_ Paolo Raimondi, economist, coordinator, Italian Committee «Razvitie Project». Report at the 5th Workshop“Developement of Transport and Infrastructure in Eurasia” within the IIASA research project “Challenges and Opportunities of Economic Integration Within a Wider European and Eurasian Space”. Laxenburg, 15 – 16 September 2015.
Development projects and credit for building a new global order
General introductory remarks
1. The crisis is not ended. On the contrary we are entering in a new phase of systemic crisis. The latest weeks irrational developments on the Chinese stock exchanges and the extraordinary repercussions on the markets in the rest of the world are just few evidences. At the same time we are in an international currency war which is engulfing the entire monetary, financial and economic system. In particularly the BRICS currencies and financial markets are under extraordinary pressure, as indicated for example by the Brazil situation.
2. In the past years the QE programs of the FED, of the UK and Japan central banks and now of the BCE have flooded of liquidity the financial system with the effect of apparently saving the large banks in crisis. But the balance sheets of the central banks grew exponentially. For example the FED balance sheet moved from about $ 800 billion of 2008 till about 5.000 billion of today. The same process is going on with the Bce. One of the main consequence of the global financial crisis and the attempts to bail out the entire banking system was the huge OECD debt’s growth: from 78% of GDP in 2005 to 94% in 2009. It is expected to increase even more in the next years, so as to reach a peak of 112% of GDP in 2014. Such large inflow of new liquidity had several significant effects. For example a zero interest rate policy and a return to a speculative level of the stock exchanges indexes.
The liquidity made available to the bank system did not flow, as naively expected, into the real economic sectors. It did not transform itself into new credits and new investments. On the contrary, for example in the EU, according to a BCE study, following the LTRO programs of 2012 of over 1.000 billion euro, the average credit in 2013 was 3,9% lower than the year before. A real “credit crunch”. Today it still remains in the negative camp.
Even the IMF had to admit that the QE polices did not generate an increase in productive investments. On the contrary from 2008 till 2013 in the advanced countries there was a reduction of 2,5% in the relation between investment and GDP.
3. The investments in the real economic sectors, through new investments in infrastructure, new technologies and industrial vanguard areas are the only way to bring the world economy on the path of development. Such policies, and not the still dominating austerity approach, will also bring the world finance and the public debts under control.
Long term infrastructure projects
One of the most significant challenge, if not the most important one, is the creation of a mechanism to finance the progressive realization of the large continental infrastructure projects, like the Trans Eurasian Development “Razvitie” (TEDR) project.
This effort will require an extraordinary dimension of credit and other financial facilities that must be put in action. It is probably useful to look at the «Trans-European networks» (TEN) projects and with the 20-20-20 targets to have a reference measure. The Trans-European Networks (TENs) are large infrastructure networks of transport, energy and telecommunications underpinning the developmental and integration goals of the European Union. The “20-20-20” targets set three key objectives for 2020: a 20% reduction in EU greenhouse gas emissions from 1990 levels; raising the share of EU energy consumption produced from renewable resources to 20%; a 20% improvement in the EU’s energy efficiency.
Preliminary estimates point to European infrastructure investment needs of between € 1.5 trillion and € 2.0 trillion thus around € 150-200 billion per year. More specifically, from now until 2020, some investment needs are estimated as follows: € 500 billion in the transportation sector, for the implementation of the Trans-European Transport Network (TEN-T) programme; € 1,100 billion in the energy sector, by public and private entities for the implementation of the Tans-European Energy Networks (TEN-E).
The OECD estimates USD 53 trillion of investment, equivalent to an annual 2.5% of global GDP, will be needed to meet demand over the coming decades. Over USD 11 trillion of that will be required for ports, airports and key rail routes alone. Increased private-sector investment in strategic transport infrastructure will be essential.
The best approximation of the financial mechanism and governance structure will be a Development Fund or a Development Bank and a cluster of funds/banks related to it and oriented by it. An example could be the most successful mechanism experienced in the last 60 year, the Kreditanstalt fuer Wiederaufbau (KfW), the German bank of reconstruction. One very important aspect of its functioning was its decision to reintegrate into its base capital all profits and other financial returns produced by the investment activities. It became in this way a permanent and self expansive credit mechanism. A second example could be the Asian Infrastructure Investments Bank (AIIB) recently created by China with the participation of many other countries, including several European countries.
