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An emerging paradigm

With an estimated $541 billion reduction in investments into the top 30 global emerging markets in 2015 a roughly 50 percent drop year-over-year from $1.1 trillion in 2014 according to calculations by the Institute of International Finance (IIF) – it’s not surprising that some investors are feeling that good emerging market deals are getting harder to find.

But according to Sonja Gibbs, director of the IIF’s global capital markets department, while the overall reduction in capital flows is remarkable, the impact on foreign direct investment (FDI), including infrastructure investments, held relatively steady with a much less staggering 9 percent slide to $535 billion in 2015 from $586 billion last year.

Consequently, if the IIF’s prediction is realised, FDI will represent 95 percent of the non-resident cash flows into the top 30 emerging markets this year.

Much of the FDI shrinkage can be credited to Russia, where Gibbs said pull-back is clear, with weak oil prices – which have brought Russian petroleum exploration to a halt – and an unstable political climate jointly to blame for lack of appetite.

“Direct investment into Russia has tended to run around $25 billion to $35 billion since the Crisis. This year it’s only expected to be $6 billion. So there’s a big hit,” Gibbs said. She further noted that Latin America and the Middle East and North Africa (MENA) regions are also expected to see lower investment this year compared with 10-year norms.

Much attention has been given to China’s recent currency devaluation, which has sent ripples across the world’s markets. Even as Asian Development Bank (ADB) deputy chief economist Juzhong Zhuang believes that the currency has stabilised and should be less exposed to volatility in the coming months, the economy itself looks to be continuing along a path of gradual, long-term growth slowdown.

“Our latest projection is 6.8 percent [GDP growth] this year and 6.7 percent next year, so we downgraded from our 7.2 percent projection in April,” Zhuang said. Chinese GDP peaked at just over 14 percent about a year before the 2008 financial crisis, and has been falling steadily from 10 percent in 2010 to just under 8 percent in 2012, when the growth rate began to stabilise.

As a consequence of this slowed demand, Zhuang said that several emerging Asian markets, such as Malaysia and Indonesia, which both heavily rely on China to import their products, are liable to take a significant hit to GDP as a result of the situation in China.

“In the latest ADB analysis we looked at how China’s growth slowdown will impact the countries that rely on commodity exports. As China’s growth slows down by 1 percentage point, growth in six exporting Asian countries are impacted by 0.7 percentage points on average,” Zhuang said, noting that a previous study had found a 1 percent GDP drop in China would lead to a 0.3 percentage point GDP decrease across Asia as a whole.

But Zhuang said that China’s slowing growth is no cause for panic: “I don’t think this is a big problem. Of course it is a problem in a sense because growth is coming down, but this sort of thing is a positive development, especially in terms of structure and balance toward more consumption and services, away from exports and manufacturing investments.”

It’s hard to speak about Latin America these days without Brazil coming immediately to mind, but there are plenty of other market developments worth discussing outside of the vast Amazonian nation.

Consider Peru, Colombia and Mexico, which have been learning from each other’s contracts and project pipelines, according to Pablo Jaramillo, who is an associate with Bogota-based Norton Rose Fulbright Colombia and an active advisor in the space.

Jaramillo is optimistic that due to growing institutional knowledge and capacity, the project pipeline in certain Latin American markets, such as Colombia and Peru, will continue to grow without becoming “aspirational”, and therefore unattractive to serious investors. While he admits the commodity cycle could significantly impact projects on the Peruvian and Colombian Pacific coasts if say, oil prices tumble further to below $50 per barrel, he remains optimistic about the region’s overall ability to attract sufficient capital to develop viable projects.

In Colombia, contracts for 4G are, if slow to reach financial close, becoming increasingly bankable, according to one public-side advisor to the tendering process. And in Peru, Jaramillo awaits the details of the Lima water distribution P3 project which, with a ticket price of $600 million, would bring Peru’s social infrastructure programme to new heights. Paraguay, which after enacting P3-enabling legislation in 2013 is finally bringing its first P3 project to market, also holds promise in Jaramillo’s eyes, especially in light of the government’s decision to publish the contracts for a six-month public comment period, which is expected to conclude in December.

Worth watching out for on the other hand are the increasing illiquidity of 4G projects, as Jaramillo predicts that upcoming projects in that programme are likely to take quite a while to reach financial close, and currency fluctuations, which are also having an impact on project costs.

“I think the current situation is pretty favourable, because equity and debt investments are much more useful when most of the cost of construction is incurred in local currency, but the fact is that this can continue into the operational stages, and therefore the possibilities that the operational revenues could be heavily affected is really something that has to be looked in to,” Jaramillo said.

