Infrastructure Development Could Use a Helping Hand

Infrastructure fosters opportunities, increases productivity, creates jobs, and contributes to economic growth. Roads and trains connect villages to cities, enabling mobility of people to more productive areas; broadband connectivity provides access to financial, health and education services through hand-held devices, even in remote locations.

In spite of its many benefits, one of the most acute problems for infrastructure development remains the availability of funds needed to close the multi-trillion-dollar financing gap. Closing this gap requires mobilization of vast sums of capital from private sources. Even so, the Global Infrastructure Hub estimates that for the past seven years, private investment in infrastructure has remained stagnant, and lower than it was 10 years ago.

Private financiers argue that the under-investment is driven by a lack of bankable projects. Put simply, there are not enough projects that are financially viable, from a risk-return perspective. This argument underscores both micro and macro level challenges.

At a micro level, the risks inherent in a typical infrastructure project tend to reduce over the project life cycle. The construction stage requires capital expenditure, whereas revenues start to trickle in only during the operational stage. Naturally, the appetite to finance projects follows an inverse trend, with more attractive financing available as risks reduce. The construction stage is susceptible to risks such as delays in project completion, cost overruns and hurdles with receiving governmental approvals, permits and licenses. On the other hand, risks in the operational stage are primarily based on the realization of projected demand, such as the number of daily commuters in a subway. Indeed a report by the World Economic Forum, based on a global survey of infrastructure investors, identified construction risk as one of the top three risks in emerging markets that would benefit from a ‘risk mitigation instrument’. 

At a macro level, infrastructure financing tends to depict cyclical patterns, i.e. financing is easily available during good times, but expensive during bad times due to an increase in risk aversion. This creates challenges for the sector that is characterized by projects of long maturity, which typically span multiple economic cycles. Such risk aversion typically derives from regulatory capital treatment for infrastructure investments that require banks to set aside large amounts of capital, thus reducing their capacity to invest and often manifesting in higher lending rates. This issue is particularly exacerbated during downturns, when bank margins are already under pressure from higher provisioning requirements due to credit deterioration in their loan books. While the Global Infrastructure Hub began examining the impact of regulatory capital charges on infrastructure investment in 2019, reforms on this front are not imminent.

For these reasons, even though infrastructure investments are hugely beneficial for the economy, they suffer from market failure. Micro and macro risks lead to under investment from the private sector. Resolving the market failure requires some level of state support to attract much-needed private sector investment, by improving the risk-return profile of the sector. Such an enabling role by the state can be two forms designed specifically to address micro and macro challenges. 

To start with, the state can address micro level challenges by supporting the completion of construction stage activities. Such support can come either in the form of funds or partial risk guarantees that fall away after projects reach operational stage. With the risk profile mitigated sufficiently, the private sector may be more amenable to take over remaining financing requirements. This would be akin to the state playing the role of an anchor investor or an early-stage incubator.

Elements of this model underlie India’s recently launched asset monetisation scheme, which envisages catalytic state support for a national pipeline of assets. Early-stage public investment acts as risk mitigation for construction risks and regulatory risks (such as approvals for land acquisition and other licenses). Once assets reach operational stage, these are transferred from public hands to private hands, on commercial terms. This creates a circular ecosystem of financing, wherein public funds are recycled from one project to another, while also generating positive returns for the state.

This widely-used global practice of capital recycling reaped positive results for India's infrastructure sector in the first year of its operation. The annual target INR 88,000 crore (roughly USD 11 billion), for the financial year ending March 2022, was exceeded with the successful transfer of assets across road, power and mining sectors, among others. 

Addressing macro level challenges is arguably more difficult. The main objective here is to ensure that the flow of infrastructure financing remains steady across economic cycles - through crests and troughs.

One way is for the state to plug gaps whenever they materialize. This typically happens during downturns, when the state uses its own fiscal capacity to allocate higher spending towards the infrastructure sector. A trend that is underway with the recent approval of post-pandemic stimulus packages in United States, United Kingdom and the European Union.

Another way is to adopt a more holistic approach, wherein the state creates institutional mechanisms to support cross-cyclical financing. This includes the formulation of an optimal mix of commercial and development-oriented financing channels, with the two channels acting in complementary ways. Compared to commercial institutions, national development-financial-institutions (DFIs), and multilateral-development-banks (MDBs) keep the financing tap flowing during downturns. They are also more amenable to provide financing for longer maturities and for more complex project-finance type transactions.

India bolstered its institutional mechanism recently with the establishment of a new DFI, after a hiatus on nearly two decades. The DFI is expected to not only extend long-term non-recourse loans but also support the development of the bonds and derivatives market, another component of the holistic approach.

The market failure in infrastructure investment seems particularly striking when one takes into consideration the vast amounts of funds lying with long-term investors such as sovereign wealth funds, pension funds and insurance companies. It is incredible that allocation of private capital in infrastructure marginally reduced over the last decade even as allocations increased in riskier avenues such as cryptocurrencies and private equity.

State-driven initiatives, such as those highlighted, can help to improve the risk-return profile of the sector and resolve the market failure. If policymakers consider the provision of infrastructure as a ‘public good’ on account of its positive multiplier effects on growth and jobs, the state’s role as an enabler may be more than welcome.

 

Views expressed by Sidharth are personal and do not necessarily represent the views of his employer.