Economic Survey 2015 - The Investment Climate: Stalled Projects, Debt Overhang and the Equity Puzzle

Introduction

• The stalling rate of projects has been increasing at an alarmingly high rate in the last five years, and the rate is much higher in the private sector.
• The good news is that the rate of stalling seems to have plateaued in the last three quarters.
• Manufacturing and infrastructure dominate in the private sector, and manufacturing dominates in total value of stalled projects even over infrastructure.The government’s stalled projects are predominantly in infrastructure.

Balance Sheet Syndrome With Indian Characteristics

• Corporate balance sheets in India continue to be over-extended.
• Debt to equity is a measure of financial leverage that indicates the proportion of debt and equity used by the company to finance its assets. Debt to equity for Indian non-financial corporates has been rising at a fairly alarming rate.
• This ability of a company to pay the interest on its outstanding debt is measured using the  Interest Coverage Ratio. ICR of Indian companies has deteriorated. 
• Many countries, including Japan in the aftermath of the real estate and equity boom of the late 1980s, have experienced over extended corporate balance sheets. But there is some difference in this Indian scenario
1. The debt overhang of the corporate sector is  accompanied by a relatively high growth of around 6 to 7 per cent.
2. It has been accompanied by high inflation (instead of the price deflation in  the Japanese example).
3. The public sector is exposed to corporate risk in the form of public private partnerships, and lending by the public sector banks.
4. Unlike many other countries with high debt to equity ratios currently, India's debt is almost exclusively financed by public sector banks.
•  A highly leveraged corporate sector- suggests that Indian firms face a classic debt overhang problem in the aftermath of a debt fuelled investment bubble, translating into a balance sheet syndrome with Indian characteristics.

Impact of Balance Sheet Syndrome On Firm Equity

•  There is a clear surge in equity values of Indian firms in the last three years. The puzzle though is that this surge coexists with rising stalling rates of big projects.
• The market is not penalising firms severely for the debt pile-up in the wake of investments turning sour.4 This may potentially be due to the pure political economy reason that the market is internalising the expectations of bailouts.

Policy Lessons

•  India needs to tread the path of investment-driven growth.
• Public investment may need to be augmented to recreate an environment to crowd-in private sector investment. Because corporate sector is highly leveraged and Banking sector is under severe stress. 
• Creative solutions are necessary for distributing pain equally amongst the stakeholders from past deals gone sour.
• An idea to fix the clean-up problem is setting up of a high powered Independent Renegotiation Committee.

Restructuring the Framework for the PPP

 Flaws in existing design

1. Existing contracts focus more on fiscal benefits than on efficient service provision.
2. Neglect principles allocating risk to the entity best able to manage it.
3. Default revenue stream is directly collected user charges. Where this is deemed insufficient, bidders can ask for a viability grant, typically disbursed during construction. This structure leaves the government with no leverage in the case of non-performance, with few contractual remedies short of termination.
4. There are no ex-ante structures for renegotiation. If a bureaucrat restructures a project, there are no rewards; instead it may lead to investigation for graft. Failed projects lead neither to penalties nor investigation. With such asymmetric incentives, bureaucrats naturally avoid renegotiation.
5. Contracts are over-dependent on market wisdom, e.g., bidders in ultra-mega power projects (UMPP) could index tariff bids to both fuel prices and exchange rates, but almost all chose very limited indexation. When fuel prices rose and the rupee fell, these bids became unviable. To enforce market discipline and penalise reckless bidding, these projects should have been allowed to fail.

 Needed Modifications

• It is better to continue combining construction and maintenance responsibilities to incentivise building quality. In many projects, especially highways, maintenance costs depend significantly on construction quality. If a single entity is responsible for both construction and maintenance, it takes lifecycle costs into account.
• Risk should only be transferred to those who can manage it. In a highway or a railway project, it is not sensible to transfer usage risk since it is outside the control of the operator.
• Financing structures should be able to attract pension and insurance funds, which are a natural funding source for long-term infrastructure projects.
• Rather than prescribe model concession agreements, states should be allowed to experiment.For example, in ports, terminals can be bid on the basis of an annual fee, with full tariff flexibility, subject to competition oversight.
• Least Present Value of Revenue (LPVR) contract.
•  bid is the lowest present value (discounted at a pre-announced rate) of total gross revenue received by the concessionaire.
• concession duration is variable and continues until the bid present value amount is received.
• it converts usage risk to risk of contract duration, which is more manageable for financial institutions.
• it discourages opportunistic bidding. Further, since the present value is protected, this structure is suitable for pension and insurance funds.