The collapse of IL&FS and what it tells us about fixing India’s critical need for infrastructure finance

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New Delhi | Published: October 12, 2018 1:31:05 AM

India has a long way to go in structuring and managing public private partnerships. Doing a better job on that front is essential.

The collapse of IL&FS and what it tells us about fixing India’s critical need for infrastructure finance

The collapse of Infrastructure Leasing and Financial Services (IL&FS) highlights India’s biggest economic problem—how to finance large, necessary investments needed for sustained economic growth. In my last column “What ails the Indian economy?” (FE, October 3;, I discussed some ways of addressing this problem, including better regulation, improved corporate governance, and more competition. These points need further elaboration.

But before discussing fixes, it is important to understand the gravity of the issues. There are two points to be made.

First, the systemic problems created by the failure of firms like IL&FS, even if there is a “successful” bailout, damage growth prospects for years. Public money spent on a bailout is unavailable for other welfare-enhancing expenditures. Furthermore, as we have already seen with bad loans by banks, private lending is adversely affected by such events, possibly for years.

Second, while we might think that a lack of basic education and health services is the biggest problem for a country like India, many of the shortfalls in the delivery of such services are created or aggravated by lack of infrastructure. Farmers cannot access markets adequately without good roads; students often cannot get good teachers, something digital infrastructure can overcome; urban sanitation infrastructure is critical for public health. The last of these examples is particularly significant: only one-third of urban sewage is treated, and the country’s rivers and groundwater are being irretrievably polluted, presaging a massive public health problem of disease and malnutrition.

Poor corporate governance and lack of adequate regulation for monitoring systemically important firms—as IL&FS clearly is—are obvious culprits. These problems are not unique to India. They have caused problems in advanced economies, particularly the United States, in recent decades.

Another cause is less obvious. It seems that IL&FS has an extraordinarily complex corporate structure, with well over 100 subsidiaries. This kind of complexity makes it difficult to understand what is truly going on. Corporate boards, regulatory monitors and even auditors have difficulty in such circumstances. This means that problems can be hidden until they explode. This happened in the case of IL&FS. A related kind of complexity helped destroy Lehman Brothers in the United States ten years ago: there it was the asset portfolios of the company that were poorly understood.

A solution to this complexity is not easy, and it is easy to over-regulate. The best approach is forcing as much disclosure and transparency as possible. Complexity of corporate structure and of asset portfolios can be counteracted by requiring more disclosure. Companies can argue that this will expose their strategies unduly, but that must be balanced against the public interest. One might argue that good managers will make sure that they understand what is going on in their firms. But if there are inadequate penalties for failure, corporate leaders can be far from ideal in their actions: we learned that with Lehman Brothers a decade ago, and are learning the same lesson over again with IL&FS now.

Transparency and disclosure will also help markets work better. IL&FS was tapping bond markets while hiding its problems, so clearly lenders did not have an accurate picture of the company’s financial position. Nor did the rating agencies, which gave the company AAA ratings, seem to know what was going on.

There is one more issue that we need to remind ourselves of, namely, kleptocracy. Corporate leaders, rating agencies, politicians and others may have an interest in hiding problems. Public ownership and influence can distort incentives and decision making. This has been a common problem in public sector banks, and was true for IL&FS. It has been suggested that at least one project in Gujarat was being funded to please the ruling party, and not on the basis of economic analysis. Of course, this reminds us of the basic problem once more—infrastructure projects are difficult to assess in terms of risks and returns. Some of these projects also have non-financial benefits that are difficult to quantify. But that tells us that one needs greater clarity in defining the objectives of firms such as IL&FS—this is a kind of complexity not present for purely private sector firms such as Lehman Brothers.

To summarise, if India is going to proceed with the kind of infrastructure investment it needs for sustained high growth, several policies need attention. One is better regulation of corporate structures, combined with greater disclosure and transparency and stronger corporate governance. Second, a clearer separation of public and private is needed, rather than the muddy links and ownership structures that now exist. For some kinds of products and services, such as air travel, there is little or no case for public involvement in ownership and management. But many kinds of infrastructure (like urban sanitation) do not lend themselves to purely private ownership and operation. But India has a long way to go in structuring and managing public private partnerships (PPPs). Doing a better job on that front is essential. Third, if the institutional framework can be strengthened, greater entry and competition can generate the financing necessary for India’s infrastructure needs.

The author is a Professor of Economics, University of California, Santa Cruz.

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