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Challenges in Infrastructure Financing in Developing Countries: An Islamic Approach, Substituting Equity and Sukuks to Debt

Posted on 1st July 2016 by Noureddine Krichene and Camille Paldi, camille@faaif.com

Challenges in Infrastructure Financing in Developing Countries: An Islamic Approach, Substituting Equity and Sukuks to Debt

 

Noureddine Krichene and Camille Paldi[1]

 

The infrastructure development has suffered significant cuts in many developing countries due to large fiscal deficits and unmanageable public debt; consequently, economic growth has stalled in these countries. A Sharia model is a promising approach to infrastructure development. It precludes interest-debt for financing infrastructure. It seeks a coordinated strategy between the government and the private sector for infrastructure development; hence, the government will not be the only responsible for the construction and maintenance of infrastructure. It allows the private sector to participate actively in the construction of infrastructure; therefore it increases considerably the supply of infrastructure. It enhances social equity to the extent that the cost of infrastructure does not fall heavily on poor people who may not be using some types of infrastructure. It leads to new laws and institutional framework that develop the private investment in infrastructure.

  1. I.                   Basic Growth Theory: Higher Growth Requires More Economic and Social Infrastructure

Economic growth depends on capital accumulation; the higher the capital/labor ratio the higher the income per capita. Poverty is identified with a shortage of capital; alleviating poverty requires increasing capital in form of housing, machinery, plants, hospitals, schools, etc. Development of economic and social infrastructure is required for human capital development and for sustained growth in any country. Infrastructure projects involve large indivisibilities and have high social rate of return. Large financial resources have to be mobilized before an infrastructure project can be implemented.

Infrastructure may be constructed by the state as well as the private sector. When provided by the state, users enjoy free access or access at a symbolic price far below cost. Hence, use of paved roads and highways is free for users, and is generally paid by government road funds or directly from taxes. Public schools, universities, and hospitals are also free of charge and are financed directly from government taxes. Nonetheless, in many areas of social and economic infrastructure, there is a large field for private sector ownership and operation at market prices and market profits. Customarily, the private sector invested considerably in railroads, turnpikes, airports, ports, universities, schools, hospitals, communications, water, electricity, and sanitation. From a Sharia perspective, the private sector has to be fully involved in infrastructure construction both on profit or non-profit basis. Such involvement is fundamental; it precludes interest-based borrowing; it enhances social justice, increases considerably economic efficiency, and allows the government to concentrate on infrastructure which addresses better the social welfare and the needs of the poor and where pricing is not desirable or not practical.

Although not all infrastructure may be privatized, still the privatization of some types of infrastructure, especially where privatization is highly practical and feasible, has great social benefits: it enhances social justice and equity to the extent that the users pay directly for the cost of infrastructure; this cost will not be borne by poor people who live in a remote area and have no use of this infrastructure. Privatization enables to mobilize considerable financial resources, which cannot be easily or justly tapped by taxation, and it will increase significantly the supply of infrastructure in the economy.[2] Hence, the economy will have more and better hospitals, universities, electricity, and water supply, better public transportation, etc. It will increase the access of the poor to education, health, water, electricity, and transport. It will bring greater efficiency in allocation of scarce resources; it will bring market prices in economic calculations which will determine the expected market rates of returns to capital and direct capital resources to the most profitable infrastructure projects. It will enable the government to concentrate on infrastructure such as streets, highways, roads, schools, hospitals, where it does not wish to apply the price mechanism and where services are provided either free or below cost.[3]

The Table below illustrates two scenarios: Scenario I where only the government invests in infrastructure; and Scenario II where both the government and the private sector invest in infrastructure.

