Noble Indian Infrastructure Preview 2009-02-13

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Clear thinking from

We do not see the Indian infrastructure sector getting out of the

doldrums for the next six months despite the governments back-to-back

stimulus packages. In light of the structural problems facing the

infrastructure sector, we prefer EPC companies to developers. Amongst

developers, we prefer companies with operating assets and assets with

lower dependence on real estate.

The Governments stimulus packages, for jump-starting private infrastructure

investments will be unsuccessful in injecting life into the sector because:

of the private sectors reduced appetite for risk. Multiple data sources point tosharply reduced private participation in infrastructure projects in 2008-09.

Hence, investment is expected to fall sharply from the US$22 bn invested in

each of 2006 and 2007 as reality dawns and bidders start considering

economic risks, fluctuating interest rates and restricted credit availability.

the Governments measures lack speed and efficacy. Monetary measures maynot drive disbursals as banks start pricing risks higher and face limits on sector

and group exposures. Moreover, lack of availability of affordable international

funds will make the External Commercial Borrowings (ECBs) relaxations

ineffective. Finally, the amplification of IIFCLs refinancing capacities by

US$850 mn seems like a stopgap measure in a long haul (XI th plan estimates

the private sector debt requirement for infrastructure to be US$90 bn).

lack of project planning deters private capital. We believe that during the past2-3 years, even ill-conceived projects managed to get funding. International

experience and industry sources stress the importance of properly planned

projects using a life-cycle approach along with policies/procedures for

adequate risk sharing and implementation. Lack of adequate project-planning

and an overly narrow focus on the specific transaction will continue to result in

a lack of private sector interest.

PREFER EPC COMPANIES WITH LIMITED DEVELOPER ROLE

In the current scenario, where inadequate project planning may keep economic

risks high and flexibility low in concession agreements, we prefer EPC companies

over developers. However, most of the EPC companies have become part

developer. Hence, we prefer EPC companies with: (a) a large proportion of cash

contracts in their order books, (b) minimal equity investment needs in infra

SPVs/subsidiaries; and (c) low leverage. Firms that meet these criteria are IVRCL,

Punj Lloyd and Simplex Infrastructure.

PREFER DEVELOPERS WITH LOW DEPENDENCE ON EXTERNAL

ASSETS

Amongst the developers, we prefer companies with operating assets and assets

with the least dependence on external real estate. We prefer roads under

operation and regulated assets such as utilities to airports and toll roads under

development. Developers owning operating toll-roads (eg: GVK, IRB) should be

preferred to Greenfield toll-road developers with toll-roads under development (eg:

Nagarjuna, Madhucon and HCC). Over the next two months we will initiatecoverage on GVK and IRB amongst the developers and Punj Lloyd and IVRCL

amongst the EPC firms.

India Infrastructure

Research preview

13 February 2009

Indian infrastructureExit the developer, enter the builder

Historical movement of the infra index

Source: Bloomberg

Table 1 Coming soon from our stable

Company Comment

IVRCL EPC/developer

Simplex Infrastructure EPC

GVK Power & Infrastructure Developer

IRB Infrastructure Developer

Nagarjuna Construction EPC/developer

Punj Lloyd EPC

Source: Noble research

Analyst

Nitin Bhasin+91 (0) 22 4211 [email protected]

Sales

Pramod Gubbi

+91 22 4211 [email protected] Ramachandran

+44 (0) 20 7763 [email protected]

0

20

40

60

80

100

120

CNX500 Inde x C NX Infra Inde x


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Indian infrastructure

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THE WELL PUBLICISED TARGETS OF THE XITH

PLAN

In order to close the increasing deficit in Indian infrastructure, the Government of

India (GoI) increased the XIth plan (FY07-12) outlay by 1.4X over the Xth plan (FY02-

07) (see Table 2). Recognising the limits of public resources and the increasing

success of public-private partnerships (PPPs) in infrastructure, the GoI increased

share of private investment to 30% in the XIth plan from 20% in the Xth plan; in

absolute terms to Rs6.2 tn, 2.6X growth from the X

th

plan. However, the relativerole of public and private sectors will vary with some sectors such as airports and

telecommunication attracting a larger share of private investment, whereas roads

and power have a lower share of private participation.

