The Budget for 2021-22, presented by Finance Minister Nirmala Sitharaman, has proposed the establishment of a development finance institution (DFI). The idea of setting up a DFI for funding of infrastructure projects has been talked of in the media for some time by various analysts.

So the announcement in the Budget is not surprising. However, what is surprising is that we have, collectively, ignored the hard-earned lessons from our experiences with both DFIs and infrastructure financing in the last few decades. Let us recapitulate the lessons and see how they can help us now while discussing about the DFI.

DFI experience

The DFIs were, more than literally, entities of the previous century. Let us revisit the special characteristics of the erstwhile DFIs and also check if the same are likely to apply now.

Subsidised funding : The DFIs sourced a good proportion of their funds at a subsidised rate from the government. This is unlikely to happen now for even the government-backed DFI. The government would provide equity capital to the latter and expect it to raise debt on its own. A government guarantee to back the borrowings, if provided, will be equivalent to bearing the first loss in case of a default by the DFI.

This is what the government has already been doing by recapitalising the banks on a regular basis. The outcome in terms of developing a sound credit culture is not quite positive.

We must remember that once money is created at a given cost, someone has to bear the entire cost. Any subsidy in cost provided to a DFI will need to be paid for by some other party, explicitly or otherwise. So, the benefit of any subsidised funding to the DFI will be a loss to some other party in the economic system.

Protection from competition: The DFIs did not, then, face competition from banks or markets in the selection or pricing of the projects financed by them. Banks would finance working capital and the long term bond market was not developed.

This is clearly not happening now. There is already some real competition from private sector banks and non-banking financial institutions. The bond market is still not developed, of course.

Risk-based pricing: The earlier set of DFIs worked on standard templates of pricing. Their assessment of risk was not quite rigorous. Subsequently, public sector banks (PSBs) have continued in the same manner, leading to a spate of non-performing assets. The private banks and institutions like IDFC performed significantly better in terms of risk assessment, yet were unable to price the risks, while lending to infrastructure projects. This was in view of the distorted pricing by a large section of their competitors — that is, the PSBs.

Now, the new DFIs will face the Hobson's choice. If they decide to price the loans as per the true risks of the projects, the cost to latter would rise significantly. Let us remember that most infrastructure projects in power, road, port, and airport sectors are in sub-investment rating categories, for valid reasons.

Infrastructure projects

Let us briefly recapitulate the legacy issues with regard to infrastructure projects.

Poor enforcement of contracts: The top reason for the failure of infrastructure projects has been poor enforcement of contracts in our economic system. One example of this has been how the various State governments have been used to unilaterally rescinding on the power purchase contracts. This has affected the entire value chain of equity and debt investors, lenders, developers, operators, and customers.

This is unlikely to change in the short term. To be sure, a few positive steps have been taken by the government. The most prominent has been the implementation of the Insolvency and Bankruptcy Code (IBC). However, the pendency of cases, delays in resolution, and continuing litigations under the IBC process have restricted it from being truly effective.

Beyond the IBC, we need to significantly enhance the capacity as well as the quality of our State agencies, especially the judicial investigation and enforcement system. Unfortunately, this area has received little attention from all governments and overlooked by most commentators.

Regulatory system: The capacity, authority, and independence of our regulators have been sub-optimal at most times. We have seen our judicial Courts reminding the governments to fill up the vacant seats in the key regulatory bodies. The focus on quality would be far-fetched when even the minimum capacity is lacking, in such instances.

There is no evidence of any material change in this status. Any improvement will require a concerted interest and action from the governments at all levels.

Pricing : For a range of reasons, our infrastructure projects have either been disallowed to price their services at market clearing levels or subjected to unfair dynamics of competition. We have not allowed the services markets to develop or function in the belief that administered prices are beneficial to a large set of consumers, without anyone bearing the cost of the same.

There is little evidence of a significant change in this respect. The recent moves to allow competition in power distribution is an acknowledgement of the failure of our past policy. This will, of course, take a tremendous amount of effort and structuring to make it successful.

Infrastructure projects, in the past, have not failed for lack of funding. They have failed in the past mainly on account of their operating with significant unhedged risks, leading to eventual risk aversion in the investors and lenders. These risks in the projects could be from under-pricing of outputs (administered tariffs), under-estimation of supply-side distortions (fuel supply agreements), poor enforcement of contracts for recovery of dues (dues from monopsonic buyers like government and large corporates), poor governance practices (by promoters, contractors, statutory bodies, etc), poor managerial capabilities (in execution and operation), and similar sources.

These are the real issues that our policymakers would do well to focus on and resolve. If these are addressed, the risk and cost of the infrastructure projects will automatically come down. That will bring in investors and lenders and reduce the cost of capital for the projects. Else, the DFIs will help, albeit only in the short term, in artificial boosting of the financing of infrastructure projects. But in the long term, as we all know, we will quite likely risk another round of accumulated non-performing assets (NPAs). This is the lesson from the past that we collectively need to not forget.

The writer is Associate Professor, Finance at Bhavan's SPJIMR.

Published on February 19, 2021