When will India unleash its real potential? This is a question that fund managers across the globe have been asking for the past two decades. India has been one of the most favored emerging market destinations for fund managers in the past two decades. India has also become the world's fastest growing major economy in recent years, helped partly by a slowdown in China. Still, the country lacks in several areas and one of them is infrastructure. Indeed, India is yet to see a China-like infrastructure boom. One of the main reasons why the country's infrastructure remains shoddy is lack of funding sources. But some financial innovation could finally provide a boost to India's infrastructure and potentially kick start a much-anticipated boom in the sector.
India's Infrastructure Problems
India liberalized its economy in the early 90s following a balance-of-payment crisis. The first wave of liberalization led to a period of robust growth at the start of the millennium. The chart below sums up how liberalization of the economy in the early 90s fueled growth.
As we can see from the chart, the Indian economy barely doubled in size from the 60s until the end of 90s. But as the reforms of the early 90s began to have an impact, the economy grew at a significantly faster pace since the start of the millennium. Indeed, since the start of the new millennium, the Indian economy has quadrupled in size.
Interestingly, this growth has been achieved in spite of a poor infrastructure. This is not to say that in the post reform years, infrastructure has been ignored. In 1998, the Indian government launched the National Highway Development Project (NHDP). In a recent report on India's infrastructure sector, Bank of America Merrill Lynch described this as, "a significant turn in highway development in India." Under the NHDP, the government planned 46,000 KM of highway construction of which 26,000 KM has already been constructed (source: Indian government data, Bank of America Merrill Lynch). In the fiscal year 2016-2017, construction of highways reached 8,142 KM, with 22.3 KM per day. While the pace of infrastructure development in India may look frantic, it is an area where the country still lacks way behind China.
Indeed, the lack of infrastructure has over the years knocked a few percentage points of India's GDP growth. In a report on India's infrastructure, S&P Global noted that, "corporate growth and investments can be hampered if the government fails to close the infrastructure deficit, which some experts estimate costs about 4%-5% of GDP due to inefficiencies."
Exactly five years ago, in 2012, India suffered an embarrassing blackout that affected 670 million people, leaving them without power for two days. More on the grid failure and the subsequent blackout can be read here and here.
To be fair, things have improved on the power front. In a recent article, the Economist noted that the country's power infrastructure has become "far more reliable." But a lot more needs to be done if India has to continue to grow at 7% and more in the years to come.
Private Sector Woes
According to the Indian government, the country needs more than $1.5 trillion in infrastructure investment over the next decade. The Indian government has increased spending on infrastructure. In the budget for the fiscal year 2017-2018, the Indian government allotted just under $14 billion for road infrastructure alone. While there is a sense of urgency, especially under the Modi-led NDA government, private sector participation is required if India wants to develop world class infrastructure. This is where the problem lies though.
The debt-laden private sector Indian infrastructure companies are not in a position to undertake new projects. Most private players in the infrastructure space remain highly leveraged.
Source: Bloomberg/Bank of America Merrill Lynch
This has also led to problems in India's banking system, with non-performing assets or NPAs at state-owned banks accounting for 11% of gross advances at the end of the calendar year December 2016. This means that out of every dollar lent by Indian state-owned banks, 11 cents are in non-performing assets. According to The Economist, 10% of the estimated $200 billion in non-performing loans in India's financial system are accounted for by deals related to infrastructure. The highly geared private sector could potentially derail India's ambitions of building world class infrastructure. The creation of infrastructure investment trusts or invITs could ease some of pressures faced by the highly leveraged private players in the infrastructure space.
invITs Can Fuel Infrastructure Boom in India
Infrastructure investment trusts or invITs are not very different to real estate investment trusts or REITs. Just like REITs, invITs pool multiple assets under the trust structure. The difference is in the nature of assets. invITs hold operational infrastructure assets. Like REITs, invITs (as structured by the Securities and Exchange Board of India or SEBI, India's equivalent of the U.S. SEC), invITs have distribute 90% of net cash flows to unitholders.
Regulators in India have allowed privately placed as well public invITs. This means that retail investors have the chance to participate. The requirement for public invITs is that more than 80% of their total investments should be in assets that are already generating revenue. This significantly reduces the risk. What makes invITs attractive to retail investors is the juicy yields on offer. In a research note, Macquarie Securities estimated that the cash flow internal rate of return on one such invIT (IRB Infrastructure Developers) could be as much as 12.5%. In the low-yield environment, those are very attractive yields. However, most readers on this platform will not be able to gain exposure to invITs as of now. But this does not mean no exposure to a potential infrastructure boom in India. In fact, I discuss invITs in this article not so much to highlight them as an investment option, at least not at the moment, but as a financial instrument that could play a major role in solving India's infrastructure woes and potentially create a boom.
How invITs Could Revive the Infra Sector in India and How You Could Participate in a Potential Boom
The main purpose the government of India introduced invITs is to help private players de-leverage. As noted in the article earlier, without private player involvement, India cannot meet its goal of bridging the infrastructure gap. But if private sector investments can be revived, it could lead to a potential boom, especially with a more business friendly government in the country. Also, invITs as a financial product could take off, given their structure and the potential high yield on offer. All this could lead to a China-like infrastructure boom in the world's third-largest economy.
Investors in the U.S. and Europe can gain direct exposure to this boom through the Columbia India Infrastructure ETF (INXX) (previously known as EGShares India Infrastructure). This year itself, the ETF has returned more than 36%. The fund currently has the highest exposure to the constructions materials industry. Below is the list of top 10 industries and their weightage in the fund as on June 30th, 2017:
Sector-wise Breakdown as on June 30th, 2017
Top Holdings as on June 30th, 2017
The main risk to the India infrastructure story is of course bureaucratic hurdles. Part of the reason why private players are saddled with debt is because they jumped in during the last boom in the infrastructure space with huge amounts of debt only to find delays due to difficulties acquiring land and other bureaucratic hurdles that delayed project completion and anticipated cash flows. That risk still exists. The current government wanted to make several amendments to the Land Acquisition Act passed by the parliament in 2013 only to back out as it lacked numbers in the upper house of the parliament. The BJP-led NDA government has a majority in the lower house of the parliament but has struggled to get crucial bills through as it lacks numbers in the upper house of the parliament. Having said that, there has been increasing focus on infrastructure and the results are already showing, with India expected to be a power surplus nation in 2018. After a few false starts, data suggests that the India infrastructure story is finally taking off.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.