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India Inc. is now officially facing an economic slowdown. But economic slowdowns aren’t made overnight. This has been in the offing for almost a year now. On 23 June 2019, the Reserve Bank of India’s deputy governor Viral Acharya handed in his resignation. Just a few months before he resigned, Acharya spoke when then governor of the RBI, Urjit Patel stepped down stating unequivocally that “governments which do not respect the central bank’s independence will sooner or later incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution”.

His speech was made at a time when the rupee had fallen to a historic low against the US dollar. The country was facing a grave liquidity crisis since Infrastructure Leasing & Financial Services Ltd’ (ILFS) — India’s biggest ‘shadow-banking’ institution— defaulted on Rs 1.2 lakh crore, sending an already debt-laden economy into a complete tailspin. Investor confidence took a huge hit following the IL&FS default, the stock market crashed, IL&FS’ credit ratings took a sudden plunge, and commentators began to call this ‘India’s Lehman Moment’.

Since then, the dominoes have only continued to fall: Yet another shadow banking institution, Dewan Housing Finance Limited (DHFL), has also defaulted and the non-banking finance sector is in deep crisis. New suspicions regarding the autonomy and objectivity of India’s primary credit rating agency, ICRA Ltd. have surfaced, following which the Managing Director (MD) and Chief Executive Officer (CEO) have been sent on indefinite leave.

Acharya’s resignation on the heels of Patel’s resignation as governor of the RBI is troubling signs that the government is mismanaging the economy. However, even as the economy is flagging, this government insists on persisting with the flawed IL&FS model despite the numerous scams and frauds that have come to light since its default.

The Minister for Road, Transport and Highways, Nitin Gadkari, issued a statement immediately after the elections stating that IL&FS will be bailed out in record time. The infrastructure giant is now being granted new projects even as its former management is being investigated by the Serious Frauds Investigation Office (SFIO).

The Narendra Modi government’s promises of a 5 trillion dollar economy ring like a poor joke considering that it would be very lucky to keep from sliding into an economic recession from here. However, the government is neither paying heed to its Harvard educated economic advisors like Acharya nor to the major red flags that signal an economic slump. So, instead of simply scrambling to get its way out of the current debt crisis, it might be more instructive to take a deeper look at India’s Lehman moment and reassess the policy environment that enabled it.

What exactly is IL&FS and how did it go wrong?

IL&FS is a shadow bank whose functioning impacts the economy at large and its classified by the Reserve Bank of India as a systemically important Non-Banking Financial Company (NBFC).  IL&FS has a number of stakeholders in India and abroad. As of March 2018, its majority shareholders were the Life Insurance Corporation (LIC) of India and ORIX Corporation of Japan. When the LIC stepped in to bail out IL&FS, the infrastructure giant was already considered ‘too big to fail’. Ironically, its very standing as a systemically important institution that was too big to fail was central to the functioning that led to its ultimate downfall.

IL&FS’ vast presence across the infrastructure sector was hitherto unprecedented. Unlike other private infrastructure companies, IL&FS was created with the unique ability to simultaneously finance, promote, and consult on infrastructure ventures. In addition to the holding company which finances projects, IL&FS has a range of subsidiaries that become private partners or consultants in infrastructure projects. It is still unclear how many subsidiaries IL&FS has since it has remained absolutely opaque ever since its credit default in September 2018. However, the latest estimate reported has declared 348 subsidiaries.

As a non-banking financial institution, IL&FS receives financing from a variety of sources. The large majority of IL&FS’ financing came from Public Sector Banks and individuals who invested in its Non-Convertible Debentures. IL&FS also raised financing from other banks, financial institutions, Non-Banking Financing Companies, corporations and state governments. IL&FS’ primary financial subsidiary, IFIN, lent this money as start-up capital to subsidiaries that would partner with Public Sector Units as promoters in Public Private Partnerships (PPPs).

