Sustainable Development for India: Solving the Infrastructure Puzzle

By Andrew Chen and Jennifer Warren Kubik

In one sense, development of public works assets can be seen as a barometer of a

countries’ economic, political, and populace well being. Infrastructure development is
critical for sustainable growth for countries such as India, Indonesia, China, and the
Philippines to name a few. In India, it is often noted that poor infrastructure—a lack of
water and sanitation, shoddy roads, and unpredictable energy supply—constrains foreign
direct investment and overall economic potential.

The Indian government has made clear recently that it will tap the private sector, in
contrast with China’s government-financed model, to help fund and develop
infrastructure projects. Deputy Chairman of India’s Planning Commission Montek Singh
Ahiuwalia expects infrastructure spending to rise to 9% of gross domestic product versus
a current 5%; thus current infrastructure investment of $50 billion would need to double
by the 2011-2012 time period.

How will India raise and attract these vast sums of private investment? In the period
2006/7, foreign direct investment inflows amounted to $16 billion, nearly triple the year
before. Large-scale projects require massive capital investment with long completion
times, however, and many carry political, regulatory and financial risk. A key issue
becomes how to attract private investors willing to participate in infrastructure projects
given their complex and risky nature. Cases of corruption and political and economic
risk make investors hesitate, especially in a developing country.

In India, one case still looms in investors’ psyche, the Enron power plant of Dabhol in
Maharashtra state. The $2.9 billion Dabhol power plant project, 180 kilometers south of
Mumbai, was initiated in April 1992 with former Houston-based Enron. Bad contracts,
politics, and economic circumstances ultimately doomed the initiative. Allegations of
corruption abound. Construction halted on the final phase in 2001 and the plant closed.
The four-fifths completed Dabhol power plant was to be the largest independent liquefied
natural gas (LNG) power plant in the world. In the end, the Indian economy and final
consumer lost out.

The case of Dabhol and various obstacles to investment have deterred investors from
India in the past. Today, companies are back with a vengeance, keen on the promise of
India once again. To fulfill the visions of India’s potential that investors and
multinationals predict, the Indian government is promoting the idea that India is open for
business and that the needed infrastructure will evolve. Out of necessity, governments
across the globe, India’s included, hail the virtues of public-private partnerships to save
the day. But infrastructure financing with transparency and efficiency in mind may do
more for India than would be obvious. A new approach is needed in financing
infrastructure to properly cultivate this form of social investment which yields more
benefits beyond the infrastructure project itself.
A Tale of Two Indias
India with its 30 states and seven union territories displays great regional disparities in
terms of economic growth and specialization. A two-speed, divergent India has emerged
with infrastructure development a key piece of the puzzle. Under typical patterns of
economic development, countries or areas tend to go through labor-intensive
manufacturing cycles before they specialize. But in India, fast growth states or areas have
skipped steps in the economic development models and focused where they appear to
have comparative advantage, according to a 2006 International Monetary Fund working
paper. That is, leading regions like Delhi, Karnataka (Bangalore), and Maharashtra
(Mumbai) which embraced the IT wave with their first-tier cities, have realized faster
growth and rising incomes alongside better infrastructure offerings.

Conversely, slow growth or lagging regions —Bihar, Madhya Pradesh, Rajasthan, and
Uttar Pradesh—suffer with growing, less-educated populations, which are expected to
follow more traditional economic growth and development patterns. These areas may
also be a political force for redistributing resources unless they are incentized to reform
governance, business climates, and infrastructure offerings. Recent research reports that
politicians in electorally competitive states announce large numbers of infrastructure
projects ahead of elections, and then don’t follow through. States, particularly in lagging
regions, have proved wasteful and corrupt in infrastructure spending.

An antidote for both fast growth states attracting most of the foreign investment—in
dynamic cities such as Delhi, Mumbai, Bangalore, and Chennai—and lagging states, may
be a new approach to private investment in infrastructure. As a new form of public-
private partnership, global capital markets can offer a viable source of funds, promote
better governance, and bring transparency to infrastructure’s complexities.

With India ready to further embark in public-private partnerships for infrastructure

projects, getting the formulas right is imperative. This can make the difference between
further regional divergences and politicization which deters reforms and development,
and the opportunity for more balanced growth for those who will need it most.

A Chance for Progress

Under existing approaches, infrastructure project financing is structured in a way which
creates flaws: inefficiencies and added costs, greater political (policy) risk, and a lack of
diverse ownership needed for transparent incentives. The Enron-Dabhol project
highlights some of the issues surrounding infrastructure projects. In this case, there was a
lack of competitive bidding, unfair contracts, and limited knowledge by the seller (the
government) in terms of project scale, technologies and complexity. Unfair competition
for contracts will not yield the longer-term goals of sustainable growth and development
and better governance records. Consequently, project sponsors and investors may then be
deterred from future projects in a host country or region as happened in India post-Enron.

