Construction Financing for Infrastructure Projects in Developing Countries

One of the top priorities for policy makers who are trying to close the infrastructure gap in developing nations is attracting private financing. However, the poorest nations have difficulty drawing in any private investors, and private financing currently makes up a very small portion of infrastructure funding overall. This essay creates a model to explain these facts. We define the parameters that allow public and private finance to coexist and describe the structure of contracts for financial and regulatory infrastructure. This calls for a compromise between social inclusion and financial viability in the form of regulated prices and public subsidies that are both sufficiently alluring to outside financiers. While more efficient bankruptcy procedures make it easier to obtain private financing, institutional adjustments that reduce the cost of public funds increase the appeal of public financing.

Overview

The infrastructure in developing nations is severely lacking. One billion people do not have access to electricity, 2.4 billion people—roughly one-third of the global population—use inadequate sanitation facilities, and 660 million people do not have access to a clean water source. The poorest nations in Asia and Africa account for the majority of this infrastructure shortfall.

There is no chance that this gap will close quickly at the current rate of investment. Based on available data, ongoing investments are significantly less than anticipated needs. For instance, annual spending estimates of between 1.9 and 3.5 percent of GDP for Africa, 3.7 and 4.7 percent of GDP for South Asia, and 2 to 3.2 percent of GDP for Latin America are reported by Fay et al. (2019). This is significantly less than the average estimated needs, which are 9.2 for Africa, 7.5 for South Asia, and 4.5 for Latin America (Rozenberg and Fay, 2019).1 The Asian Development Bank (2017) estimates that Developing Asia, excluding China, has an investment gap of 5% of GDP. According to Fay and Straub (2019), the region’s poorest 10 percent of households would need to wait between three and more than nine decades for a water connection, based on current trajectories, based on comprehensive harmonized household survey data covering 1.6 million households in 14 Latin American countries from 1992 to 2012.

This predicament is partly caused by the fact that many of the world’s poorest nations are unable to raise the necessary funds on their own to provide essential services to their citizens. They frequently rely on large amounts of bilateral and international institutions’ concessional lending. But these players can’t even close the spending gap given the size of the investments needed. For instance, Multilateral Development Banks (MDBs) have only made up 2.5 percent of infrastructure investment in Developing Asia overall, and 10 percent when China and India are taken out of the picture (ADB, 2017).

Due to this, major international donors and MDBs are now relying on the private sector to provide the resources they need. The theory behind blended finance arrangements—also known as a “billions to trillions” strategy—is that public money could, in certain situations, crowd in private capital for infrastructure projects. The World Bank’s “Maximizing Finance for Development” guidelines provide a more sophisticated version of this argument. They outline a methodical process for prioritizing and luring non-government guaranteed commercial financing by evaluating its feasibility and addressing necessary institutional and regulatory reforms (World Bank, 2017). Currently, though, the private sector accounts for only 9–13 percent of the approximate $1 trillion that is invested globally each year in developing nations (Fay et al., 2019).

By offering a theoretical framework to examine the question of the feasible level of private finance in a basic model of infrastructure funding and financing, pertinent to the various infrastructure sectors (transport, water, and energy), this paper seeks to evaluate the viability of this strategy. By outlining the major trade-offs that policymakers must consider when incorporating private finance into infrastructure projects, it clarifies the stylized facts above regarding the lack of private financing for infrastructure despite the ongoing needs. It clarifies, in particular, how the nature of the projects and the features of the institutional and economic environments impact the viability and desirability of outside financing.

The main conclusions of our findings can be demonstrated using real-world examples from a few developing and emerging nations. Turkey is the World Bank’s shining example of a private sector-based strategy. There, ten times as much was invested by private companies as a result of a $5.6 billion package of loans spread over more than ten years with the goals of energy sector reform, transmission line modernization, lowering distribution losses, and providing technical and policy support (World Bank, 2017). This occurred as Turkey’s average income level rapidly increased, positioning the nation as upper-middle-income with an estimated $10,000 per capita GDP.

The situation in other developing nations was different. With a per capita GDP of $580 and over 50% of the population living below the poverty line, Liberia is among the world’s poorest nations. Its road system is in disrepair, and less than 20% of the population has access to electricity. Subsequent to the preparation of the MCC Compact in 2014, the government of the nation requested funding for a road project. Because the baseline internal rate of return was insufficient to warrant the investment, let alone draw in private investors, the MCC rejected the project.

