Can banks ever fund the $800 billion debt imperative?

To clock an annual gross domestic product (GDP) growth of 9%, India needs to spend about $1 trillion, or Rs46 lakh crore, over the next five years on roads, power, railways, ports and airports, among others, according to the Twelfth Five Year Plan.

Considering 20-30% of a project’s cost is equity-funded by a company, about $700-800 billion will have to be raised through debt.

Raising such gargantuan debt, say experts, will be impossible unless rules of the banking system are changed or there is huge liberalisation of external debt-raising rules.

According to R Shankar Raman, senior vice-president, finance, Larsen & Toubro, bank lending accounts for 80% of all debt raised in India today.
Why is the banking system not in a position to meet the $800 billion funding  requirement?
Simply because the Reserve Bank of India (RBI) rules say a bank cannot lend more than 15% of its net worth to a particular sector (called the sectoral cap) and 25% to a particular group (called the group exposure limit).

However, in the case of infrastructure projects, the RBI has said banks can lend 5% more than the sectoral cap and another 5% if approved by the bank’s board.

Problem is, some banks have already started hitting the limits, while others are not very far away.

Ramnath Pradeep, chairman and managing director, Corporation Bank, said his bank is not lending to any more road or power projects this fiscal. “We are already full with our exposure in the power sector and almost neck-deep with roads as of September.”

To be sure, many banks are yet to bust their limits — some are far from nearing it — though they agree it’s a cause for concern.

Abizer Diwanji, head of financial services at Big Four audit firm KPMG, said banks today can’t finance infrastructure projects because of the maturity gaps that exist. “It’s difficult to fund an asset for 10-15 years. There is a maturity mismatch in the system.”

RBI deputy governor Subir Gokarn concurs. “Long gestation projects is not what banks, which basically rely on short-term deposits for their funding, are going to be financing very efficiently,” he said at the Asia Investment meet in Mumbai last Thursday.

“Unless there is some very effective way to deal with the asset-liability mismatch, there is going to be a major constraint on the system to finance infrastructure,” Gokarn said.

A senior official of the Indian Banks’ Association, who did not wish to be named, said given the kind of expansion expected and the kind of money required, it’s impossible to do anything beyong waiting and watching and seeing  what unfolds.

“Today there is so much credit needed. Exclusively financing infrastructure the way it has to happen in the country is a bit difficult for banks at this point in time or going forward,” said the official.

L&T’s Shankar Raman says temporary mismatches will happen with regard to sectoral limits given that in some infrastructure verticals like roads, a large number of projects are awarded within a short period.

“The ability to handle it depends on the size of the bank and its capital adequacy ratio. Good projects have not yet been denied funding. We at L&T have not faced any issues,” he said.

Shankar Raman believes takeout financing could be the answer to banks’ worries about lending to infrastructure projects.

Under this, a bank can transfer a part of its loans to the state-owned Indian Infrastructure Finance Company (IIFCL) after the projects have become operational, for which the bank pays the infrastructure financier a commission.
IIFCL is allowed to take over up to 75% of a single loan. This frees up capital for the bank so that they can lend to more projects.

But Ashwin Parekh, national leader for global financial practices at Ernst & Young says takeout financing doesn’t satisfy banks’ requirement because their risks are not mitigated. “The nitty-gritty of this is not clearly articulated in the takeout financing norms,” Parekh said.

So what should the RBI do? Should it hike sectoral limit for infrastructure?
Shankar Raman said instead of having sector-specific limits, there should be caps on the basis of the quality of assets across sectors.

While new funding avenues such as securitisation and private equity have emerged in the recent past, they are more an exception than the rule.

Gokarn said that the burden of funding infrastructure should be diverted from banks to more diversified areas like the corporate bond market.

“We do see the bond market as something that will supplement the capacity of the banking system and over time displace it as the primary vehicle of a large quantity of finance moving into infrastructure,” he said.
Gokarn said that RBI is ‘very focused’ on trying to do that in conjunction with other regulatory authorities.

But even as the the RBI and others do so, former RBI governor Y V Reddy on Friday questioned the efficacy of such financing model for the infrastructure sector.

“Tell me a country where the corporate bond market successfully funded large long-term infrastructure projects barring a few experiences in the US, where some such funding had happened. There is no such example in Europe or Britain or Asia. And even those American projects cannot be said to be a success as of now. Empirical evidence does not suggest that private sector funding is viable in the infrastructure space,” Reddy said at the Asia-Europe conference of central bankers and finance ministry officials that ended in Mumbai on Friday.

Reddy further questioned the viability of public-private partnership projects in the infrastructure space saying “we need proper institutional mechanism to support a corporate bond market. Unless we put in place proper institutional and governance mechanisms, public-private partnerships in the infrastructure area can well become private profit at the cost of public expenses.”

“We need to have a serious debate on the best mechanisms and facilitate funding well before crisis hits home,” said a banker who did not wish to be named.

Moreover, industry demands on allowing pension funds and insurance funds to invest in infrastructure have remained just that.

So, for now, the onus of funding India’s gargantuan infrastructure needs remains with the banks which, ironically, are just not up to it.