 

Scenario I: Only Government invests in infrastructure

Scenario II: Government and Private Sector invest in infrastructure

Taxes

Loans

$30

$70

Taxes

Loans

Private savings

$30

$70

$100

 

 

 

 

Infrastructure

$100

Infrastructure

   Public infrastructure

   Private infrastructure

$200

$100

$100

Economic growth rate = 3%

Unemployment rate = 8%

Economic growth rate = 6%

Unemployment rate = 3%

 

Scenario II is far superior in relation to scenario I; it may not be attained through taxation; even if it could be, it still remains superior since mobilization of resources through taxation is costly, and there is no safeguard that new taxes will be devoted to infrastructure only. Typically, Scenario II illustrates a case of a developing country where infrastructure is poorly developed and even deficient and where the private sector, if allowed through new legislation, could invest far higher resources in infrastructure than the government could do. For instance, in many poor countries, there is only one small government hospital in the capital city. If private investment is allowed, there could be easily three or four new hospitals better equipped that could serve the population. They could be financed by domestic of foreign private capital.

 

  1. II.                Developing country with debt crisis: Government Infrastructure Spending Suffers Dire Budget Cuts

In many countries, the state undertakes alone the construction of infrastructure projects, generally financed from taxes and borrowing. The development of infrastructure in roads, water, electricity, education, health, and communications depends heavily on government capital expenditure. There is no significant private sector investment in infrastructure such as school, hospitals, roads, ports, airports, water, electricity, railroads, etc. In retrospect, this strategy was not the best; the private sector should have been allowed an active participation in infrastructure development.

A fundamental attribution of a government is to develop and construct social and economic infrastructure. Accordingly, a sound and well-managed government is one that devotes most of its resources to infrastructure development and recurrent and maintenance spending. This implies that unproductive current expenditure have to be strictly controlled and that government revenues have to exceed total current expenditure with substantial saving devoted to infrastructure. Unfortunately, two frequent aberrations have violated this basic mission of a government with detrimental effects on economic growth and social equity:

  • ·         Either a government has managed to generate only a small fiscal current surplus which was far below the infrastructure development needs of the country;
  • ·         Or it has a large current fiscal deficits, caused by large unproductive current expenditure, which have severely harmed infrastructure development. In this latter case, the government has failed its basic attribution to serve the population and became an institution that squanders valuable resources and undermines the economic growth.

In fact, in the past decades, many developing countries faced foreign debt crisis and had an unmanageable budget with no control on current expenditure. Government current expenditure, in form of salaries, subsidies, army and security spending, had been rising at a quick pace and could not be contained; they exceeded largely government revenues, implying a large deficit on current fiscal operations, and a negative government savings. In fact, the more government squandering increases, the smaller the tax base becomes. Often, unions forced exorbitant salary increments which aggravated the fiscal deficits. Government became an institution to provide for a political class, a huge bureaucracy and army, welfare recipients, and has discarded its basic duty to provide for infrastructure. A government in dire fiscal deficit has often resorted to monetization of fiscal deficits with money advanced by the central bank and suffered high inflation.

In countries with budget imbalance, infrastructure development suffered large cuts; existing infrastructure was in decay. Capital spending cuts meant less schools, hospitals, water, electricity, roads, bridges, etc. Infrastructure was financed mainly through borrowing, often from official lenders, such as development banks. Countries that fell in arrears on their debt payments had seen project disbursements suspended and project implementation stopped. Countries that lost control of their public finance suffered from structural budgetary problems which made expenditure cuts or an increase in tax difficult options. The government was powerless to curtail current expenditure; any expenditure cut would be opposed by the bureaucracy, army, subsidies recipients, and may cause political and social agitations. In regard to increasing taxes, the option of more taxes may not be recommended; the tax base is narrow; an increase in taxes may require considerable tax administration which may be lacking; the social equity principle may not be satisfied to the extent the taxpayers who pay for a specific infrastructure may not be the direct beneficiary of this infrastructure; higher taxes will reduce private saving and are rarely directed to capital spending; they are instead used to pay for pressing current expenditures such as salaries and subsidies; hence, an increase in taxes may be detrimental to economic growth in the context of badly managed budgets.

