For the vast majority of high-growth cities, the principle of infrastructure often comes down to the ability to pay. But here - as anywhere - the reality is that funding can only effectively come from three sources; government taxation or levies, real estate and user-pay mechanisms.
Making the most of private investment
Given that many national budgets remain stretched as a result of the global financial crisis, the conditions seem ripe for the wider introduction of Public Private Partnership (PPP) structures using private finance.
Motivations for using PPP vary across markets. In developed markets, infrastructure financing has generally evolved towards government payment streams for the availability of services provided by the private sector under a PPP. But in many of the emerging markets, such as India and Brazil, the inclination is to use PPP for economic infrastructure that generates cash flows directly from the users (such as toll roads, electricity generation, and water supply).
PPPs in emerging markets
And while these models are attractive to governments seeking to minimize their up front capital investment, the success of PPP structures in high-growth markets often comes down to fully understanding the ramifications of these structures on governments, sponsors and users. For example:
- Cost of capital - In many emerging markets, the interest rates for project sponsors are typically much higher than the record lows currently being enjoyed in Europe and the US. And with Brazil and India's cost of borrowing for the private sector at 11.5-12.5 percent, the total cost of capital for projects in these regions is therefore high, which inevitably leads to higher tariff pressures on consumers.
- Inflation - High-growth markets tend to suffer from high levels of inflation (9 percent for India and 6.5 percent for Brazil). As a result, there is often a significant impact on the underlying cost of the goods and services required under the PPP agreement, which may again lead to increased pressure on tariffs.
- Currency risk - For many infrastructure projects (such as roads) revenues and expenditures are typically accounted for in local currency which, in turn, requires debt and equity to be raised in local currencies as well. But local banks are often inexperienced and lack access to capital market options leading to short-to-medium term debt (up to 15 years) that carries limited effective risk transfer. However, there are many salutary cases to illustrate the risk of this approach, and the ability to pass on this risk to users should be carefully considered.
- Demand risk - Implicit government support may be required to mitigate demand risk in the early years of a project, or to support project termination payments. Particularly for governments, there is a critical need to appropriately recognize any contingent liabilities under these contracts.
Developing successful PPP structures in emerging and high-growth markets requires both governments and sponsors to be realistic about the specific risk allocations for PPP projects, and to carefully assess the ability of projects to be free-standing economically. Getting this right will almost certainly be the key to unlocking affordable and sustainable infrastructure funding that - ultimately - will enable high-growth markets to maintain their current trajectory.