Infrastructure Investments: A Promising Strategy  

Habib F. Faris

Infrastructure investments are often referred to as the lubricant of economic development and growth. With the enormous growth rates emerging markets are witnessing, the provision of efficient infrastructure will decide about the failure or success of many countries. But infrastructure also plays an important part in the developed world. An aging population in numerous Western countries confronts infrastructure with important transformation challenges. Most important for private investors is the fact that infrastructure investments which are still dominantly financed via the public purse are becoming increasingly penetrated by capital market funding. This reflects the recognition that private investment and private management are more efficient than public governance and tax financing. Consequently, infrastructure investments will be one of the most important and lucrative investment themes for the years to come.

Infrastructure includes all long lasting capital investments ensuring the efficient functioning of a society. The definition includes transportation infrastructure, such as roads, airports, railroad, and ports. It also includes energy related facilities, such as electricity generation and distribution, gas and oil exploration and distribution. Also water production (desalination) and delivery including sewage treatment are part of the infrastructure of an economy. Eventually infrastructure involves also the provision of non-physical services, such as education and health care services.

Infrastructure facilities have to have a minimum size in order to be economically efficient. Long planning times, high initial capital outlays, extended periods of concession payments add to mean that there are high barriers for new entrants in this business. As in many cases there are only a fistful suppliers of these services, infrastructure projects become de facto strategic monopolies. Investors in infrastructure therefore have less to fear from competition than others.

Two main developments have made infrastructure, or more importantly the lack of it, a drain on global economic growth. The first factor relates to the expansion of world economic output. In 2004/05 the world economy grew at its fastest rate over the last two decades.

This was accompanied by an enormous growth in inter-national trade, with the developing world taking on the role of a "global manufacturer" and the industrialized world importing these goods at an unprecedented scale.

It is now evident that the lack of sufficient infrastructure is keeping growth rates well below their potential. Therefore it comes at no surprise that countries such as India made the improvement of infrastructure its top priority. According to World Bank estimates, the lack of sufficient road infrastructure reduces the economic growth potential in Latin America by 2 percent to 3 percent per annum. The list of infrastructure deficits can be expanded almost indefinitely. In Asia, China's major seaports are aching under the weight of over-usage and carriers have to rely increasingly on expensive alternatives to get their goods delivered. In parts of Africa, the poor conditions of roads can mean that a mere distance of 150km requires 2 days of expensive travel.

However, deficiencies in infrastructure are not confined to the developing world, as everybody who has spent hours in traffic jams or at airports knows too well. Road pricing schemes such as the fees charged at the entrance of central London are being implemented in order to overcome the massive costs of traffic congestions. Another less visible but even more threatening trend comes with the alteration of the demographic composition of most industrialized countries.

Demographic trends impact on the provision of public infrastructure in three respects. First, the revenue side of public budgets is affected; because a smaller active population contributes with income-related tax. Second, as society ages, the structure of demand for public goods shifts toward costly services, such as care for the elderly. This is combined with exploding health care costs, and thus further increases the need for public spending.

Third, with the decline in the population, the social importance of many infrastructure facilities becomes doubtful. Public amenities, like theatres and public swimming pools, and even schools are becoming even more prone to cost overruns as the eligible population shrinks.

Capital market funding of infrastructure facilities are playing an ever-important role. The idea to allocate capital via the market is not entirely new: The US and Great Britain funded most of the early railroad networks via the stock market. However, the lack of regulation led to inefficiencies which ought to be remedied by nationalization efforts, especially after WWII. Latest in the eighties it became evident that public governance was not the solution. Today health care services are going through a similar transition. Widespread inefficiencies accompanied by ballooning costs made privatization efforts almost imperative. Governments of developing countries drew their conclusions and partnered with private investors early on. The graph below illustrates the fact that especially telecommunications and the provision of electricity are increasingly financed by capital markets in emerging countries.

The enormous pent-up demand for global infrastructure services means that the timing for a collective investment vehicles open to the general pubic could not be better. Such a vehicle will not only invest in equities of companies actively engaged in the construction, provision, and operation of infrastructure services, but also in debt instruments of such companies. As many infrastructure projects are financed via syndicated loans, and other form of project financing, an investment fund committed to the infrastructure theme may also make investments in these types of instruments.

Many infrastructure projects are operated with concession payments. These payments are in most cases less affected by the economic growth cycle, as the underlying demand is steady and "indexation" is commonly applied, making infrastructure investments a powerful hedge against inflation. This characteristic also means that investments related to the infrastructure theme can be used as a diversification element in mixed with traditional investments.

This sets the scene for an attractive investment environment. The demand for the set-up, maintenance and rehabilitation of infrastructure originating from emerging markets, combined with capital market financed infrastructure demand for the industrialized world are set to continue unabated for the next decade.

(Habib F. Faris is Vice President at Clariden Bank, London)