This model allowed IL&FS to establish an enormous presence across the infrastructure sector with over 300 subsidiaries across the country in roads, transport, energy, maritime infrastructure, water, and urban management. For this reason, IL&FS is considered to have pioneered the PPP model in India. For example, the group claims to have created India’s first large scale PPP— the Delhi Noida toll bridge—in 1992 using ‘path-breaking financial innovation’. However, IL&FS subsidiaries weren’t just private partners in PPPs. The IL&FS group established subsidiaries to provide a range of consulting services to projects. So projects financed by the group often also utilised consultancy services provided by group subsidiaries themselves.

IL&FS’ vast presence, enormous clout, and systemic importance as a non-banking financial institution have now proven to have been instrumental to the many scams the group orchestrated. IL&FS was able to squander public finances by virtue of being a financial institution that also entered into PPSs and hired group subsidiaries as consultants on their own projects. This gave IL&FS the capacity to borrow vast sums from public banks and channel these funds into joint ventures that it created with public sector units to form PPPs.

The PPP was central to the model because it was used to bring in influential former IAS officers, raise funding for projects and access prime real estate using Public Sector Entities that the group partnered with. Much of this funding was then misused by hiring IL&FS group subsidiaries as consultants on projects and paying them exorbitant fees to siphon off the money. This wouldn’t have been possible if not for IL&FS’ institutional structure as a shadow-bank that operated multiple PPPs as subsidiaries. The group often used its many subsidiaries to move money around and hide the extent of debt that its projects faced. The Group’s institutional clout, personal connections, and influential position allowed it to go so far as to offer kickbacks to credit rating agencies to keep its credit ratings from going into the red.

Reportage by Sucheta Dalal in Moneylife has now revealed extensively how the PPP was used to structure one-sided deals in which the government and public sector partners financed projects, contributed land, and managed projects at a huge loss.

For example, IL&FS’ road projects in Tamil Nadu earned the company Rs 91.3 crores on an investment of Rs 69.6 crores whereas the Tamil Nadu government earned an infinitesimal return of Rs 2 lakh on an interest free investment of Rs 44 crore for the same project. Similarly, GIFT City in Gujarat saw an investment of only 2.5 crores from IL&FS while the Gujarat government contributed 880 acres of land valued at Rs 2 crores per acre. When a water project in Tirupur ran into debt, government funding was used to keep the project afloat.

Justice V Ramasubramaniam, who passed an order in a Public Interest Litigation (PIL) on the project, observed that government funding was used exclusively to pay back IL&FS’ debt which, he argues, was neither good business sense nor in public interest. IL&FS was required to bring in a mere 5 percent of start-up capital as equity to its PPPs even when they were 50:50 joint ventures. So, essentially, IL&FS had no skin in the game. It used Public Sector Banks (PSBs) to raise start-up capital and government funding when projects ran into debt.

An expose by Grant Thornton has now revealed the extensive financial fraud that enabled IL&FS’ operations. About Rs 13,299 crore was implicated in various kinds of fraud, including out and out disbursement of loans to individuals instead of companies, not requiring collateral or checking credit ratings.

IL&FS also engaged in what is called ‘round-tripping’ of loans in which money that the group lent eventually found its way back into group subsidiaries. In other cases, IL&FS lent money it received at a loss, lent to hide loan defaults among its subsidiaries, and used money borrowed as short-term loans for long-term investments. Investigations by the Serious Fraud Investigation Agency now reveal suspicions that India’s former finance minister, P. Chidambaram, may have received kickbacks from IL&FS.

To offer just one case that demonstrates the way IL&FS operates let us look at the case of Kanak Resource Management Limited (KRML). KRML was set up in 2000 as a joint venture in which an IL&FS subsidiary partnered with a trust run by Vivek Agarwal called the Centre for Development Communication (CDC) to offer municipal waste management services. The CDC specialised in municipal waste management prior to its venture with IL&FS. Once the partnership was established, KRML allegedly used CDC’s connections to collude with municipal employees to extort Rs 30 crore. But this was only the tip of the iceberg.

Agarwal soon found that KRML was being used to borrow money from a host of other IL&FS subsidiaries in gross excess of its requirements. This money was then ‘repaid’ back to the IL&FS subsidiaries with interest. Agarwal soon fell out with IL&FS due to the misuse of funds borrowed by the subsidiary. He was then harassed when he attempted to expose the workings of the group and denied even his salary. Luckily, unlike other consultants on IL&FS projects, Agarwal successfully filed a case against Il&FS with the National Company Law Tribunal.

