Addressing Asia's Infrastructure Financing Gap

4.1. Countering the Financial and Economic Turmoil

In addition to the major challenges of financing infrastructure for future growth and improving the lives of over two billion people, Asian and Pacific countries are facing headwinds from the ongoing global financial and economic turmoil. The turmoil makes raising needed funds more difficult, private sector investment is threatened in the short term and public finance is more difficult. But it also increases the importance of infrastructure investment. If private flows of credit for infrastructure decline, governments and MDBs can look to infrastructure investments for stable, long-term, and countercyclical investments. Also, the need for infrastructure services as part of the social safety net in hard times might make it an even more important priority. Thus, the crisis may change the nature of the challenges in building infrastructure networks, but the needs for infrastructure are as, if not more, important than ever. For example, the stimulus package announced by PRC in 2009 totaling US$586 billion had important infrastructure components—rural infrastructure, roads, energy, railroads, and airports. A package announced in 2008 planned to spend US$292 billion for railway development alone. Moreover, components of the package dealing with social welfare, such as education and health care, are likely to include an infrastructure component in the form of construction of new facilities (IFCE 2009; FAITC 2009).

The global turmoil and economic slowdown will hurt the finances of Asian and Pacific countries. If exports drop and economic activity slows, total savings in the region will fall, government tax revenues will decline, and additional expenditure for social security is likely. Funding for infrastructure will face stiffer competition from such other needs. At the same time, global investors see their investable funds decrease, leading to drops in capital inflows for portfolio investments and direct investment, and possibly shifts in capital outflows.

However, the special properties of infrastructure as long-term, steady investments that can offer investors lucrative returns make it suitable for countercyclical investment. Governments and multilateral lenders should accelerate infrastructure investment (compatible with overall economic fundamentals) as a countercyclical tool and support long-term economic activity. The returns on such investment will support future economic growth when conditions begin to improve. Moreover, there is potential to continue drawing in private investment from institutions, such as pension funds, that need outlets for long-term investments and, with the proper incentives and prospects for good, long-term returns, infrastructure investment may be seen as a favored investment in turbulent times. Additionally, the global crisis has significantly affected Asia's exports to advanced economies. Investing Asian savings for Asian regional connectivity can assist in rebalancing Asia's growth from high export dependency on advanced economies to enhanced regional demand and consumption through increased intraregional trade and cross-border investment.

4.2. Utilizing Asian Savings for Asian Infrastructure

While a large financing gap for infrastructure development and maintenance does exist, Asian economies have huge savings and surpluses. At present, Asian savings are heavily invested in developed countries in safe, but low yielding, securities, such as US treasury bills. At the same time, due to underdeveloped local capital markets much Asian savings are invested in non-productive sectors, such as real estate or stock market speculation. This has created a global imbalance through financing advanced economies' consumption with cheap money supplied from huge Asian savings.

To attract these savings into investments in productive sectors, there is a need to develop indigenous financial markets, particularly a strong bond market, as well as appropriate and innovative financial instruments. Furthermore, innovative instruments and incentives will be needed to create bankable projects and attract private sector participation. The following section makes recommendations about how Asian savings might be refocused to serve Asian infrastructure needs. These recommendations will draw on the earlier discussions on market integration initiatives in Europe, the potential to use Sovereign Wealth Fund (SWF) resources for infrastructure investment, and the possible role of Islamic finance in infrastructure investment.

Not addressed in this paper is a critical issue of the sequencing of changes to bolster financial market integration. The question is whether financial market integration in Asia is best achieved in stages. The stronger and financially more sophisticated economies could achieve integration first, with other economies following. A complex mix of technical and political factors will affect this decision. However, there is serious concern that those left out are increasingly uncompetitive and once left out are soon forgotten. This study has taken the view that whatever system of infrastructure financing is developed, it must address the needs of the poorer regions. There are several options that could help fill the significant gap between infrastructure demand and current levels of infrastructure financing, both institutional and instrumental. Table 2 [ PDF 48.5KB | 1 page ] presents various options for infrastructure financing in Asia.

4.3. Financing Institutions for Regional Infrastructure Investment in Asia

4.3.1 Pan-Asian and Subregional Infrastructure Funds

It is proposed that a series of special funds be set up that will support financing projects at both national and regional levels by identifying, prioritizing, designing, and then promoting the development of infrastructure projects. There is a need for a pan-Asian and/or a series of subregional infrastructure funds dedicated to cross-border projects to enhance Asia's connectivity and move toward the creation of a seamless Asia. These can be best thought of as multi-donor platforms that provide good means to collect and administer funds received and then have flexibility to move them according to suitable priorities and sequencing.

Such funds could be administered in a variety of ways and it is not necessary to set up new institutions, though that is always a possibility. For example, ADB could be the administrator of all or some of the funds as trust funds, a participant with other partners, or an investor in a new entity. Whatever the structure (which is a policy issue) it is important that the funds perform certain important functions in support of infrastructure development and financing.

The first need is identifying, prioritizing, designing, and promoting the development of infrastructure projects. The quality of this process is critical because the goal is to produce a list of well-designed, bankable projects that accurately describe the benefit, costs, and risks of projects in ways that make clear how they are good bets for large public and private investments. These funds can be supported by creating a special joint grant facility by ADB and other MDBs and bilateral contributors, such as the Japan Bank for International Cooperation (JBIC) and the Japan International Cooperation Agency (JICA), to help identify and prepare bankable cross-border projects. These funds need to provide grants and concessional financing to Asian countries that have low-incomes and low technical capacities to reduce asymmetric costs and distribute benefits among participating countries.

