under a single holding company, which will have the critical threshold to carry out a successful public offering. Such a mechanism will give sponsors and FIs an exit option from equity participation, which could be recycled for new projects. Also, the government ought to consider making the benefits of 10(23G) available to retail investors, who could then invest in dedicated infrastructure mutual funds which would use the finances so

3.2 Fiscal measures that would support private financing of infrastructure and financial market innovation
While it should be noted that fiscal concessions are not necessarily desirable, per se, they might help increase returns and hence, investment. In this context: The Ministry of Finance could consider reducing the customs duty on capital goods and machinery that are critical for roads, ports, airports, power, railways, telecommunication, oil and gas pipelines and supply and distribution of water. This fiscal incentive would significantly reduce the cost of many infrastructure projects. With respect to the fiscal concessions under section 80IA and 80IB, the government could consider extending the time horizon from the present 10+5 years (0 percent tax on the first, and 50 percent tax liabilities in the second period) to a 20 year time horizon where the project would be tax free for the first 10 years, pay a third of the tax liabilities in the next five and 50 percent of it in the final five.
41

Established under the Recovery of Debts Due to Banks and FIs Act, 1993.

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

obtained to offer longer term credit facilities to infrastructure projects.

3.3 Streamlining Approvals, Cutting Down on Red Tape and Enhancing Infrastructure Regulation
Governments need to assure potential investors that there is an intention to lay out clear policy frameworks for each sector and reduce uncertainties arising out of policy implementations and arbitrary actions in contractual commitments of the governments. All infrastructure projects involve multiple clearances from different Ministries and Departments which contribute to significant delays. In order to mitigate this problem, the GoI needs to set up sufficiently high-level Inter-Ministerial Groups (IMG) for roads, power, telecom, ports and airports. Ministries which are represented in each of these groups would vary according to the sector. It would be useful for these groups to be formed under the aegis of the Planning Commission, and for them to meet once every 45 or 60 days to discuss and resolve all outstanding Inter-Ministerial issues. In addition, each Ministry substantively dealing with the infrastructure should adopt the practice introduced by the Ministry of Power by setting up IIGs. These would consist of the infrastructure developers and senior representatives from banks and FIs. Under the leadership of the Secretary of the concerned Ministry, the IIGs would meet once a month to discuss the progress of specific
42

infrastructure projects and to resolve any outstanding issues or disputes between the developers and various funding agencies. This experiment has been very successful in the case of Power and should be replicated in other key Ministries. Infrastructure is an urgent national priority. To give it the importance it deserves, there has to be a clear signal that the ownership lies at the highest level of government. Therefore, it would be advisable for the Prime Ministers office (PMO) to have a dedicated infrastructure secretariat which would not only monitor the status of projects in different sectors but also convene quarterly meetings between the Prime Minister and those of his cabinet colleagues in charge of infrastructure ministries. This secretariat could ensure consistency in policy formulation and implementation for various infrastructure sectors, and would liaise with various government agencies to present a single window clearance to the private sector42. This act alone would demonstrate the governments focused commitment to infrastructure. Develop a policy and regulatory framework for sectors where no framework has been articulated (airports, railways) and establish independent regulators (See Annex F for details).

3.4 Stimulating Public Private PartnershipsBuilding Government Capacity43


There is a need to encourage entry of the private sector in infrastructure development through viable

The government has constituted a Committee on Infrastructure chaired by the Prime Minister. This Committee has a secretariat in the Planning Commission. This committee does focus on policy direction for improving infrastructure in the country and is aimed at ensuring inter-ministerial coordination on infrastructure issues. However, there is also a need for a more operational role for a secretariat as suggested here (to monitor progress of individual projects, responsible for inter-departmental coordination, facilitate approvals and setting up of important projects etc). 43 For a detailed discussion on this issue please see India: Building capacity for Public Private Partnerships, World Bank, May 2005.

56

Conclusions and the Way Forward

PPP projects, and it is a fact that private investors in infrastructure look for stable and friendly sectorspecific policies. An example of a PPP which has worked in the power sector is Powerlinks Transmission Ltd. The project is a joint venture between PowerGrid, a sovereign owned entity, and Tata Power, a private sector entity. The project will establish a 1,200 km transmission line between the Indo-Bhutan border and Bhandaula near Delhi and ship power generated by the 1,000 megawatt power plant in Bhutan which is largely financed by GoI. The state owned entity provides the guarantee for the use of the facility, on the back of which the private sector lenders and investors have participated in the financing. A few conclusions from IFCs experience with infrastructure projects is given in Box 6. Developing domestic capabilities to manage, participate in and finance private infrastructure projects is important to broaden the constituency of PPPs, enlarge the pool of funding, and mitigate foreign exchange risk. In industrialized countries, and increasingly in more mature reformed developing countries, one of the largest sources

of financing for investment is the utilitys own cash flow. But additional funding will have to come from domestic capital markets and from pension funds/ insurance companies. This will require strong macroeconomic framework and a solid financial infrastructure, as well as attractive investment opportunities as detailed in the earlier sections. To encourage PPPs, the GoI has announced that it will provide viability gap financing for selected infrastructure projects which are socially and economically necessary but carry either high risk or inadequate IRRs to be fully funded by the private sector. (See Box 7). According to the policy, up to 40 percent of the financing needs of such projects could be met through VGFs. This is a step in the right direction and could help to hasten the financial closure of many infrastructure projects. For instance, the 22.5 km long Trans-Harbor Bridge that is proposed for Mumbai and costing over $1 billion is not feasible without at least 30 percent viability gap funding. So too is the case for almost all major bridges as well as large sections of Indias national and state highways. Assuming that the

Box 6: Critical Success Factors for Private Sector Participation in Infrastructure Conclusions from IFCs experience The uneven pace of private infrastructure growth in developing countries is due to varying degree of political commitment to liberalization in the sector. Soundly structured investment opportunities have attracted private financing. Private sector participation in infrastructure, wherever successful, is yielding significant gains in construction and operational efficiencies. There is no single method of private sector participation, although economic benefits generally increase with the volume of assets under private control and the extent of competition. The options depend on a countrys creditworthiness, the extent of political commitment, and investor interest. Nevertheless, transactions are more likely to achieve financial closure and be sustainable if they are transparent in the broadest sense: clear, predictable and competitive. Well structured private sector infrastructure projects can be financed in countries with low income or high risk, or both. Some projects are easier to finance in such circumstances: smaller projects, those not facing severe market risk, those with strong sponsors and government support arrangements, and those earning foreign exchange. Stable regulatory regime is the key success factor. Investors get nervous very quickly and governments must make sure that they present a stable, transparent and fast acting regulatory environment. If for some reason, the concessions need to be revoked, then strong termination clauses, which provide adequate protection to lenders and investors should be built in.

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

viability gap funding policy is credible, its success will require, among other things, strengthening the institutional capacity of government to manage, participate in, and monitor PPPs. Capacities for identifying, procuring and managing PPPs could be strengthened in India so that they can make a larger contribution to meeting basic infrastructure needs. The steps

that the Centre could take to achieve this are44: Issuing a policy statement on the use of PPPs, including rationale and benefits expected; The creation of a national level PPP unit for information dissemination and guidance functions, plus transactions advisory support to central agencies and ministries in their PPP programs45;

Box 7: Proposed GoI initiatives for increased infrastructure financing In the Union Budget 2005, the Finance Minister (FM) re-iterated the importance of infrastructure for rapid economic development and acknowledged that in the governments view the most glaring deficit in India is the infrastructure deficit. In this context, he proposed to continue (and enhance) budgetary support for investment in infrastructure, including through viability gap funding and a proposed SPV. Viability Gap Funding GoI acknowledges that the needed infrastructure investments for India may not be Funding: possible out of the budgetary resources of Government of India alone. In order to remove these shortcomings and to bring in private sector resources as well as techno-managerial efficiencies, the Government has committed to promoting Public Private Partnerships (PPPs) in infrastructure development. That said, it is also recognized that infrastructure projects have a long gestation period and may not all be fully financially viable on their own. On the other hand, financial viability can often be ensured through a mechanism that provides government support to reduce project costs. The GoI has therefore proposed to set up a special facility to provide such support to PPP projects. This support is generically termed as viability gap funding and this facility will be housed in the DEA. Suitable budgetary provisions will be made on a year-to-year basis. In the last couple of years, the central government has made available budgetary resources towards viability-gap funding. However, till date no amount has been drawn down. The guidelines to avail this funding were released in August 2004. These guidelines laid out eligibility criteria for projects to receive viability gap funding support from GoI including the minimum private equity participation and sector (roads, railways, seaports, airports, power, water supply, sewerage and solid waste disposal in urban areas, and international convention centers). A provision of Rs.1500 crore for viability gap funding for infrastructure projects has been made for the current fiscal year. This is now being converted into a scheme, the details of which are being finalized. financing: A proposed SPV for long-term financing GoI believes that there are many infrastructure projects that are financially viable but, in the current situation, face difficulties in raising resources. Hence, it proposes that such projects may be funded through a financial SPV. Accordingly, an SPV will be established to finance infrastructure projects in specified sectors. Roads, ports, airports and tourism would be sectors that are stated as the most likely beneficiaries of the SPVs funding. The projects will be appraised by an IIG of banks and financial institutions. The SPV is expected to lend funds, especially debt of longer term maturity, directly to the eligible projects to supplement other loans from banks and financial institutions. The government will communicate the borrowing limit to the SPV at the beginning of each fiscal year. When large infrastructure projects are implemented, the foreign exchange resources could also be drawn for financing necessary imports, where relevant. For 2005-06, the borrowing limit has been fixed at Rs.10,000 crore. Details about the SPV structure and the mechanics of lending - are expected to be announced shortly. The SPV funding will be used in conjunction with the Viability Gap Funding support.
44 45

see India: Building capacity for Public Private Partnerships, World Bank, May 2005. In announcing the VGF scheme , GoI did lay down the rationale for and benefits of PPPs in general. It may be necessary to reinforce this more prominently and across infrastructure related departments encouraging the use of PPP models in infrastructure provisioning. Recently, GoI has also set up a PPP cell within the Department of Economic Affairs, Ministry of Finance mainly to process proposals under the VGF scheme and a PPP Appraisal Unit has been set up within the Planning Commission to review Central Government PPPs. The capacities of these units need to be built up to be able to meet current demand and to be able to play the role of a facilitation unit through information dissemination and guidance as well.

58

Conclusions and the Way Forward

Setting up a project preparation fund for identifying and procuring PPPs; and Setting up a fund to partly cover the cost of government participation under PPPs. In addition, if there is to be an increase in the usage of PPPs, the Centre would have to work to strengthen oversight of their fiscal costs and assist state governments in doing the same. The investment needs for infrastructure are enormous. India faces a very large financing gap which needs to be bridged by domestic as well as foreign private sector investments. Success in attracting private funding to infrastructure will depend partly on Indias ability to develop a more sophisticated financial sector, requiring reforms that facilitate the use of diverse financial instruments by investors, and address the current barriers to increased participation by both sponsors and financial institutions. But increasing

private investment will also require addressing fiscal barriers, red tape and procedural inefficiencies that have contributed to project delays and discouraged private investors, and the significant constraints arising from the absence of adequate infrastructure regulation that exacerbates risks and uncertainties for investors. In summary, securing increased private funding for infrastructure on a sustained basis will require widespread reforms in infrastructure reforms that go well beyond the financial sector. In the foreseeable future, Government will remain the key investor in critical infrastructure sectors, although PPPs could help reduce some of the funding pressure on Government. The Governments ability to finance infrastructure will, of course, depend crucially on the success with which it is able to progressively reduce the fiscal deficit to make available public funds for infrastructure investment.