Government should re-think how infrastructure’s role interacts with other areas that
impact firms’ decisions to invest such as bureaucracy, corruption, and macroeconomic
stability. These areas beg the question of how to reconcile existing infrastructure

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financing approaches with a country’s desire for better governance and a more attractive
business climate for private investment.

Given the vast infrastructure needs in India, a progressive approach is needed that levels
the playing field, deters political and policy risk, and develops more efficient, transparent
market mechanisms. If there is to be real progress toward development goals and reduced
poverty, this modernization of approaches offers a way forward.

A More Efficient Market

The experiences to date with privatizations and securitizations suggest that a “market
finance” approach, which creates immediate private ownership of public investment
projects among diverse groups of investors, may lead to more efficient and successful
infrastructure development. Current “contract finance” approaches have lead to
successful projects, but also spectacular failures have occurred which waste considerable
resources. The financing of projects should be guided by global capital markets’ invisible
hand to determine the economic value of an infrastructure project and provide the
necessary resources for construction, operations, and maintenance.

Project securitizations or initial public offerings of project securities can be designed with
financial innovations for any new large-scale infrastructure project. This would create
diversification, liquidity, and mitigate many of the problems that accompany existing
approaches in financing infrastructure. It would also begin to unravel the perverse
incentives pervading infrastructure spending in India.

This approach would bring true private sector participation for economic development
and legitimize further business activity. It would ensure ample funding, strong interest,
and awareness of a project on a global scale. Managerial incentives could be more
aligned with productivity, thus reducing the widespread problems of cost overruns and
inefficiency. Governments—central, state, and local—could be allocated project
securities to achieve true public-private ownership.

Financial innovations in the securities offering can serve as both a deterrent and an
incentive. For example, including event-risk provisions in project bonds can deter
politicians’ attempts to make undesirable policy changes. This can ultimately foster a
more investment-friendly environment, prized by many countries. Sound decisions and
proper management will bring its own reward through enhanced project value and the
value it brings to the community and economy at large, which must be communicated to
stakeholders. In the end, the explicit costs of debt financing for infrastructure would be
lower. Of great consequence, the invisible hand may prove more capable in setting
infrastructure project agendas which span varied administrations and political agendas.

State-of-the-art Development (Policy)

This approach to financing infrastructure is a way forward to realize economic and
development goals and greater prosperity. In addition to physical infrastructure, India has
a solid foundation in “soft” infrastructure. A reliable banking system, functional capital
markets, a well-developed legal system, and educational opportunities underpins India’s

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political and economic life. The appearance of many diverse stakeholders—foreign
investors, governments, and domestic investors and consumers—can further catalyze the
reforms needed to infuse additional private sector activity. Prior methods of infrastructure
project finance have worked, but at costs hidden to society.

The private sector is developing an enhanced capability in managing infrastructure assets

and operations on behalf of governments that are privatizing or leasing public
infrastructure. A number of international investment banks have developed infrastructure
funds, which act as project securitizations of existing projects. One Australian investment
bank’s infrastructure fund owns stakes in a major Chinese port, a Japanese turnpike, a
major English toll road plus other US and European infrastructure assets.

This new approach complements private sector developments in progress. But most
importantly, it applies to the launch of new infrastructure projects, utilizing financial
innovations to mitigate risk and participate in gains. The capital market finance approach
can also be applied to groups or consortia of new smaller-scale projects related by sector
or geography.

Individual and institutional investors alike can have new choices available in social
investment. With pension funds seeking better returns through alternative assets, holding
a portion of an Indian power plant or water utility is not so far-fetched. For economic and
financial policymakers, new incentives to attract capital and projects may emerge.
Greater access to global capital markets can further expand the mix and amount of
resources available for development as in the case of India.

Parts of the vicious cycle of infrastructure project finance can be turned more virtuous,
supporting ends beyond simply funding the infrastructure project itself. Infrastructure-
challenged India represents a fertile opportunity for a new approach that would attract
needed financial resources for sustainable development and allow even greater
participation in the global economy.

This article is based on the recent paper “ Complementing Economic Advances in India:
A New Approach in Financing Infrastructure Projects, Journal of Structured Finance
(Summer 2007).

Dr. Andrew Chen is a distinguished professor of finance at Southern Methodist

University’s Cox School of Business. Jennifer Warren Kubik is a Fellow of the Next
Generation Project at Columbia and principal of Concept Elemental, a knowledge-based
communications firm. Written June 7, 2007.

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