Sector Review:

Why Global Investors Aren't Making Inroads Into Infrastructure Funding In Asia
Primary Credit Analyst: Ian R Greer, Melbourne (61) 3-9631-2032; [email protected]

Table Of Contents
Back To The Future Lower Credit Standards Limit The Number Of Investable Projects State Funding Takes Several Forms Access To International Bond Markets Is Constrained Developing A Credit Market For Infrastructure Is Key In Asia Related Research

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Sector Review:

Why Global Investors Aren't Making Inroads Into Infrastructure Funding In Asia
Pension funds, and other non-traditional lenders, are eagerly eyeing investment opportunities in Asia's booming infrastructure sector. On paper, it looks a good fit. Mega-projects are underway across this developing region, including road-building and electricity programs. Traditionally, global pension funds have favored infrastructure sectors, given the probability of stable, long-term returns. But that isn't as certain in Asia. Economic and sovereign risks can vary enormously among Asian countries, and potential lenders may conclude the risk-rewards aren't high enough. Standard & Poor's Ratings Services also believes the stranglehold of Asian banks on infrastructure funding may prove hard to break. For those reasons, global investors aren't making the same headway into infrastructure financing as they are in the U.S. and Europe. Asian banks are highly liquid, given large savings deposits, and they have become the dominant infrastructure debt financiers in Asia's emerging economies. The banks' desire to expand their balance sheets--in contrast to counterparts in the U.S.--means they are highly motivated to keep out foreign and non-traditional lenders. At least for the time being, debt financing for Asian infrastructure remains the preserve of the Asian banks. Some banks' lending terms fall short of the credit standards that most international lenders would require, and the low cost of funds is also pricing out potential competitors. Asia's doors aren't closed to institutional investors, but success is dependent on understanding each economy in this inhomogeneous region. Clearly, opportunities exist. According to consultant McKinsey & Co., as a percentage of GDP, China (8.5%) has overtaken the U.S. (2.6%) and the E.U. (2.6%) to become the world's largest investor in infrastructure. In addition to domestic spending, much of this investment is not at home. China State Grid, for example, owns electricity transmission assets in Portugal, the Philippines, and Australia. Overview Asian banks dominate infrastructure lending, as lower credit standards and the low cost of funds push out potential competitors. Economic and sovereign risks can vary enormously among Asian countries, and potential lenders may conclude the risk-rewards aren't high enough. Infrastructure-related issuance is likely to remain muted in Asia for some time. Reducing risks will require the greater development of a credit culture and supportive framework. Most Asian governments are committed to creating a viable domestic bond market, which will also benefit from better lending practices.

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Sector Review: Why Global Investors Aren't Making Inroads Into Infrastructure Funding In Asia

Back To The Future

A look back at the 1990s indicates the difficulty in predicting the stability of cash flows and profitability in the infrastructure sector. Asia launched a slew of U.S. dollar-denominated project bonds to finance power projects throughout the decade. But it was difficult to hedge forward currency movements. Power purchase agreements therefore contained a formula that increased the tariff payable when exchange rates rose. During the Asian financial crisis in 1998, the exchange rates of many Asian countries plummeted, resulting in high prices for power. In addition, many power projects imported fuel, which was also priced in foreign currency. This led to three important lessons about financing for Asia's infrastructure market: Affordability. The service being delivered must be affordable to the end-user at all times. Counterparty risk. In some countries, the offtaker--usually the state-owned power company--is paid in full. However, some power companies didn't pay or only partly paid the power producers, leaving infrastructure investors to cover the loss. Currency risk. A mismatch can arise between the currency of revenue and costs including interest costs. Unlike the 1990s, when local banks couldn't finance domestic infrastructure, today they are very liquid. The local banks are able to fund in local currency and at rates that make infrastructure affordable. The banks typically have weak credit standards, basing their lending on the credit quality of the ownership group rather than the project. This generates three problems: International funds will require higher credit controls, which will raise costs, reduce management flexibility, and undermine the attractiveness of the yields to borrowers. Alternative funds may be more expensive because the lenders look only at the infrastructure assets and not the group. Local bank debt is short term, which requires projects to refinance and therefore leads to increased risks for international lenders. Unlike the 1990s, the currency hedge market now has greater depth, opening up the possibility of funding in foreign currency without passing this risk to the end-user.

