On why long-term investors should fund infrastructure
Investing in developing country infrastructure is a win-win strategy for long-term investors
Note: A version of this piece was first published as a Featured Article in the OECD DAC Newsletter
The world faces two major financial problems for which, luckily, there is an attractive common solution. This might be just the right time for taking the first steps towards implementing it.
The first problem is the scarcity of capital in general, and of money for infrastructure investments in particular, in large swathes of the developing world. It is widely recognised that poor infrastructure holds back development, reduces growth potential and imposes additional costs, in particular on the poor who often do not have access to energy, water, sanitation and transport.
The second problem is the current sclerotic, even negative real rate of return on listed bonds and equities in many developed economies. The concentration of the portfolios of many long-term investors in such listed securities also exposes them to high levels of systemic, and often hidden, risk.
Developed economies have substantial financial and economic inter-linkages with each other. Moreover, they are exposed to common risk factors, such as demographic decline and elevated public and private debt. This leaves large investors such as the Norwegian Sovereign Wealth Fund, which invests more than 90% of its portfolio in listed OECD securities, in highly vulnerable positions. They have locked-in low returns for what is an inordinately high level of risk.
So how are these problems connected?
Most long-term investors, including pension funds, insurance firms and sovereign wealth funds would greedily buy up chunks of well-diversified portfolios of infrastructure assets in non-OECD countries. Not only would this offer a significantly higher rate of return, but it would also diversify investors away from some of the excessive exposure in structurally similar OECD economies. The long-term nature of the investment would also match the long-term liability structures of such investors.
At the same time, developing economies such as India, are desperately short of the kind of long-term finance that is necessary to fund infrastructure. In many countries neither governments nor private domestic markets have the capacity to fully fill this funding gap. Funding for infrastructure must also come from outside investors.
But what about risk?
It is true that developing countries pose, on average, a higher degree of policy uncertainty and political risk than developed ones. It is also true that investing in infrastructure means that investors will find it hard to pull their money out on short notice so such investments pose liquidity risk. However, three significant caveats are important here.
First, the events of the past few years have demonstrated that on average, political risk and policy uncertainty in developing countries have both fallen, even as they have risen in OECD economies. About a third of my friends who worked on political risk analysis in emerging and frontier economies have been hired away to work on OECD-country political risk. It is fair to say that the gap in political/policy risk between developing and OECD economies is diminishing.
Second, financial risks in developing countries are well known and often assumed to be much higher than in OECD economies. The truth, however, is more complicated. It is OECD economies that are particularly exposed to serious risk factors such as high levels of indebtedness and demographic decline. Moreover, as the financial crisis demonstrated, they are also likely to face other “hidden” systemic risks not captured by commonly used risk models and measures. Hence, the differential between the financial riskiness of developing economies and OECD countries is less than commonly assumed.
Third, the kind of risks that dominate in developing countries, such as liquidity risks, may not be real risks for long-term investors, who don’t need liquidity. Given that the present portfolios of these investors are dominated by OECD-country investments, any new investments in the developing world look more attractive and may actually offer a reduction of risk through diversification.
Given the arguments provided above, one might ask why is it that long-term investors are not investing in developing country infrastructure in a big way?
The biggest constraint is the absence of well-diversified portfolios of infrastructure projects, and the fact that no single investor has the financial or operational capacity to develop these. Direct infrastructure investment, particularly in developing countries, is a resource-intensive process. Also, because exposure to large fractions of a few infrastructure projects is risky, most investors do not have the capacity to actively cultivate such projects. This situation, however, could be easily remedied, as there are international institutions capable of addressing these problems.
The G-20, together with the OECD and multilateral development banks, should address this collective action problem as a matter of urgency. There is an urgent need to launch a program to facilitate the development of a diversified infrastructure project pipeline in developing countries. Simultaneously, they need to ease the participation of long-term investors in funding these.
Since this work involves challenges of co-ordination more than commitments of scarce public funds, it is the most appropriate way forward in times of austerity and risk-aversion. When the rare opportunity to kill two birds with one stone arises, it must not be squandered.
Sony Kapoor is Director of the International Think Tank Re-Define and a Senior Visiting Fellow at the London School of Economics. He is also the strategy adviser to the Systemic Risk Centre at the LSE