The primary offender in this instance is the combination of the government’s incapacity to provide subsidies to replace these fee-based resources and the impossibility to impose meaningful user fees without completely suppressing demand given the low levels of individual income. Many of the poorest sub-Saharan nations, where the majority of infrastructure projects are funded by the public sector and foreign donors, have similar stories to tell.

Another nation where inadequate infrastructure impedes economic growth is Lebanon.3 The energy sector has severe inefficiencies, high generation costs due to reliance on pricey diesel fuel, up to 40% transmission and distribution losses, and prices that are significantly below cost recovery levels. As a result, it forces several-hour rolling blackouts across the nation, which has a significant negative impact on both businesses and consumers’ welfare. Furthermore, the government regularly pays the losses incurred by the state electricity company, which was responsible for nearly half of the nation’s fiscal deficit from 2008 to 2017. Both the transportation network and the telecom services suffer from comparable inefficiencies.

The nation appealed for international assistance at the 2018 Paris CEDRE conference because it lacks the funds to invest in these areas. As a result, the international community pledged $11 billion to support Lebanon’s Capital Investment Program (CIP). It was intended for the private sector to provide at least thirty-five percent of these resources. But more than two years later, there have been no signs of these investments. This is not surprising in a nation where public-private partnerships have had, at best, uneven results in the past.

Specifically, in the early 1990s, a number of telecom projects involving private foreign firms resulted in highly publicized failures. In this instance, there were evident governance failures despite the telecom PPPs’ initial great success. These included internal division, governmental opportunism, corruption, the absence of credible creditors’ rights, and the absence of an independent regulator. Customers are forced to use some of the most costly and ineffective services in the area because the Lebanese government has been unable to improve the governance of the industry since 2001, despite its profitability and the possibility of fee-based funding (the telecom regulatory board has not been renewed since 2008). The majority of projects in the transportation and energy sectors are also on hold.

These instances demonstrate that depending solely on private investors is rarely an easy way to get funding for infrastructure projects. As previously emphasised, this might actually be more difficult in nations and industries that most require those investments due to a lack of funding possibilities, problems with governance, or a lack of fundamental guarantees pertaining to creditors’ rights. Using data from a sample of infrastructure public-private partnership (PPP) projects from the World Bank Private Participation in Infrastructure (PPI) database, we further illustrate the above insights in Section 2. According to the data, the actual percentage of private debt in these PPPs is only 39%, and it varies widely not only between projects within a country but also between nations with similar levels of development. Richer nations appear to draw slightly more private capital, but some upper middle-income nations have had little success doing so—a finding that is similar to the distinction between Lebanon and Turkey that was previously discussed. Lastly, there is a correlation between the percentage of private debt and several important institutional traits. It goes down as the cost of public funds goes down and goes up in the quality of institutions and bankruptcy procedures.

See Also:Commercial Construction Loan Requirements

The model’s building blocks are presented in the following section, which draws on the country examples and stylized facts that have been discussed thus far.

An overview of the model is provided.Two related questions must be addressed in order to mobilize resources to deliver infrastructure investments. First, the financing of infrastructure, or who ultimately bears the whole expense of providing the service. Options range from full tax funding to full cost recovery through users’ fees. The second is the financing of infrastructure, or who pays up front to construct and begin using it. Here, the spectrum includes a wide range of instruments and extends from fully public to fully private financing (budgetary expenditures, bond markets, bank loans, equity issuance, etc.).

Essentially, funding is a cash flow problem: Where will the funds needed to build and run the infrastructure that will provide services eventually come from? Long-term infrastructure investments, like energy networks or roads, typically have these kinds of cash flows that build up gradually over time and are frequently heavily back-loaded, meaning that not much is available during the initial construction phase. On the other hand, financing describes the systems and agreements that enable the equivalent of this potential accumulated cash flow to be made available up front in order to construct the infrastructure and guarantee that it offers services to users.

We characterize the structure of financial contracts and derive the conditions under which public and private finance coexist in the framework of an expensive state verification contracting model that involves three main agents: the government, the service provider, and the financier. The fact that the regulatory decision on pricing, the amount of public subsidy, and, consequently, the extent of cost recovery, are all jointly determined is a key component of the model.