These funds might include private sector participation, which could be necessary to obtain adequate funding. Such private sector participation may also be designed to provide access to technical or industry expertise of the private sector, such as creating consortiums of firms in rail development or port logistics. The interface with the private sector would help in identifying and designing bankable cross-border projects and in negotiating with governments and potential private investors sectors. Finally, the fund would need to consider how to provide necessary incentives to countries (particularly low income ones) to agree to and implement cross-border projects. One option is to provide concessional funds to low-income developing countries who may not receive proportionate benefits compared to middle-income countries participating in a regional project.

4.3.2. Reserve Bank of Asia

Agarwala (2008) proposed the establishment of a Reserve Bank of Asia (RBA) to address the infrastructure financing gap of Asia, both at national and regional levels, and also to serve as a type of regional central bank. The RBA would have an authorized capital of about US$300 billion, 10% of which could be in the form of paid up capital. The bank would have authority to borrow from the central banks of Asia about 10% of their foreign exchange reserves at the rate of return on 30-year US Treasury Bills and to invest them in global equity indices.²⁰ The bank would utilize the profits earned to promote infrastructure in a public-private partnership mode.

The RBA would also be authorized to act like a regional monetary fund or central bank. It would have authority to provide balance of payments support to member countries when needed and to issue an Asian Currency Unit (ACU) as a parallel (co-circulating) currency that would be freely convertible internationally. These aspects are not very different from the concepts of the European Monetary Cooperation Fund (EMCF) and the European Currency Unit (ECU) set up in Europe in the 1970's.

The option of creating a co-circulating currency, as proposed by Agarwala (2008), is appealing in many respects, especially if it benefits economies undergoing financial turmoil that have weak and depreciating currencies. Other such proposals have been made, and in a sense the European Currency Unit (ECU) was almost a type of co-circulating unit of value that was used for public and private financial instruments in Europe. The Asian Infrastructure Currency Unit (AICU) proposed later on in this study has potential to develop into a co-circulating currency. However, there are many challenging operational aspects, such as solid funding of the alternative central bank, clearing and settlement, sharing of seigniorage, and not destabilizing regular currencies and monetary policies.

The creation of the RBA, combining functions of a reserve bank and an infrastructure financing bank like ADB, is without precedent and may not be feasible. In the past, ADB had performed the functions of the proposed RBA when it provided quick adjustment loans to some Asian crisis-affected countries, such as the Republic of Korea (hereafter Korea), but this was far more limited than the arrangement conceived by Agarwala (2008). Moreover, creating a formal regional central banking system parallel to national central banks, each with their own monetary policies and exchange rates, is challenging. It may be a better strategy to keep the investment aspects separate (handled by an expanded ADB that administers a new Asia infrastructure fund), and have a separate monetary institute that can promote a long-term financial integration program.

4.3.3. Multilateral and Bilateral Development Institutions

Multilateral development banks (MDBs) have an important role to play in reducing funding gaps if private sector funds do not meet financing needs. MDBs can also facilitate regional cooperation for the provision of regional public goods, such as sharing services and resources among neighboring countries through cross-border collective action and coordination. Through financing regional infrastructure, MDBs can assist countries in achieving the full potential of cross-border trade and investment, as well as improving their competitiveness in the region by reducing trade costs, especially cross-border costs, by helping to improve transport and logistics systems, procedures, and protocols and supply chain management.

MDBs, such as ADB and the World Bank, are already playing an important role in infrastructure development by creating bankable projects and mobilizing long-term funds through capital markets and arranging co-financing. Bilateral development banks or agencies like JICA and JBIC, are also playing a useful role, and similar bilateral development banks in major Asian economies, such as PRC, Singapore, Korea, and India, can also contribute to the provision of financing facilities. To reduce large financing gaps, MDBs need to expand their roles in mobilizing funding, particularly in arranging co-financing and providing loan and financing guarantees. Moreover, MDBs can create appropriate and innovative financial instruments for PPP projects to encourage private sector investment and can also promote further integration and enhancement of Asian financial market efficiency, liquidity, and depth, with adherence to international and regional standard best practices. This will enhance cross-border flows of capital and promote efficient infrastructure investment utilizing Asia's huge savings.

By acting jointly as money banks, knowledge banks, capacity builders, and honest brokers, MDBs can continue to support Asia's infrastructure development. Utilizing their AAA ratings and ability to raise funds in international capital markets at and lending funds with low spreads, MDBs should be active in providing loans and guarantees and catalyzing private sector financing. These institutions can also continue to be a key source of policy and technical advice, assisting in building the “soft infrastructure” (i.e., legal, regulatory, policy, customs, and procedural components) in member country governments and regional institutions. Finally, MDBs can play a key role coordinating multiple stakeholders for regional integration and infrastructure development. ADB's Regional Cooperation and Integration (RCI) Strategy passed in October 2006, for example, promotes: (i) cross-border infrastructure and associated soft infrastructure, especially greater cross-border physical connectivity and (ii) regional cooperation in the provision of regional public goods and avoidance of regional public “bads”, (such as pollution and Green House Gas emissions). These kinds of roles and responsibilities by MDB activities in the region should be further enhanced to better facilitate regional infrastructure development and financing.

Asia needs to funnel its massive savings into “bankable” projects, primarily through bond market development and better use of savings and foreign reserves. In view of this, it is important to continue developing Asia's bond market (through the ABMI) to improve regional financial intermediation. MDBs can contribute to this process by providing further technical and research assistance to ABMI Working Groups and Focal Group of the ABM Initiative, stimulating market activities by issuing prime name credit papers and local currency bonds, promoting transparency and information dissemination, and contributing to policy dialogue.

In the past, ADB in particular has been a reliable funder of a large and broad variety of development projects in Asia, including cross-border infrastructure. It has historically offered traditional financing and other types of assistance at competitive rates, in the form of loans, equity financing, various financial risk guarantees, syndication arrangements, and technical assistance. More recently, it has also begun financing projects through the use of local currency financing, finance for trade facilitation, securitization, mortgage financing, and servicing of non-performing or under-performing financial assets (ADB 2008a). Clearly, there is room for greater assistance of MDBs in the development of cross-border infrastructure, either as sole investors or in partnerships with other institutions. Recently, ADB's capital has tripled to $165 billion, which will facilitate mobilizing additional funds for infrastructure investment and poverty reduction in Asia (ADB 2009b).

