Road kill

Public private partnerships and other innovative schemes are no panacea for emerging economies’ infrastructure funding needs. Off-balance sheet financing and a surge in public investment pose more risks than often acknowledged

  • By Sid Verma
  • 12 Oct 2008
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Annual emerging market infrastructure spending will rise from $1.25 trillion to $2.25 trillion over the next three years to compensate for previous under-investment and maintain growth rates, according to Merrill Lynch.

Fuelled by vast cash reserves and trade surpluses, around 70% of this spending will be in China ($725 billion), the Middle East ($400 billion) and Russia ($325 billion). Saudi Arabia has unleashed its petrodollars to fund a $460 billion construction programme with 576 separate projects announced, 70% of which are already underway, according to National Commercial Bank.

The Indian government envisages around $500 billion will be spent on infrastructure over the next five years, of which only 30% is expected from private sources. Brazil, meanwhile, is Latin America’s trailblazer with Merrill Lynch raising its three-year spending estimate for the country to $225 billion under the country’s so-called Program for Economic Growth Acceleration (PAC).

Although the ambitious scale of investment is likely to be moderated somewhat by ineffective bureaucracies, the spending plans are nevertheless vast. And to ease pressure on strained national budgets a number of creative mechanisms – including public-private partnerships, dedicated transport funds and special purpose vehicles –are gaining currency among policy- makers in many emerging economies.

But analysts warn that such off-budget expenditure could undermine budget planning in many developing economies. Indeed, fears are growing that policy-makers are not always up to speed on the complexities of new financing mechanisms which entail contingent liabilities on the public purse – and a host of macroeconomic risks.

“Fiscal risks related to infrastructure projects are often not sufficiently well budgeted for, particularly where multi-year budget planning systems are weak and not able to capture the fiscal implications of longer-term projects,” says Gerd Schwartz, expenditure policy chief at the IMF’s fiscal affairs department. “When fiscal risks materialize the ‘fiscal space’ — or the ability of governments to take discretionary fiscal action—is reduced.”

Public good, private delivery

In recent years public-private partnership (PPP) schemes – which draw in private capital and reduce the immediate cost of public investment by taking debt off-balance sheet –have come into fashion in emerging markets as a way to bypass budgetary ceilings. For example, in Croatia, the Czech Republic, Hungary, and Poland, governments can use PPPs to circumvent EU fiscal targets.

Typically, a government will sweeten a PPP infrastructure deal through capital grants, minimum revenue guarantees, debt guarantees and annual payments. Although these are sovereign obligations of the government, they are usually not classed as public spending or debt.

But experts are increasingly urging developing economies to heed the potential costs and risks of supporting off-balance sheet PPP projects, especially given the sheer volume of deals in the pipeline.

The true cost of PPPs may be lost on policy-makers, experts warn. The projects are often “motivated by the lack of long-term budgeting, leading to a perception of the PPPs as zero-cost projects by the public policy makers and to shift the liabilities of the incumbent government to the future ones,” says Schwartz.

Egypt, for instance, is embarking on an ambitious public investment programme with its PPP programme, formally established in June 2006. The government is poised to award projects from early next year in social infrastructure work as well as in utilities and transportation.

Multilateral agencies are urging Egypt, and others with high public debt and limited public financial management, to monitor all liabilities through a medium-term budget framework to ward off the risks that PPPs could pose.

“With traditional accounting, as in Egypt, only the public investment shows up in the government accounts. Guarantees make expenditure unpredictable, which can cause problems for budgeting,” says Timothy Irwin, senior economist, infrastructure economics and finance at the World Bank.

Hidden risks

The macroeconomic impact of a sudden surge in infrastructure spending in many emerging economies is another source of concern, especially in an inflationary environment.

In Brazil, the bulk of the projects —$100 billion or 55% of the total — are in the energy sector, followed by the water/sewerage sector, where $60 billion will be spent 33%). But analysts fear the plans will perpetuate “structural deficiencies” in Latin America’s largest economy.

Around 58% of all lending to businesses are below-market rates due to government-subsidized credit via the nation’s development bank, BNDES, and Banco do Brasil, which provides cheap credit to the agricultural sector. BNDES’ annual disbursements have risen from roughly BRL30 billion in 2003 to around some BRL60 billion this year — with the majority going on infrastructure projects.

“This infrastructure spend could fuel inflation and exacerbate Brazil’s high interest rate environment, and ensure private contractors are out-competed by state companies,” says Arend Kapteyn, an economist at Deutsche Bank.

In Russia, a shortfall in private funds in light of recent market turmoil and heightened risk aversion mean that the government could ramp up in public spending on infrastructure.

