Slippery slope

Guaranteeing DFI debt will increase systemic risk

Parliament has cleared the way for setting up the National Bank for Financing Infrastructure and Development (NaBFID) to finance infrastructure projects. Financing infrastructure projects, which are not part of direct government spending, has remained a tricky issue in India as the country doesn’t have a vibrant bond market where firms can raise long-term debt capital. The burden of financing these projects often falls on commercial banks, which are ill-suited for such lending. Infrastructure projects normally have a long gestation period, which creates an asset-liability mismatch for banks. Also, banks are not well-equipped to assess risks associated with infrastructure projects.

It is in this context that the government has decided to set up a specialised entity for infrastructure finance. This is not the first time India is experimenting with the development finance institution idea. NaBFID will initially be wholly owned by the Union government, which will enable resource mobilisation at more competitive rates. After the institution attains stability, the government will over time reduce its stake to 26 per cent of the paid-up capital. But it’s noteworthy that the government is willing to guarantee bonds and other debt instruments issued by the institution. While a sovereign guarantee will enable a new entity to raise funds at comparatively low rates, it could become a slippery slope. Many long-term investors may be willing to lend only because of the guarantee without understanding the actual risks. This could result in underpricing risk. Further, the new development bank would also end up lending without adequate due diligence because a government bailout will always be on the table. This would create serious moral hazard problems.

Moreover, since the government is willing to guarantee debt issuances by NaBFID, it might also influence lending decisions as happened in the case of public-sector banks over the years. This will defeat the purpose of creating a specialised institution with professional management. Besides, it would increase fiscal risks. India’s public debt is estimated to have expanded to about 90 per cent of gross domestic product in 2020-21 and is likely to remain at a higher level in the foreseeable future. Guaranteeing additional debt — something the government does regularly for different institutions — could affect India’s fiscal profile and increase financial stability risks.

At a broader level, financing is not the only problem in the infrastructure sector. Private capital is often reluctant to participate because of overall policy uncertainty. Infrastructure projects are of long-term nature and it’s important to have a stable policy environment. Thus, it’s necessary to de-risk the sector from random regulatory or judicial interventions. The projects should be awarded transparently and governments both at the Union and states should honour contracts and enable enforcement among private parties. It is also important to note that the financing need of the sector is much bigger than the medium-term envisaged size of about Rs 3 trillion for NaBFID. The National Infrastructure Pipeline is worth about Rs 111 trillion. Thus, it’s critical to improve the overall policy environment for the sector. Extending guarantees to a new development finance institution will not solve the problem. In fact, it could end up increasing financial risk in the system.