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Japanese investors will be grateful to Highways Minister Nitin Gadkari for his proposal to give them a nine per cent guaranteed return for their investments in laying roads.
Such high guaranteed return will be a bounty for Japanese investors. The benchmark interest rate in Japan is nearly zero and the yield on the 10-year government bond is 0.57 per cent.
The London Interbank Offered Rate (Libor) has crashed to a 40-year low of 0.55 per cent for a one-year dollar loan. Libor rates on yen-denominated loans are even lower at 0.33 per cent. (See chart).
This allows top-rated Indian companies to borrow abroad cheap. ONGC Videsh, the overseas subsidiary of government-owned oil and gas producer ONGC, recently raised around $2.5 billion from a consortium of banks at an interest rate of 3.75 per cent for 10 years, excluding the cost of hedging. The issue was rated Baa2 by credit rating agency Moody's, a notch above India's sovereign rating Baa3.
"If the offer is for nine per cent return in rupees, then it is fine. Otherwise foreign loans for sectors such as infrastructure are risky with exchange rate fluctuations over 25-30 years," said Deep Narayan Mukherjee, director of ratings at India Ratings.
The government plans to set up a finance corporation with a corpus of Rs 1 lakh crore ($16.7 billion) in partnership with Japanese investors to fund highway projects. Japanese investors are likely to have a 26 per cent stake with assured returns of 9 per cent, according to media reports. Details of the corpus like the split between equity and debt and the nature of returns were not known.
If the guaranteed return is net of hedging costs, it will be a virtual gift to the Japanese. Japan International Co-operation Agency (JICA) is funding the third phase of the Delhi Metro with 30-year loans at interest rates of 1.2-1.4 per cent, including a 10-year moratorium on repayment.
Gadkari's plan will work though if Japanese investors agree to risk their capital for 9 per cent return on equity in rupees. Indian highway developers like IRB Infra and IL&FS Transportation Networks bid for projects expecting much higher returns. IRB Infra's return on equity averaged 18.5 per cent in the last three years and IL&FS Transportation Networks averaged 18.7 per cent.
"Nine per cent is low for domestic developers with borrowing costs at 11-12 per cent, but if the Japanese agree to lower the return on equity, it will be good way to scale up investment in the sector," said Pervez Umrigar, co-head of structured investments at Piramal Enterprises, which is scouting for highway projects.
Highway users will benefit by way of lower tolls. However, it is doubtful if the Japanese will settle for nine per cent return on equity with the currency risk involved. "A 5 per cent annualised depreciation in the rupee against the yen during the life of the project will kill any chance for the Japanese to make money on their investment. They will rather ask for assured returns net of currency risks," said Dhananjay Sinha, head of institutional equity at Emkay Global Financial Services.
The top 10 Japanese companies' by market value, including Toyota Motor, SoftBank Corp, Mitsubishi UFJ Financial, NTT, Japan Tobacco and Honda Motor, reported a return on equity of 12.9 per cent on average in the last three years.
In his enthusiasm to push up investments, if Gadkari offers 9 per cent return net of currency risk, it may put government finances in a spot. The government cannot borrow at 8.75 per cent and offer a return of 9 per cent on projects over 30 years.
If it happens, history will be repeating itself. In the 1850s, the government of India offered 5 per cent guaranteed returns to investors, net of currency risk, for building railroads, when the interest rate in London was 2.5 per cent. This gap, coupled with lower than promised returns on the new railway lines and the rupee's depreciation against the pound turned into a fiscal disaster.
