Time to build the new world
The growth of Asia is undoubtedly one of the great investment stories of the coming generation, and infrastructure is one of the key areas of exposure for European investors. But Martin Steward finds that the opportunity might be surprisingly short-lived
Sometimes the numbers being thrown out by emerging markets become so mind-bogglingly large that they almost cease to have any impact. Most mind-boggling of all are those associated with demographics and the related sphere of infrastructure development.
In 2008, Morgan Stanley reckoned that $22trn would be deployed throughout emerging markets over the next decade, and that nearly 70% of that would be spent in Asia. If anything, the global financial crisis will boost that figure. China is currently engaged in its 11th five-year plan, which will deploy about $1.25trn; but that was augmented by a further $580bn for 2009-2010 as part of a recession-busting stimulus plan.
Although this is clearly a long-term story, it is happening right now - not least because (however counter-intuitively) infrastructure is one of the most efficient ways to put growth-stimulating capital to work.
Jerome Booth, head of research at Ashmore Investment Management, which has been managing infrastructure in its distressed debt, private equity and special situations strategies for some time and is now rolling out infrastructure-specific joint ventures and funds, points to the impact of the coming global rebalancing. As Asia brings its current account surplus down and the West's goes up, savings that used to be exported will be redirected into the domestic economy (or to other emerging economies, as we see in the form of Chinese investment into Africa).
That enormous wave of money will hit the barrier of absorptive capacity without projects to soak it up. Infrastructure fits the bill perfectly. Big projects like road and port building are not only massively capital-intensive, they also create new investment opportunities over the medium term that can go on to absorb even more of those savings.
"Infrastructure helps to enhance cross-sectoral consumption patterns," as a recent paper on Asian infrastructure from JPMorgan's Rumi Masih, Anthony Adams and Steven Weddle puts it. "For example, investment in roads and major transport links should improve overall economic efficiency and productivity, which encourages competition and the start-up of new goods and service providers, thereby leading to self-sustaining growth in consumption."
"That's why we will see a lot of policy action," Booth agrees, "and this has been central to our winning a contract in India recently, a joint venture with PTC India to manage an energy projects fund. India has a long history of PPPs and has a huge spending plan in place. Infrastructure will be top of the list, even before real estate, to absorb those savings, because it leads to other investment opportunities."
The logic is clear - there's no point building a factory, a shopping mall or an apartment block unless you know that they will be connected to the road, water and power networks. This ‘clean slate' aspect of Asia is one reason why it is the best place to go to get ‘greenfield', capital-growth projects for your portfolio. That is not as obvious as it seems. Anyone who remembers the soul-searching after the fatal collapse of the Minneapolis motorway bridge in 2007 knows about the parlous state of US infrastructure; and the US certainly has its own stimulus plans. But that does not necessarily translate into profitable infrastructure opportunities.
"There hasn't been a new oil refinery built in the US since the late 1970s," says Jim Seymour, managing director with US-based emerging markets private equity and infrastructure specialist EMP Global. "It's been about as long since the last nuclear power plant. It's much more difficult to turn need into execution in the US, compared with Asia where there is more central planning, partly because we do, at least, already have roads, electricity and bridges - even if they are worn-out, pot-holed and in need of replacement."
Booth points out that the Obama stimulus will be far from a classic ‘Keynesian' programme in its effects: in the 1930s the economy had already adjusted, violently, and New Deal pump priming was about capital and labour replacing lost demand; now, the West is still at the beginning of a long, painful period of de-leveraging, aggregate demand is actually too high and must adjust downwards, and the stimulus is more like a parachute to manage that descent. "As an investment opportunity, it's not at all attractive," Booth argues.
Still, a stimulus is a stimulus - with a policy agenda as much as a market-driven, demand-meeting agenda. While one might expect those mind-boggling urbanisation and industrialisation numbers to reduce the ramp risk of Asian greenfield projects relative to those of the US or Europe, there is a chance that the equally mind-boggling stimulus numbers could balance that out.
"Ramp risk is the greatest risk, which is why I have more concerns about greenfield projects," says Seymour. "I believe that population trends in Asia are so great that overall ramp risk should be less, and wherever the need is greater, the risk of a project not being executed is less. But continuity of government policy will continue to be an issue."
Regulatory risk falls broadly into two categories: the risk that rules are changed; and the risk that excessive bureaucracy causes delays. The former is the greater risk in China, according to Seymour, and the latter is a greater risk in India, for example. "India has hundreds of billions of dollars worth of projects in the pipeline, but if you look at previous plans you see that only a third of them were actually executed, thanks to state politics, federal regulations and so on," he says.