59

BIBLIOGRAPHY
3-i network. Various years. India Infrastructure Report. Central Electric Authority. 2004. National Electricity Policy. Central Electricity Regulatory Commission. Various Years. Annual Reports. Department of Industrial Policy & Promotion, Ministry of Commerce. Government of India. 2004. Opportunities in Infrastructure in India. Background Paper for OECD India Workshop. New Delhi. Department of Telecommunications, Ministry of Communications & Information Technology, Government of India. 2002. Report of the Working Group on the Telecom Sector for the Xth Five-Year Plan. New Delhi. . Various Years. Annual Reports. New Delhi. . National Telecom Policy 1994. . New Telecom Policy 1999. . Broadband Policy 2004. 1994. Developing Countries. Institute of Development Studies, University of Sussex. Gupta, L.C. and C.P. Gupta. 2001. Financing Infrastructure Development, A Holistic Approach with Special Reference to the Power Sector, Society for Capital Market Research and Development. New Delhi. I-Maritime. 2003. India Port Report. Indian Roads Congress (IRC). 2000-01. Road Development Plan: Vision 2021. Industrial Development Bank of India. 2003-04. Report on Development Banking in India. Insurance Regulatory and Development Authority. 2004. Various Articles, IRDA Journal. Lok Sabha and Rajya Sabha. Various Years. Reports of the Committee on Transport, Tourism and Culture. Various Years. Reports of Committee on Information Technology. Various Years. Reports of Committee on Railways. Ministry of Finance, Government of India. 1996. Expert Group on Commercialization of Infrastructure Project. The Infrastructure Report Policy Imperatives for Growth and Welfare. Ministry of Finance, Government of India. Various Years. The Economic Survey. . Various Years. The Union Budget.

1999.

2004.

Fabella, Raul and S. M. Erd. 2003. Bond Market Development in East Asia: Issues and Challenges. Asian Development Bank (ADB). Griffith-Jones, Stephany and A. T. Fuzzo De Lima. 2004. Alternative Loan Guarantee Mechanisms and Project Finance for Infrastructure in

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

Ministry of Power, Government of India. 2002. Report of the Committee on Financing of Power Sector during the Xth and XIth Five Year Plan. . 2002a. Expert Committee on State-Specific Reforms, Structuring of APDRP, Reform, Framework and Principles of Financial Restructuring of SEBs. . Various Years. Annual Reports. Ministry of Railways, Government of India. 2001. Rakesh Mohan Committee Report. Policy Imperatives for Reinvention and Growth. --. 2002. Status Paper on Indian Railways, Issues and Options. . Various Years. Railway Budgets. Ministry of Road Transport and Highway, Government of India. Various Years. Annual Reports. Ministry of Shipping, Government of India. Various Years. Annual Reports. Planning Commission, Government of India. 1997. IXth Five-Year Plan. Planning Commission, Government of India. 2002. Xth Five-Year Plan. . Various Years. Annual Plans. . Various Years. Annual Reports.

Raju M.T., U. Bhutani and A. Sahay. 2004. Corporate Debt Market in India: Key Issues and Some Policy Recommendations, Securities and Exchange Board of India (SEBI). Mumbai. Red Herring Document. 2004. National Thermal Power Corporation Limited. Reserve Bank of India. 2005. State Finances: A Study of Budgets of 2004-05. . Various Years. Trends and Progress in Banking. . Various Years. Annual Reports. Securities and Exchange Board of India (SEBI). Various Years. Annual Report. Telecom Regulatory Authority of India. 2004. Broadband India: Recommendations on Accelerating Growth of Internet and Broadband Penetration. --------. 2004a. Consultation Paper on Growth of Telecom Services in Rural India. Vives, Antonio. 2000. Pension Funds in Infrastructure Project Finance Regulations and Instrument Design.Inter-American Development Bank. Washington D.C. World Bank. 2004. Highway Sector Financing in India, Washington D.C. World Bank. World Bank. 2005. India: Building capacity for Public Private Partnerships.

62

ANNEX A: INVESTMENT NEEDS FOR INFRASTRUCTURE, 2001-02 TO 2010-11


There is a rough-and-ready way of estimating the annual infrastructure needs for India. This involves projecting the countrys GDP growth over the period, and then attributing a certain desirable percentage of the GDP as infrastructure needs. This is far from exact, but serves the purpose of giving a very broad idea of the investment requirements to be a macro guidepost against which one can evaluate more detailed estimates. Assuming that (i) the average annual infrastructure investment needs vary from a low of 5 percent of GDP to a high of 7 percent, and (ii) a nominal GDP growth rate of 12.5 percent per year going forward, the first-cut estimate of investments needed during the period 2001-02 and 2010-11 is between Rs.17,967 billion and Rs.25,154 billion at current prices. Table A1 gives the data. It so happens that the more detailed sector-wise investment needs for roads, power, telecom, railways, ports and airports (calculated in this section of the note) adds up to Rs.19,143 billion. If one were to add investments for the urban sector as well as for the supply and distribution of water, the overall need would be in the region of Rs.25,000 billion, or what has been estimated based on 7 percent of nominal GDP. Therefore, if nothing else, the broad brush-stroke estimates given in Table A1 are in line with those given below which ought to give some additional credibility to those numbers. Having said that, it needs to be recognized that estimating the investments required for infrastructure is not an easy task. First, demand projections are notoriously difficult to calculate with a reasonable degree of accuracy. Second, even if there is a consensus on the demand side, there is the additional problem relating to the prices at which these investments are evaluated. Third, there is the issue of productivity. The efficiency and productivity of government agencies engaged in setting up infrastructure

Table A1: A Rough Estimate of Investments needed in Infrastructure, 2001-02 to 2010-11 Rs. Billion FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010 FY2011 Total GDP at current prices 20,815 22,549 25,198 28,381 31,929 35,920 40,410 45,461 51,143 57,536 Growth rate 8.3% 11.7% 12.6% 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% 5% need 1,041 1,127 1,260 1,419 1,596 1,796 2,020 2,273 2,557 2,877 17,967 6% need 1,249 1,353 1,512 1,703 1,916 2,155 2,425 2,728 3,069 3,452 21,560 7% need 1,457 1,578 1,764 1,987 2,235 2,514 2,829 3,182 3,580 4,028 25,154

Source: Economic Survey 2004-05 , CERG. World Bank

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

tends to be different from that of the private sector; and the investment requirements would differ depending on the activity mix between government and private participants. Therefore, the estimates in this section are not exact. Instead, these indicate broad orders of magnitude.

national highways, 46,045 km are under the charge of PWDs Border Road Organization (BRO). Is entrusted with the residual 5,245 km of national highways. State highways comprise approximately an additional 137,000 km, and link major centers within a state. Together, the national and state highways are estimated to carry nearly 60 percent of road freight, and 87 percent of road passenger traffic. The remaining road network comprises district and village roads, which constitute more than 90 percent of the total, but are largely un-surfaced and of very poor quality. Since independence, the main thrust in road development in India was primarily on increasing road length. Little or no attention was paid to widening and maintaining existing facilities. This took its toll on road quality, and resulted in congested roads, higher travel time, excessive wear and tear of vehicles and a terrible record of highway safety.46 The first focused attempt at improving the quality of roads occurred in 1998-99, with the announcement of the NHDP. This program has three major components: 1. The Golden Quadrilateral (GQ) or NHDP Phase I, which involves four-or-six laning of highways connecting four metro cities Delhi, Mumbai, Chennai and Kolkata with a network length of 5,846 km. As of November 30, 2004, 4,203 km of the GQ network (or 72 percent) has been completed. The residual 1,716 km are under implementation. 2. The North-South and East-West Corridors (NS-EW) or NHDP Phase II, with a total road length of 7,274 km,47 envisages

A1 Roads
India has the second largest road network in the world with a total length of about 3.3 million kilometers. Barring some sections of national highways, it is also a network that badly needs upgrading. For administrative purposes, the network is divided into: i) ii) iii) iv) v) national highways, state highways, major district roads, other district roads, and village roads.

While the Ministry of Road Transport & Highways is primarily responsible for the construction and maintenance of national highways, all other roads fall within the jurisdiction of the state governments. The development and maintenance of national highways is divided among: National Highways Authority of India (NHAI). Of the total national highways length of 65,569 km, 14,279 km (or 21.7 percent) have been entrusted to NHAI under various phases of the National Highway Development Project (NHDP), port connectivity and other schemes. State Public Works Departments (PWDs). Of the remaining non-NHDP sections of
46

In 2001, there were over 405,000 road accidents in India that killed almost 81,000 people. The number of people killed per 10,000 vehicles was 14.71. 47 This excludes 442 km which is in common with the GQ.

64

Annexures

four-or-six laning of highways connecting Srinagar in the north to Kanyakumari in the south, and Silchar in the east to Porbandar in the west. Compared to the GQ, not much has occurred on the NS-EW front. On November 30, 2004, only 675 km (or 9 percent of the total length) has been fourlaned. In addition, 356 km of four-laned roads are planned to connect 10 major ports to the national highways, of which 69 km were completed and 244 were under implementation as on November 30, 2004. Furthermore, 777 km of other important stretches in various states are also a part of NHDP, of which 194 km have been four-laned and another 121 km are under implementation 3. The NHAI has also embarked on NHDP Phase III earlier known as the Pradhan Mantri Bharat Jodo Prayojana which involves four-laning of about 10,000 km of those stretches of national highways that connect to state capitals. 4. Future expansion plans also announced improvement of 20,000 km to 2 lanes with paved shoulders (NHDP Phase IV); 6laning of selected stretches (6500 km) of NHDP I and II (NHDP Phase V); Construction of 1,000 km Expressways (NHDP Phase VI); Ring Roads, Bypasses, Grade Separators, Service Roads etc. (NHDP Phase VII) Over the last four years, the NHDP has been a success story. There are problems that have cropped up from time to time. Nevertheless, it is a fact that NHDP Phases I and II constitute Indias largest, most comprehensive and concentrated road building program. In addition, there is the village roads program or the PMGSY, which was launched in December 2000. The objective is to construct all-weather roads to provide connectivity with all habitations having a population of more than 500 persons. This program is entirely funded by the central
48

government, while the planning and execution of road works is carried out by the states. While the initial investment requirements was pegged at Rs. 600 billion, present indications are that, with somewhat greater coverage, the costs would more than double to about Rs.1,320 billion. Moreover, given past trends, it seems unlikely that providing comprehensive village connectivity will be achieved by the target date of 2007.

Roads: Investment needs


Investment needs in the road sector up to 2010-11, excluding village roads under PMGSY, have been outlined in the Road Development Plan: Vision 2021, prepared by the Indian Roads Congress (IRC) under the Ministry of Road Transport & Highways. Funds needed for the PMGSY have been separately estimated by the Ministry of Rural Development. Although the government has assumed that the targets of the PMGSY project will be achieved by 2007, present data suggests that this is unrealistic. Therefore, these investments have also been aggregated as a part of the funding requirement up to 201011. Table A2 gives the data on investments needed in roads from 2001-02 to 2010-11. The estimates in Table A2 exclude annual maintenance costs. According to the Ministry of Road Transport & Highways, these are: Rs.20 billion per year for national highways, or Rs.200 billion for 2001-02 to 2010-11; and Rs.50 billion per year for state highways and major district roads, or Rs.500 billion for the period.48
Road: Investments Needed For the period 2001-02 to 2010-11, at todays prices and including annual maintenance, upgrading the road system in India will cost at least: Rs.3,350 billion for national and state highways and major district roads, and Rs.4,670 billion if we also include village roads.

There are no estimates for maintenance cost of village roads.

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

A2 Power
The power sector leaves much to be desired. The country faced a shortfall of 7.1 percent of energy requirements and 11.2 percent of peak demand in 2003-2004. A look at Table A3 confirms that deficit levels have remained in the vicinity of 7.5 percent in the last five years. In the first nine months of fiscal 2006, the country faced a power shortage of 35,701 million units, representing 7.7 percent of the total requirement.

their internal transmission. Operationally, India, today, does not yet have a national, synchronous grid. The country is divided into five regions (northern, eastern, northeastern, southern and western), each of which operate somewhat independently of the others. The five regional grids are to be gradually integrated to form a modern national grid which could wheel surplus power from a region to a deficit zone. This task has been entrusted to the PGCIL, which is expected to achieve a national grid capacity of 37,000 MW by 2012. As it stands, inter-regional power transfers are modest, partially because of limited surplus in any one region and also because of inadequate transmission line capacity between the regions. With the advent of the Electricity Act, 2003, the scope for power trading has been enhanced in law. Some players have come into the business, such as the Power Trading Corporation, the NTPC Vidyut Vyapar Nigam Limited (an NTPC subsidiary) and the Tata Power Trading Company Private Limited. However, the volume of transaction is still very low. There in only one major case of private sector involvement in power transmission namely, the joint venture between Tata Power (51 percent) and PGCIL (49 percent) to develop a 1,200 km transmission line from Bhutan to carry surplus power from the Tata hydroelectric power station in Bhutan to the north-east. In this case, Tata Power has been guaranteed a fixed return from PGCIL which, in turn, will undertake the task of collecting the revenue from the SEBs.

