Pic By BLOOMBERG
In recent months, Turkey, Indonesia and the Islamic Development Bank have announced the formation of an Islamic infrastructure bank for the Muslim world.
Coming on the heels of the Asian Infrastructure Investment Bank, a Chinese initiative and other similar initiatives in Latin America and elsewhere, supranational infrastructure banks appear suddenly to be fashionable.
And there may be good reasons for this. The developing nations of the Muslim world have an obvious need for such a bank. The investment estimates for infrastructure needs within the developing nations of the Organisation of Islamic Cooperation are massive, whichever way one looks at it.
Infrastructure projects have a number of features that differentiate them from other investments. They have very long economic lives with benefits occurring over several generations. They can have very high economic impact. For example, a new highway can open up the interior, give market access to rural farmers/producers, and thereby have a direct impact on enlarging production capacity, poverty reduction, access to health facilities and minimise the social problems associated with transmigration to urban centres for employment.
While the benefits of development infrastructure are obvious, their funding is always a challenge, especially for poor and developing countries.
First, infrastructure projects typically require very high initial investments. Projects like dams, highways, rail transit systems, power generation plants, ports, etc, all come at very high price tags.
What makes it worse is the fact that almost all the needed investment is front-loaded; that is, the entire investment has to be made in full before the first unit of output could be derived or sold. For example, an intercity train transit system has to be completed in its entirety before the first passenger can be transported.
The inability to postpone parts of the investment and bring forward revenue generation, raises the investment hurdle of infrastructure projects. This is quite unlike the building of say, apartment blocks, where there is the flexibility to rent/sell the completed blocks while continuing to work on the others. The financial hurdle is much lower here since revenue from sold units could be used to fund later ones.
Add to these the usually long gestation period between investment and revenue generation, and the funding challenge for infrastructure becomes obvious. It is not surprising therefore that the financing of infrastructure places serious stress on government budgets. Yet, economic growth and poverty reduction cannot happen without investments in development infrastructure.
Developing countries’ governments, which are always on a budgetary tightrope, have little choice but to borrow, usually from foreign sources to fund needed infrastructure. Such borrowing brings with it a number of problems for the country.
First, the interest adds a layer of fixed costs and raises the breakeven point for the project. Keep in mind that being capital intensive, these projects inherently have a very high fixed cost to variable cost composition. In corporate finance, such projects are said to have high operating leverage and their financing should avoid financial leverage, that is, debt.
Second, the foreign funding gives rise to currency exposure. The project now becomes dependent on both foreign interest rates and exchange rates. Imagine the macroeconomic vulnerability being built when the government borrows for a second infrastructure project and then a third. The overall economy becomes highly leveraged and all that is needed for a full blown crisis is either, a rise in foreign interest, an appreciation of the foreign currency, or for anyone of the debt-funded projects to have difficulties.
In recent times, governments have tried new funding models for infrastructure. Among these are public-private partnerships (PPPs), build-operate-transfer and other variants. Under this arrangements, a private entity is tasked with funding and constructing the infrastructure, in exchange for the right to operate and earn from it for a given number of years. While this indeed reduce the stress on government budgets, two new problems become apparent.
First, since debt is not being avoided, but simply being raised by a different entity, the nation as a whole experiences the same macro- economic vulnerability. Second, with the private entities being profit-motivated and the projects being monopolistic in nature, the private partner simply chooses to gouge as much profits as possible. Governments quickly learnt that no amount of regulation can ensure desired behaviour by the private partner. Thus, despite the success stories, PPP has not turned out to be the panacea it was made out to be.
A new supranational entity that can help developing countries with infrastructure financing is an obvious help. However, one that merely lends, even at preferential interest rates, brings no real value. The world has enough multilateral lending agencies for now and their efficacy thus far is debatable.
The proposed Islamic infrastructure bank has the opportunity to bring to fruition the risk-sharing instruments of Islamic finance. Risk-sharing instruments such as the mudarabah sukuk effectively allow governments to issue “equity” to fund infrastructure.
Such alternative funding enables developing countries to avoid the debt trap in financing development infrastructure. By making at least a portion of these sukuk in small denomination, financial inclusion becomes possible as retail investors too could participate.
The recent experience of Egypt with small denomination Suez Canal certificates, that enabled the government to raise the equivalent of US$8 billion (RM33.6 billion) domestically in a matter of weeks, is a lesson of how effective a mass mobilisation of small funds can be.
Supranational institutions like the proposed infrastructure bank can have access to both institutional and retail investors. For very large projects, such a bank can simultaneously market sukuk in multiple countries.
Their reach comes from their ability to provide credit/quality enhancement, enforce better standards on funded countries and require a higher threshold of scrutiny on project execution. Most importantly, as supranational institutions are not subject to domestic politics, they come with better credibility.
- Prof Dr Obiyathulla Ismath Bacha is currently the professor of finance at the Malaysia-based International Centre for Education in Islamic Finance.