What does it take for DFIs to be successful?

At the end of March, Parliament adopted a law establishing a new development finance institution (DFI). Now is a good time to ask, what’s different? When so many people have failed, why should it succeed?

A major change is the positioning between government and private property, organization and funding. It’s an opportunity to get the best out of everyone, avoid the mistakes of the past, and learn from many other countries that have strong and performing DFIs.

Non-ideological balance

The pro-market ideological wave of the 1990s shut down Indian DFIs in the belief that bond markets would finance and private companies would build infrastructure efficiently. It is true that the DFIs were bankrupt and unable to survive once the subsidized public funding was cut. But the years of reform have revealed the inefficiency of market finance also especially in areas where there are externalities and gestation periods are long. A financial system with diverse institutions is more stable and efficient.

When bond markets did not develop, public sector banks were pressured into lending for infrastructure regardless of the asset-liability mismatch. The swelling of unproductive assets was inevitable. Despite global shocks, the assets created could have generated profits provided patient capital was available. Many new quasi-DFIs created to finance infrastructure have had similar problems with renewing funding and reporting short-term benefits. Alternative investment funds are promising since they don’t have to.

The new DFI will be endowed with public seed capital that it can mobilize in the markets using innovative financing structures that mitigate mismatches, provide better incentives and can match the risk profiles of lenders. The long-term vision of a DFI enables it to counter the procyclicality of the market and to support the countercyclical policy. Its participation can develop and deepen the bond markets.

He should be guided by the Board in all recruitment and strategic decisions with a clear mandate for the development of the country’s infrastructure and bond markets. A minimum staff will be professionally qualified and paid according to market wages. Many functions can be outsourced. Government ownership should be limited to 26 percent, with its point of view represented by two appointed trustees. National and international institutions can own shares. It can build on the considerable funding available for green infrastructure and climate change risk mitigation. The rewards and risks will be shared with the private sector.

Diversified ownership, sources of funding and board composition will foster high standards of corporate governance with decisions driven by commercial viability and not by political preferences and pressures. Considerable technical expertise needs to be developed to ensure the award of projects and the provision of guarantees after careful research and risk assessment.

Accountability, transparency, independence and dynamism, with sufficient internal and external checks and balances, can prevent capture by vested interests.

It can borrow from the RBI and obtain guarantees from the central government on merit for remuneration. The availability of long-term pension and insurance funds has also increased in India. While liquidity shouldn’t be an issue, lazy survival on grants and tax breaks should be avoided. There is some debate about the latter, however.

Learn from other countries

Despite the pro-market wave, DFIs continued in many countries. Those who behaved well restructured along market principles, while being closely aligned with government goals. For example, the China Development Bank initially went bankrupt but became profitable and extremely prosperous after professional management adopted international financial standards and practices in the late 1990s. Its bonds are treated as non-cash assets. risk and held by banks, which has contributed to the development of local bond markets.

One of the most successful German development bank KfW emphasizes innovation and technical expertise to identify and support economically viable projects that contribute to social goals such as energy efficiency. Its flexible portfolio includes risk sub-participations and loan guarantees to reduce project risks. Decisions are quick, a pipeline is ready and there is close coordination with government as well as with the private sector. There is leverage, but not too much at around 7-9 times. It is well capitalized and has proven to be very useful in helping the government to implement countercyclical spending.

In addition to finance and governance, the environment in which DFI operates must be conducive. Political risk must be reduced, or else assigned to who can best bear it. For example, if projects auctioned are pre-authorized by the governments concerned, financing costs will be reduced. A good pricing system for public services, with user charges set by the regulator, makes infrastructure lending possible.

It is important that projects generate positive returns, but monopoly service providers tend to overcharge.

Therefore, independent and professional regulators are needed when infrastructure is privatized. Cost-plus pricing reduces incentives to reduce costs, unless the cost can be accurately measured. Therefore, cost-sensitive price caps are likely to work better in developing countries. The prices of utilities in India have been frozen despite repeated cost shocks, starting with the rise in oil prices in the 1970s. Since governments set domestic prices, they have become a matter of political contestation. Prices have never changed and the quality of service has declined as a result.

States have repeatedly failed to price electricity adequately. Thus, a central regulator could be set up with a department for each state. No one will then expect this form of political patronage. As today, there are no protests when oil prices are increased, although they are overtaxed with states and central governments competing to tax them. Everyone’s share of each tax increase / decrease needs to be agreed.

The practice of price distortion has had very high indirect costs. There is a movement towards granting subsidies instead through transfers to vulnerable groups. The 15th Finance Committee encouraged the improvement of the quality of state institutions.

Although cheap financing is available abroad, it is subject to currency risk. There are no natural blankets since the domestic infrastructure earns in rupees. Therefore, national sources of funding should be given priority.

Improving the corporate governance of companies as well as of subcontractors is also essential but is fortunately underway. Contracts must be honored and payments made on time. Ultimately, success depends on improvements in governance and implementation across the ecosystem. But the DFI can contribute to this while strengthening the diversity of the financial sector as well as its institutional wealth.

The author is Professor Emeritus, IGIDR. Views are personal

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