In its other projects, IL&FS has developed a reputation for muscling out partners out to take over their businesses. In the case of their aviation project with RAHI (Regional Aviation Holdings International) they went so far as to arm-twist the judiciary and the police into imprisoning RAHI’s founder, Umesh Baveja, on trumped up charges.

Investigating agencies have now arrested four members of the senior management of IL&FS. Credit rating agencies are under the scannerand there are allegations against auditing agencies for fudging accounts. About 175 subsidiaries of IL&FS are now undergoing the insolvency and bankruptcy process. And the National Company Law Tribunal which was formed to deal with NPAs is investigating the accounts of ILFS and its financing agencies. But is all this really enough? Or is this merely band-aids on a more fundamental malaise?

Even if the debt is somehow eventually recovered, this still leaves hundreds of projects across the infrastructure sector— including steel, power, energy, housing, roads and transport, and even smart cities— with undervalued assets. IL&FS defaulted on approximately Rs 35,000 crores from PSBs and Rs 26,000 crores in Non-Convertible Debentures. The bankruptcy process will involve taking major ‘haircuts’ from these amounts to recover whatever can be salvaged.

If the bankruptcy process for Non Performing Assets(NPAs) is anything to go by the outlook certainly isn’t very good. In 2017, about 55 percent of the reduction in NPAs was due to write-offs. And between 2014 and 2018, PSBs had to write off Rs 3.16 lakh crores while recovering only a small fraction of this amount at Rs. 44,900 crores. In the meanwhile, the government has been continuing to cover up the mess this has left behind at the expense of taxpayers by repaying sovereign guarantees on IL&FS’ behalf.

Much breath has now been wasted repeating the oft-heard refrain that corruption in PSBs is to be blamed for all this. Which, of course, fuels the status quo solution: Let’s just privatise the banks, give IL&FS a rap on the knuckles, and call for more regulatory oversight from the state. However, this only elides IL&FS’ role in everything that has unfolded. Shadow-banking and PPPs were heralded as the messiahs that could finally curb public sector corruption. So why has the scale and consequence of financial fraud only increased in India’s pioneer of PPPs? And does this imply that we need to reconsider the policies that created a behemoth like IL&FS in the first place?

Liberalisation of Infrastructure Finance

The PSBs are considered to be one of India’s strongest public sector institutions. However, although banks have continued to remain public, they have also been liberalised significantly in the last few decades. These structural changes have deregulated banks and made them more beholden to the power of big business.

The banking sector in India was liberalised when the government adopted the GATT (General Agreements on Trade and Tariffs) in 1991 and underwent structural adjustment midwifed by the Narasimham Committee. Broadly speaking, bank liberalisation gave banks increased autonomy, deregulated interest rates, and fundamentally transformed the role of the Reserve Bank of India (RBI). Previously, the RBI was responsible for overseeing and regulating banks in India, but following the recommendations of the Narasimham Committee, the RBI divested the shares it held in Indian banks and minimised the Government of India’s role in regulating banks. Bank liberalisation has, therefore, systematically deregulated the banking sector and precluded executive oversight.

Bank liberalisation also marked a decisive shift in the role banks played in financing development projects. While development finance was previously separated from commercial banking, post-liberalisation development finance began to rely significantly on financing from commercial banks. This shift was inherently risky because development finance and commercial banking have considerable differences. Development banking requires vast sums of start-up capital that is lent on a long-term basis whereas commercial banks typically grant short-term loans. For this reason, infrastructure and other development ventures were previously financed by more reliable sources like the government’s own budget, the RBI’s surpluses, bonds, and development banks.

The push to neo-liberalise development finance arose from the notion that state-assisted development finance ‘distorts the playing field’ for commercial banks. Therefore, liberalisation required that the state pulls back from financing development projects from its own budget.

Business tycoons have been quick to blame PSBs for creating the NPA crisis by lending indiscriminately. But banks didn’t simply choose to do this out of the goodness of their hearts. The market pressures they were subject to as a result of financing large, capital-intensive projects didn’t leave them with much of an option. Financing development projects meant that commercial banks were left to contend with an unequal playing field: They had to lend aggressively to long-term, capital-intensive projects in an erratic market while also maintaining a capital base to finance short-term, commercial loans. Inevitably, this led to the pile up of bad loans (NPAs), which by the end of 2018 amounted to a whooping $150 billion.