To enable outside financing, attractive funding is first and foremost necessary. Private financing necessitates a service price and service provider subsidy that are both sufficiently enticing to outside financiers. When it comes to auditing the service-providing company under non-verifiability of costs, private financiers are comparative winners. Benefiting from this auditing ability, however, means paying the company a socially expensive rent. The best financial contract will increase the audit probability at a cost and raise the price above the level under verifiability at a risk of excluding the poorest customers in order to control this rent. Scaling back the firm’s operations results in the best possible balance between the cost of the audit and the informational rent of the company. It necessitates lowering demand, which raises prices. Consequently, the model shows a relationship between consumer prices and the amount of private financing that is practical.

It is more difficult to raise the price above the anticipated cost in order to generate revenue from user fees when demand is less elastic, such as in situations where consumers are severely impoverished or credit-constrained and respond angrily to price increases5. Therefore, we anticipate that projects in those contexts will depend more heavily on public subsidies, ceteris paribus. The first fundamental challenge of financing private infrastructure in developing nations is the tension that exists between inclusion and financial viability in the very locations where one would want to extend the service to a greater percentage of impoverished consumers.

Next, our model illustrates how this trade-off is impacted by various institutional and economic environment parameters. The viability requirement for private financing suggests that the cost of an audit and bankruptcy will increase the rent that the service-providing firm must pay to society. A lower service fee and increased private funding become possible when insolvency is resolved more quickly and cheaply, i.e., the audit cost goes down, lessening the previously mentioned trade-off. Therefore, it seems that protecting creditors’ rights is an essential first step in the effort to make private financing more accessible.

However, improvements for a number of characteristics lead to a decrease in both the optimal level of private finance and the service price, sometimes in a counterintuitive way. These include financial competitiveness and the cost of public funds. The decreasing cost of taxes and budgetary constraints make it more appealing for public authorities to rely on transfers instead of user fees, which also results in a decline in the proportion of private financing and service prices. Similarly, increased sensitivity of finance to the regulated price is a result of more efficient financial markets. Lower levels of private financing and lower prices are the outcomes of this.

Other important factors have more contradictory results. Higher levels of private finance are made possible by improved institutional environments, but higher service costs are the result. These improvements can be measured in terms of decreased corruption, increased bureaucratic efficiency, or improved regulatory quality. In fact, these advancements also imply that, from the perspective of economic efficiency, governments should raise prices in order to attract more funding while simultaneously limiting demand and giving regulated businesses lower rents.

Writings and Input.At least since public-private partnerships (PPPs) were revived in the 1980s, the role of private partners in infrastructure ventures has dominated the debate over infrastructure policy. Policy circles frequently tell stories about the need to create a growing number of PPPs in order to increase infrastructure investment levels. These stories rely on the need to raise additional funds as well as the idea that project efficiency is increased when private counterparts are involved. Nonetheless, the private component of PPPs still accounts for no more than 5% of the governments of developing nations’ yearly infrastructure investments (Fay et al., 2017). In the same way, the efficiency argument remains unsettled.6

In order to attract more private financing to infrastructure projects, the recent policy literature has primarily focused on creating a “infrastructure asset class” (Blanc-Brude et al., 2017), identifying the kinds of projects that could be privately financed (Cordella, 2018), generating sizable pipelines of these projects in order to attract investors, and addressing issues of pooling risk in project portfolios (Ketterer and Powell, 2018). Alternatively, the issue of private sector involvement has been approached primarily from a management standpoint (Arezki et al., 2017).

Closer to home, Estache et al. (2015) examine a particular facet, namely the ways in which the institutional environment and its constraints (capture, limited commitment, limited resources, etc.) affect the ideal mix of public finance, private debt, and private equity. Eichengreen’s (1994) analysis of the 19th-century railway development is also pertinent. In line with our findings, he demonstrates that, in the majority of cases, the only way to secure the necessary private investments was to grant various forms of public subsidies due to severe information asymmetries. However, this had an impact on the information rents that railway entrepreneurs were left with.

It is necessary to search the theoretical literature for information on the viability of private financing. The relationship between financial constraints and the regulatory, or more broadly the competitive, environment in which the firm evolves has not received much attention, despite the topic’s great importance.

