Nobel laureate economist recommends 'SeLFIE' solution for infra funding

Deferred-coupon debt instruments could help address asset-liability mismatch

Nobel Prize winner Robert C Merton, an economist famous for his contributions in developing ways to better determine the price of derivatives that helped in the development of the Black-Scholes formula, has suggested a bond-market solution for the funding problem plaguing infrastructure projects.

 

These projects often result in cash flows a decade or more after they are first initiated. Companies have to pay back loans taken for the projects before the project starts generating cash, which creates debt issues, further aggravating the situation if the projects get stalled.

 

Infrastructure can be funded by SeLFIE (Standard of Living Indexed, Forward-starting Income-only Securities) bonds, Merton, the keynote speaker at National Stock Exchange’s RH Patil Memorial Lecture, said.

 

Merton has mooted this debt instrument as part of his recent work. It is a bond which is designed with no coupons for a number of years after it is bought. This is different from typical debt instruments which pay back interest and/or principal right after they are purchased - with varying frequency - often every year or every six months. The SeLFIE bond would not pay back principal at the end of the tenure. Instead it would be paid back with the coupons, designed so that they are deferred for the initial years.

 

Infrastructure financing has been in the news following the collapse of the Infrastructure Leasing & Financial Services. The company, which helped provide capital for infrastructure projects, defaulted on payments because of several reasons, including a mismatch between the time it had for repaying the loans versus the time it takes for projects to make money.

 

He said he had not had discussions with Indian policymakers on the issue of using such bonds for infrastructure financing. However, he has discussed SeLFIE bonds with various governments for the purpose of funding retirements. “Retirement solutions also involve a need for deferred cash flows,” Merton said.

 

If people invest in bonds, intermittent coupons create reinvestment risk. For example, a fall in interest rates after the initial investment would mean lower returns on reinvesting a coupon payment. This could be addressed by only giving coupons many years after the investment, around the time that a person who has bought the bond retires. The absence of such a solution adds complexity and uncertainty to retirement planning in a world where many countries are dealing with ageing populations. 

 

“You have a problem, you have a big problem, a global problem. This solution works in many countries. It’s culture-independent, it’s a global solution not unique or specialised to one country,” he said.

 

The similarity in the structure of cash-flows between the two makes it possible to apply the same principle to infrastructure as well, he said. 

 

Merton also spoke of capital convertibility as well as the impact of technology on the financial world.

 

He said Silicon Valley evangelists say technology and artificial intelligence will result in making parts of the financial services industry redundant, including in banking and insurance.

 

He believes otherwise. Technological solutions often depend on models which are ‘black boxes’. This opaqueness in terms of the models that make decisions for consumers would be detriment to their success. There is not enough trust yet on these matters for customers to depend purely on technology. The models and the data that technological solutions depend on are not foolproof, and customers would be reluctant to rely on them.

 

Meanwhile, large financial firms are allowed to make decisions for customers as customers trust them. The advantage for large financial firms is that they have both their customer’s trust and the resources to develop or purchase the technology needed to keep up with Silicon Valley firms. Many technology firms, which don’t have customers’ trust, also lack the resources to keep up with financial firms which can buy their way into technology - giving the latter an edge.

 

“You need trust, and technology can’t do it by itself,” he said.