Many countries became heavily indebted and were not able to repay their debt. Foreign debt was in part directed to finance government current expenditure and did not contribute to build a capital base for its repayment. Despite many decades of foreign borrowing, many countries could not graduate from dependency on foreign resources and became even more dependent on these resources. Hence, infrastructure development has become too constrained by resources availability, and existing infrastructure is suffering from lack of maintenance and is deteriorating.

In case of both well-managed countries as well as countries with serious debt crisis, devolving a substantial part of infrastructure spending to the private sector is a highly promising approach. It enables to increase substantially the resources destined to infrastructure such as schools, airports, highways, sanitation, etc., and therefore to support the economic growth in the country; it avoids recourse to more taxes or more debt for financing infrastructure and its recurrent outlay.

  1. III.             Islamic Financing of Economic and Social Infrastructure

We explore an innovative Islamic approach for mobilizing domestic and foreign resources and boosting the public investment programs (PIP). Sharia strictly prohibits any interest-based debt. Such prohibition is indeed a blessing for a country because it avoids debt and relieves the government budget from any debt and debt service payments. Had debt-stressed countries observed this prohibition in the past, they would have avoided the debt burden that is derailing their development process. They would have prevented squandering and they would have grown much faster than their actual slow performance.

Sharia permits equity and risk-sharing financing of PIP. Basically, the government as well as other equity holders become joint owner of an infrastructure project. They contribute with long-term capital and hold non-redeemable property titles called common stocks. Stocks can be liquidated only on a secondary markets. The government and private equity holders face the same risk and share dividends as in any joint stock company. Besides equity financing, Islamic Sharia permits also securitization of real assets and issuance of asset-backed securities for financing PIP. The securitized assets are called sukuks; they have a return generated by the underlying real assets. Unlike common stocks, Sukuks are redeemable at a maturity date and may also be liquidated on a secondary market. Sukuk financing of the PIP is widely used in many countries.[4] To promote Islamic finance instruments, a country needs to develop a stock market as a vehicle for long-term resources and liquidity.[5] The stock holding is a main pillar of capitalism and the stock market is a main vehicle for mobilizing long-term capital and minimizing the risk of capital loss.

Sharia has a wide range of risk-sharing contracts. We may cite a few of these contracts. Mudarabah contract involves two parties: capital owners and project managers. Musharaka contract, i.e., sharing, means all parties in a project are partners. Murabaha contract relates to trade in commodities. Istisna contract relates to the sale of an asset which has yet to be constructed or manufactured. Ijara contract relates to a lease of an asset. Salam contract consists of a sale in advance of goods that have to be produced and delivered at a specified future date. These contracts and others are used by Islamic financial institutions such as the Islamic Development Bank in financing development projects. Islamic structured finance uses a mix of Islamic contracts to produce negotiable Sharia-compatible securities for mobilizing financial resources.

A country may also consider sukuks as another Sharia-compliant mobilization of financial resources. Governments and corporations use extensively sukuks. Unlike a fixed-income bond, a sukuk is a structured product based on a real asset. The primary condition for issuance of sukuks is the existence of assets on the balance sheet of the government, the corporate body, the banking and financial institution or any entity that wants to mobilize financial resources. The identification of suitable assets is a key step in the process of issuing sukuk certificates. Sharia considerations dictate that the pool of assets should not solely be composed of debts from Islamic financial contracts (e.g., murabaha, istisna), but should also comprise real assets. As in typical securitization of financial or real assets, the basic framework is that a special purpose vehicle (SPV) issues sukuks (or certificates) to investors and uses the proceeds of the issuance to purchase a pool of assets from the originator of sukuks.

