The Great Indian Conundrum – Starting the investment cycle?

The Indian economy had slowed down, for various reasons, prior to the Covid crisis.  Kick starting the economic revival to our potential growth was being actively debated. 

Then Covid happened and spread.  We had to choose between economic health and public health and we prioritised the latter, quite rightly so.

Economic activity reduced considerably affecting jobs and demand, forcing reverse migration of labour and perpetuating the cycle for further job losses and demand destruction.

At some point, we may need to resume efforts to restore normalcy and keep the fire of our economic engine stoked.

Given our fiscal position and the need for providing for the minimum needs for a vast majority of our underprivileged population, at some point of time, we may have to either relax our fiscal prudence and borrow externally, borrow internally, or open up the economy for more foreign direct investments, as we have limited head room for raising revenues and cutting expenditure beyond a point – as these will again impact jobs and consumption. The Investment cycle, therefore, will have to be started, and to expect the private sector in India to lead this may, perhaps, be quite foolhardy.  It will have to start with the Government. This will also take some time to evolve, time which we may not have.

The Indian banking sector, meantime, is sitting pretty on a pile of liquidity, possibly approx Rs 8 lac crores (USD 1 trillion); They are also quite risk averse and comfortable with lending only to public sector undertakings or investing in Government securities.

We have an urgent and immense need for investing in our infrastructure which in turn provides a much needed succour to our steel and cement industries but also accounts for employing a large number of our unskilled and semi skilled population.

As an old investment banker, I have always adhered to the adage that a deal happens when there is a convergence of interest of all stakeholders.  We may have the best policies and programs but they may fail if we do not factor in the motivations and compulsions of the stakeholders involved in their implementation.

In this paradigm, let’s look at two specific needs and opportunities. We need to build our network of highways, and we need to build airports.  We have tried to do this on a PPP basis but met with limited success.

Take for instance the road sector:

1. While Banks are comfortable lending to Institutions which have the full faith and support of the Government of India (For e.g. the Rs25,000Crs facility by SBI to NHAI), when it comes to EPC Companies they are understandably reticent.
2. Whether BOT, Annuity, Toll or Hybrid Annuity, every model has been subject to its own infirmities rendering them unbankable.
3. Even for those EPCs with acceptable credentials whose performance risk can be assessed on the basis of their balance sheet strength, the payment risk still remains a Damocles sword.  Change of project scope, disputes, arbitrations, and delayed payments in the past have undermined lenders confidence and remain largely unaddressed.  This has also led, quite sadly, to a majority of the EPC players becoming insolvent.  A few remain and if we need to build our infrastructure, we should not hope for companies from outside India to bid for our projects, given the present level of uncertainties involved.
4. Lack of robust decision making systems in nodal Institutions have exacerbated this issue.  Fear that decisions made to clear payments may come under future scrutiny, officials in these Institutions avoid/delay signing off, leading to unnecessary delays and arbitrations. 
5. From an EPC’s perspective, most of the projects require guarantees at multiple stages – Bid Bond, Advanced Money, Performance and Retention.  Given their low appetite for EPC financing, doubled with weak balance sheets of EPC Companies, and the extended tenor for the performance and retention guarantees, banks are insisting on 100% cash margin for issuing these bonds.
6. While EPC Companies are able to cough up the margin for bid bonds, delayed payments over the course of the project makes it difficult for them to provide subsequent guarantees leading to blockage of their capital and their inability to bid for subsequent projects.  This in turn, has led to delays in project execution.

Therefore, a solution to this imbroglio necessitates 

1. Shifting the Payment Risk to banks
2. Shifting the certification and, therefore, decision making process to experts outside the nodal agency for quality, quantity, cost and time certifications (These can be Institutions of high regard such as IIT Delhi or Roorkee, which are acceptable to even the Supreme Court in case of disputes)

Possible solution: Let’s look at an Infrastructure (Road) Project.

1. NHAI as the nodal authority, undertakes the DPR and calls for bids post acquiring the land for the alignment.
2. EPC Contractors submit bid bonds and provide the necessary margins to their bankers
3.  NHAI selects the EPC Company based on bids, technical and financial parameters etc  
4. NHAI applies to its banker(s) for a Letter of Credit in favour of the selected EPC.  The tenor is the expected Project Completion date plus one year.
5. The LC mentions the milestone payments to be made based on stipulated external certification (for e.g. from IIT Delhi, IIT Roorkee, or some such body on which even the SC relies).  The LC details the certification required – quality, quantity, time taken from stipulated institutions.
6. On each milestone, the LC opening bank will discount the first bill for the remaining tenor of the LC.  Similarly at the completion of the second milestone, the related bill could be discounted for the tenor remaining at that stage which will make it co-terminus with the maturity of the first bill. And so on for the subsequent milestones and related bills.
7. Given the LC is contingent on NHAI risk, the discounting rate will be much lower than typical financing cost for the EPC, bringing down the overall project cost.  Further the EPC uses the first milestone payment to work towards the second milestone, bringing down its own financing/ capital requirements.
8. Post completion of the project, for a one year time period, the usage metrics of the road are monitored – traffic density, toll collections, etc.  FasTags will make this monitoring real time and uncomplicated.
9. NHAI then has the ability to unlock project value basis estimated future revenues (backed by usage data).  Options include TOT and Infrastructure Investment Trust. Proceeds are then used by NHAI to repay the discounted LC.

The proposed model  will:

1. Use the surplus liquidity of the banks, in a risk mitigated manner, to restart the investment cycle in the country
2. The EPC sector will be revived .
3. The steel, cement  and other associated industries will also get revived.
4. Considerable employment opportunities are created
5. Consumption demand returns improving other sectors too favouring early recovery.
6. NHAI will only have to pay the LC bills one year post completion and therefore, these would not be for the next 36 to 48 months, during which our economy as also the global economy would have revived, expectedly. During this period, they will figure only as acceptances /contingent liabilities.
7. This will eventually also provide instruments for our nascent debt and bond markets in the country.

The same model can be replicated for rebuilding a few of our airports which are creaking at the capacities, and bid them out post completion through the Airports Authority of India.