Princeton, New Jersey USA
This article examines issues critical in promoting private sector investments in infrastructure within developing countries. Topics addressed include:
Note about the author: Dr. J. Michael Cobb has been involved with developing, financing and implementing infrastructure and commercial-industrial projects in many regions of the world, including the Middle East, various regions in Asia, the Caribbean, Africa, Latin America and in the US. Please see his web site for specific examples and further details.
Developing World Financial Uncertainties
The economic and financial turmoil which began in Asia within the past three years and spread to much of the emerging market economies raises many fundamental uncertainties regarding the risks inherent in large scale infrastructure development projects in the developing world. These uncertainties include developing country governments and financial institutions ability to follow through with large scale multibillion dollar infrastructure project commitments. Also, uncertainties are increasingly being voiced regarding the ability of international and local developers and investors to effectively manage and mitigate various currency, regulatory and related risk factors inherent in major mega project development. When combined with the financial, accounting and regulatory stresses resulting from the recent Enron, Global Crossing and Arthur Andersen disasters, one may conclude that financing major emerging market infrastructure projects will be increasingly problematic within the next several years.
While these many uncertainties are unlikely to be resolved anytime soon, the fundamental requirement for continued public-private efforts to effectively scope, plan, finance and execute infrastructure investment commitments remains. This article seeks to outline issues and processes necessary for helping this dialog to continue. This is done with the belief that current political and financial difficulties can provide important opportunities to creatively restructure and advance the development and investment programs needed for helping stabilize and promote further economic progress in the developing world.
Global Infrastructure Needs
Long-term economic growth in the developing world will require substantial sustained investment in efficient infrastructure in order for each country to realize the potentials from the opening of markets and the increasing globalization of the world economy.
The World Bank estimates that in the next ten years, developing economies alone will need to invest over $200 billion per year, $2 trillion by 2005, in basic infrastructure. Over $1.2 trillion is needed in east Asia alone, which implies about 7% of the region's GDP being allocated to infrastructure projects such as transport, water, power, telecommunications and related projects. Many believe the likely investments will be less than half this amount, and World Bank research evidence shows that little of the required amounts have resulted in implemented projects within the past five to ten years.
Raising these vast sums and effectively implementing this development is clearly far beyond the capability of governments alone. The international development banks and supporting institutions therefore are seek to facilitate private investment flows by assisting governments not only with finance but with the institutional reforms necessary to build the required public-private partnerships for attracting and retaining private infrastructure investment.
Infrastructure Finance versus Project Finance
Major international infrastructure projects differ from the more traditional industrial projects with which most financial institutions are familiar. Most of the more recent infrastructure projects involve variations on new techniques such as BOOT/BOO/BLT (Build-Own-Operate-Transfer, Build-Own-Operate or Build-Lease-Transfer). Also, in addition to more traditional economic, technical and financial appraisal requirements of project financing, infrastructure projects usually necessitate a much more thorough analysis of the regulatory, institutional and legal arrangements under which the project developers or promoters will operate.
Most infrastructure projects are based on non-or limited-recourse financing, which means that they look only to the planned project's cash flow, assets and financial performance as the main basis for investor security. Such projects therefore generally bear higher overall risk compared to more traditional industrial project lending where project risk is mainly covered by the sponsor's balance sheet and credit ratings and security is provide by tangible assets. (For a more detailed review of project finance "sources" and "structures", see the Global Infrastructure Finance discussion).
Enabling & Promoting Infrastructure Investment
For adequate performance, most privately financed infrastructure projects will require well-developed domestic capital markets. Also, infrastructure projects themselves can provide the important catalysts and opportunities to help develop such domestic markets.
Since most major infrastructure project investments will generate revenues in local currency, it may not be financially sustainable or wise for governments over the long term to mainly finance these projects with foreign capital alone. There appears to be both the infrastructure demand, needed for enabling economic development, as well as the institutional need in most emerging markets to develop such financial instruments along with the overall market systems to tap theses important potential sources of domestic capital needed for long term infrastructure investments.
Many feel that the massive infrastructure investment short-falls in developing countries will have to come from the world's capital markets where private corporations would implement projects based on local government debt issues under a special SEC regulation know as Rule 144A.
