Nirmal Mohanty: ECBs for infrastructure - A possible way forward

Stimulating the ECB appetite of PSUs is a good idea as is a policy bias towards hedging.

At the US-India CEO forum held in Mumbai a few weeks ago, the finance minister underlined the need for flexibility in ECB norms for infrastructure, signalling clearly the high priority that the government accords to infrastructure. Similar views have since been expressed by industry. In this article, it is argued that this proposal will entail some risks which are worth taking, provided they are well managed.

Let us first examine the context. The Planning Commission in a recent consultation paper has pointed out that the country would face a debt shortfall of $45 billion (at current prices; assuming 5 per cent annual inflation) during the 11th Plan to meet its infrastructure investment target, after making heroic assumptions on growth in domestic intermediaries' exposure to infrastructure and also assuming a moderate growth in ECBs. According to many observers, it would be naïve to believe that even with very bold reforms, the domestic intermediaries would exceed the assumed growth rates by more than a modest amount. The implication is that the bulk of the debt shortfall of $45 billion would have to be met through external loans. (To gauge what this involves, note that Indian infrastructure sectors raised ECBs of $4.3 billion in 2006-07.) This would be a huge challenge, not from a debt perspective, but because of complications in other macroeconomic management that it may entail as evidenced by recent experience. As a key step to address this problem, ECBs into India have been sought to be restricted in recent months. First, ECBs for rupee expenditure have been cut down to a paltry $20 million per company per financial year, compelling companies to use ECBs mainly to import. This restriction aims at reducing their impact on domestic liquidity as well as curbing opportunities for arbitrage (which arise only when ECBs are used for rupee expenditure). Infrastructure, which typically has lower import intensity than non-infrastructure, will obviously be a bigger loser. Note that rolling stocks such as airplanes and ships are not included in infrastructure.

Second, credit spreads for overseas borrowing have been reduced, making it more difficult to raise senior debt, subordinate debt, mezzanine financing or quasi-equity for some issuers, particularly""here again""for infrastructure developers, many of whom are new and not established.

Third, ECB flows into integrated township have been prohibited. It is unlikely that these restrictions would be lifted any time soon, considering that the underlying conditions that warranted such restrictions are expected to persist.

The irony is evident: when infrastructure development envisaged for the medium term requires significant resort to ECBs, ECB policies have been (justifiably) made restrictive, a disproportionate burden of which, particularly of the first restriction, has been falling on infrastructure. Thus, easing the current ECB regime appears desirable from one perspective (infrastructure), while continuing with it may be necessary from another (macro-management). The obvious way of reconciling these two is to prioritise infrastructure in ECBs, which is the aim of 'greater flexibility in ECB norms for infrastructure' that the finance minister has talked about. The proposed response of differentiated credit norms, considered suboptimal from the viewpoint of both the soundness of policy and ease of implementation, is certainly justified for infrastructure""but not for others such as cosmetics or air conditioners which may be severely underinvested as well""because of infrastructure's vastly superior ability to improve the productivity of labour and capital.

Giving greater flexibility in ECB norms to infrastructure vis-à-vis non-infrastructure has certain implications. First, infrastructure sectors must be well defined. This has been adequately addressed by the Master Circular of the RBI on ECB norms (July 2, 2007). Second, the supervision of end-use restrictions would become more onerous. It is well known that this task is challenging at the best of times, as money is fungible. A company engaged in both infrastructure and other sectors, would be tempted to avail flexible norms in ECBs for infrastructure, but use them for non-infrastructure including real estate and stock market. The current supervision procedure (namely, the regular reporting of end-use by borrowers to the RBI) may not be effective in preventing this, but it is the only supervisory tool available at the moment. Third, greater flexibility for infrastructure may compromise the pursuit of macro-objectives such as containing domestic liquidity.

Two observations could be useful in the design of solutions. First, central PSUs focused on infrastructure, which account for about 40 per cent of total infrastructure spending, have been shy of market borrowing in general and ECBs in particular, possibly reflecting their risk aversion. In 2006-07, for example, these enterprises invested twice as much as their private counterparts, but accounted for only $0.5 billion of ECBs as compared to $3.8 billion by private companies. Two aspects of these enterprises are noteworthy. One, it is highly unlikely that they would use their external borrowings for arbitrage, not merely because they are subject to government control but also because they do not have the incentive to do so. This indicates that the larger the share of public enterprises in ECBs, the lesser will be the supervisory burden for implementing end-use restrictions. Two, during the 11th Plan, these enterprises would be required to raise their investment substantially, while budgetary support to them would be phased out, pushing them to large-scale market borrowing including ECBs.

Second, there is no natural hedge against currency risk in infrastructure sectors with some minor exceptions. Without appropriate hedging by borrowers, users of infrastructure services would be severely inconvenienced if the rupee depreciates suddenly and substantially, the possibility of which cannot be ruled out in the long run. Given the current circumstances, this may not be an issue""ECB policies at present do not require any hedging""but could potentially become one in few years. Hedging would have two other advantages: a) there are ways of hedging that are forex-neutral, and b) hedging costs would reduce the incentives to arbitrage. So, it is perhaps not too early to nudge infrastructure companies in this direction, especially if ECBs were to become a significant debt component.

To conclude, while differentiated credit norms for infrastructure are desirable, solutions such as raising the rupee expenditure limit from $20 million to, say, $100 million can at best be ad-hoc. Stimulating the appetite of PSUs for larger ECBs and a policy bias for hedging would go a long way towards achieving the infrastructure investment target and addressing the macroeconomic risks of scaling up external financing of infrastructure under a variety of circumstances, including the current one.

The author is with IDFC Ltd. His e-mail is nirmal@idfc.com. The views are personal