In the roughly 30 years since the term was first coined, “emerging markets” have gone from being synonymous with crises to being identified with relative stability and growth (sometimes breathtaking growth).
While the term emerging markets – as well as more recently introduced acronyms such as BRIC (Brazil, Russia, India, China) and CIVETS (Colombia, Indonesia, Vietnam, Egypt, Turkey, South Africa) – belie the disparity in conditions and performance among their constituent countries, they do serve to broadly identify countries whose economies are growing much faster than those of developed markets.
In the foreseeable future, the combination of still relatively low GDP per capita, market-friendly economic reforms and sound fiscal management should support continued strong, albeit uneven, economic expansion in emerging markets.
Infrastructure investment will be critical to this continued expansion and the imperative of improving the quality of life in emerging markets where, despite considerable investment over the past two decades, the stock of infrastructure lags far behind developed markets and risks becoming a limiting factor on growth.
Even in China, where investment in infrastructure has been more aggressive than in other emerging markets, the deficit remains large. For example, its highway network covers only 35,000 kilometres, compared with 256,000 kilometres in the US.
On a current GDP basis relative to developed markets, the infrastructure stock deficit in emerging markets appears to be in excess of $5 trillion. Taken on a per capita basis, this deficit appears several- fold greater. The average infrastructure stock per capita in emerging markets is probably one-twentieth the level in developed markets. Various sources put the need for infrastructure investment in emerging markets at about $1 trillion per annum in the foreseeable future (and an equivalent amount in developed markets for rehabilitation, modernisation and expansion).
It could well be that emerging market infrastructure will be the investment story of the 21st century. What role the private sector will play in this story is becoming clearer with the prevalence of public-private partnerships (PPPs) over the past two decades. Estimates are that between 15 percent and 20 percent of investment in infrastructure will come from the private sector, or roughly $150 billion to $200 billion per annum in emerging markets.
Emerging market infrastructure has unique characteristics that present both benefits and threats to investors.
A benefit is that the market risk of most projects is lower than in developed markets as they are addressing the market at a stage where demand far outstrips supply and is relatively price inelastic.
On the other hand, a key threat is sovereign risk, in particular creeping expropriation whereby a government intervenes in a project to the detriment of its investors. This can be for commercial reasons, such as limiting the currency movement that local rate payers must absorb. It can also be for purely political reasons, such as currying favour with voters by acting to curb profits earned by foreign investors.
The tools of government intervention include the direct, such as the abrogation of off-take contracts, and the indirect, such as changes in tax laws and the removal of subsidies.
The proper selection of jurisdiction and project can go a long way to mitigating sovereign risk. Investors should seek out opportunities in jurisdictions where government policies, laws and regulations are supportive of private sector investment in infrastructure and, where possible, have been tested through proper implementation and the fair resolution of disputes. Investors should also select projects that provide an affordable service and are cost-competitive over the long run.
Furthermore, investing in projects in which development finance institutions are present provides an extra layer of protection. Proper project structuring is necessary as well to mitigate sovereign risk. As governments will typically be relied on for support, either directly through contracts or indirectly through the maintenance and enforcement of regulations, provisions for penalties for adverse changes to that support, and international dispute resolution and mediation, should be sought.
Gaining intelligent exposure
So how can investors take advantage of the opportunity while mitigating the risks?
On the listed equity side, there are many funds (including ETFs) targeting the sector, typically through relatively broad strategies that include indirect infrastructure plays such as construction and energy services. They can offer good diversification and liquidity, although it remains unclear as to how uncorrelated with the broader equity markets their performance is.
There are also many private equity funds targeting the sector both globally and regionally. As with emerging market private equity generally, the asset class is relatively new and it is still too early to be able to reliably assess its performance. In general, equity suffers first from the inevitable delays in developing infrastructure projects, delays that are relatively greater in emerging markets. Moreover, governments will typically protect the interests of lenders over shareholders, and at times punish foreign shareholders when it is politically expedient to highlight their “unfair” profits.
Fixed income provides a means for investors to earn stable absolute returns that are uncorrelated with the broader markets. However, there are few easy means to access fixed income investments in emerging market infrastructure. Project bond issuance is relatively limited, and there is only one fund that specialises in these.
Syndicated project loans originated by development finance institutions and commercial banks are far more common, but there are very few vehicles through which to invest in them. Syndicated project loans offer certain advantages over project bonds, including more active engagement in addressing underlying project issues and better deterrence against creeping expropriation. Both project bonds and syndicated loans are priced at varying premiums to relevant sovereign ratings.
Evan MacCordick is a managing director at Cordiant Capital, a manager of dedicated emerging market funds. Since 2001, Cordiant has invested over $1.8 billion on behalf of institutional investors in strategies ranging from private debt to private equity, including over $500 million in infrastructure.