Considered to be some of the largest and most sophisticated investors in the world, sovereign wealth funds (SWFs) are known for their opacity and for their long-term views, but with certain major commodity-dependent sovereigns facing budget crunches, new strategies appear to be emerging for these funds.

Dr Ghiyath Nakshbendi, a professor at American University’s Kogod School of Business, who has 30 years of project finance and fund management experience including stints with the Arab Fund for Economic and Social Development and the Kuwait Investment Authority (KIA), said that while GCC countries’ SWFs are designed to offset deficits during times of low commodity prices: “We have to recognise the fact that especially with the decrease in the price of oil, most of these [exporting] countries, including Norway, have been divesting in order to bridge the gap in their budget […] and when you are divesting you are not going to really be in the mode of finding other opportunities unless you are trying to move to a class of assets that is more risky but with higher return,” Nakshbendi said.

Some SWFs, Nakshbendi said, have invested into China, India and Southeast Asia, shifting from developed markets to developing markets in a quest for higher returns, and Kevin Lu, managing director of Partners Group’s Singapore office and World Bank alumnus, echoed this in an email. In order to satisfy their appetite for exposure to higher-yield infrastructure assets, Lu said he has seen some sovereigns turning to emerging markets, and others turning to greenfield projects.

“Sovereign long-term investors, including SWFs and sovereign pensions, are looking for both core OECD infrastructure assets and higher-yield infrastructure assets. Asian sovereigns have started to work very closely with multilateral development institutions, partially because the latter are deemed as risk mitigants,” Lu said.

“Japan’s GPIF and Singapore’s GIC entered into investment relationships with the World Bank’s IFC. The World Bank’s Global Infrastructure Facility (GIF) is also actively developing a project pipeline and engaging institutional investors. Partners Group serves on the GIF Advisory Council.”

One advisory team we spoke with recently revealed that China’s sovereign wealth fund, CIC, is actively – and somewhat aggressively – pursuing infrastructure investments in Africa, which appears to fit with the July launch of CIC Capital, a subsidiary of CIC created to make direct investments globally into private equity and infrastructure. “We expect CIC Capital to be very active,” said Lu.

Gibbs agreed that this makes sense considering China’s desire to transition from a manufacturing to a service-led economy.

“You have a broad transition away from manufacturing and toward service-led growth, and this is particularly evident in China. When there’s less reliance on manufacturing, that’s hard and it’s a transition that needs to be made in many emerging markets, because they’ve been relying a lot on exports, and if China simply isn’t going to have as much of them, both because they’re growing more slowly and because they’re shifting to a services-led economy, that’s a new paradigm,” Gibbs said.

According to numerous media reports, many are convinced that with expectation of a rate hike from the US Federal Reserve sometime in the near- to mid-term, emerging markets should be avoided until the dust has settled, and while that appears to be a solid strategy in some regard, Zhuang said that in his view, “most of the impact, the market has already factored in, market volatility, slowdown in capital inflows”.

“If and when the interest rate does increase, I think there might be added volatility but I don’t think it would be too big a surprise,” he said.

And Gibbs said it’s important to remember that while emerging markets do face a lot of domestic pressures with slowing growth and weaker commodity prices hurting government revenues, the public sectors in these markets typically have low levels of debt, and are thus in a position that allows them to consider internal infrastructure project development as a means to spur growth to counter externalities.

“Whereas mature market economies really loaded up on debt-to-GDP and over the last several years that has risen sharply and that doesn’t leave them a lot of room to develop infrastructure, at the national level, emerging market governments still have some space there,” Gibbs said. “There is also a big push to collaborate with the private sector.”

That is because, as Jaramillo points out with reference to Latin America and Zhuang points out in regard to Asia, lack of existing competitive infrastructure is behind a demand for continued development and fairly universal government support.

“Definitely we’re seeing a shrinking in the foreign investment caused by the current commodity situation that definitely impacts the Latin American markets,” Jaramillo said.

“But that being said, on the infrastructure side of things what you see is that the social demand for infrastructure development ultimately means that they have not been impacted in the same manner, because there is substantial level of governmental support for these projects, and therefore foreign investors are really seeing governments pushing for these projects to keep on going despite difficulties in the economic situation.”

Despite this pronounced demand for private capital in infrastructure development, in the increasingly competitive modern investment climate Gibbs said that caution is the word of the day.

“In the current environment with all of these broader risks for the emerging market economies, there’s definitely a more cautious tone, including for infrastructure investment,” Gibbs said.

“It’s a new world that has to be adjusted to, and it’s going to be bumpy,” concludes Gibbs.