For the realization of a multi continental long term development project the insurances and guarantees instruments will be a key factor.
It is obvious that the private intervention is essential for the realization of such investments. But to involve the private finance which is itself very hit by the crisis, one requires a precision on the timing and the costs of the project realization, a stable framework of rules and new financing structures and instruments. Private investors tend to be reluctant to put their capitals in long term investments.
We should remember that, due to the zero interest rate policy of the central banks, in the first 5 months of this year titles for about 2.000 billion euro were negotiated at a negative interest rate. With the required insurances and guarantees, private money could become more interested in participating in long term infrastructure investment.
Presently pension funds, sovereign funds and insurances manage at the global level $90.000 billion assets, of which only 3% goes to infrastructure investment. (Source Bassanini-Reviglio in Astrid 2015)
The answer is in the different forms of Public-Private-Partnership (PPP) where at the beginning the equity component, which should be covered mostly by the public finance, should be of a relevant dimension. In the PPP initiatives we can find an useful instrument to finance strategic investments.
The Development Fund is the most convenient solution because it can combine a public/private participation according to an agreed division of responsibilities. It can be very flexible in the governance and in the management. It can decide to use private and public expertises in different fields, both financial as well as for the project evaluation.
The capital participation in the strategic Development Fund should give a majority control to the capitals coming from the governments involved in the project.
In the case of the Razvitie project we could foresee that such a Fund be controlled for 70% by the two public entities, the European Union and the CIS countries, with 35% each, while the remaining 30% will be for the private participation.
Among the private participants the most welcome are primarily the pension funds and other funds directly related to people’s savings. The reason is to attract those capitals which are very close to the functioning of the real economic sectors and of their productive labour components.
Also insurances, investment funds, banks and companies and other private sources of capitals will be invited to participate.
If necessary, under the strategic Development Fund a network of other funds could be created eventually related to geographical areas of development or technological areas. For example, funds more related to the promotion of special areas, of electricity grids instead of train transportation, housing, R&D sectors, new technologies clusters, SME’ participation, etc.
The model to be followed for these funds could be the same used for the Development Fund. Or, in the case of a more geographical focus, the participation of capitals coming from the regions in discussions could have a majority or at least a bigger share.
In this context, for example, one can follow the very positive and effective model of the Marguerite network of equity funds proposed and realized in the context of the Long Term Investors Club strategy. Here the expertises of the European network of the Caisse des Depots/Cassa Depositi/KfW/EIB are very advanced and in many cases their results have been already tested successfully.
The Development Fund and the related network of funds will be based on a combination of equity and debts to create the required credit lines to support the projects realization. The equity will come from the direct capital participation of the shareholders.
We envisage that the capital formation should be based primarily by liquidity, state budget allocations (from European and national budgets), state bonds and shares of state controlled entities. This is to make sure that the basic capital has the best quality guarantees and backups. For what that concerns the European capital participation, there should be titles with the best rating provided by the European Central Bank,
One may also consider a direct capital participation in the form of some of the most solid private corporation shares, but this should have for example a special certification by the ECB. We should also exclude all other titles related to the financial derivative markets.
Private investors would participate in the capital of the Fund through special financial vehicles which will adopt the same standards of investment applied for the public participation.
One of the most important of such new financial instruments should be the project bonds. Project bonds could be issue both by the strategic Development Fund and by the other funds and they will be related directly to the realization of a part of the project or one of its specific segments, technologies or innovations.
Project bonds will be constructed in a way to attract particularly private institutional investors interested in long term secure projects. Participants will see that they can have a decent return while at the same time they could take part in investments in the real sectors of the productive and new technologies-based economy whose realization will be the guarantee for economic growth and stability producing more income and better qualified and better paid jobs.
Project bonds will be measured and valued in relations to a segment of the project by a competent agency and then placed on the market through special authorized public and private institutions which fulfil certification and given standards of seriousness, qualification and transparency. In the similar way the state bonds are allocated on the market today.
