Photo: Mint
Photo: Mint

Opinion | Bank guarantees for the construction sector

Availing BGs has become a big hurdle, as many public sector banks are grappling with stressed assets

The Indian construction sector has a significant role to play in infrastructure creation, and, thereby, economic development. With the government’s thrust on infrastructure through its key programmes in road, rail and urban infrastructure, it would not be wrong to say that the construction sector is on the cusp of a major growth opportunity. We have been witnessing a quantum increase in capital outlay for these key economic segments over the past three-four years and the trend is likely to continue over the medium term.

To leverage these opportunities, the construction industry will need to scale up its capabilities on several fronts. Much of the trickle-down growth effect for the industry will come from its ability to adapt to the increasing requirements for resources, the most critical being capital needs—both for ongoing projects as well as incremental needs for new projects. However, this will not be easy and will come with its own risks and challenges. The most critical of these is the availability of adequate bank guarantees (BGs) as these are required throughout the project life cycle, right from the bidding phase till completion, even the defects liability period. Thus, in the absence of adequate BGs, bids for new projects can neither be made, nor efficiently executed.

In these times, availing BGs has become a big hurdle, given that many public sector banks (PSBs) are grappling with highly stressed assets from the construction and infrastructure sectors in particular and are under prompt corrective action (PCA).

Banks are also demanding higher margin money and collateral requirements, in line with the increased risk perception associated with non-fund-based (NFB) limits. For many companies that have grown at a fast pace over the last three-four years, this becomes a tough condition to fulfil. Increasing demand from banks is also due to the fact that the NFB exposure of the construction sector has outpaced fund-based exposure. The former grew at a compound annual growth rate of 11.5% over the last four years and stands at over 1 trillion as of March 2018, compared to 90,000 crore for fund-based exposure.

Over two-thirds of the NFB exposure is from PSBs, of which over 20% is from the 11 banks that are under PCA at present. Taking the overall infrastructure sector, the total NFB exposure of banks is close to 4 trillion.

Going forward, as the pace of project awards increases, so will the need for BGs. Further, the additional performance guarantees required for some projects as well as the BGs needed for the release of funds against claims awarded by arbitration tribunals will increase the overall BG requirement. Moreover, the change in National Highway EPC (engineering, procurement and construction) contracts since 2014, with the defects liability period being doubled to four years, has also lengthened the BG release cycle.

With the thrust on roads, railways, Metro rail and affordable housing, construction activities have picked up in the last three-four years and their gross value added (GVA) has registered an improved growth of 11.5% in Q4 FY2018. Cement production, a lead indicator of construction activity, also witnessed sharp growth of 13-23% from November 2017 to April 2018. With more order inflows in the current fiscal, construction companies are sitting on a healthy order book and the operating income of most companies remains adequate. Their order book to operating income ratio was 3.5 times as on 31 March 2018, indicating healthy revenue visibility in the medium term.

However, while this good, the main concern is that the construction sector’s increased need for BGs has come at a time when the banks are going through a tough period. It is estimated that the sector would need incremental BGs of 15,000-20,000 crore per annum over the next three-four years, which in turn would require an additional collateral of 3,000-6,000 crore. For mid-sized companies that have grown sharply in recent times and are sitting on additional project awards, securing enhanced BGs and arranging adequate collateral could prove to be a major constraint in overall growth. These could then translate into a slowdown in the development of infrastructure.

For the construction sector to continue on its acquired growth momentum, and for the pace of infrastructure development to proceed unhindered as far as BGs go, many more policy initiatives are needed. In some countries, sureties are an alternative to BGs and can be looked at since they can help reduce margin/collateral requirement. Another alternative could be in the form of contractor-wise revolving BGs that are provided to employers being used as security for multiple contracts. The size of these BGs can be devised in such a way that they are big enough to take care of multiple projects for a contractor, but less than the total BG required if it were to be provided separately for each project. This pooling of BGs for multiple projects can reduce the overall requirement of BGs to some extent as the probability of all the projects not performing will be lower.

Shubham Jain is group head (corporate ratings) at ICRA.

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