Macroeconomic Risks – Inflation, Interest Rate & Exchange Rate Risks

Macroeconomic risks are external, economy-wide risks beyond the control of project sponsors. These can severely impact project cash flows and viability.

Types of Macroeconomic Risks

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1. Inflation Risk

Definition

The risk that inflation will erode the real value of project revenues or increase costs faster than budgeted.

Impact on Projects

A. Cost Inflation (Negative Impact)

Operating Costs Rise:

• Wage inflation: Labor costs increase by 8-10% annually
• Utility costs: Electricity, water costs rise
• Material costs: Maintenance materials become expensive

Example:

Year 1 O&M Budget: ₹50 crore
Assumed inflation: 4%
Actual inflation: 8%

Year 5 O&M:
Budgeted: ₹50 × (1.04)^4 = ₹58.5 crore
Actual: ₹50 × (1.08)^4 = ₹68 crore
Shortfall: ₹9.5 crore (16% higher!)

B. Revenue Inflation (Positive Impact, if allowed)

If tariffs are inflation-indexed:

• Toll rates escalate with WPI/CPI
• Power tariff increases annually
• Protects real revenues

The Mismatch Problem

Problem: Costs are fully exposed to inflation, but revenues may be partially or not at all indexed.

Example - Toll Road:

• Toll escalation: 3% per year (as per Concession Agreement)
• Actual inflation: 6% per year
• Real revenue decreases by 3% annually!
• Real costs constant or increasing
• Margin squeeze over time

Mitigation Strategies

1. Inflation-Indexed Tariffs:

   • Link toll/tariff to Consumer Price Index (CPI) or Wholesale Price Index (WPI)
   • Example: Toll = Base × (1 + WPI growth)

2. Periodic Tariff Revision:

   • Regulatory mechanism to revise tariff every 3-5 years
   • Based on actual cost increases

3. Escalation Clauses in Contracts:

   • O&M contract escalates with inflation
   • Passes cost increase to operator, not SPV

4. Conservative Assumptions:

   • Assume higher cost inflation (7-8%) but lower revenue inflation (3-4%)
   • Stress test the model

5. Inflation-Linked Bonds:

   • Issue bonds where interest payments are indexed to inflation
   • Matches inflation exposure on both sides of balance sheet

2. Interest Rate Risk

Definition

The risk that interest rates will increase, raising the project's debt service burden.

Fixed vs Floating Rate Debt

Reality: Most infrastructure debt in India is floating rate (linked to MCLR/Repo Rate).

Impact

Example:

Loan Amount: ₹700 crore
Interest Rate: MCLR + 2.5%
Initial MCLR: 7.5% → Total: 10%
Revised MCLR (after 2 years): 9% → Total: 11.5%

Year 1 Interest: ₹70 crore
Year 3 Interest: ₹81 crore (assuming principal outstanding ~₹700 crore)
Additional burden: ₹11 crore per year!

If DSCR was 1.30, it may drop to 1.15 after rate hike - distress territory!

Mitigation Strategies

1. Interest Rate Swap (IRS):

   • Convert floating rate to fixed rate via derivative contract
   • Example: Pay fixed 9%, receive floating MCLR+2.5%
   • Net effect: Fixed rate debt

2. Interest Rate Cap:

   • Buy an option that caps interest rate at (say) 12%
   • If market rate > 12%, option pays the difference
   • Cost: Upfront premium (0.5-1% of loan amount)

3. Fixed Rate Debt:

   • Negotiate fixed rate with lenders (rare, but possible via bond issuance)
   • Cost: Fixed rate is typically 1-1.5% higher than initial floating rate

4. Debt Service Reserve Account (DSRA):

   • Maintain 6-12 months of debt service in reserve
   • Acts as buffer if interest increases temporarily

5. Match Revenue and Debt:

   • If revenue is linked to inflation/interest rates, exposure is natural hedge
   • Example: Floating rate debt + inflation-indexed tariff

6. Conservative Financial Model:

   • Assume interest rate 200 bps (2%) higher than current
   • Check if project is viable even at higher rates

3. Exchange Rate Risk (Forex Risk)

Definition

The risk that currency depreciation will increase the rupee value of foreign currency debt or equipment payments.

When Does Forex Risk Arise?

1. Foreign Currency Debt: Borrowing in USD, EUR, JPY
2. Imported Equipment: Solar panels, turbines from China, Europe
3. Foreign Contractor: EPC contractor invoices in USD
4. Foreign Investors: Equity repatriation in foreign currency

Impact

Example:

Project borrows USD 100 million for imported equipment
Exchange Rate at borrowing: ₹75/USD
INR Equivalent: ₹750 crore

Rupee depreciates to ₹82/USD (2 years later)
New INR Equivalent: ₹820 crore
Additional burden: ₹70 crore!

For Debt Service:

Annual USD Debt Service: USD 10 million
At ₹75/USD: ₹75 crore
At ₹82/USD: ₹82 crore
₹7 crore additional outflow per year!

Natural Hedge

Best Case: Project earns revenue in same currency as debt

• Example: Export-oriented SEZ borrows in USD, earns in USD (fully hedged)
• Problem: Most infrastructure projects earn revenue in INR!

Mitigation Strategies

1. Minimize Foreign Currency Debt:

   • Prefer domestic rupee loans
   • Use foreign debt only if significantly cheaper

2. Currency Hedging (Forward Contracts):

   • Lock in exchange rate for future date
   • Example: Book forward contract to buy USD at ₹76/USD for next 3 years
   • Cost: Forward premium (~2-3% p.a.)

3. Cross-Currency Swap:

   • Swap USD debt into INR debt
   • Pay fixed INR rate, receive fixed USD rate
   • Effect: Converts currency exposure

4. ECB Hedging Guidelines:

   • RBI mandates mandatory hedging of 70-100% of ECB (External Commercial Borrowings)
   • Ensures borrowers don't take naked forex exposure

5. Revenue Indexation to USD:

   • Link tariff partially to USD (rare, mostly in SEZs)
   • Provides natural hedge

6. Export Credit Agency (ECA) Loans:

   • Fixed rate, long tenor USD loans from JICA, KfW
   • Cheaper than commercial USD loans
   • Still have forex risk, but lower cost

4. Economic Recession Risk

Impact

• Demand falls: Traffic on toll roads, power consumption drops
• Revenues decline: Lower utilization
• Credit tightening: Banks raise interest rates, reduce lending
• Asset value decline: Project value falls if sponsor wants to exit

Mitigation

• Conservative demand projections: Don't assume 8% GDP growth forever
• Stress testing: Model 2-3% GDP growth scenario
• Diversification: Don't rely on single project or sector
• Strong sponsors: With financial strength to inject equity if needed

Combined Impact - Example

Toll Road Project:

Conclusion: Macroeconomic risks can cumulatively stress the project significantly!

Summary

• Macroeconomic risks are external, economy-wide risks
• Three main types: Inflation, Interest Rate, Exchange Rate
• Inflation risk: Costs rise faster than revenues (if revenue not indexed)
• Interest rate risk: Affects floating rate debt (most common in India)
• Forex risk: Rupee depreciation increases foreign debt burden
• Mitigation: Hedging (swaps, forwards, caps), inflation-indexed tariffs, conservative assumptions
• Cumulative impact: Multiple macro risks can combine to stress DSCR
• Lenders require: Stress testing for +2% interest rate, +10% rupee depreciation scenarios

Quiz Time! 🎯

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