With prospective rates of return on OECD assets at pitifully low levels, investment managers should rationally look further afield. Five years ago the BRICS were assumed to be the solution. But their only unifying features turned out to be that they were overpriced, heavily geared on OECD prosperity, and vulnerable to the whims of their political leadership. Meanwhile, the strong performers have been the frontier economies, especially Africa. Portfolios are starting to take an interest, but the frontiers bring new risks: less information, thinner markets, and narrower economies.
Whereas portfolio managers are still judged by quarterly performance, frontier markets can only be played long: they are too illiquid to get out of the door in time. But played long, frontier markets have considerable attractions. Whereas short-term asset performance depends upon distinctive news, long-term performance depends upon distinctive structural opportunities. In the stagnant Euro-Zone and Japan such opportunities are hard to find, but in frontier markets there is a big structural shortage: infrastructure. For example, both firms and households lack electricity: public supply is so unreliable that many firms run their own diesel generators, but the resulting cost of electricity is ridiculously high. Yet, whereas investing in a power generator is classified as safe if it is in the Euro-Zone, situate it in fast-growing Africa and it is reclassified as red alert.
During the past decade, African infrastructure shortages have intensified. Demand increased because frontier economies grew during the benign phase of the commodity super-cycle. Although commodity markets have now reverted to their normal condition of mild depression, growth will continue. High commodity prices triggered prospecting in frontier economies – for example, around 30 percent of recent energy discoveries have been in Africa. In consequence, the decade of discovery will now be followed by a decade of extraction.
African governments have belatedly woken up to the need for investment in infrastructure, but lack the revenues to finance it. China has seen the opportunity, offering airports, roads and stadiums in return for resource concessions. But governments are increasingly wary of dependence upon China. Meanwhile, their traditional sources of finance, the donor agencies, have become locked into social agendas, and festooned with intrusive conditions. Belatedly, governments are recognizing the need for private finance. The question is what mechanisms would best attract serious money?
The initial mechanism has been sovereign bonds. Investors have been keen to buy them: following the Jubilee debt forgiveness, African governments were virtually debt-free so interest rates plummeted to around 7 percent. However, with a few exceptions such as Ethiopia, I doubt whether sovereign bonds are the right vehicle. Governments usually claim that they will invest the proceeds of a bond issue in productive infrastructure, but sovereign debt does not provide any means of political commitment. Once governments borrow money, every lobby group makes its claim. Further, even if all the money were to be spent on productive infrastructure, the typical frontier state captures less than a fifth of GDP in tax revenues. So investments in infrastructure like school-building, that does not directly generate revenue, would need a social return of 35 percent simply for the government to be able to break even. Finally, bond-holders are towards the back of a long queue of claimants on the public purse. The governments of Ghana and Zambia, which issued sovereign bonds at the top of the super-cycle, ostensibly for infrastructure, have already encountered such intense pressure for political spending that they have needed to call in the IMF.
A better way for international capital to finance frontier infrastructure is through projects. Some private equity funds are already operating in this mode, but the lifecycle of an infrastructure project goes through three distinct phases: design, build, and operate. Each of these phases has characteristics that make it appropriate for a different type of finance. The design phase is high risk because getting to yes is politically fraught, and sometimes very drawn out. It is hard for the team that catalyzes a project to appropriate sufficient benefits. This is why, although the design phase typically requires only a few million dollars, currently, there is an acute shortage of bankable projects. The build phase is big money and high risk: this is the stage for greedy private equity. However, once infrastructure is up and running, it should transform into a utility: boring but safe. If the services generated by the infrastructure are to be priced at around world levels, private equity, with its voracious appetite, is no longer appropriate. Utilities are better-suited to pension funds, but currently with rare exceptions pension funds will not consider them. Two transformations are required.
First, utility operation needs to be ring-fenced from mismanagement. There are now plenty of reputable international utility operators, including many in Europe for which international diversification would offer the most realistic prospect of business expansion. But in turn, reputable operators are currently deterred from African markets by fears of political interference. The solution is credible independent regulation. There is now three decades of international experience of utility regulation on which to draw: this expertise needs to be organized so as to be readily accessible to African governments. The goal is reasonable predictability, not perfection: even in the UK, the leader of the opposition recently announced, seemingly without much thought, that if elected he would freeze electricity prices.
Second, the distinctive risks of the different phases need to be unbundled. The catalytic phase, with its modest need for finance, but intense need for political connections, is ideally suited to the public risk capital agencies such as IFC and CDC: they should switch from evaluating projects to initiating them. The build phase is where private equity is needed, but it should then exit to pension funds. Rather than pension funds holding individual infrastructure projects, they could be re-bundled into infrastructure funds. This would diversify risk and economize on expertise.
If young, growing Africa became a haven for the surplus savings of an ageing OECD there would be massive mutual benefit. Specific, feasible reorganizations of utility governance and finance can unlock that potential.
