India Infrastructure

Research preview
13 February 2009

Indian infrastructure
Exit the developer, enter the builder
We do not see the Indian infrastructure sector getting out of the
doldrums for the next six months despite the government’s back-to-back
stimulus packages. In light of the structural problems facing the
infrastructure sector, we prefer EPC companies to developers. Amongst
developers, we prefer companies with operating assets and assets with
lower dependence on real estate.
The Government’s stimulus packages, for jump-starting private infrastructure
Historical movement of the infra index
investments will be unsuccessful in injecting life into the sector because:
120
• of the private sector’s reduced appetite for risk. Multiple data sources point to 100
sharply reduced private participation in infrastructure projects in 2008-09.
80
Hence, investment is expected to fall sharply from the US$22 bn invested in
60
each of 2006 and 2007 as reality dawns and bidders start considering
40
economic risks, fluctuating interest rates and restricted credit availability. CNX500 Index CNX Infra Index
20

• the Government’s measures lack speed and efficacy. Monetary measures may 0

not drive disbursals as banks start pricing risks higher and face limits on sector
and group exposures. Moreover, lack of availability of affordable international
funds will make the External Commercial Borrowings (ECBs) relaxations
Source: Bloomberg
ineffective. Finally, the amplification of IIFCL’s refinancing capacities by
US$850 mn seems like a stopgap measure in a long haul (XIth plan estimates
the private sector debt requirement for infrastructure to be US$90 bn).
• lack of project planning deters private capital. We believe that during the past
Table 1 Coming soon from our stable
2-3 years, even ill-conceived projects managed to get funding. International
experience and industry sources stress the importance of properly planned Company Comment
projects using a life-cycle approach along with policies/procedures for IVRCL EPC/developer
adequate risk sharing and implementation. Lack of adequate project-planning Simplex Infrastructure EPC
and an overly narrow focus on the specific transaction will continue to result in GVK Power & Infrastructure Developer
a lack of private sector interest. IRB Infrastructure Developer
Nagarjuna Construction EPC/developer
PREFER EPC COMPANIES WITH LIMITED DEVELOPER ROLE Punj Lloyd EPC
Source: Noble research
In the current scenario, where inadequate project planning may keep economic
risks high and flexibility low in concession agreements, we prefer EPC companies
over developers. However, most of the EPC companies have become part
developer. Hence, we prefer EPC companies with: (a) a large proportion of cash
contracts in their order books, (b) minimal equity investment needs in infra
SPVs/subsidiaries; and (c) low leverage. Firms that meet these criteria are IVRCL,
Punj Lloyd and Simplex Infrastructure.

PREFER DEVELOPERS WITH LOW DEPENDENCE ON EXTERNAL

Analyst
ASSETS
Amongst the developers, we prefer companies with operating assets and assets Nitin Bhasin
+91 (0) 22 4211 0909
with the least dependence on external real estate. We prefer roads under nitin.bhasin@noblegp.com
operation and regulated assets such as utilities to airports and toll roads under Sales
development. Developers owning operating toll-roads (eg: GVK, IRB) should be
preferred to Greenfield toll-road developers with toll-roads under development (eg: Pramod Gubbi

Nagarjuna, Madhucon and HCC). Over the next two months we will initiate +91 22 4211 0902
pramod.gubbi@noblegp.com
coverage on GVK and IRB amongst the developers and Punj Lloyd and IVRCL Sarojini Ramachandran
amongst the EPC firms. +44 (0) 20 7763 2329
sarojini@noblegp.com

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 Indian infrastructure

THE WELL PUBLICISED TARGETS OF THE XITH PLAN

In order to close the increasing deficit in Indian infrastructure, the Government of
India (GoI) increased the XIth plan (FY07-12) outlay by 1.4X over the Xth plan (FY02-
07) (see Table 2). Recognising the limits of public resources and the increasing
success of public-private partnerships (PPPs) in infrastructure, the GoI increased
share of private investment to 30% in the XIth plan from 20% in the Xth plan; in
absolute terms to Rs6.2 tn, 2.6X growth from the Xth plan. However, the relative
role of public and private sectors will vary with some sectors such as airports and
telecommunication attracting a larger share of private investment, whereas roads
and power have a lower share of private participation.
th
Table 2 Share of private investment in the XI plan to be about 30% versus 20% in Figure 1 Electricity and roads to account
th
X plan for larger share of private funding