Table 2 Share of private investment in the XIth

plan to be about 30% versus 20% in

Xth

plan

Figure 1 Electricity and roads to account

for larger share of private funding

(Rs bn) Xth plan XIth plan

Total Public Private Total Public Private

Electricity 2,919 69% 31% 6,665 72% 28%

Roads and Bridges 1,449 95% 5% 3,142 66% 34%

Telecommunications 1,034 47% 53% 2,584 31% 69%

Railways 1,197 100% 0% 2,618 81% 19%

Irrigation 1,115 100% 0% 2,533 100% 0%

Water Supply & Sanitation 648 98% 2% 1,437 96% 4%Ports 141 26% 74% 880 38% 62%

Airports 68 57% 43% 310 30% 70%

Storage 48 30% 70% 224 50% 50%

Gas 97 90% 10% 169 61% 39%

Total 8,714 80% 20% 20,562 70% 30%

Source: Planning Commission, Noble research Source: Planning Commission, Noble research

However, execution of the planned expenditure is lagging due to various

regulatory, financing and procedural constraints and we expect the overall

investments by 2012 to miss the stated targets by 30-35%. In this note we examine:

The reasons behind this expenditure shortfall The implications of this shortfall for investors in this sector Some of the steps that might be taken post elections to address the shortfallTHE DRIVERS OF THE EXPENDITURE SHORTFALL

We see the following three drivers of the shortfall:

1. The private sectors reduced appetite for risk2. The governments flawed attempts to improve financing for infrastructure3. Lack of proper project planning

1. Falling appetite for riskAfter witnessing heavy investment in 2006 and 2007, private participation in public

infrastructure is expected to be much lower in 2008 and 2009 relative to the

US$22 bn invested in each of those previous years. In 2006-07, as capital became

plentiful, the risk premium for these greenfield projects all but disappeared, even as

nominal rates and interest rate volatility were increasing. However, now with the

emerging economic risks, rising interest rates and concerns about credit

availability, private interest is waning in infrastructure investment, a fact that can be

inferred from media reports on the dismal level of bidding activity in state and

central projects. For example, recent media reports indicate that just one company

each had bid in five road tenders opened recently to develop the 6,500km

highways and that too with Viability Gap Funding (VGF) of 37-39% of the total

project cost

We believe that Indian PPP projects have been assuming more interest rate risk

over 2006-08 with senior debt funding rising and equity participation dropping.

The tenor of debt at 7-10 years continues to remain relatively short by the

standards of this industry, with a trend towards shorter reset periods. PwCs

30 %

17%9%

8%

1%9% 3%

2%1%

Electricity

Roads and Bridges

Telecommunications

Railways

Irrigation

Water Supply &SanitationPorts

Airports

Storage

Gas

Figure 2 Rising private investments in

Indian infra

Source: PPIAF, Noble research

52

43

46

3

9

8 22

22

-

5

10

15

20

25

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

(US$ bn)

Water and sewage

Transport

Telecom

Energy


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Clear thinking from

research highlights that for select PPP projects, spreads dropped in 2006 and 2007

to reach levels below AAA and AA rated corporate bonds (thus suggesting minimal

economic risk in Indian infrastructure investment!).

Figure 3 Debt-equity ratios rising for Indias PPPs Figure 4 PPP spreads fell sharply over the period 2004-07

Source: PricewaterhouseCoopers, Noble research Source: Bloomberg, PricewaterhouseCoopers, Noble research

Early evidence for 2009 suggests a reconnection between lending rates and

project risk fundamentals. The apparent underpricing of project risk during the

2006-2007 period suggests potential difficulties for a number of project loans as

they reach their first interest reset period (every two to three years on average), or

worse, as some projects recapitalise in their transition from construction to

operations.

Whilst some of the reasons for the private sectors heightened risk aversion are

linked to the credit crisis and the re-pricing of risk globally, there are some sector

specific issues in India as well such as poor project planning (discussed

subsequently) and political uncertainty with the looming elections.