According to Elena Sharipova, senior economist at Renaissance Capital in Moscow, a spending surge will make inflation — already at 15% y/y — worse, even though capital investment might in the longer term boost productivity and so ultimately help lower inflation.

But the Russian government is under pressure to spend more on infrastructure to make up for a shortfall in private capital: in the wake of the Georgia war, there is now a political premium for foreign borrowing; moreover, a shortage of available investment money has pushed up long-term funding costs for private investors.

“Contractors and developers are lobbying officials to prise open the state budget further,” says Sharipova.

“Over the last couple of months the private sector is only committing a fifth of the amount the government expected in power, road and sanitation projects.”

Nevertheless, increased government spending on infrastructure could support future economic growth which is under threat from falling commodity prices and declining private investment.

Double edged sword

Indeed, against the current backdrop of global economic slowdown, infrastructure spending is also seen as one clear way to boost economic growth. And it’s happening the world over: Taiwan announced in May that it will spend an extra T$58.3 billion on infrastructure investment over the next year. Thailand launched a fiscal stimulus package in February and a multi-year THB1.7 trillion infrastructure programme. China, too, is poised to beef up spending over the next two years to spur the economy.

But economists are increasingly pointing out that infrastructure financing sprees may be less effective than other fiscal and monetary policy responses in boosting growth in the short term, especially because of the delays typical to launching major projects.

“In the current context of slowing global growth, infrastructure projects are probably not best-suited for providing a quick fiscal stimulus, because they have a long lead time in terms of planning,” says the IMF’s Schwartz.

In China’s case, the infrastructure drive could end up aggravating structural weaknesses in the economy, says Stephen Green, Standard Chartered’s head of China research in Shanghai. Moreover, it flies in the face of more pressing development priorities: “Policy makers should channel money into supporting consumption, not infrastructure, as much as they can,” he says.

Chinese authorities are considering $31 billion of expenditure over the next year — or 0.7% of last year’s GDP, with a sizable chunk aimed at speeding up a backlog of transportation projects.

While he acknowledges that there are sectors, such as railways and power transmission, that need “a chunk” of investment, Green says that “China’s greatest need is to break its reliance upon investment and transform itself into a consumer-driven economy.”

Contingencies, liabilities

India too has adopted innovative techniques to raise private capital. In 2006 it set up India Infrastructure Finance Co Ltd (IIFCL), a special purpose vehicle under the purview of the ministry of finance. The IIFCL provides long-term loans for selected projects and raises funds from domestic sources and international capital markets.

In 2007, the IIFCL raised $550 million. This February it issued a $250 million 10-year bond at Libor to fund equipment for imports. This is part of the government’s plans to invest $5 billion of its $300 billion hard currency reserves for infrastructure development through the IIFCL.

To date, this SPV has approved loans for 22 power projects, four ports, two airports and 27 road projects, estimated at Rs12,000 crore in total, according to the Reserve Bank of India. An additional provision of Rs15 billion has been set aside from the government’s budget to act as a so-called “viability gap” fund — to finance projects with key economic benefits when private sector sponsors are absent.

The IIFCL is courting a consortium of international lenders, including Germany’s KfW for Eu280 million, $250 million from Sumitomo, Mizuho and JBIC and $600 million from the World Bank. If successful the funds raised will be guaranteed by the Indian government.

While these financing measures help ensure borrowing by the SPV is low, it raises the government’s contingent or off-budget liabilities, says Ramkishen Rajan, associate professor at the school of public policy at George Mason University in the US.

“While the SPV scheme is an innovative accounting device, for all intents and purposes, the economic consequences are identical to running an actual fiscal deficit,” says Rajan.

“India needs to be especially concerned about the size and consequences of its overall fiscal deficit since it will stand at an uncomfortably high 9% of GDP in 2009, which excludes contingent liabilities. Fiscal consolidation is urgently needed; failing which future growth may be derailed.”

The IIFCL was set up in 2006 against a backdrop of fierce currency appreciation pressures. But in the wake of recent global financial turmoil, risk averse investors have fled Indian assets, meaning that the government will have to bear the risk of any unhedged foreign currency borrowing, or offer guarantees to investors on exchange rate risks.

For Rajan, the concern is that that future government obligations are difficult to predict in standard fiscal analysis and statistics.

While economists fear the government’s infrastructure financing strategies risks further undermining the budgetary position, private investors argue that the availability of capital is not the constraining factor against investing in Indian projects.

“It is not about relying on the government for money but finding good investable projects that are well structured and getting the deal flow from public authorities,” says Rajiv Lall, head of Indian private equity firm Infrastructure Development Finance Company.

  • By Sid Verma
  • 12 Oct 2008

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