Generation
As of January 31, 2006, India had an installed capacity of 123,901 MW, the bulk of which (56.5 percent) is owned by state governments. A further 32 percent of the capacity was from SOEs owned or controlled by the central government, namely NTPC, National Hydro Electric Power Corporation (NHPC), North Eastern Electric Power Corporation (NEEPCO) and the Neyveli Lignite Corporation (NLC). Privately owned enterprises account for the remaining around 11.5 percent of the generating capacity. Among these, the more notable players are Reliance Energy, Tata Power, the RPG group and Torrent.49 Both the SOEs and the independent power producers (IPPs) have long term PPAs with specific SEBs, or their transmission companies. Table A4 shows that thermal plants are the mainstay of power generation in India with a share of 66 percent in total generation capacity. This is followed by hydroelectric with 26 percent, and nuclear and renewable energy sources with 3 and 5 percent respectively.

Distribution
Transmission and distribution have the choke points in power transmission because of inadequate capacity and distribution because of obsolescence, poor pricing, over-manning, inefficiencies, lack of adequate metering and outright power theft. The focus of recent reforms

Transmission and power trading


The Power Grid Corporation of India Limited (PGCIL) is responsible for all inter-state power transfers, which is presently mainly between the central government SOEs and the various SEBs.50 The states (or their new corporations) still own
49 50

Since 1991 till March 2004, a total capacity of around 7,400 MW from 37 private power plants were commissioned. IPPs that are not purely intra-state also rely on PGCIL for transmission. But this is a minuscule part of IPP transmission.

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Annexures

Table A2: Investment needed in roads, 2001-02 to 2010-11, excluding maintenance (Rs. billion) Types of Roads A. National Highways, incl. Expressways 1. Expressways 2. 4/6 laning 3. Two-Laning with hard shoulders 4. Strengthening Weak Pavements 5. Bypass, bridges, over-bridges, safety & drainage measures 6. Expansion of NH system Total: NH, incl. Expressways B. State Highways 1. 4/6 laning 2. Two-Laning with hard shoulders 3. Strengthening Weak Pavements 4. Bypass, bridges, over-bridges, safety & drainage measures 5. Expansion of SH system Total: SH C. Major District Roads Km 3,000 16,000 15,000 20,000 Lump sum 10,000 64,000 3,000 35,000 30,000 Lump sum 10,000 78,000 Investment needed 300.0 640.0 187.5 150.0 72.5 150.0 1,500.0 100.0 280.0 220.0 100.0 50.0 750.0 120.0 150.0 50.0 50.0 30.0 400.0

1. 2-Laning 20,000 2. Strengthening Weak Pavements 30,000 3. Improving riding quality 50,000 4. Bypass, bridges, over-bridges, safety & drainage measures Lump sum 5. Expansion of MDR system Lump sum Total: Major District Roads 100,000 D. Village Roads (PMGSY) 1. Last mile connectivity: 174,000 habitations * average length of 2.16 km * Rs.2.1 million/km 2. Upgrading existing village roads: 359,000 km * Rs.1.48 million/km Total: Village roads under PMGSY Total investment without village roads (A+B+C) Total investment including village roads (A+B+C+D)
Source: IRC, Road Development Plan: Vision 2021 Source: IRC, Road Development Plan: Vision 2021

790.0 530.0 1,320.0 2,650.0 3,970.0

Table A3 : Actual power supply situation Availability (million units) 450,494 467,400 483,350 497,890 519,398 548,115 430,408 Surplus/Deficit (+/-) (million units) -29,836 -29,816 -39,817 -48,093 -39,866 -43,258 -35,701 % of requirement -6.20% -7.80% -7.50% -8.80% -7.10% -7.30% -7.70%

Fiscal Year 2000 2001 2002 2003 2004 2005 2006 (Apr-Dec)

Requirement (million units) 480,430 507,216 522,537 545,983 559,264 591,373 466,109

Source: Central Electric Authority (CEA)

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

Table A4: All-India installed capacity as on January 31, 2006 (MW) Thermal Total State Private Central Total 70572 13420 39909 123901 Hydro 25053 910 6172 32135 Coal 38068 4358 26008 68433 Gas 3478 4765 4419 12663 Diesel 477 725 0 1202 Total Thermal 42023 9848 30427 82297 Renewable 3496 2663 0 6158 Nuclear 0 0 3310 3310

Source: Central Electric Authority (CEA)

has been on corporatizing and unbundling of the SEBs, involving the separation of generation, transmission and distribution into distinctly different corporate entities. Moreover, the Electricity Act, 2003, has provided for open access, which legally allows any generator the right of non-discriminatory access to transmission lines or distribution systems. The government has also initiated the Accelerated Power Development and Reforms Program (APDRP) to limit the average technical and commercial losses in distribution to 15 percent, foster commercial viability, reduce power outages, and increase consumer

satisfaction. Rs.400 billion has been allocated in the Tenth Plan for this purpose.51

Power: Investment needs


Based on the findings of the 16th Electric Power Survey, the Government of India produced a blueprint document called Mission 2012: Power on Demand in 2001. This envisages power for all villages by 2007, and all households by 2012. The goal is based on the survey projections which
Power: Investments Needed For the period 2001 to 2011-12, the investment needed will be at least Rs.10,591 billion.

Table A5: Demand for power in India based on 16th Electric Power Survey Region Northern Region Western Region Southern Region Eastern Region North-Eastern Region Andaman and Nicobar Lakshadweep Total All-India Energy Requirement MkWh 2006-07 220,820 224,927 194,102 69,467 9,501 236 44 719,097 2011-12 308,528 299,075 262,718 90,396 14,061 374 70 975,222 2016-17 429,480 395,859 354,599 117,248 20,756 591 Nil 1,318,644 Peak Load (MW) 2006-07 35,540 35,223 31,017 11,990 1,875 49 111 115,705 2011-12 49,674 46,825 42,061 15,664 2,789 77 17 157,107 2016-17 69,178 61,966 56,883 20,416 4,134 122 26 212,725

Source: Central Electric Authority (CEA)


51 The scheme has two components: (a) the investment component, where the GoI provides 50 percent of the project cost as grants and loans for renovation and modernization of sub-stations, transmission lines and distribution transformers, augmentation of feeders and transformers, high voltage distribution system, better feeder and consumer meters, computerized billing etc. The SEBs are expected to provide for the remaining 50 percent; (b) the incentive component, which is equivalent to 50 percent of the actual cash loss reduction by SEBs/ utilities, and is provided as grant.

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Table A6: Investments requirement for power sector, 2002-2012 (Rs. billion) Generation Transmission Distribution Rural Electrification R&M Total Central Sector* 3,227 496 3,723 State Sector* 1,200 560 950 999 250 3,959 Private Sector* 1,105 209 1,314 Total 5,532 1,265 950 999 250 8,996 1,000 595 10,591

Other investments Funds required for restructuring SEBs (APDRP) Non conventional energy projects Grand total required for 2002-2012
Note: *Forecast of likely participation by each sector. Source: Ministry of Power

predict that India will require 719,097 MkWh of power in 2006-07, 975,222 MkWh in 2011-12 and 1,318,644 MkWh in 2016-17 (Table A5). To achieve the targets set out by Mission 2012, the funding requirement was calculated by the Kohli committee setup under the aegis of the Ministry of Power. The committee estimated the funds needed to add 100,000 MW capacity an extra 41,000 MW in the Tenth Plan period and the remaining 59,000 MW in the Eleventh Plan along with the requisite balancing investments needed for transmission and distribution. The estimates are given in Table A6.

cellular services, Indias tele-density has reached 8.62 percent (92.76 million subscribers) with about 22 million new subscribers being added in 2004. The collective revenues of telecom operators (except Internet Service Providers or ISPs) increased by 30 percent from Rs.470 billion in 2003 to Rs.610 billion in 2004.

Liberalization with policy quirks


The first move towards liberalization came in 1994, with the introduction of the National Telecom Policy in 1994 which gave the broad guidelines for private operator entry into basic services. However, the sector remained a victim of governments policy quirks for almost five years. The initial approach was restricted to maximizing revenues from the private sector by charging exorbitant licence fees from sealed bid auctions. Consequently, growth in the first five years of liberalization remained largely unsatisfactory and the government was forced to change its stance. This was done in the New Telecom Policy in 1999 (NTP 99) which significantly helped the sector in breaking the shackles. Given below is a brief description of the policy regime since 1994.

A3 Telecom
The telecom sector in India is a case study of how the interplay of competition and technology can radically change the business landscape of infrastructure. Before opening-up in 1994,52 the sector was characterized by underinvestment, outdated technology and limited growth. In 1994, the waiting list for telephone connections was as high as 2.2 million or almost 31 percent of the total installed base. The constraint was not demand, but the lack of resources of the public sector enterprises. Today, thanks to the boom in
52

The telecom equipment manufacturing was opened to the private sector in 1984.

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

Cellular services
Initially, for cellular services licences, the government divided the country into 23 regions, each with two players, who were not allowed to bid in multiple regions. While this did bring in large number of players who paid huge licence fee (in some cases in excess of Rs.100 billion), none of them could achieve the requisite economies of scale. The result: extremely high tariff rates of almost Rs.16 (34 cents) per minute, low subscriber levels and huge losses for companies who were unable to pay the licence fees. Poor design of auctions and the licencing conditions resulted in legal wrangles with the government and, by the late 1990s, many foreign operators withdrew from the market altogether. This forced the government, through NTP 99, to allow old licencees of cellular services to migrate to a regime of revenue sharing based on a percentage of Adjusted Gross Revenue (AGR). The government then granted cellular mobile licence to the two central SOEs, namely Mahanagar Telephone Nigam Limited (MTNL) and Bharat Sanchar Nigam Limited (BSNL) in 1997 and 2000 respectively. In 2001, the government also decided to bring in the fourth operator in each zone.

Basic Services
Competition in basic telecom services was introduced in 1997-98. Initially, this segment was only allowed to have a duopoly, where one of the players was either of the two SOEs. The segment was opened up to allow up to four operators by NTP 99. These service operators were then permitted to offer limited mobility services in 2001.

Long-distance services
The long-distance services were the last ones to be opened to competition and remained the monopoly of SOEs until 2001. The first National Long Distance (NLD) licence was awarded in 2001 and the first International Long Distance (ILD) licence was awarded in 2002. Presently there are 4 NLD and 5 ILD operators.

