Financing infrastructure: A government guarantee

Financing infrastructure: A government guarantee

Lalu A. Damanhuri
Infrastructure Planning
& Development Specialist
Committee on Policy for
Infrastructure Development
(KKPPI)
Jakarta

The government has just relaunched its big infrastructure
projects consisting of 26 independent power producers (IPPs) --
power plant, three toll road and east flood canal projects.

Infrastructure investments have alluring benefits, but also
daunting costs. Where infrastructure is inadequate, their
provisions can do much to boost productivity and growth.

But where income and productivity are depressed by inadequate
infrastructure, the financial resources needed to underwrite
infrastructure investments are difficult to mobilize, with the
lack of infrastructure limiting finance and the lack of finance
limiting infrastructure.

If infrastructure throws off externalities that raise
productivity and profitability elsewhere in the economy, but
cannot be captured by those who finance the investment project,
then the classic efficiency argument for subsidies applies. And
even when the returns are appropriable, investment may still not
pay if domestic funds are costly; investors may then seek finance
abroad where it is cheaper.

Government guarantees and foreign borrowing are prominent
features of infrastructure finance in the respective projects.

Increasingly, these arguments for government intervention and
foreign borrowing are regarded with skepticism. The "white
elephants" subsidized by governments have underscored doubts
about the efficiency of public finance. Our debt-servicing
difficulties have raised questions about the efficacy of foreign
borrowing. Both observations encourage proposals to commercialize
and privatize infrastructure projects, and to fund them by
promoting the development of financial markets.

There is nothing new about these arguments or these
reservations. Infrastructure projects in virtually all of the
recent trend were privately financed and privately constructed.
In the past, however, government subsidies and external finance
were integral to the process of infrastructure development.
Finance was raised abroad, mainly on the overseas capital market.
This history suggests that reliance on private initiative should
not be viewed as obviating the need for government guarantees and
foreign finance.

In elucidating these historical patterns of public
intervention and external finance, there is a premise that
observed patterns are consequences of the structure of financial
markets in countries in the early stages of economic development.

Electricity and toll roads are the most prominent and capital-
intensive among infrastructure investments -- they forged unified
national markets, linked domestic producers to the expanding
economy, facilitated the development of high-speed-throughput
mass-production techniques, and incubated modern management
practices.

The local finance was difficult to generate, however, since
the capital requirements of early infrastructure projects were
more modest than those which followed, and the funds were
available in Indonesia. Elsewhere, it was necessary to seek
external finance.

In the case of infrastructure investments, government aid took
the form of subsidies and aid in kind -- often financed by the
issue of bonds designated for the purpose or the earmarking of
revenues -- and of guarantees of interest on bonded debt.

Government guarantees were particularly important for
attracting foreign investors, for whom distance was an obstacle
to the acquisition of information. Without the guarantee, it was
said, infrastructure projects were impossible to finance. Once
the guarantee was provided, however, infrastructure projects had
no difficulty in raising funds abroad. Guarantees played a role
in the construction of all of Indonesia's important
infrastructure projects.

While guarantees helped infrastructure promoters surmount
credit-rationing problems, they also weakened the incentive for
investors to monitor management. Investors no longer stood to
lose -- or to lose as much -- if promoters and their confederates
diverted resources from productive uses, since the government
promised to bail them out. This gave promoters an incentive to
negotiate sweetheart deals with contractors and channel cash into
their own pockets.

Since many partnerships were temporary, promoters had little
reason to be deterred by reputational considerations. Thus, there
was potential scope for looting. Bondholders had little incentive
to expend resources to determine whether promoters and
contractors were diverting the project's resources into their own
pockets, since the rate of return on bonded debt was guaranteed
by the government.

Only if government authorities monitored the actions of
promoters and contractors and threatened them with legal
sanctions, did the latter have reason to be deterred.

What the record reveals is that private provision and local
finance did not obviate the need for government intervention and
foreign borrowing. Although most infrastructure projects were
privately financed and constructed, government subsidies and
external finance were still integral to the process.

The characteristic of markets in the early stages of
development hindered efforts to rely on private finance. Funds
adequate to underwrite the construction of infrastructure
projects could not be mobilized through the operation of domestic
financial markets alone, which gave rise to adverse selection and
moral hazards, which in turn discouraged private investors.

Financial institutions specializing in project assessment and
monitoring management performance helped to attenuate these
information problems and to encourage private investment, but
these were typically foreign institutions with foreign
clienteles.

Foreign intermediaries had a head start as a result of having
evolved in response to the earlier economic and financial
development. Reliance on private provision and finance
consequently did not obviate the need for either government
intervention, such as the provision of bond guarantees designed
to relax credit constraints, or external borrowing.

Often, however, such government intervention simply replaced
one set of problems with another. Investors, having been
guaranteed a return by government, had little incentive to
monitor management performance. Management, freed of investor
scrutiny and having gained capital-market access courtesy of the
government, could seal sweetheart deals with construction
companies that left taxpayers holding the tab.

Guarantees might have rendered irrelevant those information
problems that hindered investors' efforts to evaluate the
commercial prospects of infrastructure projects -- but without
providing mechanisms to monitor the uses of external funds and to
protect the public interest.

These are no mean feats for any government in any setting.
Proposals for privatizing the provision and finance of
infrastructure investments notwithstanding, it seems likely that
the traditional role of the government -- and the traditional
problems associated with government intervention -- will
invariably remain.