Emerging markets are all about superlatives. But if some of them go in and out of fashion – like ‘breakneck growth cycle’, now over; or ‘hard landing’, currently ongoing – there is one that seems to remain constant over the years: their ‘whopping infrastructure gap’.
By the some accounts, developing economies will have to spend about $2 trillion a year on infrastructure over the next decade just to keep afloat. That’s $1 trillion more than what is currently being spent. A gigantic infrastructure financing gap therefore exists – and one that governments and development banks seem unable to bridge alone.
Luckily, big money is what institutional investors have aplenty these days, especially insurance companies. According to Infrastructure Investor Research & Analytics, insurers already exposed to infrastructure collectively manager about $11 trillion of assets worldwide. And with allocations standing currently at an average 1.35 percent, there’s much margin for them to invest more in the asset class.
“Infrastructure debt is of particular interest to insurance groups, in contrast to pension funds, which tend to favour infrastructure equity products,” says Bernard Sheahan, head of infrastructure at the International Finance Corporation (IFC).
Yet demand for lending opportunities in the OECD vastly outstrips supply, putting pressure on returns and leaving allocations unmet. Hence the temptation to see emerging markets as the promised land. But while Solvency II, the regulatory framework governing how insurers can invest their money, has long cast a shadow of uncertainty over the industry, recent clarity over what it entails has freed up money to be invested in developed markets.
Insurers still have to value their investments on a mark-to-market basis, and set a target amount of capital they will hold against them. However, recognition that core infrastructure debt enjoys high recovery rates has led the regulator to cut capital charges on BBB-rated assets by 30 percent (the charge was previously the same as on corporate bonds).
The issue is that emerging market infrastructure debt, perceived as riskier, will often fail to hit the credit quality threshold. Enters the IFC. Two years ago, the organisation launched a pilot scheme to build on its success in providing equity to infrastructure projects. This first structure saw IFC invest $3 billion in infrastructure debt on behalf of the Chinese central bank.
The institution is now willing to involve a wider pool of institutional investors – and in particular insurers. IFC is therefore in the advanced stages of launching separately managed accounts with a number of insurance companies. These will have a particular feature: “Following the same methodology as Moody's, we're offering to bridge the gap between emerging market debt and what investors expect from a similar opportunity in OECD markets,” Sheahan says.
Credit enhancement tools have been applied to emerging market infrastructure debt before. But here they’re used to boost the ratings of an entire portfolio to about BBB, paired with the origination and execution capabilities of the IFC. This should provide insurers with both a route to market and the guarantees they need to invest on viable terms.
Solvency II’s reduced capital charge may only be used by insurers adopting the regulator’s standard formula, since firms with sufficient in-house capabilities are also allowed to use their own models to convince the regulator that their risk parameters are sound. Most German firms fall in the former category, UK ones tend to be in the latter. But in a way that doesn’t really matter: credit enhancement should now provide all of them with better arguments to impress the powers that be.