Typically one or more Sharia-compliant contracts, such as ijara, murabaha, or musharaka contracts, form the structuring frame for sukuks. The stream of income generated from the Sharia-compliant assets is used to fund the payments to the holders of sukuks. Ijarah contract has been utilized for issuing sukuk for resource mobilization in Bahrain, Malaysia, Qatar, Saudi Arabia, and Saxony-Anhalt, Germany. The generic structure of ijarahsukuk consists of a sale of a real asset to a SPV by an originator. The SPV issues sukuks to be subscribed by investors; the proceeds of the sukuks are disbursed to the originator. The real asset is leased to the originator; the latter pays a rent which remunerates the sukuk holders. At maturity, the asset is sold back to the originators; the proceeds redeem the sukuks.

An early concession to a private company of a major infrastructure was the Suez Canal which was entrusted by the Egyptian government to a French Company for a period of 99 years. The Company completed the project during 1859-1869 and was in charge with its exploitation thereafter until its nationalization in 1956. The equity of the French company was subscribed by private stockholders. The government of Egypt received royalties from the Company. Examples of concessions are numerous. The Panama Canal was an example of infrastructure developed and operated by the private sector. In Malaysia, the North-South Highway extending over 900 kilometers from Singapore to Thailand was entrusted as a concession to a private company. The company completed the project and runs it on a commercial basis.

  1. IV.              Forms of Arrangements of Private-Public Partnership in Infrastructure

An infrastructure project can be organized as a private entity and run on a commercial basis with a system of user fees and tolls. The system of user fees is now widespread at airport facilities, sea-ports, toll roads, railroads, metros and subways, electricity, water, sanitation, etc. The government enjoys considerable royalties and taxes on the monopolies it has conceded to the private sector. For a selected infrastructure project, a government may establish a public entity that will float equity shares on the stock market, mobilize domestic and foreign resources, and construct the project. The entity will manage the project on a commercial basis and generate dividends to be paid to the shareholders. The rate of return of the project has to be competitive in relation to the stock market return in major stock exchanges. Otherwise, the infrastructure project will not be able to attract domestic and foreign subscribers, and therefore may not worth implementing.

It is a fact that the private sector is far more efficient and innovative than the public sector. Technical innovations such as computers, internet, cars, and airplanes originate in the private sector. Many countries, seeking efficiency and higher growth, have devolved to the private sector a large number of infrastructure projects that are still under the attributions and ownership of government in many other countries. Projects in schools, universities, hospitals, hydraulic and fuel electricity can be easily conceded to the private sector. Similarly, projects in water, sanitation, roads, and communications may be delegated to the private sector. In some sectors, infrastructure projects involve large indivisibilities; they can be efficiently implemented only as a natural monopoly, such as for instance a railroad, a major highway, an airport, seaport, etc. In these conditions, the government may make a concession to a private company for a period of time. The company constructs and exploits the project on a commercial basis under contractual arrangements that regulate a natural monopoly. The government may hold a portion of the capital; or it may simply hold sovereignty rights over the concession while all the assets remain privately owned by the company.

The association between the public and private sector, called private-public partnership (PPP) in the field of infrastructure projects, takes the form of build-operate-and-transfer (BOT) contracts. The BOT is a concession agreement between an entity representing the public authority and a private party whereby the private party constructs and operates an infrastructure facility for a fixed time period and after that time period the ownership of the project is transferred to the public authority without any or minimal financial obligations. The project specifications are made by the public authorities and the project development and operation is carried out by the private party with full responsibility for specifications. The private parties recover their capital cost and expected earnings from the project revenues during the period of the concession. The purchase of project output is guaranteed by the government at a specified fixed price. The public authorities provide limited or no financial accommodation but substantial market and other risk coverage and guaranties. The whole process involves several contracts for sharing the risks, liabilities, responsibilities and returns. The arrangement enables the governments to facilitate the development of infrastructure projects without a recourse to the government budget.