MDBs can also promote projects that could be considered as “Aid for Trade”, perhaps in coordination with the World Trade Organization (WTO). Aid for Trade, according to the WTO, is donor financing from developed and developing countries that is invested in soft infrastructure, such as trade-promoting infrastructure and assistance projects, including aid for supply chains and industrial (i.e., capacity) development. In 2005, a total of US$15 billion was committed to Aid for Trade by highly developed countries, including US$10 billion from Japan (ADB 2007). Such support continues to be forthcoming and assisting in structuring deals and projects so they meet the provisions of Aid for Trade programs is of great importance and is another way that MDBs can play an active role in obtaining increased financing for cross-border infrastructure.

4.3.4. Local Currency Bond Markets

The development of local currency bond markets is a key method to reduce foreign currency risk for borrowers and should be promoted to meet growing infrastructure financing needs. Developing these markets would also minimize currency and maturity mismatches, which were among the major factors behind the severe financial crisis in 1997–1998. Currency mismatch problems arise if countries borrow in foreign currency to finance infrastructure projects and the revenues are earned is in local currency. On the other hand, if countries borrow foreign currency for the short-term or medium-term, but the cash flow lags after the completion of the project, there could be maturity mismatch problems. This is a demand risk problem that can be addressed through official foreign currency guarantees.

Since the 1997–1998 financial crisis, Asian economies have undertaken considerable efforts to further develop and strengthen institutions and market infrastructure to enhance the growth of local currency bond markets. In 2003, finance ministers from ASEAN plus Japan, the People's Republic of China (PRC), and Korea introduced the ABMI. Several working groups were established to develop the infrastructure, regulations, and best practices of the local currency bond markets. Such an initiative can promote the utilization of Asia's savings and increasing foreign exchange reserves within the region, particularly for use in infrastructure development. The creation of standing working groups to promote the development of various aspects of financial market infrastructure is a strong step in the right direction and should continue to be aggressively pursued.

At the Madrid ADB annual meeting in May 2008, the commitment to the ABMI was renewed with a focus on promoting local currency bond issuance, facilitating demand for the bonds, improving the regulatory framework, and improving the market infrastructure. Efforts are voluntary, but each country is tasked to make periodic self-assessments in meeting the ABMI goals. All these steps, which are at the national level of integration with some regional oversight, appear to be moving in the right direction, but it remains to be seen how effective the approach will be.

MDBs, as banks with continuing involvement in capital markets, can play an important role in raising long-term funds for financing infrastructure projects, contributing to building market liquidity and depth and issuing local currency bonds by undertaking currency swaps. The ADB has been integral in developing Asia's bond market by providing technical and research assistance to ABMI Working Groups and the Focal Group of the ABMI; stimulating market activities by issuing prime name credit papers; promoting transparency and information dissemination; contributing to policy dialogue; and issuing local currency bonds.²¹

In order to attract private investors for local currency infrastructure bonds, the return should be attractive and high rated. According to a report by Asia Bond Monitor, the policy challenges for the development of a stable, deep, and strong bond market include:

“(i) bolster investor confidence by strengthening legal protection and thus certainty, improve standards of corporate governance and transparency, and adhere to international accounting standards;

(ii) reduce constraints to market entry, investment, and encourage investor diversity to promote greater demand for local currency bonds;

(iii) develop derivative and swap markets to broaden the investor base, increase market liquidity, and allow a wider dispersal of risk; and

(iv) strengthen broader arrangements for regulatory oversight and regional cooperation in the areas of information-sharing and in coordinated actions to maintain financial stability” (ADB 2008b: 1-2).

4.3.5. Asian Infrastructure Financing Bank or Fund

An important issue to be examined is whether Asia should establish a new, specialized investment bank for infrastructure financing similar to the European Investment Bank or the Andean Development Corporation (Corporación Andina de Fomento, or CAF). This bank might serve to intermediate (through deposit facilities, bond issuance, and transactions services) the use of the large accumulations of official financial assets for infrastructure and other regional and development projects. Another alternative could be a new Asia Infrastructure Fund (AIF) which could be managed by ADB. This fund could be dedicated to regional infrastructure projects. The new bank or fund may consider issuing liabilities in the form of equities and bonds to be contributed by participating countries and multilateral and bilateral development banks as well as private sector using some standard measure to denominate investments, such as a regional currency basket. The participating countries can use a portion of their excess foreign reserve to purchase these bonds.

There have been previous proposals for establishing either an Asian Infrastructure Investment Bank (AIIB) or an Asian Infrastructure Finance Corporation (AIFC). For example, in 2007, Kim Hak-Su, executive secretary of the United Nations Economic and Social Commission for Asia and the Pacific (UNESCAP), stated that the region could learn from India's experiences utilizing special purpose vehicles for infrastructure investment. The region could authorize an entity such as AIIB or AIFC to borrow from regional foreign exchange reserves and both invest in capital and equity markets globally—using the returns to finance regional infrastructure projects—as well as provide direct lending for infrastructure financing (UNESCAP 2007). Agarwala (2005) judged that such an Asian Investment Bank (AIB) could provide infrastructure loans and collaborate with the banking community in both raising and investing resources. It could work with the private sector by co-financing and guaranteeing private investment financing. Even if only 50% of Asia's incremental current account surpluses during the next five years are put in these assets, there would be ample funding for the huge investment needs in these regional projects. Besides raising funds, this institution could also help regional countries address non-financial constraints that discourage infrastructure investment by the private sector; these constraints could be regulatory barriers, lengthy processes or procedures, and risks involved in long-term and large-scale investment (Jayanth 2007).