Debt contracts are assumed to have a strategic impact on a firm’s relationship with its competitors or regulator in a first branch of the literature. The idea was further adapted to regulatory contexts by Spiegel and Spulber (1994) and Dasgupta and Nanda (1993), who show how a regulated firm may choose to increase its debt to grasp more of the surplus when it bargains ex post on regulated prices with its regulator.7 Brendar and Lewis (1986) demonstrated in a seminal paper that sparked a more general literature on the interaction between industrial organization and corporate finance that debt contracts make firms more aggressive on the product market because they force them to focus on the upside risk of their payoff. Although the direction of causality is still unknown, this conclusion is consistent with empirical evidence to the extent that highly leveraged firms are frequently found in regulated infrastructure sectors.9 Our model also predicts that higher regulated prices may be associated with higher debt leverage. But the mechanisms we draw attention to are essentially distinct from the liability effect that this body of work emphasizes. In fact, we turn the causality around. An argument in line with practitioners’ opinions is that outside investors are eager to invest in infrastructure sectors due to the stable regulatory environment and high return guarantees.10

Reversing the timing assumption, we embrace the New Regulatory Economics premise that governments establish the regulatory framework before businesses approach financiers.11 These decisions about timing and information structure thus suggest that our analysis cannot account for a limited liability effect. Similar to Iossa and Martimort (2012, 2015), financiers are primarily beneficial because they possess the knowledge necessary to assess the performance of the company. Nonetheless, the ideal debt contracts that financiers sign alter the company’s preferences and, consequently, how it behaves toward the regulator. To put it roughly, the cost structure of the company now has to include the agency cost of debt in addition to the cost of bankruptcy.

Lewis and Sappington (2000) examine how different informational scenarios can regulate a regulated firm’s financial structure.12 Our analysis differs from theirs in that public authorities are now interested in the economic regulation of the service, not just its financial aspects. This enables us to identify a fresh set of connections between financial contracting and regulation. Public subsidies serve as a means of facilitating access to the financial market by acting as a (public) equity stake. However, the altered cost structure of the company brought about by its connections with financiers needs to be taken into consideration when setting the regulated prices for the services. When outside financiers are present, controlled prices and profits react.

In keeping with Laffont’s (2005, Chapter 2) applied theory of the design of regulatory institutions at different stages of development, our framework endogenizes the financing structure and thereby contributes to our understanding of how various institutional reforms impact the optimal financing mix and shape access to the infrastructure service.

Arrangement. The format of the paper is as follows. The model is developed and the key findings regarding the relationship between financial contracts and regulatory prices are presented in Section 2. In Section 3, we expand upon our primary framework while focusing on a range of comparative statistics that demonstrate empirical regularities. There, we evaluate how our findings alter when we move away from perfectly competitive financial markets or include players with more complicated goals, like sovereign wealth funds, as well as when there is less commitment from public authorities and more general governance issues like corruption. We connect the results to case studies and empirically stylized facts in each Section. Section 4 concludes and addresses policy implications. Appendices contain proofs of the main results, additional model extensions, data description, and more stylized facts.

Principal components

The goal of a public agency is to create a public service. It necessitates constructing a vital facility that is financially worthwhile I. The Public Agency sets the price for the service regardless of whether it is provided by a publicly managed company or the private sector. The Public Agency may also look to private financiers to help fund this kind of infrastructure. In this instance, the cashless service provider approaches external financiers during the initial contracting phase in order to secure the necessary funding. In a moment

Different presumptions

We now evaluate how resilient our results are to different alternative hypotheses and draw relevant conclusions. We do this by employing a methodology first introduced by Laffont (2005), which entails examining particular comparative statistics that apply to developing nations within the framework of a potentially more widely applicable model.

We concentrate on two primary problems that have direct empirical relevance. First, we address governance-related issues in Section 3.1, specifically limited commitment (Section 3.1.1).

Final thoughts

We have created a model of funding and financing for infrastructure that jointly determines the amount of public subsidy, the extent of cost recovery from the pricing regulatory decision, and access to outside finance. This model illustrates some important trade-offs that policy makers must make when attempting to involve private finance in infrastructure projects. Several key lessons emerge from this model.

First, it’s necessary to raise private capital for infrastructure projects in developing nations.

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