Lessons from Asean infrastructure development

For fast-developing economies throughout the world, infrastructure holds the key to sustainable growth. Southeast Asia is no exception, particularly in light of the ambitious plan by the 10-member Association of Southeast Asian Nations to launch an Economic Community at the end of 2015.

U.S. investment bank Goldman Sachs estimated last year four big Asean countries (Indonesia, Malaysia, the Philippines and Thailand) alone would require $550 billion of infrastructure investment through 2020. Power supplies and airports are two areas most in need of funding. The report estimated the electricity gap — difference between capacity and potential demand — was about 47%. Airport capacity should also be increased by about 59% in the four economies, the report estimates. The question is how to finance these massive projects.

Buy now, pay later

There is room for the governments to issue more debt. The four countries have historically had small budget deficits of 1-4% of gross domestic product, according to Goldman Sachs. Debt levels are also relatively low, with Indonesia at the lower end, at 26% of GDP in 2013, and Malaysia at the higher end, at 58% of GDP, according to the International Monetary Fund. Savings rates are also high in these countries, at around 23% of GDP in the Philippines and 30% in Indonesia.

Private funding sources

These governments will not be able to finance all the construction needed for an efficient and integrated regional economy unless private investors come on board. One of the best ways to channel private capital is via an infrastructure bond market.

Private investment in infrastructure can also happen on a by-project basis, but going through the bond market has a number of benefits. First, as the capital market grows in size, larger projects can be financed. A deep and liquid market can also attract foreign investors, as Malaysia has shown, adding diversity to the investor base. Second, market discipline can help work out which projects are worth investing in. Third, having institutional investors as bondholders can ensure there is political pressure to keep projects transparent and accountable. Lastly, a deep and liquid long-term infrastructure bond market can insulate the underlying projects from global market fluctuations, as opposed to the more volatile equity market. In the 2008 global financial crisis, for example, the Sharia-compliant sukuk market, which is dominated by government-issued infrastructure bonds, remained resilient.

Success stories

Indonesia’s government bond market and Malaysia’s market for sukuk or Syariah bonds highlight the benefits.

The Indonesian government has built up a vibrant government bond market, practically from scratch, in a relatively short time. In 2002, the government was faced with a crisis. Some of the $65 billion in bonds issued in 1998 and 1999 as part of a bank recapitalization program were due to mature the following year.

So the government undertook a program to quickly create a domestic government bond market. One key was to issue the 2002 Government Debt Bill, which made explicit the government’s obligation to pay interest and principal on time. This was unprecedented. In most countries, the treasury can borrow at will, as long as the government budget has been approved by parliament.

Next, a debt-management office was set up with the help of the Australian and U.S. treasury departments to implement a debt-management strategy according to global best practices. A number of investment banks and securities companies were asked to help create a secondary market. The close cooperation between the government and market players built trust and a common language.

Bond issues now constitute all of the Indonesian government’s budget-deficit financing. While this approach brings fiscal discipline and transparency, some ministers and lawmakers at the outset warned the government risked forfeiting sovereignty to the market. Others pointed out that the cost of borrowing would be subject to fluctuations in global financial markets. Last year, for example, 10-year Indonesian government bond yields rose 3 percentage points, as the U.S. Federal Reserve discussed ending its quantitative easing program.

Supporters of debt financing argued a market-based budget financing system would bring stability because future governments or parliaments cannot alter the budget in a way that damages the country’s ability to service its debts. This built-in stabilizer reinforces the government’s financial credibility.

Malaysia is another success story. It began to seriously develop Islamic finance in 1990 with its first issue of sukuk bonds. By the end of 2013, Malaysia dominated the global market for these instruments, accounting for 60% of the $270 billion in total issuance, according to data from Malaysia International Islamic Financial Center.

The thriving sukuk market in Malaysia provides ample funds for the country’s infrastructure. In 2001-2013, slightly over 70% of the sukuk issued in Malaysia were dedicated to infrastructure. Participants range from domestic institutional and retail investors, to offshore investors, especially from Muslim countries in the Middle East.

The way forward

Financial auditor PricewaterhouseCoopers identifies four essential elements of a healthy infrastructure bond market. First, there must be sufficient domestic funds outside the banking system. Having large pension funds, mutual funds or insurance companies that actively invest in long-term, high-yielding assets will boost demand for infrastructure bonds.

There must also be transparency in financial reporting. Not all of the four countries in the Goldman Sachs study have adopted International Financial Reporting Standards, for example, and domestic accounting firms need to raise their auditing and reporting capabilities.

The third requirement is equal treatment for bonds and deposits as financial instruments. For retail investors, there are few differences in the tax treatment of these instruments in these countries. But for institutional investors, the situation is more complex.

It is also important for the infrastructure projects to gain credit support. For projects where the government is involved, there is automatic sovereign rating support. This works well for domestic institutional investors, such as pension funds, which are typically allowed to invest only in investment-grade bonds.

But this may not be enough to persuade international institutional investors to put their money in countries such as Indonesia, which barely holds an investment-grade rating. In such cases, rating support from multilateral institutions such as the World Bank or the Asian Development Bank is needed.

The challenge is vast. But given the pressing need for infrastructure in emerging Asia, governments would do well to take these steps and avail themselves of the benefits of a functioning bond market.

Kahlil Rowter is an economics lecturer at the University of Indonesia and chief economist at Bakrie Global Ventura. He is also an adviser at Indonesia’s Ministry of Finance.