Investment Strategies

India's infrastructure seen boosting returns

Investors can profit from the country's build-out of roads, railways and power plants

Jan 23, 2011 @ 12:01 am

By Susanta Mazumdar

India is one of Asia's most compelling economic success stories. Structural reforms, positive demographics and globalization are spurring economic growth to new heights.

Indeed, India is catching up fast to China in terms of the rate of economic growth.

Its gross domestic product growth has moved from a range of 6% in the early 2000s to 8% to 8.5%. This higher rate of economic growth is sustainable and may even overtake China's.

For India to maintain this level of growth, however, it must continue to invest in its infrastructure. Building roads or railways immediately boosts output and jobs, and it also helps to spur growth.

The World Bank estimates that a 1% increase in a country's infrastructure stock is associated with a 1% increase in the level of its GDP.

India has suffered from a number of false dawns in infrastructure development. Encouragingly, we think that there are signs that the next few years will see real progress in that area through a combination of private- and public-sector financing.

India's current five-year plan calls for $500 billion of infrastructure investment through March 2012. It appears that $300 billion to $350 billion in investments will happen during this period, implying a success rate well above the 50% norm during many past such plans.

There also is great potential for infrastructure spending to grow even further. At present, it accounts for only 7% of GDP, but the Indian government has raised that target to 10%.

Total Indian infrastructure spending over the next seven years is estimated at $750 billion, most of which is likely to be in power, roads and telecommunications, where a 3G buildup soon will be under way.

Roads in particular are looking more attractive, as the new minister of road transport and highways has indicated that the government will accelerate its building program.

In the last fiscal year, 3,166 kilometers of highway projects were awarded. In the next fiscal year, that could rise to 9,000 kilometers.

India also continues to face a major power shortfall, with peak deficits ranging from 10% to 15%. This is despite low per-capita consumption and the fact that only one-third of the population has access to electricity.

To tackle this, the Indian government has targeted capacity addition in power generation as a key objective. The availability of various financing options and an increase in bank lending for the power sector also should help accelerate investment, while the entry of private-sector players will result in growing capacity.

However, the weak financial conditions of state power distribution boards continue to work against unlocking real demand.

Encouragingly for investors, we think that infrastructure operators that have strong execution capabilities, long-term power purchase agreements and access to low-cost fuel resources should be able to post superior profits and stable returns. Additionally, since only a relatively small number of companies have the ability to develop infrastructure projects, very attractive returns can be achieved over time.

Historically, periods of rising interest rates have made it harder for infrastructure developers to raise funding capital, but we think that the highest-quality developers with the best assets will continue to succeed over the long term.

Of course, macro concerns remain, particularly as to the Indian fiscal situation and inflation. But infrastructure assets tend to offer relatively high pricing power, and assets with pricing power and stable regulatory regimes also typically exhibit high inflation protection.

Revenue is often hedged or partly hedged against the impact of price rises, either through an inflation element incorporated into the price/revenue formula of the contract or through the pricing power of the business.

The inelastic demand, high barriers to entry and the monopolylike characteristics of many infrastructure assets (such as utilities, water and electricity generation) also mean that their financial performance isn't as sensitive to the economic cycle as many other asset classes.

Given the potential for further volatility in market conditions and the distinctive characteristics of the sector, we think that the risk/return profile of the asset class is very compelling. Moreover, the Indian focus on infrastructure is very much a long-term-growth theme, which is only at the beginning of a long and sustainable cycle.

Susanta Mazumdar, who is based in Singapore, is a vice president of T. Rowe Price Group Inc. and the portfolio manager of its Global Infrastructure Fund.

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