However, there would be many disadvantages in setting up a new investment bank. First, negotiation, planning, and implementation of a new large institution would be lengthy and possibly less cost-effective than using existing institutions. The bank would need to establish a credible track record to ensure trust and confidence among member countries and their private sectors. Furthermore, the overall cost of borrowing could be higher compared with established institutions due to the additional operational cost of the bank and the bank's initial smaller scale of operation and initial lack of the AAA ratings necessary for the bank to mobilize funds at a low cost in the international capital market.

It would also be challenging for a new bank to create an adequate knowledge base and expertise comparable to that of existing institutions, which is essential for winning the trust and confidence of participating Asian countries. Organizations such as ADB, the World Bank, and UNESCAP have solid track records in providing significant assistance for infrastructure development in Asia and conceiving and implementing cross-border projects under several subregional programs, such as Greater Mekong Subregion (GMS), South Asia Subregional Economic Cooperation (SASEC), Central Asia Regional Economic Cooperation (CAREC), Brunei Darussalam Indonesia Malaysia Philippines – East ASEAN Growth Area (BIMP-EAGA), and Bay of Bengal Initiative for Multi-Sectoral Technical and Economic Cooperation (BIMSTEC)²². For example, ADB has provided approximately US$83 billion to date in infrastructure loans and grant financing in the region, and has strong financial and risk management capacity and practices and international-level disclosure standards. The resources of these organizations, however, are still limited and would be insufficient to meet the entire financing gap (ADB 2009a).

In view of the above, an Asian Infrastructure Financing Fund (or a special vehicle fund) could be set up under an appropriate governance structure such as an affiliate, subsidiary, or trust fund managed by ADB. This fund should have its own resources or capital contributed from national governments of major Asian countries. In addition, this fund could intermediate and direct Asian savings to infrastructure development and assist in meeting the infrastructure investment gap by selling bonds for cross-border infrastructure finance, customizing instruments to fit market preferences, and potentially providing guarantees, incentives, and concessionary finance. It could also generate additional funds through co-financing from other development and financial institutions, SWFs, pension funds, private portfolio investments, and special vehicle funds. A portion of major Asian countries' excess international reserves could be utilized initially to set up such a fund. A new institutional framework for this fund would allow for more flexible rules, regulations, policies, systems, and procedures. This fund could be structured to identify, prioritize, prepare, and facilitate financing commercially viable regional infrastructure projects. For making the projects viable, the fund needs to provide guarantees against major risks (e.g. political risk, credit risk, and refinancing risk) faced by large cross-border projects, as well as grant and concessional financing to low-income participating countries.

The advantages of this new infrastructure fund would include a more focused mission for specialized jobs like cross-border infrastructure financing, and the creation of simpler and more efficient systems and procedures, such as the quick processing of loans with few conditions that borrowing member countries find difficult to implement and can delay project implementation and increase project cost. Also, it would offer better customization and sophisticated techniques to meet borrower countries' needs and the utilization of Asian savings for Asian infrastructure in a cost effective manner. ADB/ADBI (2009) has proposed a similar Asian Infrastructure Fund.

4.3.6. Regional Infrastructure Companies for Financing Specific Sectors

Another alternative could be to create several regional companies that would finance and manage regional projects for specific sectors, such as transport (road, railways, seaports and airports), energy, and telecommunications. Major Asian economies could invest in these companies together, allowing for private sector participation at a later stage. Experts from various parts of Asia, and also from outside Asia, could be invited to join these companies. These companies could also raise funds from capital markets through equity or infrastructure bonds. Special sub-regional infrastructure funds could be created to finance sub-regional projects.

This alternative might take the form of the European Aeronautic Defense and Space Company (EADS), which would be jointly owned by Asian governments, public sector companies, or both together. An Asian infrastructure group for cross-border infrastructure development established akin to the EADS could be owned by Asian governments, relevant regional public sectors, and private sector firms with appropriate expertise in the infrastructure development. The sale of public shares throughout the region would help deepen equity markets and provide a needed outlet for household savings and institutions' investment funds. This group could own subsidiaries specializing in sectors, such as transport, energy, and telecommunications. Infrastructure companies need to specialize in a sector to earn credibility, and hence sectoral Asian companies (specializing in transport, telecommunication, energy, etc.) would need to be established. Subsequently, a significant portion of shares could be distributed to the public and employees to create a good governance structure. Multiple locations for operations could be selected depending on locations of planned cross-border projects.

4.3.7. Subregional Infrastructure Funds or Subregional Infrastructure Companies

There are already several subregional initiatives on infrastructure development in Asia, such as GMS, ASEAN, South Asian Association for Regional Cooperation (SAARC), CAREC, and SASEC. Special subregional infrastructure funds could be created to finance sub-regional projects. Special subregional companies could also be established to manage these infrastructure projects. Such subregional institutions could work in a way similar to that described in sections 4.3.5 and 4.3.6. Recently, ASEAN has decided to set up an ASEAN Infrastructure Fund through ADB, which in turn is now preparing the fund's needed framework (Nam News Network 2010). It is possible that this fund could initially be established by major ASEAN countries utilizing their excess international reserves, and the other ASEAN countries would be allowed to join subsequently. Once this ASEAN Infrastructure Fund has been created, other major Asian countries could join to create an ASEAN+3²³ or an ASEAN+6²⁴ infrastructure fund. This process is similar to the pattern observed in the Asian trade integration using ASEAN as a hub and forming the ASEAN+1 free trade agreement.