None of which, of course, is peculiar to emerging markets. Booth notes how freely local government changes the rules around road projects in the US Mid-West, and laments how we have had to get used to "retroactive legislation" in the West. "Political risk is arguably higher and rising in the developed world," he says. And there is significant bottom-up support in Asia as well, if the re-election of reformist governments in India and Indonesia is anything to go by. "They see the credit crunch, they gird their loins and they get on with it," says Booth. "There's no ideological nonsense."
Nonetheless, sometimes problems are practical, not ideological, even when an asset is up and-running. When services are provided for consumers who can barely afford them, demand is more elastic. Seymour recalls a Philippines toll road whose inflation-adjusted tariffs became meaningless when prices went beyond what drivers were able to pay.
Another example was in 2008 when the inflation pass-through to independent power producers in China was significantly delayed as the authorities started fretting about soaring coal prices. "The tariffs agreed were essentially what the authorities said they'd ideally like to do, but when inflation became a problem they had the power to delay passing the hikes on," says Divya Mathur, investment director in global emerging markets with SWIP, who runs an infrastructure-focused public equities strategy. "In India there is no such subjectivity, and you see that reflected in valuations between Indian and Chinese power producers. Some countries have very strict regulatory coverage of inflation pass-through and others, like China, Malaysia and Korea, don't necessarily."
These are all reasons why a diversified Asian infrastructure portfolio is desirable. It is important to recognise that, just as developed markets need new bridges and are not all about secondary, income-generating assets, emerging markets are not all about building airports in the Chinese countryside. Sector diversification is very easy to attain: China did indeed tender for almost 100 railway projects in the first half of 2009, but Taiwan and South Korea are more focused on information technology and network infrastructure, and India is a hub for power and energy.
"Greenfield projects are more risky and provide a long-term payout, so you really do need to combine them with existing income streams," Seymour advises. "We've done a lot of work in India, where it's not difficult to pick up those sorts of project." Many of these were highly-leveraged, he observes, and one of the best ways to play this market now is as distressed debt. What he does not see so much of is social infrastructure like hospitals, schools and prisons. "Efforts to turn social infrastructure projects into financially-viable investments have been very difficult in developed markets where there has been a large degree of dependence on government subsidy or reimbursement," he observes. "That kind of government relationship doesn't generally exist in Asia to make those projects financially rewarding."
The social aspect of investing in Asia is important on a number of levels. Let us remember why countries like China are building all this stuff. They need it, certainly, but it is also because they have that wave of domestic savings to absorb. Why would they want to reduce absorptive capacity by welcoming foreign capital? Masih, Adams and Weddle at JPMorgan point out that "only a quarter of the financing for projects targeted in China's stimulus package will be funded directly by the government", but that only partly addresses the risk that a considerable proportion of plans might not come to fruition at all. For Mathur at SWIP, this is one reason why a broadly-defined public equity infrastructure fund makes sense - it is easier to buy shares in a Brazilian company that sells cement to Chinese SOEs than it is to build an airport in partnership with the government. For Booth, however, it simply reinforces the intuition that investors need to go to Asia with a lot more than just dollar bills.
"It's very difficult for public-markets investors to say they bring anything more than finance, whereas a private equity investor can bring restructuring skills, technical skills and access to global markets," he says. "We have a company that has energy operations in 20-odd countries, for example; we can help a local partner do things globally that he wouldn't be able to achieve domestically - that's a compelling quid pro quo for co-investment."
Seymour agrees - but warns that this might be a tight window of opportunity. He points to the all-American entrepreneurial talent of Silicon Valley, which was always 30-40% Asian, in fact, and which has been flooding back home to set up local private equity teams that will benefit from its global experience. "Gradually foreign capital will be less necessary and less interesting, and it's going to be increasingly challenging - perhaps as soon as within 5-10 years - for Western money to access deals in Asia," he says.
The JPMorgan team also note that "the reward versus cost ratio to the investor is quite different from the reward versus cost differential to society" and that "social returns on infrastructure decline as markets mature".
Figure 2 illustrates their thesis that the social benefit curve rises steeply early on, reflecting improved levels of productivity and efficiency that result from new roads, telecoms and utilities, but tails off as the benefit of additional infrastructure grows more marginal (which takes us back to the reasons why the US is less likely to spend on new bridges than Asia). Although economies like China and India remain a long way from this point, Masih, Adams and Weddle warn that "after a certain stage of development it becomes socially ‘optimal' to maintain and upgrade existing infrastructure rather than to construct new facilities", and that "the door will not always remain as wide open to investors".
Staying ahead of that curve could be the key to European asset allocators benefiting from one of the keenest long-term investment opportunities in a generation.