(Rs bn) Xth plan XIth plan Electricity

2%
3% 1% Roads and Bridges
Total Public Private Total Public Private 9%
Telecommunications
Electricity 2,919 69% 31% 6,665 72% 28% 1% 30%
Railways
Roads and Bridges 1,449 95% 5% 3,142 66% 34%
8%
Irrigation
Telecommunications 1,034 47% 53% 2,584 31% 69%
Railways 1,197 100% 0% 2,618 81% 19% Water Supply &
Sanitation
Irrigation 1,115 100% 0% 2,533 100% 0% Ports

Water Supply & Sanitation 648 98% 2% 1,437 96% 4% Airports

Ports 141 26% 74% 880 38% 62% 29% 17% Storage

Airports 68 57% 43% 310 30% 70% Gas

Storage 48 30% 70% 224 50% 50%

Gas 97 90% 10% 169 61% 39%
Total 8,714 80% 20% 20,562 70% 30%
Source: Planning Commission, Noble research Source: Planning Commission, Noble research

However, execution of the planned expenditure is lagging due to various

regulatory, financing and procedural constraints and we expect the overall
investments by 2012 to miss the stated targets by 30-35%. In this note we examine:

• The reasons behind this expenditure shortfall

• The implications of this shortfall for investors in this sector

• Some of the steps that might be taken post elections to address the shortfall

THE DRIVERS OF THE EXPENDITURE SHORTFALL

We see the following three drivers of the shortfall:

1. The private sector’s reduced appetite for risk

2. The government’s flawed attempts to improve financing for infrastructure

3. Lack of proper project planning

1. Falling appetite for risk

After witnessing heavy investment in 2006 and 2007, private participation in public Figure 2 Rising private investments in
infrastructure is expected to be much lower in 2008 and 2009 relative to the Indian infra
US$22 bn invested in each of those previous years. In 2006-07, as capital became
25 (US$ bn) 22
plentiful, the risk premium for these greenfield projects all but disappeared, even as Water and sewage
20
nominal rates and interest rate volatility were increasing. However, now with the Transport
Telecom
emerging economic risks, rising interest rates and concerns about credit 15 Energy
availability, private interest is waning in infrastructure investment, a fact that can be 10 8 22
inferred from media reports on the dismal level of bidding activity in state and 2
3 6
3
5 5 4 9
central projects. For example, recent media reports indicate that just one company 4

each had bid in five road tenders opened recently to develop the 6,500km -
1996

1999

2006
1998

2007
2003

2005
2002
1997

2001
2000

2004

highways and that too with Viability Gap Funding (VGF) of 37-39% of the total
project cost
Source: PPIAF, Noble research
We believe that Indian PPP projects have been assuming more interest rate risk
over 2006-08 with senior debt funding rising and equity participation dropping.
The tenor of debt at 7-10 years continues to remain relatively short by the
standards of this industry, with a trend towards shorter reset periods. PwC’s

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 Indian infrastructure

research highlights that for select PPP projects, spreads dropped in 2006 and 2007
to reach levels below AAA and AA rated corporate bonds (thus suggesting minimal
economic risk in Indian infrastructure investment!).

Figure 3 Debt-equity ratios rising for India’s PPPs Figure 4 PPP spreads fell sharply over the period 2004-07

Senior debt Equity Selected PPP projects AAA bonds

Subordinated debt Government grants AA bonds BBB bonds
80 600
70
500
60
%age of total

400

Basis points
50
40 300
30
200
20
100
10
0 0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007

Source: PricewaterhouseCoopers, Noble research Source: Bloomberg, PricewaterhouseCoopers, Noble research

Early evidence for 2009 suggests a reconnection between lending rates and
project risk fundamentals. The apparent underpricing of project risk during the
2006-2007 period suggests potential difficulties for a number of project loans as
they reach their first interest reset period (every two to three years on average), or
worse, as some projects recapitalise in their transition from construction to
operations.