2. Government measures to improve funding lack speed andefficacy

Through its two stimulus packages in Dec-08 and Jan-09, the GoI has sought to

improve the infrastructure sectors access to finance by:

Allowing IIFCL to raise tax-free bonds for re-financing banks loans toinfrastructure companies at lower cost,

Relaxing ECB regulations for NBFCs focusing on infrastructure lending andborrowings by infrastructure companies,

Reduction in banks cash reserve requirements, cuts in repo and reverse reporate, upward revision of credit targets (for Public Sector Banks), and

Increase in the FII investment limit in rupee denominated corporate bonds inIndia to US$15 bn from US$6 bn.

We do not see these measures as being particularly effective for the reasons

highlighted in this section.

Banksrisk pricing and regulatory issues to keep the impact of monetary

measures muted

Pricing of project risks by banks has in the past depended more on sponsor-bank

relationships than on a broader and more rigorous evaluation of project

fundamentals. The importance of pricing project risk, and its reflection in the

interest rate charged by Indian banks has varied over time with little attention torisk analysis. This has lead to declining PPP spreads over 2004-07 (see figure 4).

However, as concerns about economic growth have come to the fore, banks are

now waking up to the risks such as inflexible concession agreements, cost overruns

0

10

20

30

40

50

60

70

80

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

%ageoftotal

Senior debt Equity

Subordinated debt Government grants

0

100

200

300

400

500

600

2002 2003 2004 2005 2006 2007

Basispoints

Selected PPP projects AAA bonds

AA bonds BBB bonds

Table 3 The Governments measures

may not have the desired impact

Impactedentity

Comments

NBFCs Relaxed ECB regulations butwhere is the foreign money?

ECBs Lack of money internationally toinvest in India on account ofincreasing spreads

Commercialbanks

Exposure at high levels withsome banks at limit levels;

heightened risk perceptionIIFCL Disbursals of Rs30 bn in FY09,one-third below the targeteddisbursal



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and user charge revenues. Not only are banks increasing risk analysis, they are also

not abiding by the earlier loan documents and are now negotiating rates on

account of the increased risk perception of the infrastructure sector. Industry

sources (NBFCs and rating agencies) highlight that banks are constrained not so

much because of liquidity concerns but because of their fear that the projects they

finance may turn out to be non-performing assets.

Bankstoo small to provide a solutionAlthough the government is increasing the credit available to the banking system,

Indian banks are relatively small. Only 11 banks had equity above US$1 bn (Rs49 bn)

in March 2007 of which two were private sector banks. Even Indias largest bank,

State Bank of India (SBI) had just over US$7 bn of capital in March 2007. The total

equity of the 82 scheduled commercial banks (including 29 foreign banks) was

US$50 bn.

Group exposure guidelines of the Reserve Bank of India (RBI) also limit a banks

exposure to any group, to 50% of its capital funds. This ceiling can be breached

very quickly for companies specialising in infrastructure projects. For instance, a

group company with two Ultra Mega Power Plants (UMPPs) of US$4 bn each, and a

US$500 mn road project executed through separate special purpose vehicles

(SPVs) can require debt funds to the tune of US$5.8bn.

IIFCL a stopgap measure at best

Amplification of IIFCLs refinancing capacities by US$850 mn (Rs400 bn) over the

next 12-15 months seems like a stopgap measure in a long haul given the large

US$90 bn private sector debt requirements over the XIth plan (see figure 5). Also,

IIFCLs refinancing of bank loans through the issue of 5-year tax-free bonds does

not address the issue of lack of long-tenor funds for the infrastructure sector.

Though the new funds raised will increase IIFCLs disbursal capabilities, we believe

it could be another 5-6 months before these new funds are disbursed to new

projects as appraisal and sanctions take time. Moreover, the increase in exposure

limits for IIFCL and heightened risk perception amongst banks could mean banks

increasingly opt for maximum refinancing (through IIFCL) and minimum exposure

(to their balance sheet), leading to a lower-than-expected impetus.

