Constructing development: financing the infrastructure gap in emerging and developing economies

  • Christopher Bredholt
Posted:
12 July, 2017

Making up the shortfall between global infrastructure investment needs and actual spending is high on the agenda for policy-makers and investors. According to McKinsey Global Institute, the world needs to invest about 3.8% of GDP, or an average of $3.3 trillion per year through 2030, in infrastructure. Emerging economies account for over half of that need, creating a potential pipeline for investors seeking long-dated yield. However, projects in these emerging markets present particular challenges for lenders. The multilateral development banks are attempting to crowd in private sector capital by mitigating these risks.

Infrastructure plays a positive role in economic growth and human development. Investment in assets including transport, energy, telecommunications and water ('economic' infrastructure) and hospitals and schools ('social' infrastructure) is of critical importance to society, underpinning economic activity and supporting human well-being.

Emerging markets will account for 60% of the estimated $3.3 trillion per year in infrastructure spending needed globally just to support expected rates of growth through 2030 (compared to current global investment of $2.5 trillion per year)[1]. With public sector resources under strain across the globe, bridging this gap will require new and existing sources of private sector capital.

Institutional investors such as pension funds, asset managers and insurance companies control substantial resources, with around $120 trillion under management by some estimates. These investors are seeking long-dated assets with yield as part of their investment portfolio. At an event during the 2017 Spring Meetings of the World Bank Group and the International Monetary Fund, Jim Yong Kim, President of the World Bank Group, observed that trillions of dollars are sitting in low or negative-interest bonds (in countries such as Germany and Japan). This means that investors will get back less than they invested, if they hold these securities to their maturity. The return is only one side of the equation, however; the risk to that capital is the other.

The opportunities presented by the infrastructure needs of emerging markets do not come without risks. In particular, investors are wary of country-specific risks, including political risk, key counterparty credit strength (or lack thereof), untested and evolving legal and regulatory frameworks, potential foreign exchange risk and concerns around transparency and global consistency. Multilateral development banks (MDBs), who have for many years supported investment in emerging market infrastructure, are now stepping up their efforts to help solve these issues.

In September 2015, world leaders attending the United Nations Sustainable Development Summit in New York adopted a range of sustainable development goals and associated measures that will stimulate action over the next 15 years in areas of critical importance to humanity and the planet. The 17 goals in the 2030 Agenda for Sustainable Development seek to address a range of economic, social and environmental challenges to sustainable development. Achieving them will require transformative change in the areas of finance, infrastructure investment and capacity development for developing countries. The measures envisaged will also require a step-change in the scope and scale of engagement between public and private sector entities to catalyse private sector finance.

The MDBs can’t meet the scale of the challenge alone, however, and are seeking ways to crowd in private capital and use their resources in new ways, for example providing contingent credit enhancement (contingent in the sense that the MDBs don’t fully fund upfront, but rather pay out to private sector lenders on the occurrence of a pre-defined event). MDBs are also working closely together to fill the financing gap, a commitment put in writing in the MDBs Joint Declaration of Aspirations on Actions to Support Infrastructure Investment [2] and agreed during China’s G20 presidency in 2016.

MDBs’ credit enhancement may mitigate certain political and country-specific risks that could otherwise cause potential private sector lenders to conclude such projects are too risky (in the industry parlance, institutional investors often seek 'investment grade' ratings). Such credit enhancements have been recently used in Turkey to finance a 1,000-bed hospital project with over €280 million of private sector debt. The debt will be repaid over 20 years (paying interest at 4-4.5%), using the revenues received from the Turkish Ministry of Health as counterparty to the project concession agreement.

The MDBs worked together in this instance: first, the Multilateral Investment Guarantee Agency (MIGA, part of the World Bank Group) provided political risk insurance (PRI), designed to cover currency inconvertibility and non-transferability, expropriation, and breach of contract (including arbitral award default and denial of recourse). Second, the European Bank for Reconstruction and Development (EBRD) provided subordinated liquidity facilities during the construction and operating phases. These can be tapped to boost the project’s resilience to delay and cost over-run during construction. In the operations phase, it can keep debt payments current in the event of Turkish Ministry of Health missed payments or protracted arbitration proceedings (in the event of a breach of contract by the government), and enhance lenders' recovery prospects.

Credit enhancements have the potential to mitigate emerging market risks and increase private sector financing of much needed infrastructure. Bankers, equity sponsors and investors are keenly discussing the usefulness of these approaches at events such as the World Bank and IMF Spring meetings. Lenders view them as a way to achieve many of their sustainable development goals and drive investment in sustainable and economically resilient infrastructure, including transport, energy, clean water and sanitation.

MDBs’ unique role in fostering sustainable development was recognized in the 2015 Addis Ababa Action Agenda, [3] which led to the establishment of a global infrastructure forum to “improve alignment and coordination among established and new infrastructure initiatives”.

These kinds of initiatives are helpful and constructive steps toward expanding global infrastructure investment and – subject to the long lead times that characterise the development of well-structured infrastructure projects – will help remedy the current mismatch between available debt capacity and investable deal flow.

Christopher Bredholt read for the MPhil in Development Studies (St Antony’s College, 2005-7) and is now a Vice President – Senior Analyst at Moody’s Investors Service, based in London.

The views expressed herein are solely those of the author and do not reflect the views of Moody’s Corporation or its affiliates.

[1] McKinsey Global Institute, Bridging Global Infrastructure Gaps (June 2016).

[2] http://g20chn.org/English/Documents/Current/201608/P020160815360318908738.pdf

[3] http://www.un.org/esa/ffd/wp-content/uploads/2015/08/AAAA_Outcome.pdf

Subscribe to the blog

About the author(s)
Christopher Bredholt