Infrastructure’s class of its own

AFTER SEVERAL months of disappointing economic indicators, China’s State Council has unveiled a “mini-stimulus” package, focused on social-housing construction and railway expansion. The decision came a month after Premier Li Keqiang’s declaration that China had set its annual growth target at “around 7.5%” – the same as last year’s goal. The implication is clear: While consumption-driven growth remains a long-term goal for China, infrastructure will continue – at least in the short term – to serve as a key driver of China’s economy. Of course, China is not the only economy that depends on infrastructure investment to buttress economic growth. The World Bank estimates that infrastructure investments accounted for nearly half of the acceleration in Sub-Saharan Africa’s economic growth in 2001-2005. According to the Bank, a 10% increase in infrastructure investment is associated with GDP growth of 1%. Such investment also creates jobs, both in the short term, by creating demand for materials and labor, and in the long term, for related services. For example, every $100 million invested in rural road maintenance translates into an estimated 25,000-50,000 job opportunities. But these benefits are diluted in China, owing to its excessive reliance on public funding. Indeed, in recent years, less than 0.03% of Chinese infrastructure investment – which amounted to roughly 9% of GDP – was derived from private capital. This problem is not limited to China; of the 7.2% of GDP that Asian countries spend, on average, on infrastructure development, only about 0.2% is privately funded. By contrast, in Latin America and the Caribbean, private capital finances, respectively, 1.9% and 1.6% of infrastructure investment. Discussions within the G-20 have produced two possible explanations for Asian countries’ inability to attract more private capital to infrastructure projects. Most developing countries argue that the problem is rooted in the provision of capital, with investors preferring to fill their infrastructure portfolios with low-risk projects, and insurance companies and banks facing overly restrictive regulations. OECD countries like Germany counter that the problem is the lack of investment-worthy assets; there are simply not enough bankable projects available. In fact, both explanations are correct – but neither is complete. It is time for Asia’s leaders to recognize that the lack of private funding for infrastructure projects cannot be reduced to one or even two problems, and to develop comprehensive solutions that account for the full scope of the challenge. This requires, first and foremost, abandoning the view that infrastructure assets fit into the paradigm of traditional asset classes like equity, debt, or real estate. Infrastructure must be redefined as a new asset class, based on several considerations. For starters, there is the public-good element of many infrastructure projects, which demands contingent government obligations like universal coverage levels for basic services. In order to make such projects more appealing to private investors, economic externalities should be internalized, and a link should be established between the internal rate of return, which matters to a commercial investor, and the economic rate of return, which matters to society. Moreover, innovative mechanisms to supply new assets to investors would be needed – and that requires the creativity found and priced by markets. To this end, private-sector sponsors must be given space to initiate valuable projects. The new asset class would need its own standardized risk/return profile, accounting, for example, for the political risks that public-sector involvement may imply and for the lower returns from infrastructure relative to traditional private equity. Moreover, the risks associated with the new asset class would change as projects progress from feasibility study to construction to operation, implying that each phase would attract different sources of funding. A clear understanding of this process would enable potential investors to assess projects more effectively, which is critical to encouraging them to put up financing. Another important consideration is the considerable technical expertise that infrastructure investments demand, which makes them more complex than most assets. Similarly, a specialized network of actors would be needed to ensure that intermediation of infrastructure transactions is efficient and cost-effective, instead of fragmented and slow, as it is now. For countries that lack China’s strong fiscal position, the need to attract private capital to infrastructure investment is obvious. With nearly 70% of Sub-Saharan Africa’s population lacking access to electricity and 65% of South Asians lacking access to basic sanitation, there is no greater imperative than to plan, fund, build, and maintain infrastructure assets. But private investment in infrastructure remains vital even in countries like China, because it brings the power and dynamism of the market, which improves the allocation of capital and promotes transparency. Indeed, more private-sector involvement would make the kind of scandals that have occurred in China’s railway sector far less likely. In short, redefining infrastructure as a new asset class is the only credible way to attract funding for infrastructure construction, and thus to boost long-term economic growth and the employment rate. It is time for Asia’s leaders to step up. Kevin Lu is a distinguished fellow at INSEAD Global Private Equity Initiative and a managing director at Partners Group, a global private equity firm Justin Yifu Lin, a former chief economist and senior vice president at the World Bank.