Where next for Indian infrastructure?

While China’s growth has been the main focus of emerging market interest, India has fallen off the radar of international investors.

And yet, India’s story in some ways is even more remarkable than China’s as it has achieved very substantial growth at a much lower relative cost. The following graph compares the effective rate of return on capital investment, as measured by relative GDP growth, over 20 years. It is clear that China’s marginal return on capital investment is declining.

Under-investment

India’s record is in stark contrast. After an initial decline, returns since 2005 have been significantly higher than China and continue to rise. While chronic under-investment is a factor, India’s focus on ‘soft’ infrastructure, such as IT and telecoms, may also have delivered a higher ‘value add’ to the economy.

The downside has been that, unlike China, India has achieved its growth by maxing out its credit card. Public debt to GDP (gross domestic product) now exceeds 65 percent. Inflation is approaching double digits and the current account deficit is widening.

In common with other emerging economies, the winding back of US quantitative easing has led to large capital outflows. When combined with the weak fiscal balances, this has led to a record low exchange rate for the rupee versus the US dollar, touching 68 Rs/US$ before bouncing back somewhat. Consequently, investment prospects in the immediate future are not good and, with an election looming, full-year 2014 is likely to be especially difficult.

Current account looks good

To achieve sustained growth, India will have to reverse the capital flows. This won’t happen until exchange rates stabilise, which will require bringing down both inflation and the current account deficit. Inflation should decline in response to reduced food pricing pressure thanks to good monsoonal rainfalls. Together with restrictions on gold imports and a freeing up of local coal supplies, the outlook for the current account in the second half of 2014 looks much brighter .

Why would a foreign infrastructure investor remain interested in India in the face of these difficulties?

The short answer is the large economic benefit generated by infrastructure investment in India which, at 5:1 benefit to investment, is more than double China’s and much higher than in developed economies . This should translate into good returns provided an appropriate share of the benefits can be captured by the investor.

In addition, India offers:
• Foreign investment-friendly government policies despite a shaky start. Infrastructure investment is seen as essential and foreign investment is acknowledged to be a critical component.
• Highly skilled professionals across multiple disciplines. They are fully capable of delivering complex projects.
• An established model for private sector involvement in infrastructure development.
• An established judicial system resulting in far less sovereign risk than many other emerging economies.

Currently, there still remain several impediments to greater foreign involvement with the Indian infrastructure sector. These include:
• Bureaucratic obstacles that mean foreign investors have to be very patient.
• Resource limitations which can slow project delivery.
• Previous restrictions on the sale of foreign shareholdings in public-private partnerships (PPPs) and unrealistically high valuations of assets by financial investors, which have slowed the development of a normal healthy secondary market.

Most of the policy, bureaucratic and resource limitation issues can be bypassed by focusing on sectors with low exposure to these risks. Renewable energy, logistics and healthcare are particularly attractive, ‘resource-lite’ examples that also leverage off India’s natural skill base. Greenfield deal flow will not be a problem.

Secondaries,please

Secondary market transactions would provide better certainty of returns by testing valuations against the market. The devaluation of the rupee now favours foreign rather than local investors. Together with the deregulation of ownership it may now provide the catalyst for kick-starting a deeper secondary infrastructure market.

On balance, India is evolving into a more familiar investment jurisdiction for developed world investors. However, it will retain some uniquely Indian characteristics that are best handled by local partners.

*Anoop Seth joined AMP Capital in 2007 and is responsible for leading its infrastructure investing business in Asia, with a primary focus on India, China and Japan. He pursues investment opportunities, including those arising from new privatisation initiatives, in these three countries.

Seth is also managing director of AMP Capital Asian Giants Infrastructure Fund, which makes infrastructure equity investments in India and China. In this role, he is responsible for managing the fund’s investments, which span a range of sectors.

Prior to joining AMP Capital, Seth held senior positions with ABN Amro (executive director, public sector), IDFC (chief financial officer) and Bechtel Enterprises (vice president). In these positions he has worked on Infrastructure projects across a range of sectors (including airports, energy, railways and water) both within India and overseas.