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If You Build It, Will They Come?

manuel_montes-tnConsumption[If the G20 Builds Platforms for Trading Infrastructure Assets, Will Investors Care?]

 

 

Is Infrastructure Investment a Win-Win Solution?

On the face of it, the highly touted global effort to mobilize significant financing from pension funds for infrastructure investment in developing countries is a proverbial win-win.

Even as developed economies expected to be in the doldrums for perhaps a decade, developing countries have been estimated to require as much as an additional trillion dollars per year (doubling the current level of spending) in (non-energy) infrastructure in the coming decade.  Clean energy investments could absorb about half a trillion more.

Infrastructure investment is important for development.  Properly planned construction creates employment for the poor, facilitates new economic activities, and upgrades the quality of life in developing countries. This is potentially the first win.

The ongoing global financial crisis itself represents the possible basis for the second win. Pension funds, whose source of funding is long-term, are anxiously searching for safer ground, looking for long-term investments to “de-risk” their portfolios. To quote the first few paragraphs from a 22 March Financial Times article[iii]:

For the people in charge of the world’s largest pension plans, the past 15 years has been a Las Vegas drama in slow motion. Many of them would like nothing more than to retire from the table – and this year many of them will be close enough to break-even that they can consider doing just that.

Retiring from the table, in this analogy, means being able to pull a lot of their pension pot out of risky assets, such as equities, which have endured two bear markets since the start of the century, and instead invest the money in safer bonds.

Unlike many investors, whose aim is to maximize returns, the managers of defined benefit pension plans have a different priority. Theirs is to make enough money to meet the promises they have made to employees, and then to sleep at night.

Given the elevated infrastructure needs from developing countries for years to come, it would seem that finding a mechanism to channel pension funds to finance such projects is a solid basis for the second win.

Indeed, it is likely that proposed new institutions are banking on this fact.  This year, the World Bank is seeking to launch a Global Infrastructure Finance Facility (GIFF) and the Asian Infrastructure Investment Bank and BRICS Bank may not be far behind.  These new institutions as well as existing ones that are re-orienting their businesses to promote infrastructure investment intended to attract long-term private financing in exchange for off-setting their risks. International labor federations have expressed support for their pensions being invested in developing country infrastructure.  Infrastructure development is a key inspiration for the proposed BRICS international development bank.

Especially since its 2012 Mexican and 2013 Russian Summits, the G20 has elevated this topic of “financing for investment” (particularly in infrastructure) to the top of its agenda.  A G20 study group has called for a “G20-sponsored convening of pension funds” with the participation “beyond managers to include key trustees, CEOs and/or CIOs, the infrastructure fund managers that the pension funds themselves work with, as well as investment consultants and union leaders where relevant”[iv].

G20 Illusions

Why would G20 orchestration be needed at all? In this suggested extra-market convening, have we managed to find the storied Invisible Hand in the G20?   Shouldn’t market incentives be sufficient to channel pension fund resources to the infrastructure needs of developing countries?

Decades of financial deregulation have in fact made it impossible for developing countries to receive the kind of long-term funding for infrastructure they need.  Financial institutions have gotten out of the business of evaluating the risks of proposed projects.  Instead, they seek to “package” these projects into bonds which can be sold to savings pools, including pension funds.

Among the managers of savings pools – including pension funds — “short-termism” prevails because their performance is measured by their quarterly results.  Indeed, it is not surprising that, from quarter to quarter, individual fund managers (along with their “herd” of fund managers) hop from financial asset to financial asset in an effort to maximize their returns.

A background study for the ongoing discussions in the United Nations on financing sustainable development suggests that volatility and short-termism now prevail in the financial sectors of both developed and developing countries. In its executive summary, this UN study says “In the United States, for example, the average holding period for stocks fell from about eight years in the 1960s, when investors were more long-term oriented, to approximately six months in 2010.”[v]

This UN study suggests that “misaligned incentives, such as short-term oriented compensation packages,” . . . “present impediments to long-term stable investment.”

The G20 proposes that pension fund managers begin to think of infrastructure investment in developing countries as a new “asset class.” But do pension fund managers have the technical capacity to analyze the risks associated with directing their money into less liquid, more long-term infrastructure projects?

