The battle for infrastructure — and how to finance it
Suddenly infrastructure is the word on every Western politician’s lips. It has become an indispensable element of a re-election campaign, a weapon with which to fight back populism and win over the hearts and minds of disgruntled electorates.
In fact, even before President-elect Donald Trump made campaign promises to spend $1tr over 10 years fixing US highways, bridges, tunnels and schools, the momentum was building.
With post-crisis monetary policy of ultra-low interest rates and huge quantitative easing programmes losing its potency, G7 governments had, one after the other, been switching their focus to fiscal stimulus last year.
Canada’s prime minister, Justin Trudeau, was the first in the wave. In March he unveiled a C$120bn six year infrastructure programme including at least 10 rail and public transit projects as well as water systems and public housing.
The UK’s new chancellor of the exchequer Philip Hammond talked of a “fiscal reset” in his first few days in the job in July. Although the actual numbers in his autumn statement disappointed (£23bn extra over the next five years for rail, telecoms and housing) the direction of travel was clear.
Then, in August, Japan announced ¥6.2tr of new infrastructure spending as part of a ¥28tr stimulus package. Even austerity-zentrum Germany got in on the act, with a €270bn 15 year infrastructure package and a proposed €15bn tax cut after this September’s general election. And in November, the European Commission called for a fiscal expansion of up to 0.5% of GDP in the eurozone in 2017.
Of course, politicians promising to spend money on infrastructure is nothing new, especially if they have elections coming up. But this time they seem to mean it. Trump’s victory and Brexit have shown politicians the world over that if they don’t have a new plan to get the economy moving again, they will be out on their ears.
Fed up
The US election and the UK referendum were votes by fed-up electorates who, with guidance from crafty politicians, blamed immigration and globalisation.
But the seeds of discontent came from a sense that austerity was not working and employment, labour productivity and wages had not made the sustained improvements over the last five years that are necessary to support gains in living standards.
The change in mood is quite sudden, considering that just four years ago Europe was in the middle of a debt crisis. Global investors were obsessing over sovereign debt sustainability and demanding fiscal consolidation to deal with the heavy public debt burden across most of the Western world.
Those heavy public debt burdens remain, of course, and in many cases are worse than ever.
But, with the help of central banks, investors have financed them at ever lower interest rates, making them tolerable for taxpayers.
Yet all this cheap money has not been enough to spur an investment boom by the private sector, leading to vigorous growth.
Increasingly, governments, investors and the public alike wonder if it is time to try something different — the government taking the lead in investment.
Quite how sensible these fiscal splurges will be when quantitative easing is withdrawn, interest rates start to go up and borrowing costs return to higher levels will be one of the big questions that will be answered over the next two years.
The OECD argues that fiscal space has been created by lower interest payments on rolled-over debt, which also increases gauges of market access and debt sustainability. It says that on average, OECD economies could use deficit-financed fiscal initiatives for three to four years, while still leaving debt-to-GDP ratios unchanged in the long term. Front-loading the effort could allow deficit finance to be tapered sooner and put the debt-to-GDP ratio sustainably on a downward path.
Bond markets at the ready
Whether the new wave of government stimulus policies prove sensible or not, the capital markets will have a crucial role to play. Governments, despite opening the fiscal floodgates, will not be able to pay for all the improvements themselves and will need the private sector.
Contrary to expectactions, the loan market has proved itself a reliable supporter of infrastructure since the crisis, despite bank balance sheets shrinking and regulation making it more expensive to lend over longer maturities. Quantitative easing has flooded the bank market with liquidity, and a lot has been sluiced off into infrastructure projects through long term loans.
However, once expansionary monetary policy is closed down that liquidity will dry up and the regulations that were put in after the crisis, in particular the liquidity coverage ratio, will begin to bite at last.
As a result, there has never been a better time to try and harness international bond markets for the world’s infrastructure financing needs.
Dual approach
There are broadly two ways this can be done. The harder of the two — but a solution that continues to hover like an oasis in the distance — is project bonds, where institutions provide capital directly to individual projects.
There is plenty of track record for the issuance of these, but they have never taken off into a big market. One reason is the perennial competition from bank lenders.
Another is that institutional investors are chary of construction risk. Ways exist to mitigate this, and the public sector is increasingly exploring them. The European Investment Bank, for example, has its Project Bond Credit Enhancement scheme.
A third impediment has simply been the lack of dealflow, meaning investors have not built up the analytical skills required.
But if these hurdles can be overcome, demand should be there. Even in the context of reducing central bank support, yields on Western sovereign and investment grade corporate debt are still historically low. Investors such as pension funds and life insurance companies need higher yield options, particularly when they are trying to match longer duration or inflation-linked obligations.
Finance is coming
The other way for capital markets to finance infrastructure is through the balance sheets of stable organisations — whether sponsor companies, banks or specialist public sector agencies.
Steven Mnuchin, Trump’s nomination for US treasury secretary, has floated the idea of setting up an infrastructure bank, as has Canada’s ruling Liberal Party.
How they will operate remains to be worked through. Helping with construction risk and providing credit enhancement will be crucial to getting investors on board. Early indications point towards government equity injections that will be leveraged four or five times with private money from the bond markets. For Canada, which has said it will put in C$35bn of equity, this means its bank could have firepower of between C$175bn and C$210bn by following the financing models of European agencies and supranationals.
2017 could therefore see a KfW of the North hit the bond markets. If it is anything like its German namesake, it will be welcomed with open arms by the global investor base — and stressed-out politicians.
