What does it take for DFIs to succeed?
Parliament passed an Act to set up a new development finance institution (DFI) in the end of March. A major change is the positioning between government and private ownership, organisation and funding. It is an opportunity to take the best of each, avoid past mistakes and learn from many other countries that have strong successful DFIs. Non-ideological balance  The ideological pro-market wave of the nineties shut down Indian DFIs, in the fond belief bond markets would finance and private corporates build infrastructure efficiently. It is true the DFIs were bankrupt and unable to survive once subsidised government finance was cut off. But the reform years have revealed the ineffectiveness of market finance also especially in areas where there are externalities and gestation lags are long. A financial system with diverse institutions is more stable and effective. When bond markets did not develop, public sector banks were pushed to lend for infrastructure disregarding the asset-liability mismatch. Ballooning non-performing assets were inevitable. Despite global shocks, assets created could have yielded profits provided patient capital was available. Many new quasi DFIs set up for infrastructure finance had similar problems of rolling over finance and reporting short-term profits. Alternative investment funds show promise since they do not have to do this. The new DFI will be provided with public seed money that it can leverage in markets using innovative financing structures that ease mismatches, provide better incentives and can match risk profiles of lenders. A DFIs long-term view allows it to counter market procyclicality and aid countercyclical policy. Its participation can develop and deepen bond markets. It is to be Board driven in all recruitment and strategic decisions with a clear mandate for developing the countrys infrastructure and bond markets. A minimal staff will be professionally qualified and paid market salaries. Many functions can be outsourced. Government ownership is to be restricted to 26 per cent, with its viewpoint represented by two nominee directors. Domestic and international institutions can hold shares. It can draw on the considerable financing available for green infrastructure and mitigating climate change risks. Rewards and risks will be shared with the private sector. Diversified ownership, funding sources and Board composition will aid high standards of corporate governance with decisions driven by commercial viability not political preferences and pressures. Considerable technical expertise is to be built up to ensure awarding of projects and 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 special interests. It can borrow from the RBI and obtain central government guarantees on merit on a fee basis. Availability of long-term pension and insurance funds has also increased in India. While liquidity should not be an issue, lazy survival on subsidies and tax concessions is to be avoided. There is some debate on the latter, however. Learning from other countries  Despite the pro-market wave, DFIs continued in many countries. Those that did well re-structured on market principles, while being closely aligned with government objectives. For example, the Chinese Development Bank was initially bankrupt but became profitable and extremely successful after a professional management adopted international financial standards and practices in the late nineties. Its bonds are treated as risk free assets and held by banks, which helped develop local bond markets. The German KfW Development Bank, one of the most successful, emphasises 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 fast, a pipeline is kept ready, and there is close coordination with the government as well as the private sector. There is leverage, but not too much at about 7-9 times. It is well capitalised and has been found very useful in helping the government implement countercyclical spending. Apart from finance and governance, the environment in which the DFI operates has to be conducive. Policy risk must be reduced, or else allocated to who can best bear it. For example, if projects auctioned are pre-cleared by the requisite governments, financing cost will reduce. A good system of pricing for utilities, with regulator set user charges, makes infrastructure lending possible. It is important that projects make positive returns, but monopolistic service providers tend to overcharge. Therefore independent and professional regulators are required when infrastructure is privatised. Cost plus pricing lowers incentives to reduce cost, unless cost can be accurately measured. Therefore price caps that are responsive to cost are likely to perform better in developing countries. The prices of utilities in India were frozen despite repeated cost shocks, starting with the 1970s oil price rise. Since governments set domestic prices they became a matter of political contestation. Prices were never changed and the quality of services fell as a result. States have repeatedly failed to price electricity adequately. Therefore, a central regulator could be set-up with a department for each State. Then no one will expect this form of political patronage. Just as now there are no protests when petrol prices are raised, although they are over-taxed with States and central governments competing to tax them. The share of each in every tax increase/decrease needs to be agreed on. The practice of distorting prices has had very high indirect costs. There is movement towards providing subsidies instead through transfers to vulnerable groups. The 15th Finance Commission has incentivised improvement in the quality of State institutions. While cheap finance is available abroad it is subject to FX risk. There are no natural hedges since domestic infrastructure earns in rupees. Therefore domestic sources of finance have to be prioritised. Improvement in corporate governance of corporates as well as contractors is also essential but fortunately is ongoing. Contracts must be honoured and payments made on time. Ultimately success hinges on improvements in governance and implementation through the ecosystem. But the DFI can contribute to these while strengthening the diversity of the financial sector as well as its institutional richness. The writer is Emeritus Professor, IGIDR. Views are personal