Because of limited technical capacity, much of the new pension interest in infrastructure is being channeled through private equity and hedge funds, the most agile operators in today’s financial markets.  With their fee structure (four percent management and 20 percent performance fees), hedge fund managers are “licking their chops” over the “discovery” of a new “asset class.” This is fair warning to friends in labor unions about the safety of their pension savings as they try to support infrastructure investment in developing countries.

The fashionable thought is that infrastructure needs to attract large financing flows to promote development and, therefore, it is essential to persuade “the private sector” to increase their investments in developing countries.  But this premise is defective.    There is no need to persuade the private sector to put money in the developing countries. The private sector is already “investing” huge amounts in emerging developing countries – about $400 billion per year (net financial inflows) before and after the onset of the global financial crisis.

But, infrastructure projects are not suitable for private funds’ “short-term” investment imperatives. As noted above, private investments in developing countries mainly consist of short-term asset positions driven by rapid changes in the mood of global investors.  In 2007, emerging market countries experienced private sector incoming flows of $1.2 trillion and outgoing flows of $825 million for net inflows of $460 million.  In 2010, the equivalent figures were $908 million incoming and $500 million outgoing, with net private capital inflows of $408 million to developing country emerging economies.  This simultaneous and frenzied level of to-ing and fro-ing can prove unnerving in the small economies and foreign exchange markets of developing countries.

The G20 insists that an open and enabling business environment will succeed in attracting and retaining investment flows.  This is a “coded” policy message calling for the removal of capital account regulations.  This policy is misguided since, capital account regulations are not meant to cage in external investors or rich locals with connections to invest abroad.  They are needed to maintain a sound domestic financial sector.  These regulations also nurture a long-term investment climate by containing the adverse impact on national exchange and interest rates of international private mood swings and developed country policy pivots.

Towards Real Solutions to Infrastructure Under-Investment

Why is the G20’s Invisible Hand attempting to manipulate markets?   It is because institutional features of today’s international financial markets obstruct the intermediation of long-term pension fund savings into long-term infrastructure projects.  As long as the “regulation” of international financial markets permits short-term, asset-hopping on the part of investors, G20 efforts will fail or fall dramatically short of expectations.  If the G20 builds platforms for trading infrastructure funds, the investors will not come, even if pension funds’ “key trustees, CEOs and CIOs”[vi] are called into the meeting.

Could the G20’s interest in promoting infrastructure investment be a smokescreen?  One that obscures its underwhelming performance in working with the Financial Stability Board (FSB), an institution that the G20 created to redesign financial regulation.  Re-regulation is needed for financial markets to make these markets, once again, assume their role in the real economy of providing upfront the money needed for long-term infrastructure investments.  But, from all appearances, the FSB is not up to the job.

For developing countries, the volatility of private capital flows has been extremely costly.  Developing country authorities are spending massive sums of money for the sole purpose of building their foreign exchange reserves, which protect them against volatility and fend off exchange rate appreciation (especially in the backwash of successive waves of quantitative easing).  For instance, in the periods 2004-2009 and 2010-2014, developing country authorities bought an average of $660 billion and $643 billion respectively a year of developed country financial assets.

Before thinking of a new international asset class to promote infrastructure investment, we need to consider how international regulations can help developing countries channel their own financial resources into their own infrastructure investments. For example, more robust capital requirements in global financial centers can reduce the volume of leveraged short-term portfolio positions in developing countries which have created destabilizing swings in exchange rates. Better oversight and supervision of shadow banking will reduce the volume of undocumented capital flows and help developing countries draw up effective capital management regulations.

Towards Equitable Risk-Taking

If one still insists that private pension funds must invest in developing country infrastructure, what kind of public guarantees, insurance schemes, and subsidies will be required to attract them and dispel their short-term funk?  How generous must these guarantees be?  Will it be necessary to transfer most of the risk to public entities (i.e., taxpayers and citizens) to mobilize pension fund financing for developing country infrastructure?

It is fair to warn developing country governments that any guarantee and risk-sharing arrangements with the private firms will quickly turn against them when infrastructure projects fail.  Developing countries have decades of experience with debt crises. The recent experience in Spain[vii] only confirms, that – in the absence of equitable methods of bailing in creditors– national governments are the sole risk holders of external financing.