IIFCLs participation in the overall project cost for sanctioned proposals has

hitherto not been more than 10-15% and its disbursals have not been very

meaningful in the overall scheme of things. Although, IIFCL expects disbursals to

increase to Rs30 bn in FY09 from Rs15 bn in FY08, these disbursals will still be

insignificant in terms of the overall debt requirements of the projects. IIFCL says

that it will disburse Rs50 bn by March 2010.

Banks are now waking up to the

economic and project-related risks

Table 4 The RBIs norms for banks

and FI lending impose company and

group restrictions

Single company Group

20% of the capitalfunds for infrastructureprojects*

20% of the capitalfunds for infrastructureprojects*

*25% with Boards approval

**55% with Boards approval

Capital funds include Tier I & II capital

Source: RBI, Noble research

Figure 5 XIth

plan projects 70% of

private investment to be met through

borrowings

Source: Planning Commission, Noble research

IIFCL disbursals will still be insignificant

in terms of overall private sector debt

requirement

Table 5 IIFCLs exposure for projects which have achieved financial closure

(Rs bn) No. of projects Project cost Loan sanctioned Amount allocated

Road 46 248 46 32

Port 4 28 4 3

Power 18 674 85 75Airport 2 147 22 8

Urban infrastructure 1 1 0 0

Total 71 1,097 156 119

Source: IIFCL, Noble research

16 2024

3138

129

-

20

40

60

80

100

120

140

US$

bn

Borrowings Private


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ECBsunavailable but also not the best option

The relaxation in ECB regulations for infrastructure investment may be a positive

move. However, past financial crises leave us less sanguine of this source as a

steady long-term funding option. Moreover, given the scarcity of credit and wide

spreads prevailing in global markets, we do not see increasing ECB flows to either

NBFCs or corporates within the infrastructure segment (it is highly unlikely that

ECBs can provide finance at sub-12% cost and that too for borrowers with weak or

non-existent credit ratings).

Moreover, raising money internationally can create problems when macro concerns

increase. For example during the financial crises in Asia in 1997 and in Argentina in

2002, many projects broke under the severe stress of such crises, as the local

currency revenues of such projects could no longer service foreign currency debt

made more expensive by steep currency devaluations.

NBFCs

There is a large chunk of infrastructure financing that comes from NBFCs, but it is

concentrated in few large NBFCs such as IDFC. Currently, the only mode of

financing for these NBFCs is, directly or indirectly, are the banks. Opening the ECB

window for these NBFCs will not serve any purpose as there is hardly any

international money on the ECB front ready to come to India (and whatever moneyis willing to come to India will not come at sub-12% interest rates).

Equity capital to match debt capital may remain in short supply

We expect increasing risk perception amongst the debt providers to increase the

share of equity in infrastructure projects from 25% to a significantly higher

proportion. However, as is well known, equity is in short-supply due to the state of

capital markets. Moreover, hitherto equity sources for Indian infrastructure have

been largely domestic (more than 80% came from project developers, with the

next largest contributor being the public sector). With the large order book

additions and ongoing infrastructure projects, the balance sheets of many private

promoters are stretched and their ability to bring in further equity is doubtful.

Participation by foreign players, particularly strategic investors, has been low eventhough PPP projects in many of the sectors are allowed to have 100% FDI. FDI

accounted for only 11% (~US$300-400 mn) of the total investment in the Indian

projects studied by Public-Private Infrastructure Advisory Facility (PPIAF) over

1995-2007. The port sector had the largest share (51%) of this foreign investment,

followed by airports (32%) and roads (16%). Only nine projects were reported to

have strategic investor participation totalling a mere US$167 mn: four in ports,

three in airports, and one each in water supply and railways.