Whilst some of the reasons for the private sector’s heightened risk aversion are
linked to the credit crisis and the re-pricing of risk globally, there are some sector
specific issues in India as well such as poor project planning (discussed
subsequently) and political uncertainty with the looming elections.

2. Government measures to improve funding lack speed and Table 3 The Government’s measures
efficacy may not have the desired impact

Through its two stimulus packages in Dec-08 and Jan-09, the GoI has sought to
Impacted Comments
improve the infrastructure sector’s access to finance by: entity
NBFCs Relaxed ECB regulations but
− Allowing IIFCL to raise tax-free bonds for re-financing banks’ loans to where is the foreign money?
infrastructure companies at lower cost, ECBs Lack of money internationally to
invest in India on account of
− Relaxing ECB regulations for NBFCs focusing on infrastructure lending and increasing spreads
borrowings by infrastructure companies, Commercial Exposure at high levels with
banks some banks at limit levels;
− Reduction in banks’ cash reserve requirements, cuts in repo and reverse repo
heightened risk perception
rate, upward revision of credit targets (for Public Sector Banks), and IIFCL Disbursals of Rs30 bn in FY09,
− Increase in the FII investment limit in rupee denominated corporate bonds in one-third below the targeted
disbursal
India to US$15 bn from US$6 bn. Source: Noble research
We do not see these measures as being particularly effective for the reasons
highlighted in this section.

Banks—risk pricing and regulatory issues to keep the impact of monetary

measures muted

Pricing of project risks by banks has in the past depended more on sponsor-bank
relationships than on a broader and more rigorous evaluation of project
fundamentals. The importance of pricing project risk, and its reflection in the
interest rate charged by Indian banks has varied over time with little attention to
risk analysis. This has lead to declining PPP spreads over 2004-07 (see figure 4).
However, as concerns about economic growth have come to the fore, banks are
now waking up to the risks such as inflexible concession agreements, cost overruns

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 Indian infrastructure

and user charge revenues. Not only are banks increasing risk analysis, they are also
not abiding by the earlier loan documents and are now negotiating rates on
account of the increased risk perception of the infrastructure sector. Industry Banks are now waking up to the
sources (NBFCs and rating agencies) highlight that banks are constrained not so economic and project-related risks
much because of liquidity concerns but because of their fear that the projects they
finance may turn out to be non-performing assets.

Banks—too small to provide a solution

Although the government is increasing the credit available to the banking system, Table 4 The RBI’s norms for banks
Indian banks are relatively small. Only 11 banks had equity above US$1 bn (Rs49 bn) and FI lending impose company and
in March 2007 —of which two were private sector banks. Even India’s largest bank, group restrictions
State Bank of India (SBI) had just over US$7 bn of capital in March 2007. The total
Single company Group
equity of the 82 scheduled commercial banks (including 29 foreign banks) was
20% of the capital 20% of the capital
US$50 bn. funds for infrastructure funds for infrastructure
projects* projects*
Group exposure guidelines of the Reserve Bank of India (RBI) also limit a bank’s *25% with Board’s approval
exposure to any group, to 50% of its capital funds. This ceiling can be breached **55% with Board’s approval
very quickly for companies specialising in infrastructure projects. For instance, a Capital funds include Tier I & II capital
group company with two Ultra Mega Power Plants (UMPPs) of US$4 bn each, and a Source: RBI, Noble research
US$500 mn road project executed through separate special purpose vehicles
(SPVs) can require debt funds to the tune of US$5.8bn.