The situation today


As of December 2004, cellular services had a subscriber base of 48 million, of which approximately 78 percent were GSM subscribers and 22 percent were under the CDMA platform. On an average, 1.62 million subscribers were added each month in 2004. The sector has seen

Chart B: Mobile subscribers and effective charge per minute

Source: TRAI

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tremendous mergers & acquisitions (M&A) activities in the last couple of years and is now left with five major players who control almost 85 percent of the market. The number of fixed line telephone (including fixed line WiLL) subscribers stood at 44.76 million as of December 30, 2004. There are five private licence operators, apart from the government owned BSNL and MTNL. However, the SOEs still control the majority of the market with 83 percent and 9 percent market share respectively. Growth in the segment has remained almost stagnant as compared to the cellular segment. There were 5.32 million internet subscribers in the country as of September 30, 2004. These were serviced by 188 ISPs, again led by BSNL. Regrettably, however, the domestic telecom instrument manufacturing industry has not been able to keep pace with the demands of the services sector. Today, bulk of the telecom equipment is imported and the entire demand for GSM and CDMA technologies are being met through import. The key growth drivers in telecom have been (i) competition, (ii) effective regulation, and (iii) an understanding of the potential market size. Each deserve some comments. Competition: This is particularly true in the cellular market, and has ensured that India now has one of the lowest tariff regimes in the world, as shown in Chart B. Effective regulator: Telecom has had the fortune of having an unbiased, transparent and efficient regulator in the form of TRAI and its appellate body Telecom Dispute Settlement Appellate Tribunal (TDSAT). Though TRAI was formed almost two years after the cellular market was opened-up and faced the risk of regulatory capture by the Department of Telecom (DoT), it has now established itself as an effective, trusted and

independent regulator. Today, the TRAI is focusing on quality of services, which are monitored and disclosed on a regular basis. Market Potential: As the only other billionplus country, India is being seen as a natural heir to the Chinese telecom sector boom. The market for telecom has been vibrant. Falling tariffs have reflected in increasing usage levels. The Minutes of Usage (MoU) in the postpaid category increased by 148 percent from 238 minutes per subscriber per month in 2000 to 590 in 2004 and 53 percent, in the pre-paid category from 197 in 2000 to 302 in 2004.

Investment requirement in telecom


The target as set out in NTP 99 was to achieve a tele-density of 7 percent (75 million connections) by 2005 and 15 percent (175 million connections) by 2010. The 2005 target has been more than achieved and, at current rates, the 2010 target will be achieved well ahead of time. Therefore, the investment needs calculated in the Tenth Plan to achieve a tele-density of 9.91 by March 2007 is understated. India will have achieved higher densities and will have different investment needs. Table A7 examines investment needs under different growth scenarios. In addition, there has to be investment in broadband to provide high speed, reliable, ondemand internet connectivity with a speed of at least 256 Kbps. Based on the report of the CII Broadband Committee, it is projected that India will have 10.1 million to 10.6 million subscribers
Telecom: Investments Needed Assuming 25 percent annual growth, and a tele-density of 25 percent by 2010-11, the investment needed will be Rs.1,996 billion. To this should be added an extra Rs.147 billion for broadband.

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by 2010 and will require an investment of Rs.147.4 billion.

A4 Railways
The Indian Railways (IR) is the second largest railway network in the world with 63,122 route kilometer (rkm) operating out of 16 zones and 67 divisions53. But it is in distress. Unlike other modes of transport, IR has failed to rise to the challenge of being an efficient and reliable provider of transport infrastructure. Political compulsions have forced the IR to expand networks to commercially unviable areas, highly subsidize passenger fares and raise freight tariffs to a point where traditional long haul goods traffic in items such as cement, iron and steel and petroleum has shifted to roads or pipelines. These issues have severely eroded the cost competitiveness of the railways and it finds itself in the midst of financial distress. As observed by

the standing committee of the Parliament in 2004, the share of planned investment through internal generation has touched the lowest point yet and is likely to go down to about 20 percent during the Tenth Plan in comparison to 58 percent in Eighth Plan. The market borrowings have increased substantially, and is expected to be Rs.147.74 billion during the Tenth Plan. According to the IR, there are two major ongoing projects. The first is the National Rail Vikas Yojana (NRVY), which was announced on August 15, 2002, and consists of the following components: Strengthening of the GQ connecting the four metro cities at an estimated cost Rs.80 billion. Providing rail based port-connectivity and development of corridors to hinterland including multi-modal corridors for movement of containers, estimated at Rs.30 billion.

Table A7: Investments in telecom under different growth scenarios (Rs. billion) Subscriber Base 200 million subscribers (tele-density of 17%) 250 million subscribers (tele-density of 21.3%) 300 million subscribers (tele-density of 25.6%) 350 million subscribers (tele-density of 29.8%) 400 million subscribers (tele-density of 34.1%) 500 million subscribers (tele-density of 42.6%) Assumed CAGR 13.7% 18.0% 21.6% 24.8% 27.6% 32.4% Amount 1,012 1,496 1,996 2,496 2,996 3,996

Notes and assumptions 1. According to latest estimates it costs Rs.20,000 to setup a new fixed line and Rs.5,000 to setup a cellular phone line. 2. The first two estimates (investments needed for 200 and 250 million subscribers) are based on the statement of the Minister of Telecom in Parliament on December 22, 2004. 3. Working backwards from the Ministers statement, the per line estimate works out to be in the range of Rs.9,600 to 9,900 per line. 4. We assume per line cost to be Rs.10,000 beyond the 250 million mark. This implicitly assumes that the market would have a structure of 2/3 mobile phones and 1/3 fixed line. 3. Exchange rate assumed is vis--vis the USD: 1$=Rs.44. 4. The population in 2010 is assumed to be 1.174 billion based on UNDP projections. Source : Authors analysis
53

72 percent of the route kilometres is broad gauge, 23 percent is metre gauge and 5 percent is narrow gauge. The fleet consists of 214,760 wagons, 39,852 coaches and 7,681 locomotives. IR runs 14,761 trains daily, which include about 8,927 passenger trains.

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Constructing major bridges at Patna and Munger over the Ganga, at Bogibeel over the Brahmaputra and at Nirmali over the Kosi which is estimated to cost Rs.35 billion to Rs.40 billion. Thus, the total estimated investment in NRVY is expected to be Rs.150 billion. Under the present funding plan for NRVY, the GoI will provide budgetary funds as equity of Rs.30 billion (including Rs.15 billion of ADB funding) for the GQ projects. The balance Rs.120 billion for other projects is expected to be mobilized through the market which may include BOT schemes, domestic borrowings, SPVs, etc. The second project envisaged by the railways was announced in the interim Budget of 200405 and is called Remote Area Rail Sampark Yojana (RARSY). This involves executing and completing hitherto sanctioned projects related to connecting remote and backward areas with the rail network till 2010. The total investments in these projects is valued at Rs.200 billion. Presumably this is to be entirely funded by budget support.

Investment needs of the Railways till 2010


Given below are two estimates of the investment needs of the railways in the next five years. The first is based on the report of the Expert Group on Railways (Rakesh Mohan Committee) which was released in 2001; and the second is based on the estimated investment of the IR for the schemes and projects it has announced or launched. Expert Group on Railways: The Expert Group suggested capital expenditure requirements for IR under three scenarios business as usual low growth, medium to high growth, and strategic high growth. All estimates are at constant prices. The low growth variant was considered
Indian Railways: Investments Needed According to the medium-to-high growth projected by the Rakesh Mohan Group, the investment needs at constant prices up to 201011 are Rs.1,101 billion. Assuming 5 percent annual inflation, this translates to Rs.1,242 billion at current prices. According to IRs own estimates, all it needs is Rs.700 billion. This is an underestimate.

Table A8: Investment requirements in IR till 2010, Rakesh Mohan Group (Rs. billion) (Footnotes) Medium to high growth (constant price) 107 124 126 128 130 105 92 94 97 99 1,101 Medium to high growth (current price) 97 118 126 134 143 122 112 120 130 139 1,242

2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 Total

Source: Rakesh Mohan Committee report and authors analysis

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

Table A9: Investment requirements for railways for projects announced/undertaken (Rs. billion) Heads National Rail Vikas Yojana (NRVY) Remote Area Rail Sampark Yojana (RARSY) Modernization Plan Other projects in the pipeline Total
Source: Various news reports

Amount 150 200 240 110 700

unsustainable for IR. Table A8 gives the data for the more realistic medium to high growth scenario at constant and current prices, the latter assuming 5 percent annual inflation. Estimate based on the various programs being undertaken by IR: The other estimate is based on the funds required to complete the announced IR projects. The data has been collated from various speeches, budget documents and news reports, and is given in Table A9.

airports in the Asia-Pacific region for all 19 service parameters included in the survey. With a rating of 2.3 and 2.6 on a scale of 1 (very poor) to 5 (excellent) for Mumbai and Delhi airports respectively, these airports were adjudged to offer the lowest service levels in terms of overall satisfaction. The need for airport up-gradation has assumed further urgency with a spurt in domestic and international passenger traffic. With the addition of many new private airlines, varying fares including cut-rate cheap fares, the traffic at the metro airports has grown by more than 20 percent. The urgent need for reforms was reiterated by the Naresh Chandra Committee, which suggested unbundling of the AAI and corporatization of large airports. It also recommended that smaller airports could be grouped together on regional basis and corporatized.

A5 Airports
There are 449 airports/airstrips in the country. Of these, 126 airports which include 11 international airports, 89 domestic airports and 26 civil enclaves are owned, managed and operated by the Airports Authority of India (AAI) under the Ministry of Civil Aviation. The traffic flow at these airports is very uneven. Six airports (Mumbai, Delhi, Chennai, Bangalore, Kolkata and Hyderabad) account for 90.5 percent of the total international passenger traffic and 91.7 percent of total passenger traffic. At present, only 61 airports are being used by various airlines. Most of the airports are underdeveloped and underutilized while others have become overcrowded and are stretched to capacity. 54 A survey done by the International Air Transport Association (IATA) in 1999 ranked the Mumbai and Delhi airports amongst the three worst
54

Ongoing status of airport development in India


While many plans for airport development have been extensively discussed and debated, none has been actually implemented due to political pressures as well as bureaucratic inertia. A look at the annual report of Ministry of Civil Aviation confirms that the development work undertaken by AAI at various airports is restricted to regular maintenance or minor modernization activities. For Mumbai and Delhi Airports, because of the

The GoI has taken a decision on the development of the 35 non-metro airports in three phases. An Inter-Ministerial Committee (IMC) has also been set up to suggest the financing pattern for these investments.

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Box A1: The story of Mumbai and Delhi airport privatization The decision to invite private sector participants to modernize the airports in Mumbai and Delhi was taken by the Government in January 2000. Here is the story of how, six years after the initial decision, the Mumbai and Delhi airports have only been recently awarded for modernization and privatization. January 2000: Government decides to restructure the airports through long-term lease route and conducts road-shows abroad. Parliament objects on the ground that the AAI does not have the power under the Airports Authority of India Act, 1994, to transfer airports on long-term lease to private investors. June 2003: Airports Authority of India (Amendment) Bill passed by the Parliament authorizing AAI to transfer the operations and management of its existing airports by way of long-term lease to private investors. September 2003: Cabinet decides to instead adopt the Joint Venture route and accords approval for the restructuring of Delhi and Mumbai airports. September 2003: Cabinet constitutes an Empowered Group of Ministers (EGOM) to take decisions on various issues connected with the restructuring of Mumbai and Delhi airports. Also constitutes IMG to assist EGOM. January 2004: ABN AMRO selected as financial consultants. February 2004: EGOM allows for registration of expressions of interest from interested parties to acquire 74 percent equity stake in the JV. Last date for submission set at June 4, 2004. June 2004: With the formation of the new government, the last date of submission is extended to July 20, 2004. The cabinet reconstitutes the EGOM. July 2004: The reconstituted EGOM decides to reduce cap on Foreign Direct Investment (FDI) to 49 percent, allows equity participation by Indian scheduled airlines up to 10 percent, increases the deputation period of employees in the JVCs from 2 to 3 years. The EGOM also decides to give weightage to bidders who induct more employees of AAI over and above the mandatory induction of 40 percent. Further, the EGOM approves the appointment of Airplan, Australia as the Global Technical Advisor. Six consortia bid for the Mumbai airport revamp while five of them bid for the Delhi airport. The process of inviting bids, putting them through a pre-qualifying selection round, and then shortlisting them before opening the financial bids went on for nine months. January 12, 2006 The Group of Ministers asked the Delhi Metro Rail Corporation managing director E. Sreedharan to re-evaluate all six bidders, including four who had initially filed tenders to bag the Delhi and Mumbai airport contracts. The Sreedharan panel of experts at the final stage of the evaluation process found only one consortium qualified for bidding.Recently, the government has completed the process of inviting private sector participants to modernize the airports in Delhi and Mumbai, nearly six years after it initiated the process. The Government chose two private consortia for modernising and restructuring the Delhi and Mumbai airports. While the GMR-Fraport consortium won the bid for the Delhi airport, the GVK-South African Airports combine have been awarded the Mumbai airport project.
Source : Various news reports

proposed privatization, the AAI has been postponing undertaking any projects costing more than Rs.100 million since 2000 (Box A1).

on capital expenditure estimates presented by the AAI to the Standing Committee of the Parliament in 2002.
Airports: Investments Needed Based on various secondary sources, the investment needed is around Rs.145 billion. According to the Standing Committee of Parliament, it is Rs.191 billion.