Figure 7 FDI flow in sectors like power is already declining

Source: DIPP, Noble research

2822

51

89

7

44

70 74

2

21

87

78

47

39

24

14

57

9

-

10

20

30

40

50

60

7080

90

100

2005-06 2006-07 2007-08 2008

(Apr-Oct)

Rsbn

Telecommuni

cations

Construction

Real estate

Power

Oil & gas

Figure 6 ECB availability has been

declining since the beginning of 2008

Source: Bloomberg, Noble research

Domestic companies and developers are

reluctant to part with equity at current

valuations

0

500

1,000

1,500

2,000

2,500

3,000

ECB/FCCB moving

average last 12months (US$ mn)


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3. Lack of planning and policies deters private capitalPrivate investment in infrastructure is not only being held back due to inadequate

funding but also due to a shortage of well-conceptualised projects.

Lot of projects lack in project evaluation methodology

In India, Centre and states suffer from a lack of project preparation capacity. As per

the Comptroller and Auditor General (CAG) of India more than two-thirds of the

National Highways Development Project (NHDP) Phase I projects were delayed

because of preparation of faulty detailed project reports (DPRs). As India

transitions from procuring and bidding out a large portfolio of PPPs, to managing

and overseeing this portfolio and spreading the program to other sectors, it needs

a robust evaluation mechanism. Industry sources point out that during the last 2-3

years even ill-conceived projects with improper sharing of risk also received private

investments and bank funding (example: Noida Toll Bridge, which went through

restructuring in its early days of operations). CAGs report also points to lack of

evaluations: it states that if the National Highways Authority (NHAI) had fixed toll

rates and concession periods on the basis of sound evaluation, the concession

period of the Jaipur-Kishangarh and Delhi-Gurgaon projects could have been

restricted to 12 and 14 years, respectively (as opposed to the actual 18 years and 20

years, respectively, for which those concessions have been granted).

International experience also suggests that poor or incomplete project evaluations

were the primary reason that many PPP projects around the world in the 1990s

were halted due to stakeholder disputes. A 2002 study found that, on average, in

nine out of ten transport infrastructure projects (generally among the most

expensive PPP projects), costs are underestimated, in some sectors such as rail, by

much as 45% on average.

IMPLICATIONS FOR INVESTORS

Given that the policy and the process shortfalls highlighted in the previous sections

are not going to disappear in the short-medium term and given that private

capitals risk appetite will not return to FY07/FY08 levels for some time to come,

we prefer EPC companies to developer companies. Given the lack of private

capital, we expect governments (central and state) to increase outlay on

infrastructure activities as announced in the recent stimulus package. This should

result in the continuing business for EPC players.

We prefer EPC companies over developers

Our research indicates that about 50% of the overall infrastructure expenditure in

the Xth plan will be the construction component i.e about Rs10 tn (US$200 bn)

over FY07-12. In the current scenario, where inadequate project planning may keep

economic risks high and flexibility low in concession agreements, we prefer EPC

companies over developers. Where developers face uncertainties with regards tohigher interest rates and the changing economic scenario, EPC companies cash

contracts are relatively insulated (barring the rising working capital costs and

barring a complete standstill in the construction activity). We further expect EPC

players to benefit from additional government spending in Indian infrastructure.

Limited pure EPC players... developer role creating incentive problems

Though we prefer EPC companies in the current scenario compared to the

developers, we highlight that most of the EPC companies have become part

developers creating efficiency problems and incentive compatibility challenges.

GMRs woes in DIAL is a model case ofimproper evaluation wherein GMR has

sought support from government early

on for traffic and revenue shortfall and

inability to raise funds by trumpeting the

possibilities of halting of work due to

running out of financial resources. The

recent levy of Airport Development Fee

(ADF) has also come after Indian Law

Ministry had rejected the same in

December 2008 citing agreements

signed in 2006

During the last 2-3 years even ill-

conceived projects received private

investments and bank funding

We prefer EPC player over developers;

within the sector we prefer power and

roads to airports

Table 6 Near-term coverage

Company Comment

IVRCL EPC/developer

GVK Power & Infrastructure Developer

IRB Infrastructure Developer

Nagarjuna Construction EPC/developer

Punj Lloyd EPC



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Table 7 EPC players increasingly assuming developer role

