Investors yet to embrace government initiatives

Raji Vishwanathan, Larsan & Toubro

Both measures are designed to help increase funding in the infrastructure sector, and are part of the government’s stated plan of doubling investment to US$1 trillion during the 12th Five Year Plan starting in 2012. However, while they are encouraging developments for investors, challenges remain before the effects of these measures can be fully realised.

Luring foreign investors

In a bid to boost FII investment in infrastructure, the government of India increased the FII limit in corporate bonds in this sector to US$40 billion from the existing limit of US$20 billion, with an additional US$5 billion limit in bonds with a residual maturity of over five years. Given that most infrastructure companies are organised in the form of special purpose vehicles, the government also permitted FIIs to invest in unlisted bonds with a minimum lock-in period of three years. FIIs are allowed to trade among themselves during this lock-in period.

“The government’s principal objectives appear to be to enable the flow of long-term resources to the infrastructure sector,” says Khaitan & Co partner Amitabh Sharma, “and take some pressure off the local money market for infrastructure sector development funding requirements.”

According to the government’s plan, private investment will eventually surpass its own spending in critical infrastructure such as bridges, highways and ports. One corporate counsel at an Indian infrastructure company says: “The Indian regulators have identified the need to create more liquid debt markets, especially for capital intensive sectors like infrastructure – where an active debt market is almost a pre-requisite. This is clearly a step in furthering development in this area.”

The changes to FII investment have generally been welcomed by participants in the infrastructure sector, with deal data in May 2011 indicating that FII investment in the bond market had surpassed the US$21 billion mark. However, the reports also suggest that while some infrastructure companies – including government-owned companies – were quick to tap the corporate bond market, the FIIs have been slow to buy infrastructure bonds with a residual maturity of over five years.

Raji Vishwanathan, chief legal adviser in Larsen & Toubro’s financial services business, says: “FIIs have been reluctant to buy the infrastructure bonds, which need to have a residual maturity of five years, and have preferred to buy paper of shorter duration.” She believes this can be partly explained by fluctuating valuations of long-term bonds as well as procedural difficulties when it comes to FII investment in bonds – such as obtaining a letter ascertaining that the issuer is an infrastructure company.

Either way, most practitioners agree it is still too early to see the full effects of liberalisation. Sharma says: “Since the liberalisation was made with a long-term objective, a two–and-a-half month period is too short a period of time to make a fair assessment.”

Tax benefits

On June 24, the Ministry of Finance issued a press release in which it proposed a broad structure for the introduction of IDFs. Vishwanathan says: “This step has been taken to accelerate and enhance the flow of long-term debt in infrastructure projects for funding the government’s ambitious programmes of infrastructure development.”

Bahram Vakil, AZB & Partners

The government has rolled out a series of tax incentives in a bid to attract offshore funds into its ambitious infrastructure projects. These include a reduction of withholding tax from 20% to 5% on the interest payments of IDF borrowings and making IDF income exempt from income tax.

The proposed guidelines on IDFs contemplate a trust structure and a non-banking financial company (NBFC) structure, each with its own set of pros and cons. One of the problems with a trust-based fund is that the risk remains with the investor whereas in company form the risk is limited to the shareholding, says Trilegal partner Ameya Khandge. “A trust cannot undertake credit enhancement, while in the company format there is greater manoeuvrability.”

IDF bonds have to compete with AAA-rated papers of public sector units, as well as private sector companies, since the bond market in India is currently dominated by high rated papers. As a result, Phoenix Legal partner Sawant Singh warns against investor exuberance “in the absence of fine print setting out the final regulatory framework for the functioning of IDFs”.

The IDFs are a nascent development, admits Bahram Vakil of AZB & Partners. “Regulators have conveyed their understanding that there was a sense that foreign banks were completely out of the market,” he says. “This is a development that hopes to bridge that gap.”

He adds: “At the moment, there is some interest from foreign banks. But, on the debt side of funding, regulations are very restrictive and the appetite for the necessary 10-year, longer-term view is just not there. Even if investors should take this long-term approach, they see the regulatory hurdles and then say ‘forget it’.”

Infrastructure is frequently cited as a potential driving force for the Indian economy. In order for this to be the case, the regulatory authorities will have to ensure that the guidelines and regulations do not create jurisdictional gridlocks. It is imperative that they revise regulations to better reflect market realities if they wish to successfully tap foreign investment.