Higher yields in emerging markets should compensate for greater infrastructure risks. But, as Christopher O’Dea writes, do not underestimate the risks
Investors need to adopt an entirely new way of thinking about risk when financing emerging market infrastructure projects. When all risks are accounted for, the higher yields offered in emerging markets often look less enticing and pricing in developed markets looks less aggressive. A host of factors can impede infrastructure projects in emerging markets from the earliest stages of obtaining permits to the ongoing operation of assets under purportedly stable concession agreements.
On top of pure project economics, infrastructure investment in an emerging market comes with the risk that a change in political rule might divert funds from one sector to another, potentially impairing work in progress or changing the operating economics of a project. Regulators, often semi-autonomous bureaucracies, can also change safety rules, terms of road, airport and other concessions, again introducing potentially deal-threatening revisions in the terms of both greenfield and brownfield infrastructure. Reform programmes, which are usually well-intentioned efforts to modernise infrastructure and streamline the procedures that govern the provision of essential services, too often become mired in horse-trading between business, government and unions, each seeking to improve its position.
Despite these impediments, there is a need for private capital to fund infrastructure in the emerging markets, especially in Southeast Asia and India. While this presents an opportunity for long-term investors, it is imperative that investors take all risks into account when deciding where – and whether – to invest.
“Emerging market infrastructure isn’t something that financial investors intuitively understand,” says Jim Barry, managing director and global head of the Infrastructure Group at BlackRock. “The risk is idiosyncratic, and differs country by country depending on the level of the rule of law, political and regulatory risk, sovereign credit risk and other factors you have to assess at the country level.
He adds: “The challenge with emerging markets is that when you overlay the country situation on an asset, it’s not necessarily an infrastructure investment anymore.”
The distinction between an asset and investment hinges on several factors, Barry says, the most critical being the host country and its legal and regulatory regimes, the asset’s position in the lifecycle for its respective sector, and the contractual terms governing operations, revenue, finance and maintenance costs.
The Asian Development Banks estimates that $730bn in infrastructure capital is needed in Asia per year for the next decade. McKinsey and the Council on Foreign Relations estimate that India alone requires more than $1trn of investment in infrastructure over the next five years, as the country’s inadequate transport, energy and water infrastructure prevent its economy from growing at a greater pace.
However, according to a report by S&P Ratings Direct on Asian private infrastructure investing, “actual private investment remains limited”. S&P says: “Investors remain concerned about the institutional, legal, and regulatory frameworks in most countries.” In a study on doing business in emerging markets, the World Bank Group highlighted two factors that are critical for success: the time to obtain permits, and the time and cost of enforcing contracts in the event of a dispute during the operating phase of a project. The report found that major emerging countries were at a distinct disadvantage as an investment destination.
The World Bank says it took an average of 182 days to obtain construction permits in India, 210 days in Indonesia, and more than 120 in the Philippines, compared with under 20 days in Australia and under 30 in Malaysia. There are real costs associated with those delays. The Bank says the additional time and cost of obtaining permits in India could reach 28% of the construction value of a project. For a $1bn project funded 80% with debt, investors would also have to bear an additional 3.14% of the total building cost as a contingency fund, S&P says, compared with just 0.22% in Australia. Infrastructure projects carry liquidity reserves to cover potential disputes – to cover the interest and other costs associated with an assumed 10% claim, an Indian project would require an additional contingency of about 17% of construction cost.
S&P concludes that “the cost of a project encapsulates not only the direct cost of building and operating but also adequate contingencies against known risks”. As a result “risk allocation between the public and private sector can have a significant impact on the overall economics of a transaction, and could lead to materially different outcomes”.
India is a good example of the political and regulatory risks associated with infrastructure investing. Prime minister Modi’s sweeping economic policy and regulatory reforms were aimed at clearing away the laws and bureaucracy that slow investment. Following the spring sessions of the Indian legislature, it looks increasingly like potential investors will have to settle for limited streamlining of administrative procedures, and rely on commitments by pro-Modi ministers to use leniency in applying some of India’s most onerous statutes, such as the law allowing retroactive taxation, which is a major cause of uncertainty for foreign investors.
“There is an enormous need for private capital to fund infrastructure in the emerging markets”
Early optimism that Modi’s election would lead to changes has given way to the reality that infrastructure investing might continue to be a rocky road. Modi’s biggest challenge was to succeed in his effort to reform land laws to make it easier for the government to acquire rural land needed for infrastructure projects. The opposition Congress party branded the initiative an anti-farmer policy. The epithet stuck in this largely rural nation and, after prolonged, heated debate this spring, India’s parliament failed to pass the land reform bill.
Political factors can make or break an emerging market’s potential as an investment destination, according to Christopher Garman, head of country analysis at Eurasia Group, the risk research and consulting firm. Eurasia Group says all developing countries are struggling with the effects of the end of an emerging-market super-cycle that will slow growth just as nascent middle-class populations start demanding better housing, wages and infrastructure.
But some infrastructure projects are moving ahead. Brazil, for example, and despite the widening Petrobras scandal, is offering 15 new management concessions for regional airports to private investors in the next two years. The concession terms are expected to be changed to allow infrastructure operations and investors to earn better returns from ongoing operations, Garman says. The changes reflect recognition of what is needed to attract global private capital, as well as the impact of the Petrobras scandal on Brazil’s construction sector, he adds.
The first wave of Brazilian airport concessions offered low IRRs, with local construction firms garnering most profits from building rather than from airport operating revenue that attracts institutional investors. Now mired in the Petrobras scandal, the construction firms have no access to international capital markets, some executives are in prison, and it is not clear which firms will survive, Garman says. So Brazil’s Civil Aviation Ministry is trying to attract foreign capital and untainted second-tier Brazilian contractors.
Emerging nations want to attract passenger and cargo flights, while mitigating capital flight out of their countries. But regulatory and political uncertainty continue to pose a threat to private capital even in countries that need large amounts of inbound investment to build or upgrade essential infrastructure. Last spring, the Airports Economic Regulatory Authority of India told Frankfurt-based airport company Fraport that it was reducing the charges for using the Delhi International Airport (DIAL) by 78%. Fraport holds a 10% stake in DIAL, which was formed in 2006 to modernise Delhi’s airport.
The tariff reduction would erase DIAL’s net worth, Fraport says, in its challenge to the proposal, which would affect the second five-year tranche of the joint venture. The move highlights the risks investors face when deploying capital abroad. Fraport has said that honouring the concession agreement “is a very important issue not only for us but for all private airport operators and investors”.
With Modi’s land reforms stalled, sudden changes to major infrastructure contracts will not encourage private investors to invest. Unless the concession agreement is honoured, Fraport says, “investors in airport and other large-scale infrastructure projects may be deterred from putting their money into India”.