What?s special about SPVs?

Special purpose vehicles (SPV) are currently in fashion as innovative means for catalysing investment, particularly in infrastructure. With $350 billion worth of infrastructure investment needed over the next 5-6 years in India, and FRBM deficit limits at least loosely in place, SPVs give the government some flexibility to bridge the infrastructure gap. The SPVs also seem to do the trick in attracting private co-investors, having scored several big wins lately in the successful award of two ultra mega power projects, and in last Friday?s launch of the $5 billion India Infrastructure Financing Initiative.

But not so long ago, SPVs made the headlines for very different reasons: as the off-balance sheet entities that Enron used to camouflage its true position. Here is where prevention is better than cure. Government-sponsored SPVs seem to be proliferating. They are being proposed for everything from renewable energy to shipping to state-level irrigation, too, apart from infrastructure. There is speculation that the Budget will unfold yet another mega SPV for public-private partnership. Some of these offer guarantees, some do not. Some packages embed together approvals for a project, others facilitate project finance by removing some part of the revenues from a project from the general city/state/central government budget.

However, all SPVs are part of the overall public sector fiscal position. They may not be included as part of the ?deficit? for legal purposes, but they are integral to the public sector balance for purposes of macroeconomic stability. They can add to the overall vulnerability in several ways that can sneak up quickly because they are hard to monitor. The guarantees extended to raise funds for IDFC or IIFC create explicit contingent liabilities, or government obligations triggered by particular but uncertain events. The SPVs can also increase vulnerability by encouraging false optimism. Government backing means something even when it is not explicit. Fitch?s investment grade rating of PFC in January, for example, was based on its ?assessment of the strategic importance of the company to the Government of India and the support that is likely to be available to the organisation should it be in distress?. This seems to be a general phenomenon: recent research on commercial SPVs (Gorton and Souleles) shows that investors? rating of SPV creditworthiness depends on their sponsors? creditworthiness, even though sponsors are not legally committed to support them.

SPVs also let problems get swept under the rug. There are many reasons that private investment eludes public infrastructure projects in India. An SPV as a financial vehicle can and should fix some of these. In the end, risks like delays and uncertainties in land acquisition, politicised user charges, or complicated permit processes need to be dealt with through other policies rather than having the government assume the risk.

Finally, SPVs are only as safe (for the government) as their project appraisal and selection method. An SPV that selects projects on a political basis or on inept appraisal, but raises private investor money based on an implicit or explicit guarantee, becomes a hidden fiscal ?grenade? in the accounts. ?Competitive bidding? seems to be the gold standard for choosing projects, but the bidding is only as good as the surrounding incentives to bid with sincerity. With viability gap funding, for example, the upfront mechanism?a capital grant to the private entity that bids the lowest amount for capital subsidy?makes sense in general. It is weaker if the bidding is done strategically in the hope of renegotiating later (if and when the bids prove too low), or seeking additional funding from the sponsoring ministry or state government.

The larger SPVs, IDFC and IIFLC, seem to be set up to minimise risk. These are professionally run. It is the smaller SPVs, and future SPVs, that could be more troubling. With these, a stitch in time in the form of a ?public SPV code? to encourage transparency and market discipline could ward off future fiscal worries. An SPV proposal should clearly state the reasons that it is necessary, either in terms of its function in public finance, or its role in attracting investors. Maybe the SPV needs to ring-fence a project in a way that makes for repayment credibility that would enable borrowing at a lower rate. SPVs that offer any kind of explicit guarantee should have an additional burden of explanation. What kind of risk is the guarantee offsetting? And what kind of risk is the government shouldering? What specifically would have to happen for the guarantee to be invoked?how optimistic are the assumptions?

The SPVs themselves can become an instrument of reducing risk. If a state government has a big fiscal stake in a project that requires land acquisition and timely rehabilitation, then outside investors might feel more comfortable that these steps will be taken.

SPV transparency and commonality of standards is also essential for market discipline. Credit ratings, bond prices, interest rates, and other ways to price risk depend on buyers being able to understand risks.

The SPVs are ?special? in mitigating risks and strengthening private investor confidence. They are not a panacea for all our woes. Financial engineering is no substitute for reforms.

?Regular columnist NK Singh and Professor Jessica Wallack of the University of California, San Diego are collaborating on a book on infrastructure reform on India. Essays based on their research will appear on this page