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Our banking system is suffering from the heavy burden of non-performing assets (NPAs), especially from long gestation infrastructure projects in the power and metals sectors. Often, projects are delayed due to multitude of regulatory approvals from local, state and central governments, each of which has high discretionary power. Judicial intervention through public interest litigations or otherwise also delay projects, especially since the judicial system itself is struggling with pending cases. Many infrastructure projects start with high leverage and promoters often delay raising equity so that they can get better valuation when the project nears completion. But if there is delay in completion, unavailability of equity makes the project excessively leveraged. Most end up having cost overruns even in today’s deflationary era. Rupee depreciation is one of the contributors to these cost overruns.

Funding this excess many a times entails getting money at an even higher cost as it has to be raised from wherever possible. So, the promoter, instead of focusing on completing the project, spends more time arranging finances. Furthermore, interest during construction from being a reasonable part of a normal project cost becomes a significant part of a delayed project cost, hampering future competitiveness.

Developers must feel like Abhimanyu going into the chakravyuh— they know how to enter but don’t know whether they will exit or not. They start the battle with the time consuming, costly and complex process of land acquisition, then fight with inadequate infrastructure to set up the project (which also means building the infrastructure at their own cost), then obtain multiple approvals from authorities with discretionary powers, fight lack of equity, and leverage to the hilt at high interest cost to complete projects. By the time the project is complete, delays have taken a toll and the cost has shot up. This vicious cycle of high cost of land acquisition, multiple approvals, lack of appropriate infrastructure, lack of equity, high leverage and higher interest rates along with delayed execution makes the project uncompetitive.

Kotak Mutual Fund analysed a power project where the costs have overrun by about 56% over the first publicly available estimate. About 67% of the overrun is due to higher interest cost, and 22% is due to rupee depreciation, which increases the cost of engineering, procurement and construction (EPC). The break-even point for the power project is now up about 53% from the earlier estimates.

The burden of the increased cost has to be borne by the equity holder also as market value diminishes. Sometimes, the promoter company safeguards itself by taking its equity out through inflated project costs. Minority shareholders demand high returns to cover potential risk, which reduces their participation in such equity offerings. Banks, having provided finance, now stare at restructuring, interest waiver, moratorium on loan or bad debts. Late recognition of NPAs restricts course correction. Users pay for delayed execution through higher cost. Sometimes, the burden is shared between promoters, minority shareholders, banks and users, which adversely impacts everyone but is not lethal enough to force corrective action.

Such a situation makes the domestic industry vulnerable to dumping by global peers. And the country responds by depreciating the rupee to provide protection to the domestic industry. A depreciating currency requires higher interest rates to attract global flows to fund trade deficit. This creates a vicious cycle that adversely impacts our competitiveness and results in even higher interest rates and depreciating currency.

While it is important to speed up the approval process and put infrastructure in place, the importance of the role that interest rate plays can’t be ignored. Interest cost as part of project cost during construction, from being at a reasonable level (10-15%), is now becoming bigger (15-30%). This has the potential to unleash a vicious cycle of diminution in equity value, higher NPAs, loss of competitiveness and depreciating currency.

Inflation is managed by curbing demand. That approach presupposes a tight fiscal and monetary policy reflected in high interest rates and low liquidity. Aggregate demand is influenced through calibrated growth in money supply to keep prices under check. India, for bulk of the past era, has followed this path. However, with growth in people’s aspirations and also the population, suppressed demand bounces back to keep inflation elevated. Maybe we should take the risk of creating ample supply. We should follow a focused but loose monetary and fiscal policy to create capacities and even supply. We should create capacities through local resources funded by the government debt owned by the Reserve Bank of India or the public, and which converts local raw material to finished goods for local consumption and exports. Creation of supply will keep prices under check. And assurance of supply will keep inflationary expectations down.

Availability of capital at a lower cost along with speedier execution of projects or increased ease of doing business will create a virtuous cycle of better equity valuation, lower NPAs, increased competitiveness and a stable currency.

Nilesh Shah, managing director, Kotak Mahindra Asset Management Ltd.

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