Investments required in airports


Two estimates are considered. The first is based on various secondary sources such as news reports, public statements and press releases by the Minister in charge, while the second is based

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

Table A10: Estimated investments for airports (Rs. billion) Category Greenfield airport at Bangalore Greenfield airport at Hyderabad (phase I) Modernization of Delhi and Mumbai Airports Greenfield airports at Goa, Navi Mumbai, Pune, Kanpur and Nagpur Up gradation of Chennai airport* Total Amount 12.6 12.0 45.0 60.0 15.0 144.6

Source: Various news reports. *The estimated cost of upgrading Chennai airport has been assumed, in absence reliable estimates .

Estimate 1. Based on various secondary sources. This is given in Table A10. Estimate 2. Based on the report of the Standing Committee of Parliament and given in Table A11.55

Key issues and trends


In 2003-04, the total cargo traffic at major ports increased by 9.9 percent to 344.5 million metric tons (MT). Almost, 80 percent of the traffic handled in 2003-04 was in the form of day and liquid bulk, the rest 20 percent was in the form of general cargo including containers. In the past five years container traffic has grown by over 15 percent and is expected to form a sizeable part of traffic in future. Efficiency of the major ports has improved over time. The average turnaround time has come down to almost 3.5 days at present from 5.7 days in 1998-99. The average output per ship-berth-day has increased to almost 9,000 MT in 2003-04 compared to 8,500 MT in 2002-03. Pre-berthing time has also dropped from 6.9 hours in 2002-03 to 5 hours in 2003-04. The port sector does not have a full-fledged regulator yet. However, the government has set-up and independent body called Tariff Authority for Major Ports (TAMP) to regulate tariffs at major ports. The TAMP has been fairly successful in regulating tariff levels

A6 Ports
India has 12 major and 185 minor/intermediate ports covering its 6,000 km coastline. The major ports handle about 76 percent of the total maritime traffic and are managed by Port Trust of India under the central government. Minor ports are managed by the state governments. Lately, the minor ports have emerged as a major player in cargo handling. Their share in traffic has gone up from 10 percent in 1996-97 to 24 percent in 2003-04. The development of ports in India has been a part-success story. The major positives have been the improvement in technical parameters at most of the major ports and the involvement of the private sector in port development and handling. The major negative still continues to be the problem of lack of adequate road and rail connectivity.
55

These estimates are based on the following paragraph of the report: In addition to the planned outlays, preliminary feasibility studies and proposals being reviewed by the state governments and the private sector. Other initiatives, not included in the Airports Authority of Indias plan, are in the range of about Rs.19,100 crores. These investments are contemplated for new airports - Mumbai, Bangalore, Goa and Hyderabad amounting to about Rs.14,600 crores, terminal buildings at various airport locations amounting to Rs.2,400 crores, related supporting airport infrastructure of Rs.1,500 crores and cargo facilities of Rs.600 crores.

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Table A11: Standing Committee of Parliaments estimates of investments in airports (Rs. billion) Category New airports at Mumbai, Bangalore, Goa and Hyderabad Terminal buildings at various airport locations Supporting airport infrastructure Cargo facilities Total
Source: Extract from report of the Standing Committee of Parliament

Amount 146 24 15 6 191

while still giving major ports some amount of flexibility in tariff setting. However, as a regulator it lacks operational flexibility due to its limited mandate. Indian ports are progressively moving to a model where major ports have become landlords, while cargo-handling services are given out to private players. In the last five years, five container terminals have been handed to private players. The biggest success story of this model is the Nhava Sheva International Container Terminal (NSICT). Promoted by P&O Port of Australia, the NSICT was the first private container terminal in India and construction commenced on the 30-year BOT in 1997. The P&O operations at NSICT has set new competency benchmarks for ports in India. Not only was the construction completed before the due date but also efficiency levels are at least two-thirds higher than Jawaharlal Nehru Port Trust (JNPT). In 2003-04, the traffic at NSICT increased to 12.3 million twenty-foot Equivalent Units (TEUs), while it was projected to be 5 million TEUs at the time of construction. The biggest constraint to port development today remains the bottlenecks of inland connectivity through railways and roads. CONCOR, a subsidiary of Indian Railways, has the monopoly of managing and linking up ICDs with CFSs at ports. This CONCOR monopoly does not auger well for port development.

A 1996 study undertaken by the Indian Institute of Management (IIM) and the Railway Staff College, Baroda cited the following reasons on why shippers preferred roads to railways for freight movement: 1. Irregular supply of wagons: Shippers are not often sure of the availability of wagon stock on demand. The variability in supply of wagons complicates the planning process for shippers and also increases inventory costs. 2. Irregular delivery at destination: Shippers are not assured of the arrival of their consignments within a specified time frame. 3. Inflexibility in service. While road transport provides door-to-door service, a similar service is not provided to the shipper by railways. All shipments by rail, which necessarily have a component of road transport at the dispatch and destination ends, have to be arranged by shippers themselves.

Private sector involvement in ports


Ports were opened-up to the private sector in 1996. The objectives were primarily two-fold to attract new technology and increase investments and led to a series of privatization initiatives in various segments of the Indian port sector. This included container terminals, liquid cargo berths and terminals, solid bulk terminals,

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

Table A12: Estimated investments for ports up to 2010-11 (Rs. billion) Category Modernization of JNPT and Kochi ports Capacity addition of 266 tonnes at major ports Capacity addition of 118 tonnes at minor ports Total
Source: Budget 2003-04 and own analysis

Amount 75 160 71 306

and other warehousing infrastructure facilities.

and

logistics operationalized, with an investment of Rs.20 billion. At least 25 projects with capacity addition of around 85.3 MT and investment of Rs.55 billion are at various stages of evaluation/ implementation.

Private sector participation was not restricted to major ports. New minor ports were also developed by private players the two examples being Mundra and Pipavav ports on the Gujarat coast. Three new private ports in Gujarat are also expected to be fully-operational in the next few years at Dholera, Hazira and Marol. The major international players in the Indian ports sector include P&O Ports (Australia), Port of Singapore (PSA), Dubai Port Authority, Maersk Logistics while Adani Exports and Seaking Infrastructure (though it has sold its stake at Pipavav to Maersk) are two of the bigger domestic companies. Investments have been flowing in the sector. Till March 2004, 11 private or captive projects with capacity addition of around 38.2 MT had been

Investments required for ports


It is difficult to quantify the investments needed for ports primarily due to two reasons. First, the investment cost of per unit capacity addition varies enormously on a case to case basis and depends on, among other factors, the amount of dredging required, construction of breakwater facilities, the kind of traffic to be handled etc. Second, the cost of green-field ports also varies considerably. However, assuming a conservative Compounded Annual Growth Rate (CAGR) of 10 percent of

Table A13: Overall investment needs in infrastructure up to 2010-11 (Rs. billion) Roads* Power** Telecommunications*** Railways**** Airports***** Ports Total Rs. billion 4,670 10,591 2,143 1,242 191 306 19,143

*: Including village roads under PMGSY and cost of maintenance. **: Up to 2011-12. ***: Including investment in broadband. ****: The medium-to-high growth scenario of the Rakesh Mohan Expert Group. *****: As given by the Standing Committee of Parliament. Source:Summary of earlier tables.

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traffic at major ports till 2010-11, the required capacity addition at major ports comes to approximately 266 MT or 44 MT annually. Also, assuming a conservative CAGR of 15 percent growth in traffic at minor ports, the required capacity addition at minor ports will be 118 MT till 2010-11. The rough investment requirement estimates for these and the modernization plans for Cochin and JNPT ports as announced in the budget of 2003-04 is given in Table A12.

tolls will be unfailingly reinvested in roads. A gap calculated by this method could, therefore, understate the actual private sector funding needs. The other approach is to deduct the gross budgetary support (GBS) as well as the internal and extra-budgetary resources (IEBR) as stated in the central and state plan documents from the investment needs of the sector. This method, too, has its disadvantages, for it assumes the government financing estimates are both correct and credible. However, it does away with the difficulties of estimating revenues from uncertain future traffic flows. This note has adopted the second approach. Table A14 gives an estimate of this financing gap for 2001-02 to 2010-11. From this is netted out the finances that have already flowed from government to roads up to 2003-04. The residual, therefore, is the financing gap for 2004-05 to 2010-11. As Table A14 shows, the financing gap for roads over 2001-02 to 2010-11 is Rs.1,106 billion (or Rs.110,600 crore). Assuming that government outlays including budget support, internal and extra budgetary resources of NHAI and funds available to government from multilateral agencies can be no more than what is given in Table 14, then this is the amount which needs to be met through private sector investments as well as revenue from tolls and vehicle registrations.

A7 The overall investment needs in infrastructure up to 2010-11


Table A13 gives the overall investment needs in key infrastructure sectors up to 2010-11. As is evident, mobilizing the necessary funds presents a daunting challenge.

A8 Estimating the Financing Gap


It is not easy to estimate the financing gap in infrastructure. There are multiple data sources as well as estimates, and integrating these into a consistent whole is not straightforward. More significantly, there are definitional issues regarding the concept of the financing gap. Therefore, just as in the previous section, the estimates given here should be treated as broadly indicative.

A8.1 Financing gap in roads


There seem to be two ways of defining the gap. The first is to estimate the investment requirements and then to net out that part of the tax revenue from roads (vehicle registration fees, tolls, etc.) which is assumed to be ploughed back to the sector. While conceptually correct, this method has two major empirical lacunae. First, it assumes a robust knowledge of the future growth of traffic, which is notoriously easy to overestimate. And second, in a milieu of central and state government budget deficits, it assumes ex ante credibility namely, that a percentage of the amount collected from registration and

A8.2 Financing gap in power


Here, too, is subtracted the government outlays (grants, gross budgetary support and IEBR of the power SOEs) from the overall investment needs of the sector. The estimate is given in Table A15.

A8.3 Financing gap in telecom


It is assumed that India will continue its accelerated pace of telecom penetration and increase its tele-density from 8.6 percent to 25.6 percent in 2010-11 i.e., it will grow at a compound annual rate of 25 percent. In other

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

Table A14: Estimate of the financing gap for roads, 2001-02 to 2010-11 (Rs. billion) (In Rs. billion) Investment needed 2001-02 to 2010-11 (see Table 1) Investment needed for NH and expressways Investment needed for state highways Investment needed for major district roads Investment needed for village roads under PMGSY Total investment including village roads (a) Government Plan Outlays A1. Central Govt., 10th Five Year Plan, 2002-03 to 2006-07 1. Ministry of Roads & Highways 2. Ministry of Rural Development (for PMGSY) Total of (A1) A2. Central Govt., likely financing in 11th Plan, 2007-08 to 2010-11 1.Ministry of Roads & Highways* 2.Ministry of Rural Development (for PMGSY)* Total of (A2) A3. State and UT Plan outlays, 2002-03 to 2006-07 1. States Plan Outlay on Roads and Bridges 2. Union Territories Plan Outlay Total of (A3) A4. State and UT Plan likely outlays, 2007-08 to 2010-11 1. States Plan Outlay on Roads and Bridges** 2. Union Territories Plan Outlay* Total of (A4) A5. Central Govt. Plan outlay for 2001-02 A6. States and UTs outlay for 2001-02 Grand Total (A1+A2+A3+A4+A5+A6) (b) Finance gap: (a) minus (b) 1,500 750 400 1,320 3,970 GBSa 348 125

IEBRb 247 -

Total 595 125 720 714 150 864 471 32 503 528 38 566 120 91 2,864 1,106

417 150

296 -

Notes: a: GBS: Gross Budgetary Support of the central government. b: IEBR: Internal and Extra-Budgetary Resources of central government undertakings, here the NHAI. *: Assumes a 50 percent growth in outlay in 11th Plan over 10th Plan, of which four-fifths is spent across 2007-08, 2008-09, 2009-10 and 2010-11. **: Assumes a 40 percent growth in outlay.: Source: Planning Commission

words, India will have 300 million subscribers, up from 93 million in 2004. Table A16 gives an estimate of the financing gap.

finance gap for Indian Railways is a relatively modest Rs.151 billion, as shown in Table A17.

