Rating Games: Will A New Infrastructure Rating Scale Really Help The Sector?

Estimates of the amount of money India needs to fund infrastructure growth run into trillions of dollars. The latest figure - $1.5 trillion. That’s how much Finance Minister Arun Jaitley estimates that India will need over the next 10 years.

Each successive government has struggled with ideas to fund that gap. The current government is banking on the National Infrastructure Investment Fund (NIIF) announced in Budget 2015. But the problem doesn’t end with fund raising. The funds then have to find bankable projects to invest in. In the past this, too, has been a struggle since few infrastructure projects are rated high enough for investors, particularly conservative sovereign investors, to put their money in.

In Budget 2016, Jaitley had a solution to offer. Let’s change the methodology used to rate infrastructure projects, he said.

With another budget around the corner, rating agencies have been cajoled into putting out a new system which can be used to rate infrastructure projects.

“As a step towards innovation, CRISIL, in consultation with the Ministry of Finance and other stakeholders, has developed a new credit rating framework for infrastructure projects that would facilitate greater participation by long-term investors and lenders,” said India’s largest rating agency in a release on January 12.

India Ratings issued a similar statement on January 16.

Understanding The New Rating System

According to the media statement issued by both agencies, the new credit rating system is based on the ‘expected loss’ methodology. It takes into account the probability of default and the prospects of recovery, said the agencies.

How is this different from the existing rating system?

Somasekhar Vemuri, senior director at CRISIL Ratings said that the new rating scale will take greater cognizance of the “ultimate” expected loss for the investor. In a phone conversation with BloombergQuint, Vemuri explained that infrastructure projects often face temporary cash-flow mismatches for a variety of reasons. This may lead to delayed payment, which in turn would result in an immediate markdown of the rating of an infrastructure project to ‘default’. However, a number of these projects may be fundamentally sound and the prospects of eventual recovery for the investor may be strong.

The new rating methodology would take this into account, said Vemuri. He clarified that the new ‘EL’ rating would be a separate scale from the existing rating system and is likely to be an add-on to the traditional rating taken by a company. Since rating agencies function on a model where ratings are paid for by the issuer, it is up to companies to decide whether they should take this additional rating or not.

In technical parlance, the new rating methodology marries ‘probability of default’ with ‘loss given default’, said Chintan Lakhani, associate director of infrastructure ratings at India Ratings & Research. The idea is to inform the investor not only of the likelihood of default but also the probability of recovery, said Lakhani. The likely recovery is assessed over the duration of the debt instrument being rated, he added.

But Does It Really Help?

The new rating scale, however, may do little to help in the near term. There are a few reasons why.

For one, the amount of capital that an investor needs to set aside against investment in a security is linked to its conventional rating. This is prescribed by regulations. In the case of banks, Basel rules define how much capital needs to be set aside. Despite the new rating methodology, investors will still need to set aside risk capital based on conventional ratings unless regulations change. This means, that the cost of funding will likely not drop sharply even if an infrastructure project secures a higher EL rating.

Another concern is that while assessing ‘loss given default’ the rating agency basically judges the potential for recovery based on likely cash flows and the value of the investment. Practical difficulties like the time taken to work through an arbitration process, for instance, are not taken into account.

Finally, rating agencies are currently planning to use this methodology only for operational projects. This means that under construction projects, that need the most hand-holding in terms of financing, will see little relief.

Vinayak Chatterjee, chairman of Feedback Infra has a different view.

Conventional ratings do not take the peculiarities of infrastructure projects into account, said Chatterjee in a phone conversation with BloombergQuint. As an example, he points to the nature of agreements between a concessionaire and authorities like the National Highway Authority of India (NHAI) which may actually build in recovery safeguards for investors. Such factors, along with others, like the length of steady cash flows, are not captured in conventional ratings, said Chatterjee.

Chatterjee, in fact, suggests that the process be taken a step further. He recommends different rating systems for four different life stages of an infrastructure project - the stage where a PPP agreement is put in place; the bid stage; the construction stage and the operation stage. This, he said, will be the best way to assess the risk involved at each stage of an infrastructure project and, in turn, improve the efficiency of operations and reduce the cost of funding.