While PSBs are now being accused of lending indiscriminately, the boom-and-bust lending pattern we have witnessed over the last two decades is typical to liberalised economies. Liberalisation opened India up to large flows of foreign capital which grew exponentially after 1991. These rose from less than a billion dollars to $4.2 billion in 1993-4 and stayed at approximately $6 billion through the 90s. By 2009-10 this figure had reached $70 billion even despite the financial crisis of 2008. This meant that the banks were suddenly responsible for  an ever-expanding capital base that they needed to generate interest from.

The obvious choice for these now-deregulated banks with little accountability was to lend aggressively to capital-intensive infrastructure projects. The share of infrastructure lending correspondingly went from 2 percent in 1998 to 35 percent by 2015. An analysis by Credit Suisse in 2013 revealed that lending in the post 2007-8 period resulted in banks becoming significantly overleveraged.

Following liberalisation, the majority of infrastructure projects have been financed by PSBs in India. Even the ‘non-banking’ financial institutions that emerged in the 2000s borrowed heavily from PSBs. However, the emergence of non-banking financial institutions brought about its own set of transformations to infrastructure finance.

Shadow banks, or Non-Banking Financial Corporations(NBFCs) are financial intermediaries. The existence of NBFCs can be traced back to the 1950s. However, the role played by NBFCs has changed considerably in the last decade. There are broadly two different kinds of NBFCs—deposit-taking and non-deposit taking banks (such as IL&FS). Non-deposit taking banks are subject to little regulation by the Reserve Bank of India since they don’t deal with individual depositors.

Regulatory oversight over NBFCs was significantly limited in 2005, following which there was an overall increase in non-deposit taking NBFCs. NBFCs also became a major source of finance for infrastructure projects after this. Their contribution to the economy grew from 8.4 percent in 2006 to over 14 percen in 2015 and they accounted for about a third of all lending in India between 2015 and 2018.

NBFCs are considered an important source of finance for the infrastructure sector because they take higher liquidity risks than traditional banks. However, NBFCs are weakly regulated and lack accountability. For example, they are not subject to oversight by institutions such as the Comptroller and Auditor General of India (CAG). They rely primarily on private auditors such as Deloitte who are now suspected of having helped institutions like IL&FS fudge its accounts and credit rating agencies such as ICRA whose senior management is now being investigated for fraud.

Finally, while much of the NPA crisis is misattributed to public sector corruption, an ongoing probe by the Central Bureau of Investigation reveals that managers of one of India’s foremost private banks, ICICI, received kickbacks to lend to Videocon, which is now one of India’s largest defaulters.

PPPs: Public capitulation for private profit

Liberalising infrastructure finance also involved privatisation through the PPP model. IL&FS is said to have pioneered PPPs in India by initiating some of the largest projects to adopt the model. While PPPs have been hailed as the miracle that will bring private capital into infrastructure and curb public sector corruption, IL&FS relied extensively on the PPP model to orchestrate an elaborate financial scam. So how did PPPs come to dominate the infrastructure sector and what makes them so susceptible to misuse?

In keeping with the general trend towards privatisation, the state has been deemed to be incapable of financing infrastructure. However, this doesn’t hold up empirically. The state can and does finance infrastructure projects. For example, even infrastructure projects undertaken through the PPP model are accompanied by what is known as ‘Viability Gap Funding’ through which the state commits to providing infrastructure, assets, and connectivity required for a project. Essentially, each project spawns additional public sector and state investment for secondary projects. This is all financed through state budgets.

The 2019-20 Union Budget allocates Rs. 4.56 lakh crores for the infrastructure sector. This is about 4.5 times the amount that IL&FS defaulted on! So the state, along with Public Sector Banks, evidently has adequate capacity to finance infrastructure projects. There is also a push to grant only ‘butterfly projects’ —i.e. projects which are already up and running—to private players. So, again, it is the state that will bear the burden of the large amount of initial risk capital that is required to get infrastructure projects up and running and the private players that will reap the benefits.

