New DFI model for infrastructure finance

Recently an article on the need for a new DFI model was published. The author has assessed that the financial model implemented through DFIs of the past, failed as it was flawed. He has very ably analysed that in the present situation the banks are overall reluctant to provide long-term project finance and the financial markets have not acquired the depth or liquidity to fund new projects.
He has floated the idea that, given Pakistan's huge investment needs, instead of waiting for financial markets to mature, the old DFI model might be replaced with a new DFI model that has the right balance of efficiency in managing the risk of the loan portfolios and supports the growth of the SMEs. In view of the importance of the topic, this piece attempts to review important characteristics of the old DFIs and suggests the need for a new DFI model for financing of national infrastructure projects, instead of the SMEs.
The DFIs have played an important role for the promotion of industries and economic development of the country. In late 1950s and throughout the 1960s, the old DFIs (PICIC, the major player and IDBP) and the entrepreneurs, mostly migrants from British India, worked together for financing and promotion of industries in Pakistan. Both flourished.
The DFIs provided to the entrepreneurs foreign loans at official exchange rates for setting up new industries. Depending on the need, long term loans in local currency were also made available.
Appraisal reports prepared by the DFIs were simple, but together with other procedures in place largely covered the main project risks. The provision of working capital was left to the commercial banks. As a result, new industries were coming up fast to meet local demand for different products.
In addition, the new industries created large number of new jobs in different parts of the country. The industries were mostly profitable and the DFIs had negligible non-performing loans (NPLs).
The DFIs in those days were new for most counties including Pakistan. They needed nurturing and care in the initial years to be able to play the important role of financing viable industries. Therefore, in addition to financial and technical support from the World Bank, the distinguished persons like Chaudhry Muhammad Ali and N. M. Uqaili were associated as Chairman/Managing Director with PICIC in its early days. Muhammad Ali had earlier been the Prime Minister of Pakistan. Uqaili was with PICIC when he was taken as the Federal Finance Minister. Subsequently, he returned to PICIC and remained Chairman of the Board for a number of years.
The government rightly protected the industries in their nascent years from foreign competition. During the first two decades, the new entrepreneurs were encouraged for setting up of new industries.
This helped in the acceleration of industrialisation process. However, now it is felt that such a policy had a downside as well. Due to prevailing protection and incentives, the industries did not fully value the need for efficiency and discipline in their operations. Therefore, when the business conditions worsened due to different reasons, these industries had problems and started defaulting on DFI loans.
Perhaps, our industries had enjoyed the protection for too long. Even today they would not hesitate to grasp such a benefit if the authorities offer them half a chance.
It may be appreciated that PICIC, the premier DFI, all along has fared relatively better due largely to policies and supervision of its cosmopolitan Board, while other DFIs have had checkered performance. PICIC had a large Board with directors representing foreign shareholders including IFC, private local shareholders and public sector institutions such as the National Bank of Pakistan (NBP).
The private local shareholders were resented on the Board normally by the heads of the business houses such as Dawood, Adamjee, Fancy, Valika, Crescent, etc. The senior management was supported by foreign experts in different fields. Proper manuals and procedures were in place. Selection of officers was on merit. PICIC was the best pay master after City Bank in those days. PICIC was providing loans in local and foreign curries, making equity investment and underwriting issue of new shares to the public.
PICIC was catering to the needs of large and medium industries while IDBP was providing financing facilities largely to the small and selected medium industries
Besides PICIC and IDBP, there are other old DFI model institutions in the country. These are four joint-venture DFIs between Pakistan and the respective foreign governments on 50:50 ownership bases. Pak Oman is quite new while Pak Kuwait, Pak Libya and Saudi Pak were set up in late 1970s or early 1980s. In every DFI, the number of directors on the Board and the top management positions are shared equally. Each country has three directors. The foreign investors have the Chairman of the Board while the Chief Executive is from Pakistan. The joint ventures have been capitalised much better than were the old DFIs- PICIC, IBBP and NDFC.
The joint-venture DFIs have been doing very well as against the old DFIs, partly because of their better capitalisation, shared management and composition of their respective Boards.
Before 1971, head office of IDBP was shifted from Karachi to Dacca, while PICIC was already maintaining there a large regional office. The events of 1971, adversely affected the assets, operations and profitability of PICIC and IDBP. Later, these DFIs were further affected because of substantial devaluation of Pak Rupee and nationalisation of basic industries in Pakistan.
In the circumstances, there should have been re-focus of operational priorities by the DFIs and increase in their capitalisation by the stakeholders. It is felt that to meet new challenges; the government was not pursued vigorously for improving financial conditions of these DFIs.
After nationalisation of basic industries, PICIC was reluctant to start financing public sector, in addition to its traditional role of financing private sector. Therefore, to fill the gap, NDFC was set up in 1973 to finance public sector projects. Later, the government allowed NDFC to finance private sector projects as well.