A8.5 Financing gap in airports A8.4 Financing gap in railways


Based on the investment needs at current prices to fund the medium-to-high growth scenario outlined by the Rakesh Mohan Expert Group, the The estimate of investments in airports is based on the Standing Committees estimates. The financing gap is arrived by deducting the government outlays from the required

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Table A15: Estimate of the financing gap for power, 2001-02 to 2011-12 (Rs. billion) Total Requirement Government Plans Tenth Plan Outlays A. Ministry of Power B. Department of Atomic Energy C. Ministry of Non-Conventional Energy D. Towards APDRP* E States & Union Territories F. Towards PMGY & Kutir Jyoti* Total for the Tenth Plan (a) Likely Eleventh Plan Outlays E. Ministry of Power F. Department of Atomic Energy G. Ministry of Non-Conventional Energy H. Towards APDRP* I. State & Union Territories J. Towards PMGY & Kutir Jyoti* Total for the Eleventh Plan (b) Total government outlays in the Tenth and Eleventh Plans (a)+(b) Financing gap 1,434 256 17 400 948 60 3,115 2,151 384 25 1,328 90 3,977 7,092 3,500 10,591

*Additional Central Assistance. Notes: 1) Only power sector related outlays of Department of Atomic Energy and Ministry of Non-conventional Energy have been taken 2) Planned outlay assumed to grow at 50 percent for Central Government Ministries and 40 percent for State Government outlays in the Eleventh Plan.3) APDRP is envisaged to end after the Tenth Plan.
Source: Planning Commission

investments, and is given in Table A18.

A8.6 Financing gap in ports


Based on an investment need of Rs.306 billion, the financing gap is estimated in Table A19.

A8.7 Total financing gap


Based on the calculations above, the total financing gap is Rs.5,542 billion. Table A20 gives the break-up of the total financing gap.
56

It would be a mistake if the challenges to resource mobilization were ranked merely in terms of the magnitude of the financing gaps. The financing gaps in some sectors can be filled by private sector more easily than in others. For instance, even though the gap for telecoms is considerably larger than that for railways, under the present scenario it seems much more plausible to mobilize Rs.478 billion of private investment for telecom than the Rs.151 billion for railways.56

In India, the two key issues which make some infrastructure sectors more attractive than others are the risks of uncertainty in demand and the degree of regulatory barriers. Thus, on one end of the spectrum, private sector investment in roads, greenfield ports and power are impeded by the traffic risks and risks of recovery, while on the other end private investment in sectors like airports and railways has fallen victim to regulatory barriers. The success in telecom has been possible due to a favourable mix of healthy demand and low regulatory barriers.

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Table A16: An estimate of the finance gap for telecom, 2001-02 to 2010-11 (Rs. billion) Investment required 300 million subscribers Broadband Total investment required (a) Tenth Central Plan Budget Outlay Bharat Sanchar Nigam Ltd. (BSNL) Mahanagar Telephone Nigam Ltd. (MTNL) Total Tenth Plan Outlay (b) Likely Eleventh Plan Budget Outlay till 2010 Bharat Sanchar Nigam Ltd. (BSNL) Mahanagar Telephone Nigam Ltd. (MTNL) Total likely Eleventh Plan Outlay (c) Financing Gap (a) (b) (c) 1996 147 2143 664.1 119.6 783.7 747.1 134.5 881.6 477.7

Notes: 1). Exchange rate assumed vis--vis the USD: 1$=Rs.44 2). Budget outlay for BSNL and MTNL assumed to grow by 50 percent in the Eleventh plan 3.) Eleventh Budget Outlay assumed to be used to the extend of 75 percent till December 2010
Source: Planning Commission

Table A17: An estimate of the financing gap for IR, 2001-02 to 2010-11 (Rs. billion) Investment required Medium to high growth scenario (2001-02 to 2010-11) at current prices Government Outlays Tenth Plan Outlay: Ministry of Railways Likely Eleventh Plan Outlay till 2010-11: Ministry of Railways Total government resources available Financing gap Note: Eleventh plan outlay for railways assumed to remain constant.
Source: Planning Commission

1,242 606 485 1091 151

Table A18: An estimate of the finance gap for airports, 2001-02 to 2010-11 (Rs. billion) Investment required Standing Committee Estimates Government Outlays Outlay: Tenth Plan Outlay Airport Authority of India Likely Eleventh Plan Outlay till 2010-11: Airport Authority of India Total government resources available Financing gap
Note: Eleventh Plan outlay assumed to increase by 50 percent. Source: Planning Commission

191 54 64.9 118.9 72.1

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Table A19: An estimate of the finance gap for ports, 2001-02 to 2010-11 (Rs. billion) Investment required Modernization and capacity addition Government Plans Tenth Plan Outlays Ministry of Shipping (Ports) State and UTs Total Tenth Plan Outlay Likely Eleventh Plan Outlay till 2010-11 Ministry of Shipping (Ports) State and UTs Total likely Eleventh Plan Outlay Financing gap
Note: Eleventh Plan outlay assumed to increase by 50 percent Source: Planning Commission

306

54 5 59 65 5 70 235.6

Table A20: Overall financing gap in infrastructure up to 2010-11 (Rs. billion) Sectors Roads Power Telecommunications Railways Airports Ports Total
Source: Planning Commission

Investment needed 4,670 10,591 2,143 1,242 191 306 19,143

Financing gap 1,106 3,500 478 151 72 236 5,542

83

ANNEX B: CASE STUDY: TAKEOUT FINANCING


Company: Project: Noida Toll Bridge Company Limited (NTBCL) Designing, constructing, maintaining and operating the 8-lane, 552.5 m long toll bridge across river Yamuna, along with approach roads. The project also includes a flyover at Ashram Chowk in South Delhi. Infrastructure Leasing and Financial Services Limited (IL&FS) and NOIDA. Rs. 4.08 billion

Promoters: Project Cost:

Means of Finance
Source of Funds Equity IL&FS NOIDA IFCI Intertoll (O&M Contractor) Private Equity Funds Public 360.0 100.0 50.0 106.2 400.0 207.8 1224.0 2357.7 500.0 4081.7 Amount (Rs. Million)

Sub Total Senior Debt Deep Discount Bonds (DDBs)57 Total Means of Finance

IDFC Assistance:

Takeout Assistance
IDFC has provided Takeout assistance for the DDBs issued by NTBCL with a face value of Rs.300 million and the interest accrued thereon.

Tranche Issue Date (ID) Face Value Value of IDFC portion on - Issue Date - Takeout Date (5 yr from ID) - Takeout Date (9 yr from ID) - Redemption Date (16 yr from ID)
57

Rs. Million Nov 3, 1999 500.0 300.0 570.0 990.0 2700.0

With Takeout Assistance of Rs. 300 million by IDFC and Rs. 200 million by IL&FS. DDBs were subscribed to by retail investors.

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Key terms of the DDBs:


Coupon rate till first Takeout Date: Coupon rate till second Takeout Date: Coupon rate till maturity: Takeout Fee (upto Takeout Date): 13.70 percent p.a. 14.19 percent p.a. 14.72 percent p.a. 1.6 percent p.a. on principal plus accrued interest

Security Package First charge on Companys movable and immovable assets; Assignment of all rights, titles, interest, benefit, claims and demands under project documents; Charge on the Debt Service Reserve Account, Trust and Retention Account and other accounts of the Company.

Status:

Takeout On the first takeout date, Nov 3, 2004, 37.1 percent of the total DDBs issued was offered for takeout by the DDB holders. The total takeout amount was Rs.351.7 million and was funded by IDFC and IL&FS in the ratio 60:40. As on date, IDFC has the following two exposures to the Company: i. Funded exposure of Rs.211.5 million in the form of DDBs

ii. Non-funded exposure of Rs.358.5 million as takeout assistance on Nov 3, 2004 and accrued interest thereon (Value of IDFC takeout portion on first Takeout date (Rs.570 million) less actual amount taken-out (Rs.211.5 million).

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ANNEX C : STATUS OF DEBT MARKET IN INDIA


Table C1: Cross country comparison of the size of the bond market Nominal GDP 2003 (USD bn) Size of the total bond market 2003 (USD bn) 17662.7 98.7 445.5 58.3 299.9 196.8 Size of the corporate bond market (Dec. 2003) (USD bn.) 2484 44.9 167.6 5.3 2.7 1.9 Total bond Corporate bond market size market size as % of GDP % of GDP (USD bn.) (2003) 160.5% 95.2% 73.7% 63.1% 59.0% 32.7% 22.6% 43.3% 27.7% 5.7% 0.5% 0.3%

United States Malaysia South Korea Singapore Brazil India

11,004 104 605 92 509 601

Source: BIS, DB research

Table C2: Primary issuance of long tenor (more than 10 years) government bonds since 1 April 2002 Issue Description 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 GOI LOAN 7.50% 2034 GOI LOAN 7.95% 2032 GOI LOAN 6.13% 2028 GOI LOAN 6.01% 2028 GOI LOAN 5.97% 2025 GOI LOAN 6.17% 2023 GOI LOAN(20 YR STK) 6.30% 2023 Issue Dt. 10-Aug-04 28-Aug-02 4-Jun-03 8-Aug-03 25-Sep-03 12-Jun-03 9-Apr-03 14-May-02 28-Aug-03 2-Jan-03 12-Jun-03 2-Jan-04 25-Sep-03 2-Jan-03 28-Aug-02 2-Jul-02 16-Apr-02 3-Sep-02 Mat Dt. 10-Aug-34 28-Aug-32 4-Jun-28 25-Mar-28 25-Sep-25 12-Jun-23 9-Apr-23 14-May-22 28-Aug-22 2-Jan-20 12-Jun-19 2-Jan-19 25-Sep-18 2-Jan-18 28-Aug-17 2-Jul-17 16-Apr-17 3-Sep-15 Years 30 30 25 25 22 20 20 20 19 17 16 15 15 15 15 15 15 13 Cpn Rate Last Trd. Date 7.50 7.95 6.13 6.01 5.97 6.17 6.30 8.35 5.87 6.35 6.05 5.64 5.69 6.25 7.46 5.99 7.49 7.38 28-Feb-05 23-Feb-05 25-Feb-05 19-Feb-05 28-Feb-05 25-Feb-05 28-Feb-05 8-May-04 28-Feb-05 27-Dec-04 14-Sep-04 7-Jan-05 28-Feb-05 28-Feb-05 29-Sep-04 24-Jan-05 28-Feb-05 Last Trd. Qty 500 1000 2500 230 30 5000 1000 500 500 500 50 500 500 500 500 500 500

GOI LOAN 8.35% 2022 GOI 5.87% 2022 GOI LOAN 6.35% 2020 GOI LOAN 6.05% 2019 GOI LOAN 5.64% 2019 GOI LOAN 5.69% 2018 GOI LOAN 6.25% 2018 GOI LOAN 7.46% 2017 GOI FLOATING RATE + 0.34% 2017 17 GOI LOAN 7.49% 2017 18 GOI LOAN 7.38% 2015

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19 20 21 22 23 24 25 26 27 28 29 30

GOVT LOAN 5.59% 2016 GOI FRB +0.04% 2016 GOI LOAN 7.37% 2014 GOI FLOATING RATE + 0.50% 2015 GOI FLOATING RATE + 0.19% 2015 GOI FLOATING RATE + 0.14% 2014 GOI LOAN 6.72% 2014 GOI LOAN 7.27% 2013 GOI LOAN 5.32% 2014 GOI LOAN 6.72% 2012 GOI LOAN 6.85% 2012 GOI LOAN 7.40% 2012

