Closing the Infrastructure Gap

Written by Ryan McGuine //

In 2017 the McKinsey Global Institute estimated that the world would need to spend $67tn by 2035, or $3.7tn annually — roughly $1.3tn more than was spent in 2013 — on infrastructure in order to merely keep up with projected economic growth. This difference between current spending on infrastructure and the need for additional funding according to growth projections, commonly referred to as the “infrastructure gap,” is present nearly everywhere, but is particularly detrimental to growth in developing countries. This is the case because developing countries tend to have more difficulty financing large projects themselves, tend to lag further behind in infrastructure construction, and tend to have the potential for faster growth compared to high-income countries.

Infrastructure supports economic growth in a number of ways. For example, it can help boost productivity growth — the main driver of overall economic growth. Cheap and reliable electricity powers labor-saving machinery, reducing the cost of manufacturing goods. Similarly, clean water delivery reduces the burden of disease by enabling safe water use, reducing the time employees miss work. In addition to enabling productivity growth, infrastructure also plays a role in reducing “transaction costs.” Michael Munger establishes three categories of transaction costs: triangulation, transfer, and trust. Good ports, roads, and railways reduce transfer costs by facilitating the movement of goods, and digital communications reduce both triangulation costs by enabling producers to sell their goods where prices are highest, and trust costs by enabling distributed ratings of economic actors. Recognizing these linkages, the UN chose “Industry, Innovation, and Infrastructure” as the 9th Sustainable Development Goal.

The reasons for today’s investment gap stem from the pattern of development paradigms advocated by Western technocrats following World War II. Between the 1950s and 1970s, many developing countries pursued import-substitution industrialization (ISI), which called for a proactive government role in subsidizing and erecting trade barriers to protect domestic industries that could not compete in the world economy. ISI was based on the ideas of Raul Prebisch and Hans Singer, who argued that primary products — long the main export of developing countries — have a low elasticity of demand compared to manufactured goods. As such, technological advancements that enable productivity gains drive up demand for manufactured goods faster than primary goods, so the price of exports relative to imports for developing countries declines over time.

ISI did succeed in spurring economic growth in some places, particularly those with large domestic economies, since an economy’s level of specialization depends on its market size. However, the emphasis on state support of uncompetitive sectors, rather than on removing constraints faced by sectors with latent comparative advantages, fostered many problems. Chief among them were rent-seeking activities by elites and oligarchs, and inflationary spending backed by variable-rate loans. After decades of heavy spending and interest rate hikes in the early 1980s, the finances of many developing economies around the world were in poor shape.

In response, the International Monetary Fund (IMF), a body established at the Bretton Woods Conference to provide economic advise and short-term funding to member countries, pushed “structural adjustment” programs during the 1980s and 1990s. The IMF brokered debt restructuring agreements between large banks and debt-ridden developing countries, conditional on their implementation of austerity measures like currency stabilization, trade liberalization, deregulation, and privatization of state owned enterprises. These prescriptions aimed to eliminate government budget deficits, putting significant strain on state infrastructure spending in the process. While infrastructure spending has ticked up slightly in recent years, the gaps persist to this day. Fortunately, there are channels that countries can use to get funding for infrastructure projects, other than using their coffers exclusively. The Solow Model suggests that this is beneficial, since they are able to effectively increase their investment rate without sacrificing consumption today.

One place developing country governments can find infrastructure funding is multilateral development banks (MDBs). These include the World Bank, as well as regional development banks including the African Development Bank, the Asian Development Bank, the European Bank for Reconstruction and Development, the Islamic Development Bank, and the Inter-American Development Bank. MDBs borrow money from capital markets, and use it to provide grants and low-interest loans to actors in developing countries. These low interest rates on loans are possible because MDBs are backed by member countries, which guarantee to assist if the bank exhausts its capital before repaying bondholders. MDBs provide about 6% of infrastructure financing in emerging markets.