Inadequate money for project preparation is often cited as an explanation for inadequate infrastructure financing. Good design is important. Infrastructure investment is highly risky, but there are many ways to make it much less risky without exempting pension funds from sharing the cost when things go wrong.

How can infrastructure investment be less risky?  It is crucial to minimize the currency mismatch in projects. As much as possible, projects should use foreign currency financing only to pay for imported goods and services.  Relying more on domestic currency financing will require upgrading the domestic financial sector, but this is a desirable end in itself.

In almost all developing countries, this will require the revival of national development banking.  Such domestic intermediaries would perform better in project identification, design, and implementation than external intermediaries. As a development bank, itself, the World Bank has spent decades arguing against national development banks; it is time to change this stance. The presence of national development banking intermediaries produces many co-benefits.  For example, under the United Nations’ climate change framework, the newly established Green Climate Fund (GCF) will be deploying funding for mitigation and adaptation in the developing countries.  Development banks with capability in developing countries to undertake long-term projects can serve as effective intermediaries in this global effort.

Sound infrastructure projects are those which provide affordable services to domestic users.  In the coming years, with a sluggish and uncertain international economy, serious consideration must be given to projects that are less dependent on exports and more dependent on the growth of domestic incomes.  Also, climate resilient projects should have priority, since their debt financing can be repaid over the long-term.

Meanwhile, megaprojects should be avoided.  While they might enjoy economies of scale, they seldom benefit the poor.  Moreover, they can dislocate and damage the interests of affected communities and harm the natural environment. Project identification is recurrently successful when women prioritize investments, such as in providing water and sanitation services in low income areas.

The G20’s “Invisible Hand” attempt to manipulate markets is misguided.  It is unlikely to solve the dilemma facing pension funds or usefully meet the infrastructure needs of developing countries.  The G20 needs to shift its direction and face the pressing need to re-regulate international finance.  Until it takes steps to do so, global financial volatility and imbalances will plague the developed and developing world and the promise of infrastructure will remain a mirage.

If the objective is to expand the scale of infrastructure investment in developing countries as a matter of development partnership, the international community could not start in a better place than to address systemic shortcomings in the global economic and financial architecture that gave rise to the current crisis.  One place to accelerate this is in the current intergovernmental negotiations in the United Nations toward a strengthened and expanded Global Partnership for Development.[viii]

 



[i] The title is a quote from the 1989 movie “Field of Dreams” in which a farmer prophecied  that, if he built a baseball diamond on his land, crowds would come to see famous, long-gone stars play the game.

[ii] Senior Advisor on Finance and Development, the South Centre. I am solely responsible for all errors, opinions and analyses.  Email: montes@southcentre.int.

[iii] See Financial Times (2014) “US pensions pick up the pace in race to de-risk” by Stephen Foley, 24 February 2014.  (available in http://www.ft.com/cms/s/0/0f8afaea-9d2b-11e3-83c5-00144feab7de.html).

[iv] CGD Study Group (2014) “Five New Deliverables for the G20’s Infrastructure Agenda Infrastructure Agenda, Centre for Global Development, Washington DC, (available at http://www.cgdev.org/sites/default/files/Five-New-Deliverables-G20.pdf).

[v] United Nations (2014) UN System Task Team on the Post-2015 UN Development Agenda, Working Group on “Financing for sustainable development” Executive Summary, (available at http://sustainabledevelopment.un.org/content/documents/2091Executive%20Summary-UNTT%20WG%20on%20SDF.pdf)

[vi] CGD Study Group (2014) “Five New Deliverables for the G20’s Infrastructure Agenda Infrastructure Agenda, Centre for Global Development, Washington DC, (available at http://www.cgdev.org/sites/default/files/Five-New-Deliverables-G20.pdf).

[vii] In Spain, municipal governments borrowed from German, Dutch, and French banks for infrastructure and building projects.  The national government had to assume this debt and its servicing when the financial crisis struck.

[viii] See paragraphs 34 and 35 of “The Future We Want” (United Nations 2012, available at http://sustainabledevelopment.un.org/futurewewant.html) and  http://www.un.org/millenniumgoals/global.shtml

 

This article was published in E-Newsletter: G20 AND BRICS UPDATE (April 2014) by Heinrich Böll Foundation

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