Speaking at the Institute of International Finance's (IIF) concurrent G20 conference, Hakan Binbasgil (CEO of leading Turkish bank Akbank) declared “Turkey needs to triple its roads, triple its rail and do more on aviation and maritime, as well as doubling its electricity generation and also doing more in health care, broadband, and urban development for earthquake-proneness”.
"There are critical barriers to investment, including regulatory incentives and poorly structured projects, affecting banks, insurers and other funds."
Brad Carr, Senior adviser at the Institute of International Finance
As Binbasgil's eye-catching comments allude, infrastructure is a critical enabler of economic growth for more than just the immediate construction jobs. Infrastructure creates routes to get produce to markets and the reliable generation and transmission of energy.
But the need for added investment is not unique to Turkey. Last year's joint IIF-SwissRe analysis identified a need for global annual infrastructure investment to increase by US$1.6 trillion, reaching an aggregate in new investment of around US$60 trillion over the next fifteen years.
There are, however, critical barriers to such investment, including regulatory incentives and poorly structured projects, affecting banks, insurers and other funds.
Globally, non-bank or insurance investors report their target allocation to infrastructure is 5.7 per cent of their funds under management (FUM) but their realised investment levels in 2014 were just 4.3 per cent. The reasons often cited include a bias for liquid assets (despite the long-dated liability profile of infrastructure) and a lack of “bankable” or “well-structured” projects available.
To overcome the various barriers to attracting wider private-sector investment in new infrastructure, unifying capital pools and diversifying asset risk are key factors.
As G20 host, Turkish Deputy Prime Minister Ali Babacan sought to rally G20 member governments around setting binding national investment targets to help promote global growth but he drew only a fairly muted response from his G20 peers.
To some extent, this reflects the current political dynamic. Public spending is not popular (whether in recurring spending and infrastructure investment), notwithstanding the current cheap government borrowing rates. And whilst last year's Australian G20 presidency drew favourable international attention to the model of churning the funds raised from privatised assets into new infrastructure, recent state election campaigns show this too is highly controversial even in Australia.
So leaving the public sector's funding and political challenges to one side, what can be done in policy settings to help encourage greater private sector investment in new infrastructure? As ANZ's submission to last year's Financial System Inquiry noted, there are pools of private finance available to invest in infrastructure if the practical and regulatory obstructions can be overcome.
Risk and Capital Requirements
At the IIF's G20 Conference, UBS Chairman and former Bundesbank President Axel Webber cited the required levels of capital as a deterrent for banks and insurers – both the Basel requirements for bank lending and Solvency II for insurers' investments. Whilst Solvency II is currently a European standard, the emerging global Insurance Capital Standard (ICS) will bring mandatory regulatory capital requirements on investments for all large and internationally-active insurers which could potentially cascade to domestic insurers subsequently.
Webber identified Basel's requirements for banks' infrastructure lending to assume a high level of credit risk that is not aligned with the actual historical evidence in loss rates for such assets. He proposed the Financial Stability Board (FSB) and Basel Committee should revisit this.
Webber's point was reiterated in Istanbul by Prudential's Chief Investment Officer Scott Sleyster who contrasted the infrastructure scenario of having a tangible asset and underlying concession against that of unsecured corporate lending. This view is also supported by Moody's Investors Service analysis with a 2011 study finding cumulative default rates were comparable to low investment grade or high speculative grade corporate credits while recovery rates are comparable to corporate credits despite projects' higher gearing. (Moody's Investor Service, Default and Recovery Rates for Project Finance Bank Loans 1983-2009, 17 October 2011).
These issues in regulatory capital treatments come on top of the new Basel III liquidity requirements. The combination of Basel III's Net Stable Funding Ratio and Liquidity Coverage Ratio promotes a fundamental shift in how banks manage their funding profiles, steering them away from their traditional role of 'maturity transformation' (where they borrowed shorter-dated funding and provided longer-term lending to borrowers) and towards a matched-funded profile.
In a market like Australia where banks need to 'import' wholesale funding, this has far-reaching consequences for the longer-tenor lending needed for major projects.
Outside of the regulated banking and insurance sectors, other private sector investors include pension and superannuation funds, who logically need long-dated assets to match their long-dated liabilities in funding members' retirement. This is particularly relevant for Australia, the 4th-largest pension system in the world FUM of A$1.94 trillion. (APRA, Quarterly Superannuation Performance Statistics, December 2014 (published February 2015).
Illiquidity
The liquidity issue is exacerbated in Australia by member switching requirements, encouraging funds to tilt their asset mix towards assets that can be readily traded if members exercise their rights to change investment options or switch funds. The current asset allocation of Australian superannuation portfolios is 4 per cent in infrastructure. (APRA, Quarterly Superannuation Performance Statistics, December 2014 (published February 2015).
The situation is marginally better in Canada, where funds more commonly have a Defined Benefit structure and so don't need to manage to the same member switching scenarios. Canada's 10 largest public sector pension funds invest 6.1 per cent of their FUM in infrastructure.
Projects' Structures
Another challenge is a shortage of bankable or well-structured projects. This can mean a number of things, each related in some way to a project's risk profile.
In some cases, there may be concern about sovereign risk, either in the government's terms and conditions on a project or that a government might subsequently renege on allowing market-based tolls and charges. Cases where each project might have a unique set of terms create uncertainty for investors.
There can also be commercial risk on projects where the investor is exposed to patronage – for instance in some of the cases in Australia where toll roads were built on optimistic traffic forecasts or where community mindsets are not conducive to paying a toll for a route that provides insufficient time-saving. Less commonly, it may be a project's equity tranche is too skinny and doesn't fully cover the construction risk.
Unify and Diversify
Firstly, we need to expand the depth of the investor-base for infrastructure debt, whether as bonds or syndicated loans, including the insurers and banks that Webber spoke about, as well as superannuation and pension funds. The regulatory treatments Webber cited loom large and the case for revisiting Project Finance risk-weights (as supported by the Moody's default data) warrants consideration.
It is also important barriers to capital flows across borders are reduced to promote a secondary market based on a larger, common capital pool and assets that are more fungible, as opposed to small illiquid pools that are fragmented along national lines.
As the pool of available capital is expanded, it then becomes possible to expand the suite of specific investment options and generate a viable secondary market that enables investors to trade in and out. Getting to a critical mass is a precursor for meeting more specialised investor needs.
Similarly, if projects adopt more standardised structures, terms and documentation, this not only provides greater certainty but also enables individual infrastructure assets to be more readily pooled together to enable diversification of asset risk. These could then potentially be divided into tranches of different seniority to fit various investor appetites or packaged into unitised funds.
However any single solution is unlikely to be a panacea and policy initiatives need to consider a suite of concurrent factors. But moves to help enable a larger, common pool of capital and diversification of risk would seem a good place to start.
Brad Carr is a senior adviser at the Institute of International Finance.
Photo: Resul Muslu / Shutterstock.com.
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
23 Feb 2015
11 Nov 2014