An analysis of the Narendra Modi government’s flagship infrastructure development programme, Sagarmala, reveals that it proposes only 26 percent of the long-gestation, high-risk infrastructure projects for private investment. This means that the majority of the ports, roads, railways, smart cities, and industrial zones proposed by the project will not be financed with private capital. Instead, the state will take on the greatest risk by putting up large sums of start-up capital that can only be recovered in the long-term.

As former chief economist of the World Bank, Kaushik Basu, has rightly said: “We pay lip service to PPPs or public-private partnerships, without attention to detail. This partnership between the private and public is however fraught with risks, because it is like bringing two very different animals inside the arena. If the design of incentives and boundaries of action are not well-specified, PPPs can be a disaster, with one side draining the other or totally stalling its functioning. Remember, crony capitalism is also a form of public-private partnership.”

This is precisely what happened in the IL&FS case, where the shadow bank brought in the majority of its funding through Public Sector Banks and used Public Partners in PPPs to borrow excessive amounts which were then siphoned off by the infrastructure giant. This wouldn’t have been possible if it weren’t for the ‘project finance’ model that PPPs are based on.

Project Finance

The now ubiquitous PPP model brought in what is known as ‘project finance’ which is expressly designed to limit the amount of risk capital that a private player brings in. Project finance essentially involves financing a project based on projected returns on investment rather than actually existing collateral. A ‘Special Purpose Vehicle’ (SPV) is created to anchor each project. The SPV is usually some form of partnership between a public sector company and a private capitalist.

Once the partnership is formed, the SPV takes on a life of its own and its risks and liabilities become insulated from the parent company. When projects are financed through the project finance model loans are taken by the SPV. Since the SPV is an entirely new entity, loans granted to it are not based on its balance sheets or collateral but on its projected value. This is partly how India’s billionaire tycoon, Vijay Mallya, was sanctioned loans purely against his brand value estimated at Rs 3,406 crore before he went bankrupt. The type of debt taken on by an SPV under project finance is ‘non-recourse debt’, which means that the assets of the parent company cannot be seized even in the event of a default or declaration of bankruptcy by the SPV. So essentially, the parent company is in no way liable for the losses of the SPV.

Over the last decade, project finance has become the predominant model of infrastructure finance along with the rise in non-banking finance. It is by no accident then that the last decade has witnessed the ubiquity of PPP projects. The predominance of project finance in India since 2004 is a reflection of a global push towards PPPs. International investments in PPPs rose exponentially from $19 billion in 2004 to $144 billion by the year 2012. Moreover, in addition to the number of PPPs increasing during this period, the amount of investment in projects has also risen dramatically. In 2017 alone, the average size of projects increased from $88 billion to $315 billion.

As one report states, “In 2005 alone, India’s market share in project-financed transactions in the Asia-Pacific region increased from 2.8 percent to 12.5 percent. By 2009, India ranked first globally in the number of project financed projects. In that year, India raised $30 billion for project finance, accounting for 21.5 per cent of the global project finance market. This put it ahead of even the top American, British, and French banks”.

International financial institutions such as the World Bank Group and other Multilateral Development Banks like the Japan Development Bank have aggressively promoted changes in regulatory frameworks to facilitate PPPs. For example, India’s new track record in financing PPPs is one of the factors that accounts for the recent jump in India’s position on the World Bank’s ‘ease of doing business’ rankings. The 2015 United Nations Conference on Financing for Development also emphasised PPPs as an instrument of the 2030 Sustainable Development Goals (SDGs) which have now come to define the international development agenda.

The exponential growth of project finance indicates that the privatisation of infrastructure has not resulted in private players bringing in their own capital or raising funds from the open market. Instead, private players in India have relied excessively on financing from over-leveraged public sector banks. This should come as no surprise considering that project finance disincentivises private players from bringing in their own capital.

Investment in capital-intensive infrastructure projects is naturally risky since these projects have long gestation periods. Project finance is designed to protect private partners from having to bring in this initial risk capital.This means project finance is a model that seeks to maintain a high debt-equity ratio.