4.4. Instruments for Financing Asia's Regional Infrastructure

4.4.1. Guaranteed and Linked Bonds

Infrastructure projects could also be financed through innovative bond structures that would include guarantees or enhancements to protect investors in terms of various risks, insulate borrowers from adverse changes in servicing costs, and customize issues to fit the specific needs of lenders and borrowers. Contemporary financial markets have become quite sophisticated in fashioning instruments to cover specific situations and to appeal to different classes of borrowers. Where these techniques could be married with availability of concessional finance, it could be possible to craft lending instruments that could strongly promote economic development.

Customization could involve enhancing instruments with one or more guarantees, links that would provide protection against specific types of risk, or spreading returns and risks to better fit the profiles of lenders and borrowers. A wide range of instruments could provide the enhancements—direct guarantees or insurance could be used, derivatives like forwards and options would be possible, income and expense flows could be capped, income flows could be swapped, instruments could be linked to commodity prices or other measures, etc.—depending on the specific borrowing situation and the sophistication of markets in crafting instruments. Types of risks and examples of instruments that could be use to mitigate them could include:

Financial sophistication would be needed to design and implement the full range of these instruments. Cross-border issues would require additional skills to deal with differing institutions, practices, and legal frameworks. Only a limited number of institutions and markets could be expected to provide the range of skills required, which could reside both in public institutions and private markets. Asian financial market development would benefit from the building of such skills at ADB, other Asian public institutions, and also in key regional private markets. Infrastructure projects in countries that do not have the skills available domestically would have to have ready and cost efficient access to markets where they are available. ADB or other regional public institutions could deal directly with projects anywhere in the region, but it would also be important to have easy cross-border access to private markets in key financial centers within Asia.

4.4.2. Sovereign Wealth Funds

Several Asian economies, as well as economies of other regions, have created sovereign wealth funds (SWFs) to hold and invest part of their large holdings of international reserve currencies. This subsection examines the potential for SWFs, and other large national pools of investable funds such as national pension funds, to invest in Asian infrastructure. The specific character of infrastructure investments often fits the investment profile of SWFs. Moreover, the global financial crisis has highlighted the usefulness of regional infrastructure investment as an important source of stimulus funding as short- or medium-term countercyclical measures, but that also offers high, long-term economic benefits. It will describe an important initiative in this regard by ASEAN to set up a regional infrastructure fund that will draw on resources similar to SWFs, and which may become a model for use of SWFs for infrastructure funding.

The best source of information on SWFs is the initial report of the International Working Group on Sovereign Wealth Funds (IWG) that presents 24 voluntary Generally Accepted Principles and Practices (GAPP) for SWFs, called the “Santiago Principles” (IWG 2008).²⁶ SWFs are defined by the working group as:

“Special purpose investment vehicles or arrangements owned by the general government. Created by the general government for macroeconomic purposes, SWFs hold, manage, or administer assets to achieve financial objectives, and employ a set of investment strategies that include investing in foreign financial assets. SWFs have diverse legal, institutional, and governance structures. They are a heterogeneous group, comprising fiscal stabilization funds, savings funds, reserve investment corporations, development funds, and pension reserve funds without explicit pension liabilities” (IWG 2008: 3).

The formal definition of SWFs excludes foreign currency reserves assets held by monetary authorities for traditional balance of payments or monetary policy purposes, state-owned enterprises, government employee pension funds, and assets managed for the benefit of individuals. These are important exclusions, but for the purposes of this study on a case-by-case basis the investment profiles of such funds might include infrastructure investments. For example, state-owned enterprises might seek infrastructure investments ancillary to their main line of business. Thus, these non-SWF pools of investable funds might be approached with investment proposals, but they will not be further discussed here.

Many SWFs segregate funds into accounts separate from countries' official international reserves to generate higher returns and many are explicitly designed to pass wealth to future generations, especially when the income is derived from exploitation of an expendable resource.²⁷ Although the capital and income from SWFs are intended for strategic or future use, the rules to draw on SWFs vary by country and have often not been transparent, although application of the GAPP could change that. It has been reported that during the crisis a number of SWFs have been tapped as stimulus funds for domestic projects.

In broad terms, three different types of SWFs can be distinguished. Different investment strategies and policy perspectives may apply to each type.

• Commodity-based SWFs: These SWFs are based on high returns from the production of commodities. Strong demand and favorable price movements for a commodity, such as oil, can result in rapid accumulations of foreign currency assets. These funds are unencumbered assets that are not associated with specific liabilities and thus can be freely invested by the SWFs in accordance with their directives. Countries with these types of SWFs may create them to isolate funds from the domestic economy, use them as stabilization funds to cushion drops in prices, or build long-term investment income to support the economy after the resource is depleted. The funds might also be domestically invested to help the economy diversify, but such investment must avoid destabilizing the economy.
• Pension-based SWFs: Some countries create SWFs from funds raised from pension or social security contributions (funds with explicit liabilities to individual pension holders are excluded). These funds must be invested with a long-term perspective and with recognition of the liability to cover future payments. Long-term infrastructure investments with stable return profiles fit the investment needs of this type of SWF well.
• SWFs for countries with a large current account surplus and large international reserve assets. The assets are often acquired due to sterilization of export earnings, which creates a liability to the public. PRC and several other Asian economies have this type of accumulation of foreign currency assets that can be used to fund SWFs. These types of SWFs often play a key role in the macro-financial stance of the country and can affect policies on exchange rates, capital flows, inflation, and money and credit. The investment strategies of these types of funds must not contradict the sterilization policies that led to their creation in the first place, but are otherwise flexible. Because this type of SWF is based on an explicit policy configuration, changes in the policies (such as an exchange rate appreciation or shifts in national absorption) can affect the SWF, including the possibility of slowing or capping the SWF's future growth. These types of SWFs may be constrained from making domestic infrastructure investments because they were launched to isolate the funds from the domestic economy, but they could do so if it is compatible with balanced macroeconomic conditions. However, they might be good sources for regional infrastructure funding.