IIFCL — a stopgap measure at best Figure 5

th
XI plan projects 70% of
Amplification of IIFCL’s refinancing capacities by US$850 mn (Rs400 bn) over the private investment to be met through
next 12-15 months seems like a stopgap measure in a long haul given the large borrowings
US$90 bn private sector debt requirements over the XIth plan (see figure 5). Also,
IIFCL’s refinancing of bank loans through the issue of 5-year tax-free bonds does Borrowings Private

140 129
not address the issue of lack of long-tenor funds for the infrastructure sector. 120
100
Though the new funds raised will increase IIFCL’s disbursal capabilities, we believe

US$ bn
80

it could be another 5-6 months before these new funds are disbursed to new 60
38
40 31
24
projects as appraisal and sanctions take time. Moreover, the increase in exposure 20
16 20

limits for IIFCL and heightened risk perception amongst banks could mean banks -

increasingly opt for maximum refinancing (through IIFCL) and minimum exposure
(to their balance sheet), leading to a lower-than-expected impetus.

IIFCL’s participation in the overall project cost for sanctioned proposals has Source: Planning Commission, Noble research
hitherto not been more than 10-15% and its disbursals have not been very
meaningful in the overall scheme of things. Although, IIFCL expects disbursals to
increase to Rs30 bn in FY09 from Rs15 bn in FY08, these disbursals will still be IIFCL disbursals will still be insignificant
insignificant in terms of the overall debt requirements of the projects. IIFCL says in terms of overall private sector debt
that it will disburse Rs50 bn by March 2010. requirement

Table 5 IIFCL’s exposure for projects which have achieved financial closure

(Rs bn) No. of projects Project cost Loan sanctioned Amount allocated
Road 46 248 46 32
Port 4 28 4 3
Power 18 674 85 75
Airport 2 147 22 8
Urban infrastructure 1 1 0 0
Total 71 1,097 156 119
Source: IIFCL, Noble research

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 Indian infrastructure

ECBs—unavailable but also not the best option

The relaxation in ECB regulations for infrastructure investment may be a positive
Figure 6 ECB availability has been
move. However, past financial crises leave us less sanguine of this source as a
declining since the beginning of 2008
steady long-term funding option. Moreover, given the scarcity of credit and wide
spreads prevailing in global markets, we do not see increasing ECB flows to either 3,000

NBFCs or corporates within the infrastructure segment (it is highly unlikely that 2,500 ECB/FCCB moving
ECBs can provide finance at sub-12% cost and that too for borrowers with weak or average last 12
2,000
months (US$ mn)
non-existent credit ratings). 1,500

1,000
Moreover, raising money internationally can create problems when macro concerns
500
increase. For example during the financial crises in Asia in 1997 and in Argentina in
0
2002, many projects broke under the severe stress of such crises, as the local
currency revenues of such projects could no longer service foreign currency debt
made more expensive by steep currency devaluations.
Source: Bloomberg, Noble research

NBFCs
There is a large chunk of infrastructure financing that comes from NBFCs, but it is
concentrated in few large NBFCs such as IDFC. Currently, the only mode of
financing for these NBFCs is, directly or indirectly, are the banks. Opening the ECB
window for these NBFCs will not serve any purpose as there is hardly any
international money on the ECB front ready to come to India (and whatever money
is willing to come to India will not come at sub-12% interest rates).

Equity capital to match debt capital may remain in short supply

We expect increasing risk perception amongst the debt providers to increase the Domestic companies and developers are
share of equity in infrastructure projects from 25% to a significantly higher reluctant to part with equity at current
proportion. However, as is well known, equity is in short-supply due to the state of valuations
capital markets. Moreover, hitherto equity sources for Indian infrastructure have
been largely domestic (more than 80% came from project developers, with the
next largest contributor being the public sector). With the large order book
additions and ongoing infrastructure projects, the balance sheets of many private
promoters are stretched and their ability to bring in further equity is doubtful.

Participation by foreign players, particularly strategic investors, has been low even
though PPP projects in many of the sectors are allowed to have 100% FDI. FDI
accounted for only 11% (~US$300-400 mn) of the total investment in the Indian
projects studied by Public-Private Infrastructure Advisory Facility (PPIAF) over
1995-2007. The port sector had the largest share (51%) of this foreign investment,
followed by airports (32%) and roads (16%). Only nine projects were reported to
have strategic investor participation totalling a mere US$167 mn: four in ports,
three in airports, and one each in water supply and railways.