These issues were not limited to PPPs in India alone. An analysis of ten PPPs across countries revealed that all projects involved major cost overruns. This was ultimately riskier for the state than private companies because the public sector had bear the burden when things went wrong. In India, the National Thermal Power Corporation is currently salvaging the power sector assets of companies that have declared bankruptcy in an effort to meet rising demands for power following the near collapse of the power sector in the country.

While there are many different models of PPPs from the basic 50:50 Joint Venture between the public and private partners, to the Build Own Operate (BOO), Build Operate Transfer (BOT), the Mine Developer and Operator (MDO) model and so on. Ultimately, the degree of risk allocation and accountability depends on both the model and contract of a PPP. Regardless of the model of a particular project, you can always have reckless contracts. For example, a consultant associated with IL&FS on one of its 50:50 Joint Venture projects created a contract through which they were paid an upfront fee of Rs. 400 crore for services they failed to perform while also making sure that they were not liable to return the fee even if the work was not completed.

It is remarkable that PPPs haven’t come under more serious scrutiny considering the multitude of scams, frauds, and failures that have been associated with their functioning. Criticisms of the PPP model have largely remained limited to the need to ‘get them right’ and analyses of why PPPs fail uncritically fault the state for project cancellations even though most projects that have faced financial closures are the ones that have received the sweetest deals.

For example, private partners in the roads and transport sector are required to bring in only 12 percent of the project cost as equity. They are also assured of recovering 60 percent of the project cost with a 10 percent interest in tolls once the project becomes operational. However, 56 out of 104 proposed projects in the sector faced financial closure in 2018 because private companies chosen to execute the projects turned out to be financially weak.

Despite these evident flaws, the PPP remains the preferred model for privatising infrastructure development. India has recently declared that it will privatise six airports under the PPP model at an estimated cost of Rs 2 trillion over the next ten years. As usual, this outlay is expected to come from private players. However, given the intrinsic design of the PPP model, it should be no surprise if 10 years later we find that the financing has come instead from PSBs.

The PPP model skews the terms of negotiation in favour of private sector partners by distributing risk disproportionately, removing liability for private sector partners systemically through the use of Special Purpose Vehicles (SPVs), and failing to create adequate vetting process to ensure that private sector partners are capable of successfully executing projects.

The way out?

The underlying economic logic used to justify shadow banking and PPPs is that we need to bring private capital into infrastructure. However, we now find ourselves in the midst of an unprecedented economic crisis. India’s previous ‘season of scams’, which included the famed 2G scam and Vijay Mallya’s spectacular default in Kingfisher Airlines, pale in comparison to IL&FS which has defaulted on over 1 lakh crore rupees. While the previous season of scams didn’t prove detrimental to economic growth, the fallout of NPAs and the IL&FS crisis has led to drastic measures that threaten to jeopardise the entire economy.

Viral Acharya’s exit from the RBI is a result of the government going against any economic good sense to strong-arm the RBI into using its capital reserves to recapitalise banks. The bankruptcy process is creating an unhealthy business environment by exempting buyers of stressed assets from competition laws. The upshot of these decisions is that the Indian economy has suffered a wholesale transfer of public assets to private capital. This includes the deposits in public banks, the vast amounts of land that have been acquired for projects that are now bankrupt or stalled, and the undervalued assets that these projects have become by going up for sale to the lowest bidder.

IL&FS has not just failed to bring private capital into the infrastructure sector. It has used public assets to create opportunities for itself —a private entity—to siphon off vast amounts. While there are important and valid concerns that are currently being raised about how IL&FS is being dealt with, i.e.: Is the credit rating system fundamentally broken? Shouldn’t IAS officers and bureaucrats who are implicated in IL&FS’ dealings be taken off the new board?

Perhaps, it is time to also ask ourselves why an experiment with liberalising infrastructure finance for over two decades has left us with private investment at a 15- year low. And whether this means we need to rethink infrastructure finance. After all, the China model has effectively demonstrated how a state can successfully finance infrastructure.

(The writer is a PhD candidate at Johns Hopkins University and recipient of the Smitu Kothari Fellowship from the Centre for Financial Accountability)

The article, first published on the Firspost, can be accessed here.

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