According to NDFC Act, the Chairman was the Chief Executive of the Corporation as well as the Chairman of its Board of Directors. In the 1990s, when it needed more attention for consolidation, NDFC saw frequent changes at the level of the Chairman.
Variable re-lending rates and margins are recent phenomena. PICIC, IDBP and later NDFC have been largely making foreign and local currency loans on fixed interest rate. Foreign credit lines were availed by the DFIs mostly from the World Bank, ADB and US-EXIM and local currency refinance from the State Bank of Pakistan (SBP).
In all cases margins to the DFIs were fixed and so were the re-lending rates payable by the industrial borrowers. This did not allow the DFIs any flexibility to adjust upward the re-lending rates and margins when dealing with the industrial borrowers having relatively lower credit standing. As such, allocation of loans was not very efficient and the loan pricing did not reflect risk accurately.
The fixed mark up rates continues even these days for some of the refinance facilities from the SBP.
In the mid 1990s, the World Bank and ADB were not inclined to provide fresh credit lines to the old DFIs (PICIC, IDBP, NDFC and BEL) mainly because of their failure to maintain 85 % loan recovery. Instead, the World Bank declared eligible a small number of new leasing companies and investment banks for its Financial Sector Deepening Project.
However, very little of this credit line has been actually utilised for loaning purposes. It is felt that the old DFIs could be possibly saved if the World Bank had at that time suggested introduction of major reforms to the government.
In connection with mounting NPLs and eventual redundancy of old DFI model, the author of the earlier article has mentioned a number of factors such as managerial incompetence, weak institutional capacity, bureaucratic and political interference and poor governance.
The industries were adversely affected due to other reasons as well such as cut-throat competition, frequent policy changes by the government, deteriorating law and order, high cost of electricity, etc. Many industries defaulted on loans from DFIs.
As a result, the old DFIs had high NPLs and became ineligible to borrow fresh funds from the World Bank and ADB. There is no guarantee that any new DFI model would survive if confronted with circumstances similar to the ones mentioned above.
There is urgent need to reform the old DFIs still surviving in the light of present day developments and requirements. Institutional and organisational safeguards must also be provided against factors affecting the DFIs in the past. It may be mentioned that in the same period the joint-venture DFIs largely remained unaffected.
The funding needs of the SMEs can be fully met by the reformed old DFIs. Besides, the four joint-venture DFIs are already providing finance to the SMEs.
Moreover, the banks and DFIs now have access to the SBP for financing of export-oriented SMEs. Therefore, financing should not be a problem now to credit-worthy SMEs for viable projects.
In addition, the SMEs can access the venture capital institutions. It is strange that venture capital culture has not flourished in our part of the world. One reason for the phenomena could be that many SMEs do not wish to share control and profits with the joint-venture partners. On the other hand, the joint-venture institutions might be reluctant to go all out for financing the SMEs due to some doubts about quick enforceability of the contractual arrangements in case of problems.
It is suggested that the issues might be debated and solutions found. In view of the above, there appears no big justification for a new DFI model for project financing of the SMEs.
Long-term project finance is generally based on stream of cash flow for the concession period, which is guaranteed through contractual arrangements among different stakeholders. As the contractual arrangements are difficult to negotiate, time-consuming and costly, project finance model is considered unsuitable for financing of the SMEs.
The Independent Power Producers (IPPs), which are highly capital intensive, have been financed through the project finance model in Pakistan.
The country has apparently big appetite for the financing and construction of large national and regional infrastructure projects. The new DFI model for long term project finance is suitable for implementation of such infrastructure projects.
For accelerated development, Pakistan badly needs to build more of power generation plants, power transmission lines, network of gas lines, highways, railways, bridges over rivers, airports, sea ports, etc. The funds for early construction of such highly capital intensive projects could be arranged through properly structured public-private partnerships. The new DFI model could possible play an important role in the financing of infrastructure projects by local / foreign banks / DFIs for implementation by the private sector under BOT / BOO.
The new DFI model is after all not so new to Pakistan. To meet power generation shortfall in the public sector, in the 1980s the government decided to induct private sector in power generation.
The government, with assistance from the World Bank, USAID and other donors, had established the Private Sector Energy Development Fund (PSEDF) for part financing the IPPs. Based on a proper study, the administration of the PSEDF was entrusted to NDFC. For this purpose, NDFC established a specialised unit known as the Private Energy Division (PED) which handled the financing of a number of IPPs and energy related infrastructure projects financed under BOT / BOO arrangements. On merger of NDFC, the PED and the Fund are now with the NBP.
Development of the PED into a new independent DFI for infrastructure finance might be more feasible and the government is urged to consider this option.