Companies Toll-roads Captive power Real estate Airports Ports

HCC Gammon IVRCL Patel Engineering Simplex

Nagarjuna Construction Lanco Infratech Source: Company data, Noble research

Many construction firms have formed project companies to bid on big projects,

because they cannot afford the opportunity cost of missing out on the construction

contracts that are embedded in them. Companies have been increasingly willing to

bet their balance sheets on concessions or greenfield construction projects that

ostensibly tie them to a bankable revenue stream (from tolls, tariffs or government

transfers). This enables them to raise project financing (or did when the going was

good). However, this creates a risk for construction companies in so far as they can

get stuck in low margin businesses as in the case of Gammon. That being said,

academic research suggests that EPC companies have good reason to become

developers.

Sirtaine, Pinglo, Guasch and Fosters (2005) find that for Latin American

developers the IRR is below the weighted average cost of capital (WACC) (see

figure 8). However, after making standard accounting adjustments (for example, to

add to the utilities the high rates of management fees and transfers to subsidiaries

through purchases) mainly for the EPC companies assuming a developer role, the

rate of return surpasses the costs of capital.

Be that as it may, within the EPC sub-sector, we prefer EPC companies with: (a)

large proportion of cash contracts in their order books, (b) minimal equity

investment needs in infra SPVs/subsidiaries, and (c) low leverage. Firms that meet

these criteria are IVRCL, Punj Lloyd and Simplex Infrastructure.

Over the next 2 months we will initiate coverage on the following EPC firms:

- Punj Lloyd (PUNJ.IN, market cap US$590 mn) is a pure Engineering &Construction (E&C) major catering to the hydrocarbons and civil construction

sectors across India, Asia and the Middle East. The recent acquisition of

Sembawang has helped it scale up its expertise in large scale urban

infrastructure in Asia and Africa.

- IVRCL (IVRC.IN, market cap US$327 mn) is the leading water-segmentengineering procurement, construction and commissioning (EPCC) player with

minimal developer (one road and Chennai water desalination project) role.

IVRCL through its subsidiary IVR Prime has exposure to real estate

development.

- Simplex Infrastructure (SINF.IN, US$152 mn) is a pure EPC company withbusiness experience spanning across industrial, infrastructure and residential

projects in India and the Middle East. The company has recently forayed intoonshore oil drilling.

Amongst developers, we prefer power and roads to airports

Within the infrastructure developer segment, we prefer developer companies with

projects with economic profiles which are the least dependent on external assets

such as the attached real estate. We believe airport assets to be the riskiest as

these projects are heavily dependent on the adjoining real estate (examples: Delhi

(GMR) and Mumbai (GVK)). Developers owning operating toll-roads (eg: GVK,

IRB) should be preferred to Greenfield toll-road developers with toll-roads under

development (eg: Nagarjuna, Madhucon and HCC). Within utilities, although new

generation capacities may find financial closure difficult, regulation assures returns

with comparably lower risk profile for new generation companies; however, some

level of merchant power capacity can improve the economic profile of powergeneration projects.

Figure 8 EPC companies can improve

IRRs through captive contracts (Latin

American data)

Source: Sirtaine, Pinglo, Guasch and Foster2005 (Latin America: 34 concessions)

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

Transport Water Telecom Energy

WACC Adjusted IRR Unadjusted IRR


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Table 8 Risks and rewards of infrastructure segments

Asset segment Risk Avg cash yield(yrs 1-5)*

Averageleveraged IRR**

Capitalappreciation

potential

Toll roads (operating) Low 4-8% 8-12% Limited

Regulated assets Low-med 6-10% 10-15% Limited

Rail Medium 8-12% 14-18% Yes

Airports/ seaports Medium 5-10% 15-18% YesToll roads (development) Med-high 3-5% 12-20% Yes

Note: * Cash distribution to equity holders as a percentage of equity investment** Assumes debt of50% to 85% and investment periods of not less than five to seven years

Source: Larry W. Beeferman, Noble research

Over the next two months we will initiate coverage on the following developers:

- GVK Power and Infrastructure (GVKP.IN, market cap US$610 mn) is one of theleading infrastructure developers in India with a portfolio of assets spanning

power, roads, SEZ and airport (Mumbai International airport).