Besides the BOT, there is the Build, Operate & Renewal of Concession (BORC). It is a BOT, but with an option to re-negotiate the agreement of renewal of contract for operation at the end of a contract period. As a result of the negotiation the operation will either remain with the same project company or the ownership will be transferred to the public authority. This option makes the contract flexible and efficient provided the obligations and risk sharing processes are clearly defined, understood and implemented.

There is the Build, Own and Operate (BOO) contract. The BOO is a variant of BOT as far as the specifications and obligations are concerned. However, generally BOOs are permanent franchises in which the private party keeps ownership until its performance on obligations is seen satisfactory by the public authority. In this sense it is a hybrid of BOT and BORC. Since many infrastructure facilities exist; however, in deteriorating conditions, a government may consider “Rehabilitate, Own and Operate (ROO)” contract. Under an ROO an existing public project is given over to a private firm for rehabilitation according to specifications. The private firm will own the project until it meets the initial conditions.

The pricing of the user fees is an important aspect for an efficient allocation of resources in an economy or cross-borders. Capital has to be invested in projects where it has highest returns. Investors want to acquire shares in projects that pay higher expected return. Pricing of the user fees has therefore to be such as to yield a fair return to investors which is not below the average rate of return to the capital in the economy. Often, total annual cost for a given infrastructure, including a fair rate of return is fixed. A private company may wish to operate at cost recovery principle and charge the price that equates its total annual revenues to its total annual costs, including a normal profit. It may also chose to operate at profit maximizing principle, in which case it charges the price that maximizes its profit. In these conditions, the number of users may be far less. The lower the fees, the higher the number of users. The price is the control variable.

  1. V.                 Role of the Stock Market in Infrastructure Financing

To promote private investment in infrastructure, a country has to have appropriate institutional and legal framework, such as laws that deal with concessions and the investment code. To promote risk-sharing, a country needs to develop a local stock market that can be also integrated to regional stock markets. A vibrant stock market is a necessity for mobilizing long-term resources and enhancing liquidity.

Governments should consider an Islamic approach to their PIP and innovate in risk-sharing and sukuks emission. They should consider that stock markets are an important vehicle for mobilizing domestic and foreign resources and reduce debt financing. This approach has a number of advantages:

  • ·         It demonstrates that stock markets can be used as a tool of risk and financial management.
  • ·         It reduces the reliance of government budget on borrowing, thus imparting greater stability to the budget and mitigating the risk of “sudden stops”.
  • ·         It promotes tax equity and reduces the burden of taxation.
  • ·         It has positive distributional effect in that the financial resources that would normally go to service public debt can now be spread wider among the people as returns to the shares of government projects.
  • ·         It enhances the potential for financing of larger portfolio of public goods projects without the fear of creating an undue burden on the budget.
  • ·         It promotes ownership of public goods by citizens, which should have a salutary effect on maintenance of public goods as it creates an ownership concern among the people and to some extent mitigate “the tragedy of commons”.
  • ·         It promotes better governance by involving citizens as share-holder-owners of public projects.
  • ·         It provides an excellent risk-sharing instrument for financing of long-term public sector investment.
  • ·         It is an effective instrument for firms and individuals to use to mitigate liquidity risks.
  • ·         By providing greater depth and breadth to the stock market and minimizing the cost of market participation, governments convert the stock market into an instrument of international risk sharing as other countries and their people can invest in the stock market.

 

  1. VI.              Indonesia: Medium-Term Development Plan 2015-2019: Priority for Infrastructure

The Government of Indonesia has adopted an ambitious development plan (2015-2019). The key macro-targets are:

  • ·         Achieve GDP growth of 8% (from a 2014 baseline of 5.1%) and a per capita income over US$6,000 by 2019 (US$3,524 in 2015);
  • ·         Improve human development index (HDI) from 73.8 to 76.3;
  • ·         Reduce poverty rate from 11% to 7 - 8%, and bring down unemployment to 4 - 5%.