Figure 7 FDI flow in sectors like power is already declining

100
87 89 Telecommuni
90
78 cations
80 74
70
70 Construction
57
60 51
50 44 Real estate
Rs bn

39
40
28
30 22 21 24 Power
20
7 7 9
10 24 1 4
Oil & gas
-
2005-06 2006-07 2007-08 2008
(Apr-Oct)

Source: DIPP, Noble research

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 Indian infrastructure

3. Lack of planning and policies deters private capital

Private investment in infrastructure is not only being held back due to inadequate
funding but also due to a shortage of well-conceptualised projects.

Lot of projects lack in project evaluation methodology

In India, Centre and states suffer from a lack of project preparation capacity. As per
GMR’s woes in DIAL is a model case of
the Comptroller and Auditor General (CAG) of India more than two-thirds of the
improper evaluation wherein GMR has
National Highways Development Project (NHDP) Phase I projects were delayed
sought support from government early
because of preparation of faulty detailed project reports (DPRs). As India
on for traffic and revenue shortfall and
transitions from procuring and bidding out a large portfolio of PPPs, to managing
inability to raise funds by trumpeting the
and overseeing this portfolio and spreading the program to other sectors, it needs
possibilities of halting of work due to
a robust evaluation mechanism. Industry sources point out that during the last 2-3
running out of financial resources. The
years even ill-conceived projects with improper sharing of risk also received private
recent levy of Airport Development Fee
investments and bank funding (example: Noida Toll Bridge, which went through
(ADF) has also come after Indian Law
restructuring in its early days of operations). CAG’s report also points to lack of
Ministry had rejected the same in
evaluations: it states that if the National Highways Authority (NHAI) had fixed toll
December 2008 citing agreements
rates and concession periods on the basis of sound evaluation, the concession
signed in 2006
period of the Jaipur-Kishangarh and Delhi-Gurgaon projects could have been
restricted to 12 and 14 years, respectively (as opposed to the actual 18 years and 20
years, respectively, for which those concessions have been granted).

International experience also suggests that poor or incomplete project evaluations During the last 2-3 years even ill-
were the primary reason that many PPP projects around the world in the 1990s conceived projects received private
were halted due to stakeholder disputes. A 2002 study found that, on average, in investments and bank funding
nine out of ten transport infrastructure projects (generally among the most
expensive PPP projects), costs are underestimated, in some sectors such as rail, by
much as 45% on average.

IMPLICATIONS FOR INVESTORS

Given that the policy and the process shortfalls highlighted in the previous sections We prefer EPC player over developers;
are not going to disappear in the short-medium term and given that private within the sector we prefer power and
capital’s risk appetite will not return to FY07/FY08 levels for some time to come, roads to airports
we prefer EPC companies to developer companies. Given the lack of private
capital, we expect governments (central and state) to increase outlay on
infrastructure activities as announced in the recent stimulus package. This should
result in the continuing business for EPC players.

We prefer EPC companies over developers

Our research indicates that about 50% of the overall infrastructure expenditure in Table 6 Near-term coverage
the Xth plan will be the construction component i.e about Rs10 tn (US$200 bn)
over FY07-12. In the current scenario, where inadequate project planning may keep Company Comment
economic risks high and flexibility low in concession agreements, we prefer EPC IVRCL EPC/developer
companies over developers. Where developers face uncertainties with regards to GVK Power & Infrastructure Developer
IRB Infrastructure Developer
higher interest rates and the changing economic scenario, EPC companies’ cash
Nagarjuna Construction EPC/developer
contracts are relatively insulated (barring the rising working capital costs and Punj Lloyd EPC
barring a complete standstill in the construction activity). We further expect EPC Source: Noble research
players to benefit from additional government spending in Indian infrastructure.

Limited pure EPC players... developer role creating incentive problems

Though we prefer EPC companies in the current scenario compared to the

developers, we highlight that most of the EPC companies have become part
developers creating efficiency problems and incentive compatibility challenges.