There are many advantages to borrowing from MDBs, the most obvious of which is their low interest rates. Additionally, aspiring toward the goals of the G-20’s Hamburg Principles, MDBs are able to finance projects that are not commercially viable, and de-risk those that are close to being commercially viable in order to “crowd in” private sector financing. MDBs are also uniquely positioned to build state capacity, which can ease private concerns about the regulatory environment. Despite this, MDBs are constrained by nature of the fact that they operate in political space, and are characterized by slow, inflexible operations.

Another source of infrastructure funding is foreign direct investment (FDI) — investments by an individual or firm into enterprises in another country. Crucially, FDI that is used to fund infrastructure projects helps attract FDI in other sectors, since transaction costs are a significant deterrent significant deterrent of investment in emerging markets. The most common instrument used to implement FDI for infrastructure is the public-private partnership (PPP). PPPs account for about 15-20% of all infrastructure finance in emerging markets. There are many theoretical benefits to PPPs, but they often remain unrealized. In practice, benefits from more effective private management are diminished by excessive regulation driven by rent-seeking by civil serants, and the transactions cost reductions do not always render significant poverty reductions — measures that boost economic growth tend to reduce poverty, but this is not always the case, and can take decades for the effect to become apparent.

Finally, developing countries can look to national development finance organizations for infrastructure funding. Many developed countries fund development projects, including but not limited to infrastructure. Mechanisms for doing so range from Chinese banks which implement the policies of the Chinese government using state money, to development finance institutions (DFIs) of Western countries which give loans to private companies investing in emerging markets. National development organizations provide approximately 10% of all infrastructure financing in emerging markets.

In 2013, China launched its Belt and Road Initiative, a $5tn infrastructure spending spree across 64 countries. To put the scale of Belt and Road in perspective, by the end of 2014, the China Development Bank and the Export-Import Bank of China had the same amount of outstanding loans as the World Bank and the five leading regional MDBs combined. There are many incentives for China to spend huge amounts of state money on development abroad — it will enable the country to export some of its foreign exchange reserves and excess cement and steel capacity, create new opportunities for Chinese businesses, and shore up security concerns in central Asia. Chinese development assistance is popular among developing countries because in contrast to many other creditors, China places little or no requirements on financial or government reform in debtor countries.

America’s chief development finance organ is the Overseas Private Investment Corporation (OPIC). Created in 1971, OPIC assists American private companies do business in emerging markets by providing loans to projects that are not commercially viable, insuring against a certain degree of political risk, and supporting private equity funds that invest in new emerging market companies. Determining OPIC’s methods outdated and its size tiny, the American Congress passed the BUILD Act in 2018, and it was promptly signed by President Trump. The BUILD Act creates the US International Development Finance Corporation (USIDFC), which will be able to invest in equity, provide technical assistance, increase the spending cap from OPIC’s $29bn to $60bn, and act with a preference, rather than a requirement, for US investors.

Of course national development finance cannot be separated from efforts by industrialized countries to promote their vision of world order, turning developing countries into ideological battlegrounds. Lately the Chinese government has come under fire for “trapping” developing countries in debt and wielding its creditor status to exert political and cultural influence abroad. Insofar as the BUILD Act advances the principles of democracy and individual freedom abroad, it should be welcomed as a counterweight to China’s pragmatic ambivalence toward liberalism. However, while the BUILD Act has been promoted in Washington as a measure to counter China’s growing influence, it has different goals and does different things than Chinese development finance. As such, the “countering China” point is mostly framing to gain political support.

There are daunting challenges in coming decades that depend on the expansion of functional infrastructure — from continued urbanization to disease prevention to climate change adaptation. Any source of infrastructure funding has benefits and drawbacks, so there is no one-size-fits all approach to funding infrastructure projects. What is clear, though, is that more funding needs to find its way to infrastructure projects. Some of the gap will no doubt be met by finding new ways to increase the amount of money flowing to infrastructure from all sources. That said, McKinsey points out that one of the largest constraints to closing the infrastructure gap is the lack of a sufficient pipeline of well-prepared, bankable projects that provide investors with appropriate returns. Solving this problem would go a long way.

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