John Maynard Keynes once remarked “The difficulty lies not so much in developing new ideas as in escaping from old ones”. Wise words that the Credit Enhancement Fund expected to be operational by the end of March 2018 should be cognizant of. This fund was proposed by the Honourable Finance Minister in last year’s budget and is a welcome step. The fund can potentially boost infrastructure investments in India through improving the credit quality of infrastructure projects. But this will only be possible if the infrastructure sector does not repeat the mistakes of the past such as choosing bad projects and using excessive debt to fund projects.
The credit enhancement fund by providing partial guarantees on the bonds of infrastructure projects will increase the attractiveness of such project bonds for institutional investors. For instance, a bond rated “BBB” might be able to be rated higher at “A” with the credit enhancement because of the extra fund available to improve the cashflow profile of the project underlying the bond. The bond will be more attractive from a regulatory perspective to the institutional investor since a lot of investors are able to invest in securities only above a certain threshold rating level such as “A”. Hence the credit enhancement fund can significantly contribute towards making project bonds attractive from a ratings perspective. The credit enhancement fund will also improve the “cashflow stabilization” of projects. Infrastructure projects in the initial phase of operations do not always generate the cashflow needed to pay the debt holders and meet the debt covenant conditions. Having access to a credit fund especially at the beginning of a project helps stabilize the cashflows. This cashflow stabilization also gives investors a lot more confidence, thus leading to greater flow of credit to infrastructure. Another advantage of relatively stable cashflows is that investors are more confident about lending for longer tenures of debt. Being able to borrow for longer tenures helps long dated infrastructure projects in avoiding an asset liability mismatch given that infrastructure assets are usually long dated. In an Indian context, a part of the non-performing asset problem that Indian banks face is that banks with short dated liabilities were financing long dated assets in infrastructure. Hence a credit enhancement fund boosts investor confidence in infrastructure projects.
But the greatest advantage of the credit enhancement fund is that due to the aforementioned factors the cost of credit for the infrastructure projects goes down. Given that investors due to the credit enhancement fund have access to project bonds that have higher ratings and projects with more stable cashflows, the investors are willing to lend money at a lower interest rate. This lowering of credit cost significantly assists infrastructure projects to succeed.
It is important to realize that while a credit enhancement fund can greatly improve the flow of credit to infrastructure projects, it is not an excuse to choose poor projects. A project that is not sustainable and profitable is just that. Using a credit enhancement fund will simply delay the inevitable. For the credit enhancement fund to succeed in India there must be an equal amount of focus on choosing the right projects and choosing the right capital structure in terms of how much debt and equity are optimal to finance a project. Credit enhancement funds should not also be an excuse to use excessive debt for projects. Good project selection, efficient conflict resolution mechanisms and good financing mechanisms cannot be replaced by a credit enhancement fund.
In summary, a government sponsored credit enhancement fund will be just the fillip Indian infrastructure needs now. Making projects more accessible to institutional investors and stabilizing project cashflows are amongst some of the most needed requirements of the Indian infrastructure sector. However, as we have stated we must be careful to not repeat the mistakes of the past!
By Taponeel Mukherjee
(The views expressed in this article are personal and that of the author. The author heads Development Tracks, an infrastructure advisory firm. He can be contacted at firstname.lastname@example.org or @taponeel on Twitter)