Tue, Oct 8, 2013

Infrastructure Investment in Developing Asia, Perspectives on Risk

In almost all developing Asian countries, high growth has created the demand for better economic and social infrastructure. These countries have not only expanded tremendously in terms of income and population. They have also experienced rapid urbanization, a growing middle class, and in some countries, the intensifying realization among the political classes—especially in countries where there exists an electoral process—that citizens will judge the performance of their leaders by the economic and social facilities they deliver.

High absolute demand for better infrastructure in South and Southeast Asia occurs at a time when experts claim there is a marked increase in infrastructure investment globally. Conventional wisdom is that economic infrastructure assets are inherently monopolistic and therefore less sensitive to spells of economic weakness. This probably holds true more in developed countries than in developing ones where the risks of political instability, currency depreciation and indeed, the expropriation of an asset could swiftly eradicate the promise of high returns from a monopoly situation. Many foreign investors who were forced to renegotiate contracts or had them canceled in the aftermath of the 1997 Asian crisis would appropriately remind us of this fact.

But there are enduring signs of change since that time: there is greater political stability in most Asian countries, currencies are flexible and the public-private partnership model has made wholesale seizure of assets in the infrastructure sector less likely.

There are also other factors driving infrastructure investment in Asia:

  • Despite inconsistencies in execution, improvements in the business and regulatory environment are reducing barriers to entry. Legislative reforms passed or slated in Indonesia (e.g., amendments to the law on public-private partnerships and land acquisition), Thailand, Philippines and even Myanmar, have coupled with relatively favorable concessions offered to foreign investors by governments looking to attract infrastructure investment.
  • The hunger for natural resources; exploration, development, production, transportation and distribution of resources requires good infrastructure. This has been one of the drivers of
  • Chinese infrastructure investment in Southeast Asia (and elsewhere).
  • Overcapacity on the part of Japanese and Malaysian companies has forced them to look for new investment opportunities in “near-abroad” markets. These countries, alongside
  • China, have deeper domestic capital markets and therefore able to fund infrastructure investments led by their blue-chip companies. Telecommunication investments in India and recently in Myanmar have also benefited from a similar driver (in these cases, Russian and Middle Eastern petrodollars funded the investments).
  • Long-term, open-end infrastructure investment funds have given global investors a new way to bet on emerging markets growth. Allocations are increasing annually. This is not “hot money” that flees the moment that US monetary policy changes. Investors are aware that their capital will be tied up for a long time. Moreover, with the development of regional financial and offshore centers such as Hong Kong and Singapore, funds are finding innovative ways to reduce the impact of foreign exchange risk and to some extent, sovereign risk.

These factors have brought private financing into countries historically unable to fund infrastructure projects.

Risk Mitigation Strategies

There are also negative factors underlying the prospects for infrastructure investment in developing Asia. Based on our conversations with clients, the recent slowdown in China and India, Asia’s two largest growth markets, is not top of their list of concerns—investing in a country’s infrastructure involves betting on long-term growth and the continued demand for services in these countries.

Investors are more concerned about stalled reforms in India and bureaucratic delays in approving projects (Mumbai’s Sea Link famously took 20 years to be approved). Lack of transparency in Indonesia, the prevalence of corruption in Philippines and populist changes to policy all present serious challenges. A political and regulatory risk assessment should be conducted at the outset of infrastructure projects to understand and mitigate these risks. Taking a macro view on probable political scenarios is not enough. It is critical to understand the relative positions of all stakeholders, covering policymakers at the central government level, administrators at the provincial level (or even at the sub-provincial level), local residents, organized labor, and environmental NGOs as well as undisclosed stakeholders such as local businesses with hidden agendas who can alter the outcome of a project.

For example, in 2012, spurred by legislative reform, a Japanese-led consortium won the bid to build a new power plant in Central Java that would provide electricity for 8 million people. However, this year certain landowners refused to sell a portion of land accounting for 20% of the planned construction site. If the dispute is not resolved in time, the consortium faces losing the concession. An in-depth market entry assessment conducted at the outset of the investment cycle may have identified this risk.

It is also important to conduct benchmarking of competitors at the tender stage. This exercise will not only inform a more effective bid, but could also mitigate the risk of competitors seeking annulment of a concession after the tender is closed.

In the construction phase of the investment cycle, supply chain issues always surface. This is not just a matter of performance risk. Fraudulent collusion between suppliers and local managers (or managers of JV partners) can give rise to large financial losses and cause delays in the project, heightening completion risk. If bribery and corruption issues emerge, the project can be embroiled in debilitating controversy and serious legal problems, locally and internationally. Over and above the initial due diligence of subcontractors and partners, Kroll is frequently asked to conduct regular fraud reviews to mitigate the risk of corruption and theft as well as contract audits to reduce the risk of overpaying. Such assignments require the deployment of investigators with experience working in the locality supported by forensic accountants and data analytics experts.

Companies in the infrastructure sector are accustomed to assessing market conditions before making massive upfront investments. They may have a history of studiously considering political and regulatory risk before stepping into an environment of multiple competing interests, where pricing policies or tax regimes can suddenly change at any point in the long investment cycle. All these risks can be managed, especially against the backdrop of favorable politico-economic trends. But infrastructure is ultimately an investment in an operating business, and the realities of operating in South and Southeast Asian countries may present risks with which many companies are unfamiliar.

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