- IRB Infrastructure (IRB.IN, market cap US$786 mn) is Indias leading toll-roadoperator on a build-operate-transfer (BOT) basis with 11 operational roads, one

under construction and two at financial closure stage.

Developers face multiple risks

While actual economic growth in recent years has exceeded the expectations of

some of the project feasibility studies, none anticipated the current economic

slowdown. As a result, developers project cash flows and asset values are highly

susceptible to construction delays, the current economic slowdown and interest

rate risk (the latter due to the frequent interest reset periods of the loans). Though

infrastructure assets are long-term in nature and their intrinsic value should not be

significantly affected by short-term movements in the changing economic

landscape, many assets in India do not have any operating track record and may

face risks not factored during aggressive bidding for these assets in 2006-07.

We expect developer companies to face serious challenges as most of the

infrastructure developers projections for cash flows from projects did not involve

stress testing. For projects with full market exposure, and aggressive debt

amortisation, a sudden economic downturn could push debt service coverage

levels dangerously near the loans covenant, requiring a restructuring of project

debt. Rating agencies such as Fitch expect a large amount of loan restructuring to

take place over the next few years, as a wave of projects exit the construction

phase and enter operations.

Good examples of projects beset by these challenges are the Noida Toll Bridge

and the Delhi International Airport (DIAL) being developed by GMR Infrastructure.

Back-ended revenue profile coupled with high interest rates not only led torestructuring of Noida Toll Bridges but also for extension of the concession

period.

Early into its operations DIAL has witnessed traffic declines and debt hasbecome scarce. This has lead to repeated requests for levy of additional fees

for making the revenue shortfall. Waning interest in the adjoining real estate

has also impacted the funding for the airport.

Interest reset periods for outstanding project loans are aggressive, occurring every

two to three years, and in some cases, even annually. Most projects have reset

periods that coincide with projects entering their operating phase. While project

concession agreements contain annual tariff adjustment clauses that are usually

tied to inflation, this natural hedge is not perfect. Moreover, regulatory hurdles such

as the new Model Concession Agreement (MCA) capping overall project returns by

linking traffic growth with the concession period can be a dampener for investment

returns for developers.

While actual economic growth in recent

years has exceeded the expectations of

some of the project feasibility studies,

none anticipated the current economic

slowdown

Cash flows for most of the projects were

built as annuities and did not involve

stress testing


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THE WAY FORWARD FOR INDIAN INFRASTRUCTURE

In order to improve debt and long-term funding availability and concurrently

increase private participation in the infrastructure sector, the GoI needs to push for

structural changes in the financial system, increase participation of financial

investors and follow a life-cycle approach to planning infrastructure projects.

1. Development of long-term bond marketsThe creation of a deep and robust debt capital market can increase the flow of

long-term funds and reduce reliance on banks. The Indian corporate bond market,

though one of the largest in Asia, is still at an early stage of development, and its

growth is hampered by institutional, legal, and regulatory constraints that make

bonds a more expensive way of financing debt. The domestic bond market

continues to be dominated by public borrowingNational Thermal Power

Corporation (NTPC), NHAI and Power Finance Corporation (PFC)and does not

address the needs of the corporate market.

Moreover, to increase the efficiency of the private placement market for debt, the

GoI needs to reduce the regulatory asymmetry between loans and bonds. The

regulations relating to investments in bonds are far more restrictive compared to

granting of loans(i) Banks cannot invest in unrated debt instruments but can

invest in unrated loans, and (ii) Banks grant loans with no mark-to-market

implications, but their bond investments are subject to mark-to-market regulations.

2. Increased investment by pension/insurance fundsThe projected growth of pension funds and life insurance assets and their natural

synergy with infrastructure can support long-term infra financing with tenors of 10-

20 years. The Insurance Regulatory and Development Authoritys (IRDA) recent

move to increase the exposure limit of insurance companies to a single

infrastructure company to 20% from the present ceiling of 10% is a step in the right

direction.