Lower Credit Standards Limit The Number Of Investable Projects

The biggest problem for private financing is having a steady flow of investable projects. In banking circles, a project is considered bankable if it meets the minimum credit criteria that the banks require. Similarly, for bonds, an investor will invest only if the debt meets minimum credit quality and return parameters. We can dub this "investability." Many offshore investors expect higher returns from Asian infrastructure to reflect the greater risk. However, they are competing with liquid local banks that can charge lower costs and lend on weaker credit standards. As a result, there's little incentive for governments to structure projects that international investors would consider investable. If an infrastructure asset has short-term debt, the refinancing-risk premium adds to the required return. But affordability limits the cash flows from an asset. In the early 2000s, many investors increased the returns from infrastructure through "financial engineering." But such modeling performed poorly during the global financial crisis, and is now out

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Sector Review: Why Global Investors Aren't Making Inroads Into Infrastructure Funding In Asia

of favor. The key criteria for a project to be investable are: A reliable, predictable revenue stream--the funding; A creditworthy counterparty to deliver the cash flow; and A fair and reliable legal system that is enforced in a timely manner to protect the investors' rights.

State Funding Takes Several Forms

Asian governments will continue to write the checks for most infrastructure projects as part of their normal procurement since most projects aren't supportive of private financing. These investments become part of the government debt levels. While private funding is proportionally small, it's nonetheless a large amount and alleviates pressure on government finances. Infrastructure projects can capture the funding in three ways: Government payment streams--such as public private partnerships or power purchase agreements for utilities; Assuming patronage risksuch as for toll roads, where the private sector is paid from the tolls that road users directly pay; and Fees or tariffs. Projects with power purchase agreements can attract private finance, but as they are a fixed obligation to the government they are treated as quasi-debt obligations. For toll roads, transferring the risks for ensuring traffic levels to the private sector can reduce the impact on the government's credit quality. In Australia, however, some infrastructure companies overbid on a number of toll roads, with actual traffic well-below forecasts--by as much as one-third in some cases. That means the private sector is now unwilling to assume "greenfield" traffic risk, or the risks for traffic levels in newly developed locations. Privatizing an infrastructure asset can also help governments to reduce their own financial burden provided: (1) they use the cash to fund other infrastructure projects or reduce debt; and (2) they sell the asset at a higher price than the discounted revenue stream the government would have received if the asset had remained in government ownership. There is ready demand for investment in "brownfield" assets, such as established ports or toll roads with established demand patterns, supported by reliable regulations.

Access To International Bond Markets Is Constrained

Infrastructure-related issuance is likely to remain muted in Asia for some time. Bond markets in Asia (ex Japan and Australia) have grown rapidly over the past 20 years from almost nothing. But corporate bonds represent just one-third of issuance (see chart). The largest domestic bond markets are China, Korea, Malaysia, Thailand, Taiwan, Singapore, and Hong Kong. The Philippines and Indonesia are a long way behind. Apart from in Korea and Malaysia, most bonds are government debt.

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Sector Review: Why Global Investors Aren't Making Inroads Into Infrastructure Funding In Asia

Infrastructure projects are domestically based and in many cases reliant on a government-owned entity for cash flows. Consequently, sovereign ratings can influence access to international markets. Hong Kong, China, Japan, and Korea are relatively highly rated, increasing the opportunities for issuance for companies there. Country risk assessments can also influence bond ratings, given variations in legal systems and economic conditions across the region. We wouldn't expect to rate a debt issue above the sovereign rating unless an external party guaranteed the issuance.

Developing A Credit Market For Infrastructure Is Key In Asia

The stages of development vary across Asia, but those Asian governments in high-growth countries may face difficulties in maintaining growth and funding for all their infrastructure needs. They will need the private sector to channel funds into some projects, or face the prospect of a slowdown in investments that will constrain economic growth. We also question the ability of domestic banks to keep pace with the demand for infrastructure. But attracting foreign investment will necessitate risk-adjusted returns. Lower returns will require lower risks. And reducing risks will require the greater development of a credit culture and supportive framework. Most Asian governments are committed to creating a viable domestic bond market, which will also benefit from better lending practices. Without good credit financing for infrastructure, the banking sector may face increased risks, as has

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Sector Review: Why Global Investors Aren't Making Inroads Into Infrastructure Funding In Asia

happened in China (see "How Big A Worry Are Chinese Local Government Debts," March 14, 2010). For now, state investment and bank financing looks likely to remain the main funding source for many Asian infrastructure projects.

Related Research
Global Infrastructure: How To Fill A $500 Billion Hole, Jan. 16, 2014 Credit FAQ: How Can Infrastructure Be Funded In Australia? Dec. 20, 2012 India's Power-Sector Debt Restructuring Proposal: A Salve, Not A Cure, Sept. 7, 2012 Financing Asia's Infrastructure Gap, March 1, 2011 How Big A Worry Are Chinese Local Government Debts, March 14, 2010
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