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Table 7 EPC players increasingly assuming developer role

Companies Toll-roads Captive power Real estate Airports Ports

HCC √ √
Gammon √ √ √ √
IVRCL √ √
Patel Engineering √ √ √
Simplex
Nagarjuna Construction √ √ √ √ √
Lanco Infratech √ √
Source: Company data, Noble research

Many construction firms have formed project companies to bid on big projects,
because they cannot afford the opportunity cost of missing out on the construction
contracts that are embedded in them. Companies have been increasingly willing to
bet their balance sheets on concessions or greenfield construction projects that
ostensibly tie them to a bankable revenue stream (from tolls, tariffs or government Figure 8 EPC companies can improve
transfers). This enables them to raise project financing (or did when the going was IRRs through captive contracts (Latin
good). However, this creates a risk for construction companies in so far as they can American data)
get stuck in low margin businesses as in the case of Gammon. That being said,
academic research suggests that EPC companies have good reason to become 20%
WACC Adjusted IRR Unadjusted IRR

developers. 18%
16%

Sirtaine, Pinglo, Guasch and Foster’s (2005) find that for Latin American 14%
12%
developers the IRR is below the weighted average cost of capital (WACC) (see 10%

figure 8). However, after making standard accounting adjustments (for example, to 8%
6%
add to the utilities the high rates of management fees and transfers to subsidiaries 4%

through purchases) mainly for the EPC companies assuming a developer role, the 2%
0%
rate of return surpasses the costs of capital. Transport Water Telecom Energy

Be that as it may, within the EPC sub-sector, we prefer EPC companies with: (a) Source: Sirtaine, Pinglo, Guasch and Foster
2005 (Latin America: 34 concessions)
large proportion of cash contracts in their order books, (b) minimal equity
investment needs in infra SPVs/subsidiaries, and (c) low leverage. Firms that meet
these criteria are IVRCL, Punj Lloyd and Simplex Infrastructure.

Over the next 2 months we will initiate coverage on the following EPC firms:

- Punj Lloyd (PUNJ.IN, market cap US$590 mn) is a pure Engineering &
Construction (E&C) major catering to the hydrocarbons and civil construction
sectors across India, Asia and the Middle East. The recent acquisition of
Sembawang has helped it scale up its expertise in large scale urban
infrastructure in Asia and Africa.

- IVRCL (IVRC.IN, market cap US$327 mn) is the leading water-segment

engineering procurement, construction and commissioning (EPCC) player with
minimal developer (one road and Chennai water desalination project) role.
IVRCL through its subsidiary IVR Prime has exposure to real estate
development.

- Simplex Infrastructure (SINF.IN, US$152 mn) is a pure EPC company with

business experience spanning across industrial, infrastructure and residential
projects in India and the Middle East. The company has recently forayed into
onshore oil drilling.

Amongst developers, we prefer power and roads to airports

Within the infrastructure developer segment, we prefer developer companies with
projects with economic profiles which are the least dependent on external assets
such as the attached real estate. We believe airport assets to be the riskiest as
these projects are heavily dependent on the adjoining real estate (examples: Delhi
(GMR) and Mumbai (GVK)). Developers owning operating toll-roads (eg: GVK,
IRB) should be preferred to Greenfield toll-road developers with toll-roads under
development (eg: Nagarjuna, Madhucon and HCC). Within utilities, although new
generation capacities may find financial closure difficult, regulation assures returns
with comparably lower risk profile for new generation companies; however, some
level of merchant power capacity can improve the economic profile of power
generation projects.

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 Indian infrastructure

Table 8 Risks and rewards of infrastructure segments

Asset segment Risk Avg cash yield Average Capital

(yrs 1-5)* leveraged IRR** appreciation
potential
Toll roads (operating) Low 4-8% 8-12% Limited
Regulated assets Low-med 6-10% 10-15% Limited
Rail Medium 8-12% 14-18% Yes
Airports/ seaports Medium 5-10% 15-18% Yes
Toll roads (development) Med-high 3-5% 12-20% Yes
Note: * Cash distribution to equity holders as a percentage of equity investment** Assumes debt of
50% to 85% and investment periods of not less than five to seven years

Source: Larry W. Beeferman, Noble research

Over the next two months we will initiate coverage on the following developers:

- GVK Power and Infrastructure (GVKP.IN, market cap US$610 mn) is one of the
leading infrastructure developers in India with a portfolio of assets spanning
power, roads, SEZ and airport (Mumbai International airport).

