The Hindu Business Line : SPV route for infrastructure projects — Enticing, but flawed, financial engineering

A variant of the proposal to use forex reserves for infrastructure, the special purpose vehicle route, is expected to raise long-term funds for select projects. The SPV mechanism is expected to boost infrastructure without affecting the fiscal deficit because such borrowings would not be reflected in the government's accounts. Though such financial engineering seems enticing, one must consider its economic consequences, say Amarendu Nandy and Bithin Mahanta.

INDIA is currently facing the problem of plenty on the foreign exchange reserves front. The country ranks sixth after Japan, China, Taiwan, South Korea, and Hong Kong for highest foreign reserves. With the increase in quasi-fiscal costs of holding large reserves, and the need to increase the yield on current reserves (which stood at over $140 billion in mid-April) policymakers have advocated the use of the `excess' reserves to augment the country's physical infrastructural capacity.

Substandard infrastructure remains a significant constraint as India embarks on the path of broader core reforms to become a major player in the global economy. The country spends only about 6 per cent of the GDP on infrastructure (China spends about 20 per cent). The Prime Minister, Dr Manmohan Singh, has observed that the Indian economy can absorb up to $150 billion of investment in the infrastructure sector over the next decade.

The government needs to play a pro-active role in building world-class infrastructure and a conducive environment for Indian businesses to compete globally, and to attract long-term investment flows in the form of FDI. Private sector participation is not expected to substitute initiatives and spending by the government in this sector with long gestation projects, unless the overall investment climate improves and pricing and regulatory constraints are addressed.

With this caveat in mind, the Mr Montek Singh Ahluwalia, Deputy Chairman of India's Planning Commission, mooted a proposal last year to use a part of the reserves to fund infrastructure projects.

He proposed to annually use $5 billion (about the same amount that India attracts inward FDI annually) of the central bank's reserves over the next two-three years to free the economy from supply bottlenecks, thereby enhancing long-term growth and the social return on infrastructure.

His idea was to hike the fiscal deficit and, therefore, government borrowings. However, since increasing fiscal deficits might crowd out private investment, the deficit would be monetised by asking the Reserve Bank of India (RBI) to directly pick up these securities.

The rupee resources raised by the government would then be used to purchase foreign exchange from the central bank or from the market (in this case, the RBI would have to release foreign exchange in the market to maintain the exchange rate).

The foreign exchange so bought would be used to set up a 100 per cent imported infrastructure project. This would have served the dual purpose of developing infrastructure, and also as a restraint on the (costly) growth of foreign reserves.

The Montek proposal was fraught with dangers owing to its potential inflationary impact though, per se, the monetisation of the deficit would not have led to an increase in the money supply since the initial increase in reserve money consequent to monetisation would be fully negated by the purchase of foreign exchange from the RBI.

It was also argued that there would be no net injection of excess demand in the system since the additional investment demand would be exactly offset by an increase in imports.

However, since infrastructure projects have a high local or non-tradable component, there were understandable apprehensions on the part of the RBI and the Finance Ministry about the inflationary consequences, and an increase in fiscal deficit if the reserves were spent on domestic goods and services, and not entirely on imports.

This would have also meant an unwelcome revision of fiscal correction target as laid out in the Fiscal Responsibility and Budget Management Act, 2003.

Even if it were assumed that the exchange rate and import duties are reduced to encourage imports of infrastructure project goods, it would be contingent on import intensivity and import elasticity of such goods.

Further, only allowing the exchange rate to fall would itself lead to depletion in the value of reserves and erode export competitiveness.

This is against the basic philosophy of the RBI's exchange rate management. Therefore, some sort of accounting device had to be developed to address the above concerns.

The Finance Minister responded to this by introducing a Special Purpose Vehicle (SPV) in the Budget for "financially viable" infrastructure projects in sectors such as roads, ports, airports and tourism, which will work in a public-private partnership framework under the Ministry.

A variant of the Montek proposal, the SPV is expected to raise long-term funds from the domestic and/or international capital markets for this purpose and, in turn, offer long-term loans for selected infrastructure projects.

A part of it is also expected to be financed from the country's pool of foreign exchange reserves. The lending limit for the first year has been set at Rs 10,000 crore, with an additional Rs 1,500 crore as ``viability gap'' fund (sourced from the Budget) which is meant to fill critical shortfalls in the capital funding required to make a project viable and attractive for private investments.

The whole idea of using the SPV mechanism is to boost infrastructure without affecting the fiscal deficit because such borrowings would not be reflected in the account of the government. Though such financial engineering seems enticing, one must consider its economic consequences.

First, the SPV will have a counter-guarantee by the Centre, thereby increasing the contingent or off-Budget liability of the government.

The deficit is `hidden', and the economic consequences are akin to running an actual fiscal deficit. Second, the Finance Minister focusses on `financially viable' projects with the assumption that there are potentially solvent projects with dearth of private investments. This clearly is not a rational assumption because projects may be financially unviable to private investors due to weak regulatory framework, delivery mechanism, and pricing policies.

Third, the desired outcome of routing investments through an SPV does not augment money supply as long they are spent on tradables. But since infrastructure projects have high a non-tradable component, it is expected to result in monetisation.

Recent estimates by CRISIL show that usage of Rs 10,000 crore of forex reserves to fund infrastructure development will result in a 2.2 per cent increase in money supply in the system. Therefore, the SPV mechanism is deficit financing behind a veil.

The effective monetisation of fiscal deficits can be damaging, especially for inflation, monetary policy, external liquidity, and investor confidence. Moreover, the demand-pull factor arising from augmented money supply may add to inflationary expectations in the present scenario of cost-push situation created by the increase in crude oil prices.

Reserves can be put to alternative uses given the exchange rate flexibility and access to international borrowing. However, financial literature shows that theoretical determinants of optimal reserves (a lot has been written about the Indian level of reserves being more than adequate) are only indicative in nature and that adequacy of reserves can be judged only contextually.

There is also an element of perception that creeps in, which will lead to any level of reserves being inadequate when the participants in international capital markets deem them to be inadequate. Falling reserves will erode confidence and that, in turn, will lead to depleted reserves.

This idea of funding infrastructure through reserves can, perhaps, be given a thought only when regional mechanisms such as swap arrangements have been firmly put in place.

The best solution to develop infrastructure is to liberalise the external sector and improve the competitiveness of the economy by creating the right kind of environment. Using reserves for spending on import-intensive investment in infrastructure may only be a second-best choice.

(Amarendu Nandy is a research scholar at the department of economics at the National University of Singapore, and Bithin Mahanta is Manager, Integrated Surveillance Department, SEBI. The views are personal.)

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