Debt and Debt-financing

upon to contribute 22% to the absolute spend (PTI, 2019a). Since the 1990s, governments all over the world have been encouraging the use of FDI (Foreign Direct Investment) in various sectors of infrastructure. Likewise, India also underwent major economic reforms encouraging Liberalisation, Privatisation, and Globalisation (“Liberalization, Privatisation and Globalisation, ” 2018). FDI helps in bridging financial gaps between the quantum of funds needed to sustain a level of growth and domestic availability of funds. It is estimated that the “Foreign Direct Investment in the Construction Development sector alone (townships, housing, built-up infrastructure and construction development projects) stood at US$ 25.66 billion during April 2000 to March 2020, according to the Department for Promotion of Industry and Internal Trade (DPIIT). ”(IBEF, 2020)

The costs for the development of all these projects is enormous, and the government often needs financial support from the private sector through Public-Private Partnerships (PPP).

Debt and Debt-financing

The necessary funds for development of infrastructure projects can be raised by either of two methods- equity financing and debt financing. Equity financing involves giving away part-ownership in exchange for money. The advantage is that no repayment is required, whereas the disadvantage is that part ownership is transferred, regaining which will probably be more expensive in the future. Debt financing comprises of borrowing money (eg. loans) to be repaid with interest in due course of time. The advantages of this system are that ownership is not diminished and that it provides a leveraging effect due to the tax-deductible interest, which results in higher profits. Infrastructure projects are usually based on debt-financed capital. The hefty size and scale of such projects require sound decisions of where one wants to borrow money from.

Two of the fundamental parties in the system of debt financing are the creditors (lenders) and the debtors (borrowers):

Creditors are the banks, investors, shareholders who lend the money to debtors at a certain interest rate. For infrastructure development, the creditors generally lend the funds to specific groups working with infrastructure. These creditors choose to diversify their portfolio, i.e. they do not invest in individual projects, since that would be high-risk investments (all eggs in one basket situation). They choose to invest in Infrastructure Leasing & Financial Services (IL&FS) and similar companies, which work on a diversified portfolio of projects, thereby reducing the risk involved in the investment. These creditors also usually lack the specialised knowledge to work in infrastructure projects.

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The debtors who dabble with infrastructure, are usually private sector companies which specialise in the field. Making profits is their primary aim. They borrow money from the creditors as short term loans (eg. in the form of commercial papers for a period of 6-12 months). This is advantageous to them due to the low-interest rates. They invest this borrowed money in long-term projects at a higher interest rate, which gives them a high net income margin. In order to repay their debts, they have to roll over their liabilities by borrowing from another investor to repay an older debt. This is not prudent financing, for it leads to an asset-liability mismatch - borrowing short term and investing long term (Chanda, 2019). If creditors lose confidence in these debtors, they will not advance more loans, which will not allow them to roll over liabilities, and they shall default on loan repayments.

Debt financing was first introduced during the redevelopment of Paris in the 1850s - The chapter “Paris” from the book The City in Mind: Notes on the Urban Condition, by James Kunstler (published in 2001), describes the effort that went into transforming the city of Paris from an unsanitary and dilapidated place to the beautiful and tranquil city the world cherishes today.

The government’s treasury lacked the funds needed for full-scale city redevelopment. This was one among the many reasons why Georges Eugene Haussmann, the administrative chief of the empire, crafted the method of debt financing. The government’s procedures were tedious and slow and did not permit debt-financing. Therefore, Haussmann’s method was unauthorized and disguised.

His system involved paying contractors in instalments with a proxy bond for a “completed” project, which in reality had not been started yet. These bonds were exchanged by them at the government’s mortgage bank for cash. This allowed Haussmann to circumvent the then government for authorization for any project. The system was made complicated to conceal the money trail back to him, and he was the sole authority raising credit for the projects in Paris (Kunstler, 2001, chap. Paris).

Paris is one of the most successful and promising results of debt-financing for infrastructure projects. It can be observed, however, that the role of the government in this financial mechanism has evolved over time. From being oblivious and averse to deficit financing - they have imbibed it today into their economic models, and tax incentives make debt financing the preferred option for infrastructure financing.

Moreover, governments today seize every opportunity to attract investments by the private sector, which are largely debt-financed. One seemingly remarkable method to attract international investments and develop world class infrastructure is to host international sporting events like the Olympics. Developing nations resort to these events in hopes of building the nation. However, it sometimes leads to more problems than solutions, like in the recent case of 6