They should respond to specific conditions and give concrete guarantees. For example, in the case of money coming from citizens savings one could apply the same State minimum capital guarantee given to each person in the European Union for their savings kept in the banking account, which is today about 110.000 euros per person.
A second participation form in such a large infrastructure project could be through Eurobonds and similar bonds linked to other Eurasian regions. Eurobonds are issued directly by the European Union in relations to the restructuring of the national debts but also for the technological modernization of the SME and other economic players. In this second possibility they could be used for European SME involved in the project when their participation will require an advancement in the technologies.
Insurance and Guarantees
One very important aspects of the Fund and project will be the guarantees for the investors we will be able to create.
Such guarantees must be realistic and clearly defined to show the convenience for investors to participate.
One of the immediate guarantee could be in the form of fiscal treatment. It is clear that the long term investments could not be treated a short term financial operations. Unfortunately both Basel III and Solvency III do not make any difference between long term and short term investments. In this way the long term operations are punished and undermined.
A better fiscal treatment could simply be in a form of lower taxes. Government agencies should indicate the criteria to define what is a long term productive investments. They should include such specific investments in a priority list and consequently treat them in a different way.
A second type of guarantee could be in the form of a state guarantee in the investment financial returns. This is easier for the Fund bonds because their return is related to a fix interest rate. But also this could be helped by an additional state guarantee that will intervene to make sure that for a number of years not only the Fund but also the governments provide a bond solvency and interest rate payment guarantee.
For what concern equity participation a correct policy could be more complexes but also more decisive to reach a successful result.
One way to answer to such a challenge would be to give for example some guarantees by the Fund and by the States of a basic financial return for a number of years. This operation could be based on a mix of interventions: partial financial returns, better fiscal treatment for the participants in relations to the level of their participation, rights to partially manage the project and to partially participate in the collections of fees, services, tariffs, etc. in relations to the different projects.
Another important instrument already used for example by the EIB in infrastructure investments is the risk-sharing instruments financed by the European Commission. A special Risk Sharing Finance Facility was created to cover EIB risk in its financing of long term research, development and innovation with qualified firms, research centres and other institutions but with low credit worth or non investment grade. It is also extended to local banks that provide credit for R&D for high tech middle size enterprises. This allow finance mediators to free more capitals and participate in larger financing.
A second instrument is the so called mezzanine fund for quasi-equity and hybrid capital financing of SME projects. This implies guarantees for specific and more risky aspects of an investment to facilitate other private financial participations for the realization of a project.
The EIB already developed a Loan Guarantee to Transportation TENs (LGTT), co-financed by the European Commission, to supply a guarantee called “contingent mezzanine debt” for the traffic risks in the first years of the exploitation of a transport project. This guarantee reduces the risk linked to the project and creates the possibilities for other private financial participation. Indeed project bonds whose interest and capital payments depend exclusively on the project capability to generate adequate profits, are very rare.
A way to maintain the private capital participation and to secure a strategic investor could be to offer loyalty shares with which one replaces the dividend payment with a warrant. The warrant could be of a special qualities, related to the time of loyalty and therefore to some rights and privileges for whom hold them. This will also help to align shareholder and management objectives.
It is very important also to be able to offer, if the conditions would allow them, different kinds of guarantees (preference, minimum interest payment guarantee, tax reduction, etc) on the titles issued by those entities explicitly created to finance a project. In such situations the project bonds investors could benefit of an higher credit worthiness on their titles, or on tranches of them, with the possibility to count also on the project evaluation competences of such entities. This would make easier to find project bonds buyers on the market. The same result of credit enhancement could be reached by financing subordinate emission tranches of project titles thus to make the senior tranches more sure and therefore more attractive for specific private investors. One could also consider to create new guarantee products to cover some specific risks, like those ones related to extra cost of project construction, financial performance and others.
Indeed, the large long term infrastructure projects, like the Razvitie project, represent a major strategic conceptual, productive and technological revolution. Its long term credit support is a fundamental financial revolution as well.
Such continental projects often operate through swap agreements in national currencies. In this way payments and monetary agreements among different countries bypass the dollar system. Such developments are paving the way for the creation of a new international multi polar monetary system based on a “basket of currencies”. This is a way to create a more just and peaceful international economic and political order.