Table 3 [ PDF 34.4KB | 1 page ] lists 13 Asian and Pacific countries (including Russia) that are often considered to have SWFs. The SWFs themselves have different functions and range in size. Estimates of the size of assets held by SWFs vary widely, but the Asian SWFs listed below appear to hold somewhere between US$700 and US$950 billion, which is about one-third of total assets held by the more than 30 SWFs currently operating worldwide. By size of total assets in early 2008, the largest SWFs in Asia were in the PRC, Singapore, Russia, and Australia.

Most SWFs are professionally invested to earn good market returns that exceed the earnings on official international reserves, which usually are invested in very safe, low return assets. SWFs are typically granted wide latitude in making investments, including in equities. Although most SWF investments are in foreign countries, investments within the home country or within a region are also common. Investments at home can be made for national strategic development purposes; for example, the Libyan SWF directly makes domestic infrastructure investments (IWG 2008). As noted previously, the appropriate investment strategy can differ depending on the type of SWF funding, the associated liability, and the public policy goals of the SWF.

The GAPP makes it clear that there is great diversity in SWF investment strategies. Domestic investments are made by some SWFs, and some SWFs may address social, environmental, or other factors in their investment policy. Whenever investments are made on such grounds, the GAPP recommend that the policies should be publicly disclosed (IWG 2008).

Infrastructure projects appear to fit the investment profile of many SWFs because of their size, long-term tenor, competitive returns, ability to diversify portfolios with cyclically or financial market uncorrelated investments, and because they often have investment guarantees. Moreover, the current turmoil in global financial markets may shrink other investment opportunities and increase the competitiveness of infrastructure investments.

Also, a point made strongly in the GAPP is that investment strategies must respect macroeconomic and macro financial limitations; they must not contribute to overheating of the domestic economy or contradiction of sterilization, exchange rate, or capital flows policies. SWF activities can affect domestic fiscal and monetary conditions and therefore should fit within a country's overall macroeconomic policy framework and coordinated with domestic authorities. Several of the Asian SWFs have activities that involve exchanges between domestic and foreign currencies, which may affect monetary conditions, exchange rates, and domestic demand and that must be subjected to regular macroeconomic policy oversight as national macroeconomic or financial policies would be affected.²⁸

Currently available information about the activities and governance of SWFs is still limited, but has improved in recent years. SWFs that implement the GAPP would provide substantially more information, reporting in line with host country or international standards and improving both internal and external reporting, and such SWFs would provide regulatory and statistical information for use in macroeconomic accounts.

Several prominent SWFs have made public statements regarding their goals and policies. They clearly seek to assure the public and officials in host countries that investment decisions have been based on commercial considerations only and that there should be no fear of political or other motivations. Overwhelmingly, the investment goals are to produce long-term gains, competitive with market returns or better. Two SWFs pay regular dividends to the government, two invest in accordance with guidance from their governments on the types or allocations of investments and the situation with the others in each case is uncertain.

The information in these statements provides some clues about how SWFs may respond regarding possible investments in infrastructure. Overall, using SWFs to induce substantial investment in infrastructure is challenging because this type of investment is still unfamiliar to most SWFs and their investment managers. It does not fit into a seeming preference for more arms-length investment, and may not generate the higher returns that SWFs are seeking. However, the long run tenor of infrastructure investment and the opportunity to diversify and hedge cyclical exposures may make it an attractive investment for some SWFs. Investments packaged with exchange rate or traffic guarantees could be especially interesting for SWFs.

SWFs could become a regular source of funding for infrastructure within the home country and within the region, but because of the limited information about them and the diverse objectives of SWFs, it is hard to be specific about under what conditions and how much they would be willing to invest in infrastructure projects.²⁹ Although there are major uncertainties, a strategy for drawing on their resources for infrastructure investment is proposed below.

First, planning for infrastructure development should involve a serious commitment to attempt to tap SWFs to support Asian cross-border infrastructure investment. This type of commitment should be initiated early in the project planning process and should involve SWFs within the affected region and outreach by organizations such as ADB to SWFs in other Asian countries or in the Middle-East. This early interaction with SWFs will allow customization of financial packages to fit the preferences of SWFs. Also, the strong profit motivation of SWFs will require that infrastructure investment proposals provide market returns or better. Attracting investment by SWFs may require extension of enhancements or guarantees by governments, development banks, etc. to ensure that investments are secure and profitable.

SWFs often are expected to invest to support national strategic economic development priorities, so it could be argued that infrastructure investment is a natural area of investment that supports the strategic development strategies for the country. SWFs could adopt a strategy to create mixed and hedged portfolios, along the lines of commercial practice, of which part will be in long-term infrastructure investments. Here, a target of 10% investment in Asian infrastructure is suggested.³⁰ Equity investment by SWFs could also be encouraged, especially when the pattern of returns is uncertain or cannot be easily valued. Equity investments would be well suited to situations where the returns on the infrastructure have social or welfare benefits, such as educational or health benefits.

Finally, a portion of SWF funds should be used as official development assistance (ODA), although tapping SWFs set up as pension funds for ODA may be inappropriate. ODA contributions by SWFs are not explicitly mentioned in the GAPP, but the GAPP recognizes that social or environmental factors could be taken into consideration in lending. For ODA, a target of 1% is suggested.³¹ This contribution recognizes that SWFs are official institutions subject to national policy priorities, and one strategy could be to focus any development aid into areas of financial market development and technical capacity in the financial sector. In Islamic finance, there is a zakat³² obligation for those that can afford it to provide a portion of earnings (2.5%) to the poor. The earnings of SWFs of Islamic states could be sources of zakat as ODA to those in need. Very roughly, annually this might equal about 0.1 to 0.2% of SWF asset holdings. To take an arbitrary example, this could amount to US$20 to US$40 million annually from Malaysia's Khazanah Fund.