Traditionally, when an entity issues debt to the public investors, credit and security agencies require stringent regulations and standards. However, as infrastructure projects have cash flow difficult to ascertain, Rule 144A may be used to issue debt under less rigorous criteria to designated sophisticated investors, such as insurance companies, pension funds or other institutional investors.
Therefore, the trends for infrastructure
project development appears to be less bank financing based on credit ratings
and more on project bond ratings where projects are specifically structured to
allow agency ratings, as a basis of attracting institutional sources of finance. In certain
cases, such as Enron's Subic Bay power station in the Philippines, they used Rule 144A to
get more attractive debt financing from the capital markets than available from commercial
While project finance relies on cash flows from the project as a source of repayment for the debt and dividend payments, the longer time periods for development of mass transit, roads and other infrastructure projects, however, are not likely to generate adequate cash flows to fully repay private investors. As a result, major infrastructure projects will likely need some recourse to public support beyond cash flows to insure long term viability of the project. It is this joint public-private investment which is the most difficult to structure but in the long run is likely needed for sustainable project implementation success.
Benefits of Private Finance
Research by World Bank and others has produced a significant body of evidence indicating that major infrastructure projects solely planned and financed by government entities are often inappropriately scaled and implemented to provide sustainable economic development benefits. They are also often commercially nonviable. However, investment decisions made by financially autonomous or private operating companies have been found more reflective of market conditions and appropriately scaled operational considerations which are needed for effective longer term viability.
Also, project research by the Bank and other international agencies has shown that private investment in developing economies promotes better risk allocation, project management, monitoring and overall project accountability, while at the same time providing critical sources of additional funding.
An important point is that evaluation of numerous examples from differing countries has shown that infrastructure projects across all sectors tend to have high leverage ratios. Also, because the levels of retained earnings over and above depreciation allowances are low (after accounting for debt service or other capital-servicing costs, required taxes and possibly other capital reserve requirements), infrastructure developers typically fund projects with debt finance.
Developers also generally depart from the conventional hierarchical rank order approach to traditional corporate finance, which prefers to use retained earnings in preference to debt, and debt in preference to issuing public equity, as a basis for funding asset acquisition or development. Therefore, initial recourse to debt funding for major infrastructure investments is relatively high, with subsequent project expansions or renovation also being funded mainly through debt finance.
Project Financing Criteria
Evaluating potential investments for securing project financing commitments, whether debt or equity, governmental or private sources, usually will involve the following criteria:
Understanding and applying these criteria are essential steps in determining project financing potentials for major infrastructure investments.
Experience to date worldwide indicates that the most important financial issues related to promoting infrastructure investment in developing economies is not adequacy of funding, but development of the critical necessary institutional frameworks.
These are those critical domestic institutional factors which promote and insure development transparency, reasonable regulatory predictability, open markets and level playing fields, well understood risk mitigation and allocation, and financial arrangements and instruments which help integrate the investment horizons of savers, project borrowers and investors in the economy. The promotion of private infrastructure finance, therefore, offers important opportunities for initiating long term sustainable economic growth for developing countries as well as providing attractive longer opportunities for international and domestic investors.
Many international bankers have observed that project and infrastructure finance is essentially a western concept. This concept is based on complex contractual rules and obligations regarding dispute resolution within established well developed institutional frameworks, conditions which do not exist within much of the developing world.
Therefore, project finance is a complex expensive understanding involving substantial analysis of many factors associated with determining risk and ultimate project feasibility. For such projects to move forward, the structures tying joint public-private implementation responsibilities and commitments, especially risk allocation, must be well understood and agreed by all parties before major investments commitments from the private sector are likely to be made.
Governments that do not give these requirements adequate attention are unlikely to have the infrastructure investment commitments need for enabling their economies to flourish.
Should you require assistance in formulating or evaluating investment potentials in transportation, infrastructure or commercial-industrial real estate projects, please contact us to see how we may assist. Also, please visit our web site to learn more of our capabilities and experience. For references and financial details for specific example projects, see Bangkok's Mass Transit: Financing the Mega Projects and Lebanon's Reconstruction: Development & Finance.