Table 10 More room for insurance sectors exposure to infrastructure

Investment in infrastructure andsocial sectors (Rs bn)

Investment in infrastructure andsocial sectors as a proportion to

total investment by insurancecompanies (%)

Life insurers

2006-07 698 13.0

2005-06 496 12.5

2004-05 455 12.4

Non-life insurers

2006-07 61 12.1

2005-06 50 12.7

2004-05 44 12.6

Source: IRDA, Noble research

However, we believe there is more to be done as IRDAs current guidelines call for

project ratings of not less than AA for debt securities. Generally, infrastructure

projects that depend on, say, toll collections or airport traffic get a BBB rating.

Therefore, important road or national highway projects may not be able to get

investment from the insurance sector unless regulations are amended.

3. Dominance of certain developers can make matters worseGovernment regulations and policies are restrictive for bidding of projects in roads,

ports and airports. Clauses in the Request for Quotation (RFQ) allow a fixed

number of tenders to enter the final phase of price bids. This has not affected roads

only but also airports and ports. Another bottleneck is assigning marks on the

basis of experience at the pre-qualification stage, which automatically disqualifies

new companies wanting to enter the infrastructure development space. Industry

sources say that these clauses should apply to larger projects rather than the

smaller ones. Since Dec-07, as many as 60 tenders under NHDP III have been on

hold because of restrictive clauses.

Table 9 Public borrowings dominate

domestic debt securities in India

(%)Public Private

FIsCorporate

entities

All issuers 49 40 12

Argentina 72 9 19

Brazil 78 21 1

PRC 56 42 2

India 96 3 1

Mexico 82 3 15

South Korea 48 21 31

Thailand 34 42 23

Source: BIS (2006), Noble research

Same set of developers that do other

EPC jobs for govt/non-govt could limit

the overall execution capabilities in the

country


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Page 10 of 12

Clear thinking from

4. Life-cycle approach towards projectsWe believe in order to attract increasing private investments the government

should follow a full life-cycle approach (e.g., a clear framework) for partnerships

that confers adequate attention to all phases of a PPPfrom policy and planning, to

the transaction phase, and then to managing the concession. Such an approach can

help avoid problems of poor setup, lack of clarity about outcomes, inadequate

internal capacity, lack of interest from the private sector, and an overly narrow

focus on the transaction.

Figure 9 Life-cycle approach to project planning increases bankable projects

Source: ADB

Government budget

Int. Long-term Fund Providers

Project Revenue

Commercial Banks

Infrastructure Funds

Capital Markets

Bankable projects

Increasing pool

of funds

Easing Financing

ConstraintsDeveloping long-termbond marketsEncouraging pensionand mutualfunds, insurancecompaniesand financialinstitutions to invest in

infrastructureDedicated long-termfinancing institutionsRating of projects


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Page 11 of 12

Clear thinking from

CONTACT DETAILS

Saurabh Mukherjea, Head of Indian Equitiest. +91 22 4211 0901 e: [email protected]

SALES

Pramod Gubbi t +91 22 4211 0902; e: [email protected]

Sarojini Ramachandran t: +44 20 7763 2329 e: [email protected]

LEAD ANALYSTS BY SECTOR

Banks and Financial Services:

Aditi Thapliyal t +9122 4211 0904; [email protected]

Consumer:

Jaibir Singh Sethi t +91 22 4211 0905; [email protected]

Infrastructure:

Nitin Bhasin t +91 22 4211 0909; [email protected]

Power:

Bhargav Buddhadev t 91 22 4211 0910; [email protected]

Technology:

Ankur Rudra t +91 22 4211 0906; [email protected]

Economy and Country Research:

Dipankar Mitra t +91 22 4211 0920; [email protected]

701 Powai Plaza 120 Old Broad StreetHiranandani Gardens LondonMumbai 400076 EC2N 1AR

t: +91 22 4211 0999 t: +44 020 7763 2200f: +91 22 25701154 f: +44 020 7763 2397

e: [email protected]


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Clear thinking from

Disclaimer - Important Information

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