4-Jun-04 4-Jun-16 7-May-04 7-May-16 16-Apr-02 16-Apr-14 10-Aug-04 10-Aug-15 2-Jul-04 20-May-03 24-Feb-03 3-Sep-02 16-Feb-04 18-Jul-02 5-Apr-02 3-May-02 2-Jul-15 20-May-14 24-Feb-14 3-Sep-13 16-Feb-14 18-Jul-12 5-Apr-12 3-May-12

12 12 12 11 11 11 11 11 10 10 10 10

5.59 4.49 7.37 5.12 4.71 4.59 6.72 7.27 5.32 6.72 6.85 7.40

7-Jan-05 27-Dec-04 22-Feb-05 15-Feb-05 8-Feb-05 8-Feb-05 21-Dec-04 26-Feb-05 25-Oct-04 9-Feb-05 28-Feb-05

500 5000 500 1000 2000 2000 1000 500 500 500 500

Source: NSE

Table C3: Range of YTMs in Primary Issues of Government Securities by tenor (%) Years 1995-96 1996-97 1997-98 1998-99 199-00 2000-01 2001-02 2002-03
Source: NSE

Under 5 years 13.25-13.73 13.40-13.72 10.85-12.14 11.40-11.68 9.47-10.95 -

5-10 years 13.25-14.00 13.55-13.85 11.15-13.05 11.10-12.25 10.73-11.99 9.88-11.69 6.98-9.81 6.65-8.14

Over 10 years 12.25-12.60 10.77-12.45 10.47-11.70 7.18-11.00 6.84-8.62

Table C:4 Trading in WDM at NSE Month Mar-05 Feb-05 Jan-05 Dec-04 Nov-04 Oct-04 Sep-04 Aug-04 Jul-04 Jun-04 May-04 Apr-04
Source: NSE

Number of trades 6,486 10,156 8,384 10,321 5,767 8,437 12,659 9,241 9,303 11,382 13,097 19,075

Average daily value (Rs. billion) 22.4 30.7 25.5 27.9 19.8 24.2 35.1 25.5 24.4 31.7 38.1 60.7

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

Table C5: Time-series of data on trading in WDM at NSE Year 2004-05 2003-04 2002-03 2001-02 2000-01 1999-00 1998-99 1997-98 1996-97 1995-96 1994-95
Source: NSE

Number of Trades 124,308 189,518 167,778 144,851 64,470 46,987 16,092 16,821 7,804 2,991 1,021

Net Traded Value (Rs. billion) 8,873 13,161 10,687 9,472 4,286 3,042 1,055 1,113 423 119 68

Table C6: Trading in Retail Debt Market (RDM) at NSE Month / Year Mar-05 Feb-05 Jan-05 Dec-04 Nov-04 Oct-04 Sep-04 Aug-04 Jul-04 Jun-04 May-04 Apr-04
Source: NSE

No of trades 2 1 1 6 2 15 4

Traded quantity 20 300 290 10,310 140 57,000 54,330

Traded Value (Rs. million) 0.0 0.0 0.0 1.3 0.0 7.2 6.4

Table C7: Details of trading of select government securities in WDM at NSE No. of Trades (1 Apr 04-31 Mar 05) CG2034- Issue Name 7.5% CG2023 - Issue.Name 6.17% CG2018 - Issue.Name 5.69% CG2014 - Issue.Name 6.72%
Source: NSE

Tenor (years) 30 20 15 10

Average monthly number of trades 44 81 14 41

525 972 168 495

88

ANNEX D: USE OF FINANCIAL INSTRUMENTS TO INCREASE LIQUIDITY


Country Repos and Reverse Repos Yes Yes Yes Yes Yes Yes Yes Yes Yes Short selling Securities Borrowing and lending Yes No No No Yes No Yes Yes Yes FuturesInterest Bond FuturesInterest Rate and Options Swaps No No No Yes Yes Yes Yes Yes No Yes No Yes Yes Yes Yes Yes Yes

India Brazil Chinese Taipei Singapore South Africa Argentina Hungary Korea Thailand

No No No Yes Yes Yes Yes Yes Yes

Source: The development of corporate bond markets in emerging market countries, IOSCO publication, May 2002

89

ANNEX E: PARTICIPATION BY FIs IN INFRASTRUCTURE PROJECTS


Infrastructure financing by FIs so far has fallen short of estimated needs. The Industrial Development Bank of India (IDBI)s58 report on the sanctions and disbursements of FIs reveals that the total loans sanctioned by these institutions towards infrastructure in the first three years of the period 2001-02 to 2010-11 has been Rs.460.6 billion, or a mere 8.3 percent of our estimated aggregate financing gap of Rs.5,542 billion. (Please refer Table E1, which gives details of infrastructure loan sanctions and disbursements of these FIs between 2001-02 and 2003-04). At this rate, the total sanctions for infrastructure projected forward for the decade 2001-02 to 2010-11 turns out to be a little more than Rs.1,500 billion, or 28 percent of the aggregate finance gap. Clearly, these FIs have a long way to go. Table E1 also highlights another disturbing trend. While sanctions have been low compared to the financing gaps in infrastructure, disbursements have been lower still. For the three years ending 2003-04, total disbursement of the FIs has be Rs.287.6 billion, which translates to 5.2 percent of the finance gap for 2001-02 to 2010-11. Within the sectors, it is clear that the FIs have a much higher appetite to lend for power projects than others. Power generation accounts for 62 percent of the value of infrastructure loans sanctioned and 55 percent of disbursals. Telecommunication comes second, accounting for 20 percent of total infrastructure sanctions, and 24 percent of disbursals (Table E2). The increasing participation from LIC, is a healthy sign of increasing supply of long tenor funds, albeit predominantly financing public sector infrastructure projects as of now. Despite sanctions and disbursals being inadequate relative to the financing needs of infrastructure, LIC has emerged as the biggest term lending institution with its disbursements exceeding the combined disbursements of IDBI, IFCI, IDFC, IIBI and SIDBI. There are at least two

Table E1: Sanctions and disbursement to infrastructure by FIs (Rs. billion) Sanctioned 2001-02 2002-03 2003-04 Electricity generation 63.0 Transmission & distribution 2.7 Telecommunications 56.2 Roads/ports/bridges/railways 21.0 Total 142.9 11.8 9.4 4.2 17.2 42.6 209.1 10.3 31.7 24.0 275.1 Disbursed 3 years 2001-02 2002-03 2003-04 283.9 22.4 92.1 62.2 460.6 54.2 9.1 39.1 18.4 120.8 37.8 1.1 6.0 9.1 54.0 65.2 7.4 25.3 14.9 112.8 3 years 157.2 17.6 70.4 42.4 287.6

Source: IDBI, Report on Development Banking in India.


58

The Industrial Development Bank of India (IDBI)s annually prepares a report of the sanctions and disbursements of FIs, including towards the infrastructure sectors. The list of institutions included in this report are IDBI, IFCI, ICICI Bank, IIBI, IDFC and SIDBI (which are classified as all-India development banks), specialized FIs such as the Exim Bank and NABARD, and investment institutions i.e. LIC, GIC, NIC, NIA, OIC, UII and UTI.

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Table E2: Share of sectors in loans sanctioned and disbursed by FIs For 2001-02 to 2003-04 Electricity generation Transmission & distribution Telecommunications Roads/ports/bridges/railways Total
Source: IDBI, Report on Development Banking in India.

Sanctioned 62% 5% 20% 14% 100%

Disbursed 55% 6% 24% 15% 100%

reasons why this is an encouraging development. The first is the sheer size of the long-term liability portfolio of insurance companies, most of which are endowment and money-back policies extending over a tenor of 15 years or longer. And second, the involvement of insurance companies in infrastructure project financing gives any such project greater credibility and opens the door for bank finance, mezzanine and take out finance as well as other cheaper funds. However, most of the involvement of LIC and the other state-owned insurance companies is in infrastructure projects of the central and state governments SOEs backed by government guarantees. These are often not based on credibility or the detailed economics of the project. In fact, in the past, state governments have raised funds from the insurance SOEs ostensibly for financing infrastructure, which have then been diverted to the states consolidated finances.

Commercial banks have only been marginal players in terms of their share of infrastructure financing in the recent past, though this segment has registered strong growth in the last two years. Barring a few, banks in India have generally stayed away from serious financing of infrastructure. While this may have marginally changed in recent times with excess liquidity in the banking system, the fact of the matter is that most banks still appear to be very shy of funding infrastructure projects.59 Table E3 gives the sector-wise details on exposure of scheduled commercial banks in infrastructure for the past three years. That said, the encouraging development in the recent past has been that, despite their natural disinclination, banks are developing an increasing appetite for infrastructure funding. As Table E3 shows, notwithstanding a low base, gross bank credit for infrastructure increased by almost 31 percent in 2002-03, and by 42 percent in the

Table E3: Gross bank credit outstanding for infrastructure sectors from scheduled banks in India, 2001-02 to 2003-04 (Rs. billion) March-02 Power Telecommunications Roads and Ports Total 108 41 52 201 March-03 150 58 55 263 March-04 197 84 92 373 % of total 53% 23% 25% 100%

Source: RBI, Trends and Progress of Banking in India


59

The exceptions are ICICI Bank (which has leveraged its historical expertise in longer term project finance) and the State Bank of India. Of late, a few other state-owned banks have also shown somewhat greater appetite for being a part of consortium lending to infrastructure.

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

following year. The credit to infrastructure as share of total non-food credit increased from 2.4 percent in 2001-02 to 4.8 percent in 2003-04.

What explains the limited participation of FIs and banks in infrastructure financing?
Regulatory uncertainty has increased the risk-profile of infrastructure sectors, limiting the number of potentially viable projects and increasing the risk-aversion towards infrastructure financing. The less-thandesirable participation of development FIs and banks is in part due to the risk-aversion of these institutions to lend to this sector, which is characterized by its unique, higher risk-profile as explained earlier in this section. Moreover, the high regulatory risk associated with the infrastructure sectors in India further increases the risk perception (and hence risk-aversion) towards these sectors. Even in cases where projects are being regulated through contracts, the inability to enforce the contract conditions and threat (and actual experience) of reopening of these contracts by government, greatly increases the risk profile of the projects (a discussion on regulatory constraints in different sectors is presented in section 2.4). The risk-aversion of FIs in financing infrastructure projects also manifests itself in the late entry of certain FIs into projects, resulting in delays or failure in achieving financial closure for many projects. One of the main reasons cited for viable projects not reaching financial closure quickly enough has been the lack of financial support at the initial stage. In India, external equity financing is usually undertaken by specialized FIs. Commercial banks rarely take equity positions in infrastructure projects. Unfortunately, in order to reduce the risk of non-performing loans, most FIs, including
60

Infrastructure Leasing and Financial Services Ld. (IL&FS) and Infrastructure Development Finance Company (IDFC), have preferred to enter projects only after the COD phase. One of the main reasons cited for this is the high concentration of project risks in the early phase of project life cycle. However, critics state that a rationale for setting up specialized infrastructure financing institutions such as IL&FS and IDFC and for creating the Infrastructure Development Fund (IDF) was to carefully appraise such projects and, after the green light was given, to take initial equity positions in these ventures, which was supposed to signal confidence in the project and attract further capital. Thus, according to the critics, while late entry of these specialized FIs has protected their balance sheets, this hinders additional infrastructure financing. The reason why Indian FIs are reluctant to get involved at earlier stages is linked to their mindset, i.e., risk aversion.60 This is changing, but only gradually. Commercial banks also face constraints from the inherent asset-liability mismatch and lack of sufficient appraisal skills for infrastructure financing. While, lack of viable projects resulting largely from regulatory uncertainty in infrastructure sectors appears to be the predominant reason for the limited participation of the DFIs in infrastructure financing, the commercial banks disinclination to lend to infrastructure sectors is explained further by their asset-liability mismatch and lack of relevant project appraisal skills required for infrastructure financing. The asset liability mismatch occurs on account of the difference in tenor between the banks liabilities and the tenor of advances needed for infrastructure financing. For instance, while infrastructure lending has an average tenor of 7-10 years, the average maturity period of 58 percent of deposits of scheduled commercial banks in India was under two years as of March 2003. Thus, in absence

The risk aversion of Indian FIs may be linked, at least in part, to the regulatory/procedural uncertainties discussed above.

