THE BLOG

To Finance the World's Infrastructure, We Need a New Asset Class

In the APEC Leaders' Meeting that is taking place this week in Bali, infrastructure features prominently. Russian President Vladimir Putin excitedly talked about his ambitious plan to re-build infrastructure in Russia, including Trans-Siberian Railway and the Baikal-Amur Mainline. Chinese President Xi Jingpin shared China's new proposal to establish an Asian Infrastructure Investment Bank. At the G20 summit last month, World Bank President Jim Yong Kim announced that the World Bank is setting up a Global Infrastructure Facility (GIF), a major new multilateral investment platform to fund infrastructure projects in developing countries. In academia, Justin Lin and Yan Wang recently proposed to establish an infrastructure-focused Global Structural Transformation Fund (GSTF).

The development and economic imperatives of infrastructure development for both developing and developed economies are strong. Nearly one in four people in the developing world do not have electricity in their home. Much of the developing world -- including two-thirds of African households -- have no household water connection and no improved form of sanitation. The regions which have underinvested in infrastructure hit inflation when growth reaches 3 or 4 percent. In a post-crisis world in search of growth drivers, infrastructure development creates jobs, increases connectivity and paves the way for economic growths in many sectors.

While the annual infrastructure financing needs of developing countries are estimated to be $1.2 - 1.5 trillion, less than half are currently being met. Private financing accounts for only less than 15 percent of the total infrastructure financing needs. At the same time, trillions of dollars of capital are sitting with pension funds, insurance companies, sovereign wealth funds and other long-term investors. These investors are desperately looking for yields from assets that are long-dated and inflation-linked.

Two schools of thoughts exist among policy makers and investors as to why the long-term capital does not flow into infrastructure. One school argues that the main problem resides with the capital. Investors may be risk-averse, e.g. preferring to have more liquid assets. Current insurance regulations, e.g., may not be conducive. Capital charges to banks may be too high. The other school believes that the main problem resides with lack of assets, i.e. there are simply not enough bankable projects in the market that investors could consider.

We believe that the most urgent problem is neither capital nor assets. We believe that we first need to fully define and construct a new asset class. Without a new asset class comprehensively defined and standardized, assets will not be efficiently created and capital will not flow. Infrastructure as a new asset class differs from the traditional equity or credit assets in at least six significant ways.

First, compared to existing mainstream asset classes, infrastructure is much more dependent on the right sector economics. The role of public finance from national government, donors and multilateral institutions is critical in many cases. The public-good nature of many infrastructure projects calls for contingent government obligations such as universal coverage levels for basic services or tariffs that are below cost recovery levels. An economically beneficial infrastructure project by itself may not necessarily be attractive to commercial investors. Economic externalities should be internalized, and there needs to be a bridge between the internal rate of return (which matters to a commercial investor) and the economic rate of return (which matters to the broader economy).

Second, this new asset class calls for unique ways to supply new assets to the market. The process of preparing infrastructure projects is complex. Their gestation period is long. In many cases, governments need to set up commercially-minded, quasi-public agencies to get line ministries to act collaboratively so that project proposals can be developed. Private-sector sponsors should be given room to bring the creativity and proactivity of markets to identify and initiate projects, instead of being told to wait for the next tender by the government.

Third, we need to define the unique risk/return profile of this new asset class. On the risk side, due to the inherent role of the public sector in infrastructure, political and other non-commercial risks are common; investors should factor those in and look for mitigation mechanisms. On returns, expecting infrastructure to deliver the traditional private equity return, at 20 percent or more, is unrealistic and socially unacceptable -- again, given the public good elements of infrastructure services. Trying to achieve a return that is unrealistically high for this asset class may, for example, lead investors to try to negotiate overly favorable concession terms and then find themselves under political attack later on, risking a breach of contract by a new government. On the contrary, looking at infrastructure as an independent asset class with its unique set of risk/return trade-offs would allow investors and financiers to take measured risks, mobilize risk coverage when necessary and expect reasonable returns.

Fourth, infrastructure as a new asset class has its own life cycle, with feasibility, construction and operational stages each bearing its own risk and liquidity features, thus attracting different sources of financing. Funding from multilateral funds such as GIF -- and the use of their balance sheets for new risk instruments -- could bridge these phases of the life cycle and allow lower risk investors to take out financing when higher risk periods have passed.

Fifth, infrastructure investment calls for a full set of technical expertise that is more complex than investing in most existing asset classes. Most long-term capital holders such as pension funds are unlikely to have the expertise already in place in house. To recognize that infrastructure is a new asset class is also to recognize that investors need to develop the corresponding expertise.

Finally, as with other asset classes, infrastructure will need its own ecosystem of players, including in particular effective and specialized intermediaries. Today, as infrastructure is not yet recognized as a full asset class, intermediation of infrastructure transactions is highly fragmented. Private equity funds, project finance banks, merchant banks, financial advisors, legal advisors, multilaterals, project promoters, government line ministries, planning ministries, finance ministries, PPP centers and investment promotion agencies (just to name a few) are doing a small fraction of this work, resulting in chaotic and highly inefficient and costly intermediation.

A sizeable, global infrastructure platform like GIF that could make use of public and private capital and that has the ability to combine funding, knowledge, advisory services and credibility would play a catalytic role for this new asset class to emerge and to be further defined.

Infrastructure as a better and comprehensively defined asset class as detailed above -- with enhanced visibility and a standardized return profile and risk allocation -- will be better placed to make use of public and multilateral funds while attracting the right sources of private investment and financing. It would find a home for the trillions of dollars of patient capital that is currently hunting for yield. It would also allow power to switch on, clean water and sanitation to be more accessible, people and goods to move more freely, jobs to be created, and economic growth to be sustained.

Justin Lin is the Honorary Dean of the National School of Development, Peking University and former Chief Economist of the World Bank. He is also Vice Chairman of the All-China Federation of Industry and Commerce.

Kevin Lu is the Asia Pacific Regional Director of the World Bank Group's Multilateral Investment Guarantee Agency. He is also a member of the World Economic Forum's Global Agenda Council on China.

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