 

However, in order to achieve high growth of 8% the Government of Indonesia has planned to mobilize US$1.9 trillion that would be required in terms of investment in various sectors of the economy. Under the Infrastructure Development Plan, the Government plans to increase infrastructure investment to 8-9% of GDP annually during the current Development Plan (2015-2019), equivalent to a total projected amount of US$450 billion during 2015-2019. The Government (including central and local government and state enterprises) is expected to finance about 70% of total cost of infrastructure development plan (i.e. US$450 billion) while the rest would be raised from the private sector and foreign borrowings particularly through capital markets as well as bilateral and multilateral development partners.

 

Quality of overall infrastructure had improved significantly since 2010 but still more improvement is needed in order to achieve 8% growth. Indonesia suffers inadequate and poor quality of overall infrastructure (in particular transport networks, electricity supply, and irrigation supply). Long-term financing for infrastructure remained in the past and it will likely remain in the future as one of the key constraints to infrastructure development and consequently achieving sustainable economic growth, although the Government of Indonesia is trying to address it through various policy measures.

 

The Government plans to merge two state financing bodies (i.e. Sarana Multi Infrastruktur and Perusahaan Investasi Pemerintah) to form a new Infrastructure Bank to facilitate and help finance long-term projects. The merger is expected to be completed soon and the Infrastructure Bank will be set up by 2017. In addition, Indonesia is also playing a major role in a new Chinese-led Asian Infrastructure Investment Bank (AIIB), which will also help country’s long-term funding needs for infrastructure development. It is most likely that Indonesia will be the biggest client of AIIB as it needs significant funding to build new roads, ports and bridges.

 

The Government of Indonesia would enhance considerably its infrastructure by allowing an active private sector role in infrastructure development. In fact, financial disequilibria of government budget as well as the high rate of price inflation (6%/year) oblige to foster an important role of the private sector in infrastructure development, especially in areas where private initiative far exceeds the public one in terms of efficiency and adequacy of supply of infrastructure services.  

 

  1. VII.          Conclusions

 

Infrastructure is a pillar of economic growth. An economy cannot develop without an adequate and expanding infrastructure. The construction of infrastructure is a fundamental attribution of the government. However, a model where only the government constructs infrastructure is not optimal. In the same vein, a model where only the private sector constructs infrastructure is not feasible and even non optimal. Hence, there should a mix where both the government and the private sector construct infrastructure. This mix depends on the political, legal, and institutional framework. When the business environment is hostile to the private sector, there will be limited scope to attract domestic and foreign investors into highly capitalistic projects such as infrastructure. However, if the business environment is highly propitious to private investment, large private capital will be investment in infrastructure.

 

A large number of countries suffer current fiscal deficits and had to drastically cut infrastructure maintenance and development. Moreover, development banks lent directly to the government and were not able to recover their loans. A new strategy of the government as well as development banks to associate the private sector will be salutary in many countries.

 

The legal and institutional framework may have to be drastically revised to attract both domestic and foreign investors in infrastructure.  

 



[1] Dr. Krichene is a former economist at the International Monetary Fund; a former advisor to the Islamic Development Bank, and former professor of finance. He holds a PhD in economics from UCLA.

[2]Pension funds, investment funds, insurance companies, development banks, etc., would be shareholders in infrastructure projects.

[3] For instance, it is very important to maximize facilities for primary and high school education so to absorb most of school age population, or to maximize health facilities. This may not be easy in countries where no private sector is allowed to participate in education and health and where the state is the only provider of services in these areas. The social loss was too great in many countries because the state had no resources, was very slow or unable to plan for the needs of the population.

[4] See Noureddine Krichene, 2012, Islamic Capital Markets, Theory and Practice, Wiley and Sons.

[5] See Askari, H., Z. Iqbal, N. Krichene, and A. Mirakhor, 2012, Risk Sharing in Finance, the Islamic Finance Alternative, Wiley and Sons.

Posted on 1st July 2016 by Noureddine Krichene and Camille Paldi


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