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of a take-out or mezzanine finance mechanisms, it is difficult beyond a point for banks to manage longer tenor assets with shorter-tenor liabilities. Another important factor constraining the growth of the infrastructure business for banks is that, the banking sector (and even insurance companies and pension funds) lacks the specialization and experience to appraise the risks and returns associated with large and complex infrastructure projects. Commercial banks have generally focused on working capital finance, trade funding and bill discounting and, therefore, have not developed sufficient expertise to appraise complex and risky infrastructure projects with long gestation periods.61 Though, in recent times the State Bank of India (SBI) has developed relatively strong skills in project evaluation and infrastructure project advisory, most banks know little about the sectors. Consequently, entities that have access to large amounts of relatively cheap depositors funds shy away from infrastructure investment, unless proposal s are appraised by specialized FIs like IDFC. Banks lack the incentive and the wherewithal to shore-up their appraisal skills. Additionally, the existing employees incentive structure in the public sector, including promotion and rotation policies, of public sector banks, makes it difficult for these banks to develop and/ or leverage on such a skill-set. For commercial banks, regulatory restrictions also limit participation in infrastructure financing to some extent. While there are no serious regulatory constraints emanating from RBI guidelines, for banks to increase their exposure to infrastructure sectors, a couple of regulations reduce the flexibility of banks in becoming more active in this segment,
61

if they should want to. As mentioned earlier, RBIs regulations preventing banks from participating in the credit derivatives markets, precludes them from taking on higher credit risk with the option of hedging these risks to the extent needed through these products. Further, the similar treatment of subordinate and senior debt in NPA provisioning, reduces the attractiveness of banks participation in mezzanine financing. Hence, faced with the uncertain regulatory environment, asset-liability mismatch, lack of sufficient appraisal skills and more attractive yields from other business segments (retail lending, corporate, and G-sec market) on a risk adjusted basis, the banks have chosen to limit their exposure to the infrastructure sectors in the past few years. In other words, the incentives have not been strong enough for banks to invest in building this segment of business. Limited participation of insurance companies and pension funds is explained largely by their restrictive investment guidelines and risk aversion. It is widely accepted that insurance companies and pension funds are ideal candidates for supplying long tenor financing given the long-tenor nature of their liabilities. The longer term debt market in India remains narrow as well as shallow due to lack of adequate activity from insurance companies and pension funds whose funds have been traditionally used by government to augment its resources beyond tax revenues. Instead of being active players in funding long term corporate bonds for financing infrastructure, almost all of their investments have been directed to purchasing government paper. Although the tenure of liabilities of insurance companies are 15 years or longer, the

This has been a handicap in project risk management, which covers the entire gamut of exposure i.e. engineering, construction, start-up and operations. To evaluate and mitigate such risks requires comprehensive due diligence, including a rigorous analysis of the assumptions underpinning the financial model which majority of the banks are ill-equipped to handle.

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fact of the matter is that, barring LIC, in recent times, most life insurance companies have not focused on funding infrastructure. Part of this has to do with restrictions on the investment portfolio imposed by the Insurance Regulatory and Development Authority (IRDA). Additionally, to some extent, the internal investment guidelines (and philosophy) of these entities has been influenced by the historical lack of competitive pressures to earn above-market rates of returns. Until recently, before facing private competition and the transition to marketlinked plans, the investment departments of these institutions were merely administrators of funds, without any significant performance pressures on returns. Any shortfall on guaranteed returns to pension and insurance plans were expected to be met through government support. With these entities now competing to attract consumers and with the fiscal support increasingly being withdrawn, these entities would need to enhance their investment management skills. As regards insurance companies, it is noteworthy that the investment guidelines of insurance companies specified by IRDA require them to invest not less than 15 percent of their investments in infrastructure and social sectors.62 However, the guidelines also lay down a minimum rating of AA for investments in debt paper which would automatically exclude investment by insurance companies in debt paper of private infrastructure sponsors. But most of it stems from the lack of sufficient knowledge and appraisal skills related to infrastructure projects and, consequently, a notion that these are far
62

too risky investments for fiduciary entities. Pension and provident funds, both EPF and PPF, are also repositories of large amount of longterm finance. However, as a legacy of government regulations, pension funds remain a notionally funded scheme. For one, almost 72 percent of the fund exists in the form of special deposits with the central government. Under the existing stipulations, these funds cannot be drawn out for deployment in other avenues and, thus, remains a black-hole. For another, a significant portion of the remaining funds are deployed in government securities, which, too, remain locked in for two reasons. First, once a government security is subscribed, regulations mandate that they be held till maturity. Second, investment guidelines also mandate that interest received from government securities be reinvested in those securities itself. Investment guidelines for investing new monies are given in Box 3. As can be seen, even more than insurance companies, the investment profile of pension funds are highly regulated with a massive bias towards government securities. This precludes the largest source of long-term funds from bridging the financing gap in infrastructure. A survey of pension fund investment guidelines of some of the Latin American countries 63 suggest that while significant exposure to government debt is stipulated there is considerable freedom for these funds to invest in a mix of financial instruments with varying riskreturn profiles. While it would not be appropriate or practical64 to introduce radical changes in investment guidelines at this stage, there is

It is understood that most of the investments by insurance companies in infrastructure are made to State-owned specialized FIs such as National Thermal Power Corporation (NTPC), Power Finance Corporation (PFC) (which have a AAA ratings) as also to housing sector which qualifies under infrastructure investments. This clearly indicates the low risktaking outlook of the insurance companies. 63 Since the early eighties, pension funds have become important players in capital markets of many Latin American countries due to radical reforms to the social security systems. However, Pension funds are subject to quantitative restrictions including list of authorized assets, diversification rules, conflicts of interest regulation, valuation rules etc. 64 Primarily because issues such as high rate of assured return, deficiencies in the accounting methodology, lack of skills in fund management need to be resolved first.

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certainly a need to deregulate these sources of long-term finance and formulate prudential norms for infrastructure related projects. Going forward, with appropriate changes in the investment guidelines, three mechanisms could be used to channel pension funds in to infrastructure projects without distorting their risk-return profile. First, to initialize entry in to such projects at the lowest risk level, pension funds should be allowed to invest in projects where a multilateral agency or central

government extends a guarantee on the minimum rate of return. The multilateral agency in turn could charge the project sponsor (such as NHAI) a commercial fee to extend this guarantee. Second, pension funds should be permitted to deposit part of their funds with banks for long periods and ensure that the banks use them exclusively for infrastructure financing. Third, in the longer term, pension funds should be allowed to deploy funds in projects appraised by the all-India FIs.

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ANNEX F: SECTOR SPECIFIC RECOMMENDATIONS TO IMPROVE THE REGULATORY ENVIRONMENT


F1 Roads
Given the size of the national highway network that is to be 4- or 6-laned under NHDP II (the NS-EW corridor) and NHDP III, it seems unlikely that the NHAI will have sufficient funds both as equity from the fuel cess and from market borrowings to finance all the projects. Thanks to the overwhelming preponderance of awarding pure works contracts in NHDP I (the GQ project) as well as other demands for the cess, NHAI faces a serious danger of a shrinking corpus. The only way out of this problem is to focus much more aggressively on pure PPPs involving annuity, BOT as well as shadow tolling. In other words, the proportion of PPP projects for national highways has to increase substantially. For there to be a far greater number of viable PPP projects in NHDP II and III, the contracts have to be of significantly longer road length. Awarding a large number of small lot projects may be good for small and medium size contractors, but it certainly does not create an environment that will attract, create and foster global sized players who can have the resources to build, operate and maintain a road network for 15 to 20 years. Without the emergence of these players, we will not see a major structural shift in roads, notwithstanding all the good that has happened in the recent past. While the cess of Rs.1.50 on per liter of petrol and diesel has worked very well, the government may wish to consider having a statutorily independent body administering the Central Road Fund. There are serious concerns about the financial and implementation capacity of states to modernize state highways and major district roads. As far as finances are concerned, the states should consider levying a cess to create statutorily protected, independently regulated ring-fenced corpus for funding their road program. In this corpus could also flow funds from the CRF, fees, tolls and fines collected from roads, payments made by the concessionaire to the government as per the concession agreement etc.

F2 Power
The most important aspect of power sector reform is to recognize the fundamental truth of the maxim, No money no power. No amount of economic or financial sophistry can ensure funding for projects where consumers do not even pay for the marginal cost of a good or service sold. Unless this mindset is changed which will require changes in the political economy there can be no significant power sector reform or improvement. The Electricity Act, 2003, is a welcome step in the right direction. However it needs to be operationalized at the level of each state. The Planning Commission may consider leveraging its relationship with the states to accelerate this process. Thermal power projects depend critically upon the credibility of the fuel supply

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agreements. Of late, there have been many delays and breakdowns on this front. It is imperative that senior representatives of the Ministries of Petroleum and Natural Gas and of Coal be a part of a coordinating group with the Ministry of Power to ensure ex ante credibility as well as ex post performance of power supply agreements. Subject to the overriding issue of paying proper user charges, the power sector is bedeviled with problems of regulatory capture of the SERCs as well as frequent reneging of escrows and PPAs by bankrupt state governments. This requires intervention at the highest level, without which the entire PPP framework for power and reforms envisaged by the Electricity Act, 2003, will be under risk.

precisely here that the role of an independent regulator would be critical.

F4 Ports
Although there have been considerable reforms in this sector, neither major nor minor ports have independent regulatory authorities. TAMP has done a commendable job in creating a fair play regarding tariffs and charges levied on private service providers at major ports. However, TAMPs remit is limited. Going forward, the government should seriously consider restructuring TAMP as an independent authority with wider regulatory powers. Concomitantly, state governments should also consider creating appropriate independent regulatory bodies for the minor ports that fall under their jurisdiction. As far as new ports are concerned, connectivity has been a major issue. It is imperative that Indian Railways, the Ministry of Roads, Transport and Highways and port authorities actively coordinate with each other at the time of project design and implementation to eliminate connectivity problems. This should not only result in concurrent approvals but also expedite the process of financial closure. Notwithstanding the groundswell of demand for greenfield ports (especially from developers), there are good reasons to believe that such projects are not only expensive but also very risky. Data suggests that the economic gains from sustained privatization of berths outweigh those from setting up new ports. Therefore, the major thrust should be steady privatization of berths and other facilities in existing major and minor ports.

F3 Railways
There are many reform issues related to Indian Railways its serious financial state, inadequate investments in safety, lines, signaling and rolling stock, and others. Most of these, however, fall outside the ambit of this note. There are two recommendations that are worth considering. First, the need for Indian Railways to have an independent regulatory authority that can de-politicize fares, stipulate minimum service standards for freight and logistics, and ensure a level playing field between CONCOR and any other potential entrant. Second, it is important to ensure that CONCOR provides competitively priced, world-class container transport services, especially between ports and inland container depots. International experience suggests that the best way of doing this is by introducing at least one preferably two other global sized competitors. It is
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The Airport Regulatory Authority Bill to set up an independent regulator is currently under the consideration of the GoI

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INDIA Financing Infrastructure : Addressing Constraints and Challenges

F5 Airports
Airports too have no independent regulatory authority.65 The AAI is a creation of the Ministry of Civil Aviation. Given the stated objective of privatizing facilities in Mumbai and Delhi airports as well as the approval of new private airports in Bangalore and Hyderabad, it is imperative that the

government appoints an independent regulatory authority for this sector. Besides this, the issue is one of implementation. Enough reform policies have been suggested in the report of the Naresh Chandra Committee on civil aviation. It is time that the Ministry focuses on implementing them quickly.

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