Throughout the world, governments in indebted countries have seized the idea that investment in infrastructure is the single most effective policy option available to them to stimulate their economies. Developing countries are engaged in similar activity in order to build a firm base from which they can develop.
On an aggregate basis there is concern that demand for funds exceeds the global supply by a significant margin and that only the most credit-worthy states will be able to attract private sector finance.
This may be a key structural issue that will determine the way in which the balance of the global economy will be reshaped over the next 20 years.
Recessions are transformative events. Economic theorists argue that the virtue of recessions is that they recycle a significant fraction of assets simultaneously, enabling a dysfunctional economic balance to be replaced by a new structure.
Survival is vital, but the precise way in which you emerge is key to subsequent prosperity and this is true for states and companies.
The received wisdom, most closely associated with John Maynard Keynes in the 1930’s, is that in recession a government should borrow to finance major public works projects in order to stimulate investment and employment. The marginal debt can be repaid when the economy is buoyant and tax revenues increase.
The adoption of this Keynesian solution has become so widespread that the global aggregate proposed expenditure on state sponsored infrastructure projects is estimated to be UD$ 50tn over the 17 years to 2030.
If this proposed expenditure was distributed evenly across the period it would absorb around 4%1 of global GDP.
If the distribution of expenditure is skewed toward the short term, which is likely, it could exceed 6% of GDP during the initial period.
Compare this data with the fact that the USA expenditure on infrastructure has fallen to 2.4% of GDP, whereas India and China spend around 9% of GDP.
In the 10 years to 2010, global credit expanded from US$57tn to US$109tn and must grow to US$210tn by 2020 if the ratio of credit to global GDP is to be preserved.
But the principal features of the current recession are that many states are already over -leveraged and need to reduce their national debt at the time when, according to Keynes, they should borrow to invest. The natural alternative is to turn to private sector funding under some variant of the established PPP structure.
The second key feature of the recession is that the banking sector has been damaged severely and is not in a position to provide the volume of debt that would traditionally been used to fund PPP projects.
Given the constraints in banking and the need for it to expand credit to underpin the growth of world trade it is unlikely that it will be able to provide the debt funding required to support the projected global infrastructure expenditure.
So if the unprecedented demand for infrastructure cannot be funded by sovereign debt or by the banking sector, what is to happen?
The easy answer is to believe that the private sector will fill the gap.
The value of assets globally held in institutional funds is estimated to be US$65tn and these institutions seem unlikely to invest more than 6% (US$ 4tn) in infrastructure as part of a balanced portfolio.
Consequently, if the normal annual global average expenditure in infrastructure was 4% of GDP but over the next five years this increases to 6% of GDP, then the marginal increase equals US$1.4tn pa, which cannot be funded through credit growth.
Were this marginal increase to be funded from institutional funds over the next five years, it would represent US$7tn or an additional 11% of the sectors assets in real terms.
Our estimate is that at least 20% of the proposed expenditure of US$50tn is not fundable.
If debt-to-equity ratios are also modified to reduce leverage, we estimate that the non-fundable proportion may rise to 30% or US$15tn.
This data makes no allowance for the observed trend that infrastructure projects can exceed their original budget by 30% to 80% and therefore those projects that do proceed will need to secure this ‘contingency’ funding. This implies that, to accommodate the low level of probable overspend, only US$25tn or 50% of the proposed expenditure on infrastructure may be able to commence.
Demand pressure will cause the cost of infrastructure finance to increase and only projects proposed by the most credit-worthy states and those offering the highest investment returns will absorb the limited funds available.
We believe that these projects will need to generate a minimum IRR to equity of 15-20%.
Funds will flow to countries offering the lowest credit risk and it is conceivable that wealthy nations may absorb the entire volume of funds available globally for the infrastructure asset class, mitigated only by the balancing of geopolitical risk. Such distortions may not necessarily increase the availability of finance to projects considered to occupy a higher risk category and where funds are available, they may not be priced at margins that projects can support. Capital markets will be concerned with the problem of deciding which projects to support.
The consequence of rationing funding for infrastructure projects will, if Keynes’ thesis is correct about this being the prime mover of economic recovery, be to reshape global economic topography to benefit those nations that are financially wealthy but asset-poor and disadvantage those nations that are asset rich but financially challenged. Developing nations that are both financially and asset-poor will find the acquisition of finance to be extremely difficult.