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.