- IRB Infrastructure (IRB.IN, market cap US$786 mn) is India’s leading toll-road
operator on a build-operate-transfer (BOT) basis with 11 operational roads, one
under construction and two at financial closure stage.

Developers face multiple risks

While actual economic growth in recent years has exceeded the expectations of While actual economic growth in recent
some of the project feasibility studies, none anticipated the current economic years has exceeded the expectations of
slowdown. As a result, developers’ project cash flows and asset values are highly some of the project feasibility studies,
susceptible to construction delays, the current economic slowdown and interest none anticipated the current economic
rate risk (the latter due to the frequent interest reset periods of the loans). Though slowdown
infrastructure assets are long-term in nature and their intrinsic value should not be
significantly affected by short-term movements in the changing economic
landscape, many assets in India do not have any operating track record and may
face risks not factored during aggressive bidding for these assets in 2006-07.

We expect developer companies to face serious challenges as most of the Cash flows for most of the projects were
infrastructure developers’ projections for cash flows from projects did not involve built as annuities and did not involve
stress testing. For projects with full market exposure, and aggressive debt stress testing
amortisation, a sudden economic downturn could push debt service coverage
levels dangerously near the loan’s covenant, requiring a restructuring of project
debt. Rating agencies such as Fitch expect a large amount of loan restructuring to
take place over the next few years, as a wave of projects exit the construction
phase and enter operations.

Good examples of projects beset by these challenges are the Noida Toll Bridge
and the Delhi International Airport (DIAL) being developed by GMR Infrastructure.

• Back-ended revenue profile coupled with high interest rates not only led to
restructuring of Noida Toll Bridge’s but also for extension of the concession
period.

• Early into its operations DIAL has witnessed traffic declines and debt has
become scarce. This has lead to repeated requests for levy of additional fees
for making the revenue shortfall. Waning interest in the adjoining real estate
has also impacted the funding for the airport.

Interest reset periods for outstanding project loans are aggressive, occurring every
two to three years, and in some cases, even annually. Most projects have reset
periods that coincide with projects entering their operating phase. While project
concession agreements contain annual tariff adjustment clauses that are usually
tied to inflation, this natural hedge is not perfect. Moreover, regulatory hurdles such
as the new Model Concession Agreement (MCA) capping overall project returns by
linking traffic growth with the concession period can be a dampener for investment
returns for developers.

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THE WAY FORWARD FOR INDIAN INFRASTRUCTURE

In order to improve debt and long-term funding availability and concurrently
increase private participation in the infrastructure sector, the GoI needs to push for
structural changes in the financial system, increase participation of financial
investors and follow a life-cycle approach to planning infrastructure projects.

1. Development of long-term bond markets

The creation of a deep and robust debt capital market can increase the flow of
Table 9 Public borrowings dominate
long-term funds and reduce reliance on banks. The Indian corporate bond market,
domestic debt securities in India
though one of the largest in Asia, is still at an early stage of development, and its
growth is hampered by institutional, legal, and regulatory constraints that make Public Private Corporate
bonds a more expensive way of financing debt. The domestic bond market (%) FIs entities
continues to be dominated by public borrowing—National Thermal Power All issuers 49 40 12
Corporation (NTPC), NHAI and Power Finance Corporation (PFC)—and does not Argentina 72 9 19
address the needs of the corporate market. Brazil 78 21 1
PRC 56 42 2
Moreover, to increase the efficiency of the private placement market for debt, the India 96 3 1
GoI needs to reduce the regulatory asymmetry between loans and bonds. The Mexico 82 3 15
South Korea 48 21 31
regulations relating to investments in bonds are far more restrictive compared to
Thailand 34 42 23
granting of loans—(i) Banks cannot invest in unrated debt instruments but can Source: BIS (2006), Noble research
invest in unrated loans, and (ii) Banks grant loans with no mark-to-market
implications, but their bond investments are subject to mark-to-market regulations.

