Recalibrate credit risk to unlock infrastructure growth prospects

The government has embraced infrastructure as a key growth engine, recognizing its force multiplier impact on the country’s development.
The government has embraced infrastructure as a key growth engine, recognizing its force multiplier impact on the country’s development.

Summary

Loss expectations matter as much as default likelihoods and assessing both for credit pricing will favour the sector in India

Infrastructure has been one of the key pillars of the ‘India story’ over the past several years and is expected to remain so in the next decade. Crisil estimates that about 80-85 trillion in capital expenditure will be made in this sector between 2022-23 and 2026-27. Debt, typically contributing about 70% of the project funding requirement, is expected to play a key role. Given the scale of the funds required, embracing risk-based pricing can help mobilize finance at an optimum cost. Probability of default (PD) and loss given default (LGD), which are two fundamental components of credit risk assessment, can play a crucial role in evaluating risk and determining loan pricing.

PD, indicated by credit ratings, evaluates the ability and willingness of a borrower to repay its debt obligations in full and on time. A credit rating of ‘AAA’ indicates the lowest probability of default, while a rating of ‘D’ indicates default.

LGD represents the loss that investors or lenders (hereafter used interchangeably) would incur should a debt instrument default. So, if the lender has an exposure of 100 crore, an LGD of 65% indicates the lender may suffer a loss of 65 crore in the case of default.

While information on PD is readily available, obtaining data related to LGD poses a challenge— this is the case globally, not just in India—which makes it difficult for lenders to gauge the extent of credit risk involved in infrastructure projects. Indeed, given the paucity of data, lenders tend to factor in a high LGD rate for infrastructure projects —with 60-80% being the typical assumption in India—even though these are way less risky assets, as a Crisil Ratings study indicates.

Infrastructure is an evolved sector today: The government has embraced infrastructure as a key growth engine, recognizing its force multiplier impact on the country’s development. This is unlikely to change in a hurry. The sector has seen a slew of policies over the past 10 years that have helped shore up India’s attractiveness as an investment destination. All this has reflected in the median credit ratings of infrastructure assets in the Crisil Ratings portfolio having improved from ‘BBB’ in 2017 to ‘A+’ in 2023, indicating lower credit risk for the sector overall.

The LGD for infrastructure projects has also benefitted from sector-specific improvements. Key reform measures that have a positive bearing on the LGD for infrastructure projects are:

One: Better risk-sharing in the contracts awarded and an increased role played by central agencies as key stakeholders have improved the overall viability and stability of infrastructure projects in the country.

Two: The introduction of the Insolvency and Bankruptcy Code (IBC) and the Reserve Bank of India’s push for pre-IBC resolution are leading to early detection of stressed assets and quicker resolutions.

Three: The introduction and wider acceptability of investment vehicles such as infrastructure investment trusts (InvITs) are resulting in better price discovery for infrastructure assets.

Data validates lower LGD for infra projects: To gain insights into the LGD for different infrastructure sub-sectors, Crisil Ratings conducted a study on infrastructure defaults that have occurred over the past decade. The findings were interesting. The LGD for infrastructure assets was found to be in the 20-60% range, well below the typical LGD (60-80%) factored in by lenders. Sectors such as renewables and transmission were on the lower end of the LGD spectrum, while thermal power assets were at the higher end. Toll and annuity roads rested in the middle.

It is important to note that this study has its limitations. It spans the past decade and comprises a mixed bag of projects, so the LGD obtained relates to a transition period. It includes projects that defaulted a decade ago and also those that defaulted recently.

Legacy defaults involve assets burdened by substantial debt on account of cost over-runs and unresolved problems like delays in receiving right-of-way clearances for road projects or fuel supply hold-ups for thermal power projects. Prolonged stress has had an impact on the underlying value of such assets, leading to elevated LGDs for lenders, despite a better scorecard of resolution in the latter half of the past decade.

In contrast, the recent defaults that were studied have benefited from timely identification and resolution, yielding lower LGDs. It is also important to note that the study’s conclusions are based on available data from a sample of reliable cases and some sub-segments have very small samples. Therefore, the study’s findings must be interpreted in the context of these limitations.

Takeaways for stakeholders: Operational infrastructure assets demonstrate favourable LGD data compared with general corporate borrowers, thanks to inherent characteristics such as simpler operations that require minimal intervention after project completion, limited ongoing capital expenditure and low working capital needs.

International studies corroborate this view. S&P Ratings’ ‘2021 Annual Infrastructure Default and Rating Transition Study,’ covering defaults predominantly in the US from 1988 to 2020, indicates an LGD of 23% for infrastructure assets against 40% for non-financial corporates .

As India is in the process of transitioning to a structurally lower LGD scenario, LGD information can play a differentiating role in determining risk-based pricing, along with PD-based credit ratings. However, data availability for LGD is a challenge because information on defaults and resulting losses is rarely available in the public domain.

To overcome this challenge, lenders and investors may consider using expected loss (EL) ratings, along with PD ratings. Crisil’s EL Ratings, for one, combines PD and LGD to better capture the structural strengths of infrastructure assets. The scale was designed specifically for infrastructure projects at the behest of the ministry of finance. For the record, these EL ratings are recognized by Indian regulators like the Securities and Exchange Board of India, Insurance Regulatory and Development Authority of India and Pension Funds Regulatory and Development Authority. EL ratings can act as an additional input for lenders, investors and issuers as they price credit on the basis of risks. This has the potential to enhance lender comfort vis-a-vis infrastructure projects and consequently increase credit flow to the sector.

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