On 2 April 2008, the World Bank proposed the “one-percent solution”, that SWFs invest 1% of their nearly US$3 trillion assets in Africa, or about US$30 billion (Mufson 2008). The proposal stressed equity investment. This total is significantly large, but for individual SWFs, does not represent a critical risk and less than needed for prudent diversification of the portfolio. Following this suggestion could bring some emerging economies into the group of providers of ODA.³³ Alternatively, rather than make direct contributions, the SWFs might transfer funds to other government agencies that specialize in aid or capacity building.

The receptivity of SWFs to making infrastructure investments is yet unknown. Some may be hesitant to take direct equity positions, but be willing to invest in securities based on the infrastructure investment or take equity positions in companies making the investment. A high level inquiry into SWFs and their governments (or the proposed standing organization of SWFs) might help to learn more about the potential and the conditions, and solicit views from SWFs on how they might contribute to infrastructure investment in Asia.

An important note of caution is that the use of SWFs for infrastructure investment in the home country or in other Asian countries could have macroeconomic or financial ramifications. Any SWF investment in infrastructure in the home country or elsewhere within Asia should be scrutinized to see that it does not contribute to overheating or contradiction of sterilization or other policies. One implication is that new regional oversight arrangements may be needed that bring SWFs under macroeconomic surveillance as an integral part of the overall macroeconomic and macrofinancial policy framework. An excellent example, identified by Radhakrishnan (2008), is India where a SWF has not been created, but the policy has been to channel reserves accumulations into infrastructure. In one promising, but still relatively small, program (US$5 billion), India Infrastructure Finance Co. Ltd. set up an offshore subsidiary in London that can borrow reserves and lend them on to Indian infrastructure companies to meet their capital expenditure solely outside India. The main condition is that such financing should not lead to any domestic absorption of liquidity.

Finally, two initiatives could serve as models for infrastructure investment that may apply to SWFs. Asia can create an Asian SWF dedicated to infrastructure development out of excess international reserve assets. Many state-owned enterprises in major Asian countries have been witnessing high savings and profit. Asian countries can also form national infrastructure funds based on the contribution of a portion of the excess profit of major state-owned enterprises.

4.4.3. Mobilizing Funds from Islamic Financial Markets

Islamic finance has a distinctly different form than conventional finance—no interest, no fixed returns, sharing of risk, prohibition of certain types of investment, and obligation to contribute to the poor, among others.³⁴ It is a growing field, but practices still vary and are unsettled, affected by differing interpretations of Islamic financial law. In many ways, it increasingly emulates the results of financing with conventional instruments, but sometimes with difficulty or inefficiency. While there are cases of blurring with conventional instruments, it remains largely separate from conventional finance.

Zeti Akhtar Aziz, the governor of Bank Negara Malaysia (Malaysia's central bank), has argued that Islamic financing will be critical to the future development of infrastructure in Asia. At the London Sukuk Summit in June 2007, she mentioned that the global sukuk market is estimated to be US$18 billion and these funds could be utilized to increase liquidity in the Islamic world. The Islamic bond market has typically been 10 to 20 basis points lower than mainstream bonds, but more multilateral agencies are issuing sukuks to finance development projects and government agencies and the corporate sector have considered doing the same (Aziz 2007).

One major issue facing the prospect of utilizing Islamic finance for infrastructure investment is the shortfall of basic banking and savings instruments for Islamic populations. Many of the more than one billion Moslems in Asia have no, or limited, access to modern financial instruments. In some cases, Moslems may need to use conventional banks and instruments, but compensate through actions such as donating interest earnings as zakat contributions to the poor. The lack of basic banking facilities imposes major hardships on this population segment, which is denied the means to save and transact. Development of Islamic instruments to serve basic individual and community financial needs and effectively delivering them to the target population would have two important impacts. First, it would contribute to poverty alleviation for a very large population and, second, it would mobilize the savings of a very large population in ways that might help support infrastructure development. By taking action on increasing access to basic, Islamic financial services, over time a new pool of Islamic investment funds could be developed.³⁵

Another major issue in Islamic finance for infrastructure investment involves bonds and equity participation. Markets for Islamic bonds and equity participation exist, called sukuk, which are based on principles of sharing of the profit or loss of investment projects. Kuala Lumpur and Dubai are currently the most active markets, but there is some activity in other Asian markets as well. Islamic bond and equity participation instruments are naturally suited for project finance and their potential should be explored through consultations early on in the project development process so that the financing plan can be tailored to the specific requirements of Islamic finance.

Prospects for using Islamic bonds to support infrastructure funding are also limited because of difficulties in constructing long-term instruments that are not specifically tied to sharing of income or loss on specific projects, which is not in the nature of many types of infrastructure projects, and because of lack of standardization of instruments because of unharmonized Shari'a (Islamic law) interpretations, which acts to segment the market and prevent development of market signals that can help direct the flow of funding into high priority infrastructure projects. The Islamic Financial Services Board's “Ten Year Framework and Strategies” states that harmonization of Shari'a interpretations and effective legal interaction with conventional finance will play an important role in fostering greater growth of the industry (ISDB/IFSB 2005). This is obviously a specialized topic related to infrastructure finance, but mobilizing Asian savings and directing them to Asian and subregional infrastructure development will need to address how to involve the large Moslem community.

Working with the Islamic Development Bank (IsDB), which channels donations for investment in infrastructure among other things, is another way that Islamic financing could be used for Asian infrastructure projects. Projects should consider how IsDB programs might link to ADB or other regional infrastructure initiatives, or how the IsDB programs might evolve to provide more support for infrastructure. In the past few years, the IsDB has begun issuing sukuk bonds in international capital markets, which opens the potential for future issuing of bonds focused on infrastructure development (Gulfnews 2005). In September 2008, the IsDB and ADB signed a co-financing agreement in which both institutions stated that they would collaborate on projects in common member countries.³⁶ Each will contribute US$2 billion from 2009 to 2012 for a range of projects, including infrastructure projects. The agreement also opens new avenues to promote infrastructure investment by third party funds and through private sector participation (Gulfnews 2008).