2. Increased investment by pension/insurance funds

The projected growth of pension funds and life insurance assets and their natural
synergy with infrastructure can support long-term infra financing with tenors of 10-
20 years. The Insurance Regulatory and Development Authority’s (IRDA) recent
move to increase the exposure limit of insurance companies to a single
infrastructure company to 20% from the present ceiling of 10% is a step in the right
direction.
Table 10 More room for insurance sector’s exposure to infrastructure

Investment in infrastructure and Investment in infrastructure and

social sectors (Rs bn) social sectors as a proportion to
total investment by insurance
companies (%)
Life insurers
2006-07 698 13.0
2005-06 496 12.5
2004-05 455 12.4
Non-life insurers
2006-07 61 12.1
2005-06 50 12.7
2004-05 44 12.6
Source: IRDA, Noble research

However, we believe there is more to be done as IRDA’s current guidelines call for
project ratings of not less than AA for debt securities. Generally, infrastructure
projects that depend on, say, toll collections or airport traffic get a BBB rating.
Therefore, important road or national highway projects may not be able to get
investment from the insurance sector unless regulations are amended.

3. Dominance of certain developers can make matters worse

Government regulations and policies are restrictive for bidding of projects in roads, Same set of developers that do other
ports and airports. Clauses in the Request for Quotation (RFQ) allow a fixed EPC jobs for govt/non-govt could limit
number of tenders to enter the final phase of price bids. This has not affected roads the overall execution capabilities in the
only but also airports and ports. Another bottleneck is assigning marks on the country
basis of experience at the pre-qualification stage, which automatically disqualifies
new companies wanting to enter the infrastructure development space. Industry
sources say that these clauses should apply to larger projects rather than the
smaller ones. Since Dec-07, as many as 60 tenders under NHDP III have been on
hold because of restrictive clauses.

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4. Life-cycle approach towards projects

We believe in order to attract increasing private investments the government
should follow a full life-cycle approach (e.g., a clear framework) for partnerships
that confers adequate attention to all phases of a PPP—from policy and planning, to
the transaction phase, and then to managing the concession. Such an approach can
help avoid problems of poor setup, lack of clarity about outcomes, inadequate
internal capacity, lack of interest from the private sector, and an overly narrow
focus on the transaction.
Figure 9 Life-cycle approach to project planning increases bankable projects

Increasing pool
of funds

Easing Financing
Constraints
•Developing long-term
Capital Markets bond markets
•Encouraging pension
Infrastructure Funds and mutual
Commercial Banks funds, insurance
companies and financial
Project Revenue institutions to invest in
infrastructure
Int. Long-term Fund Providers
•Dedicated long-term
Government budget financing institutions
•Rating of projects

Bankable projects
Source: ADB

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CONTACT DETAILS
Saurabh Mukherjea, Head of Indian Equities

t. +91 22 4211 0901 e: saurabh.mukherjea@noblegp.com

SALES

Pramod Gubbi t +91 22 4211 0902; e: pramod.gubbi@noblegp.com

Sarojini Ramachandran t: +44 20 7763 2329 e: sarojini@noblegp.com

LEAD ANALYSTS BY SECTOR

Banks and Financial Services:

Aditi Thapliyal t +9122 4211 0904; eaditi.thapliyal@noblegp.com

Consumer:

Jaibir Singh Sethi t +91 22 4211 0905; ejaibir.sethi@noblegp.com

Infrastructure:

Nitin Bhasin t +91 22 4211 0909; enitin.bhasin@noblegp.com

Power:

Bhargav Buddhadev t 91 22 4211 0910; ebhargav.b@noblegp.com

Technology:

Ankur Rudra t +91 22 4211 0906; eankur.rudra@noblegp.com

Economy and Country Research:

Dipankar Mitra t +91 22 4211 0920; edipankar.mitra@noblegp.com

701 Powai Plaza 120 Old Broad Street

Hiranandani Gardens London
Mumbai – 400076 EC2N 1AR

t: +91 22 4211 0999 t: +44 020 7763 2200

f: +91 22 25701154 f: +44 020 7763 2397
e: research.india@noblegp.com

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Disclaimer - Important Information

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