Significant funds for infrastructure investment should be available through Islamic bond and equity markets in Kuala Lumpur and the Middle East. This requires that consultations begin during the planning stages of infrastructure projects on how to configure the financial package to meet Shari'a requirements and to appeal to Islamic investors. Also, currently each project requires customization to meet Islamic requirements, but work is underway to create standardized documentation. This will greatly facilitate the process. ADB could create a small working group on Islamic Finance for Infrastructure to work primarily with the Islamic Financial Services Board in Kuala Lumpur and the Islamic Development Bank (IsDB) in Jeddah to promote this standardization and explore the potential for expanding Islamic financing. The recent announcement of collaboration between the ADB and IsDB is a promising step in the right direction.

4.4.4. Public-Private Partnerships (PPP)

It is expected that the bulk of financing for new physical infrastructure (greenfield projects) and maintenance or upgrading of existing infrastructure (brownfield) projects will come from the public sector, ODA, or multilateral development banks, but the private sector also can contribute substantial amounts, up to perhaps 30% of total investment needs. For example, for the estimated investment in India, as mentioned above, the private sector is expected to contribute around 30% (about US$150 billion) of the total infrastructure spending, whereas the federal government will invest a further 37.2% and provincial governments will cover the remaining 32.8%.

PPPs are required not only for funding, but also for technology and efficiency in the project implementation. In order to attract private sector funds, Asian governments need to create good business environments and find ways to manage potential projects risks that cannot be addressed by the private sector. PPP projects could be undertaken through various modalities, such as joint ventures, concessions, management contracts, BOO (Build Own Operate), BOT (Build Operate and Transfer), BOOT (Build Own Operate Transfer), and BOLT (Build Own Lease Transfer)³⁷.

One of the major weaknesses of Asian developing countries is their level of skills and capacities in handling PPP projects, particularly in their procurement and service delivery. At the same time, the private sector should consider PPP infrastructure projects as a new market opportunity. They need to gather market intelligence and conduct appropriate technical analysis to evaluate and prepare bankable or commercially viable projects in developing countries. At present, there exists a significant information asymmetry between the public and private sector regarding infrastructure development. Further details on the potential for PPP options are discussed in another paper prepared for the ADB/ADBI Flagship Study by van der Geest and Nunez-Ferrer (2010).

4.4.5. Asian Infrastructure Currency Unit Based Bond (AICU)

The lengthy implementation of infrastructure projects exposes borrowers and lenders to substantial currency risk, which is one of the major risks for financing regional projects. This calls for financing schemes that can minimize exchange rate risk. One way to minimize exchange rate risk would be to create an Asian Infrastructure Currency Unit (AICU) consisting of major Asian and non-Asian advanced economies' currencies. An AICU is simply an accounting device for use in valuing infrastructure investments and repayment obligations that equals some weighted measure of Asia and non-Asian currencies. An infrastructure AICU bond will have reduced exchange rate risk for Asian lenders and borrowing countries based on de facto relative stability between Asian currencies.³⁸ The AICU could be a precursor to the type of parallel currency described by Agarwala (2008), but it lacks many of the features of a true currency as it is basically just an accounting device.

The weights may depend on factors such as GDP, international reserves, trade or any other appropriate variable of those selected economies. A weighting scheme that uses the basket of currencies used for infrastructure investment itself merits consideration. Total infrastructure currency demand in Asia could be estimated, providing a measure of value related to the costs and benefits of the infrastructure projects. Investors would gain access to investment instruments using a standard measure of value that has muted exchange rate risk; borrowers would be able to raise funds that have value related to projects' costs that would also have the feature of muted exchange rate risk. One variant of this weighting scheme includes only the weights of currencies estimated needed for infrastructure investment in Asia (or in a subregion such as ASEAN). A second variant adds the currency requirements for official funding of cross-border initiatives in Asia, such as funding of a development bank. In the second case, countries would pay their official obligations in AICU, giving it a natural initial market.

Europe created a similar valuation scheme that evolved over time, beginning with the European Unit of Account (EUA) and changing into the European Currency Unit (ECU) in 1979, which ultimately became a real currency, the euro. The EUA was established as a “closed” basket of fixed quantities of the nine EEC currencies. In contrast, the ECU was intended to be revised every 5 years. The ECU was initially a virtual currency, with settlements made in other “real” currencies. Subsequently settlements were made in ECU. The synthetic ECU currency unit was also used for denomination of bonds, including private sector bonds. Many Asian countries cannot issue bonds denominated in their own currencies, but if AICU is established, they could issue AICU bonds. This would diversify their risk by not issuing bonds in one international currency but in a basket of Asian currencies (Castell et al. 2007). Creating a virtual unit such as the AICU should involve surveillance of the participating currencies by a regional entity because changes in any currency in the basket affects the weighted average value and could force fellow participants in the scheme to make adjustments as a result of poor policy of another member. Thus, each currency should be obligated to bear the burden of macroeconomic surveillance because all currencies are affected by the actions of each individual currency (this oversight feature is in line with the proposed Asian Monetary Fund (AMF)³⁹ or Asian Surveillance Unit⁴⁰ model, in which a transnational oversight entity is created.

It would be useful to create an institution for managing regional infrastructure financing bonds (or build such capability into existing institutions). Countries participating in a regional project could raise funds through AICU denominated bonds, which would minimize the risk of repayment for any individual country. The entity might also include arrangements to guarantee AICU-denominated bonds issued by public entities, or provide insurance for a fee to private issuers.

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