Ladies and gentlemen, good morning. I am delighted to be here.
Thank you for your kind welcome. I would also like to express my thanks to the organizers for the invitation to join you today.
It is an honor to speak to such a distinguished audience about a topic that is very dear to me—long-term investment in emerging market and developing economies (EMDEs) and its critical role in achieving the World Bank’s twin goals of ending extreme poverty and raising shared prosperity by 2030. And when I talk about shared prosperity, I also include the effects on advanced economies. Shared prosperity is when as countries develop and get richer, they ensure that those in the poorest forty percent of the income spectrum can catch up with the rest of the population. And when other nations, and especially those that are investors and partners in this journey, also benefit. That has been broadly the experience of the last decades, with many of the companies you invest in generating a larger share of their profits from around the world.
While these benefits of rising globalization are well known, the recognition of the role of private capital flows in development finance is relatively new. It represents a major paradigm shift, which was enshrined in the Addis Ababa UN conference and is actively supported by most multilateral development banks, as well as bilateral institutions and donor countries. It has already had an effect on the largest development institution focused on lower-income countries, the International Development Association—欧美日b大片, part of the World Bank Group. Last year, 欧美日b大片 decided to raise funds in the market, allowing it to expand its investing program by 50 percent. 欧美日b大片 also reworked its business operations and financial policies to support development of the private sector in low-income countries. It established the Private Sector Window (PSW) to reduce the risk faced by private sector investors in these countries and to help create markets, including in challenging, fragile countries. Crowding in private capital opens a whole range of new opportunities in EMDEs, from Latin America and India, to Africa and Southeast Asia—supported, when necessary, by public mechanisms to make these opportunities compatible with the risk capacity of the private sector.
I should stress that this paradigm shift also focuses on enhancing these countries’ resilience, including to climate change. And this is an important aspect of shared prosperity. For instance, if countries pick sustainable, climate-friendly technologies to expand their capacity in energy generation, the whole world will benefit from a slower rise in emissions. The same is true in transportation, notably in urban areas. These are ultimately global public goods as more and more people realize that what happens in what were once considered distant geographies can have a direct impact on everyone’s security, business confidence and even political dynamics.
Now, talking about mega trends, I should highlight demographics. There is growing awareness of the impact of adverse demographic trends on the long-term sustainability of pension systems, especially in advanced economies in Europe, but also in countries like China, and even in Latin America. While rising longevity is a tremendous societal achievement, it is not fully accounted for in the design of pension systems. The math is such that in some cases there will not be enough workers to support an increasing number of retirees in pay-as-you-go (PAYG) systems as the share of the working population continues to decline. For instance, today, in the European Union, four workers support the pension of every person aged 65, but by 2050, there will be just two.[1] This has significant implications for the sustainability of social pension systems, especially if we factor in the low level of real growth. And given the low returns in capital markets, we may conclude that there is not enough capital in the pre-funded system either.
We are cognizant of many economic and policy challenges affecting pre-funded pension systems around the globe. In recent years, we have heard a lot about the causes of the current low-growth environment and the still sluggish recovery. In addition to demographic trends, the deleveraging after the global financial crisis, and also rising income inequality in advanced economies have been listed as likely causes. The response to these challenges has been lower interest rates—in both nominal and real terms. But low interest rates go beyond monetary policy. According to the secular stagnation hypothesis, it would also reflect an imbalance between higher savings as baby-boomers age and lower demand for capital as new technologies require less capital. In this sense, the value of capital has dropped, and savings by workers in advanced economies have become less valuable. The real issue is this: are there ways to increase the value of capital? Of course, artificially increasing the demand for capital may increase its price in the short run. However, what matters ultimately is whether capital is used efficiently, and if it leads to productive investment that will generate adequate income streams.
Today, in many advanced economies, the returns of pension funds on an aggregate basis continue to be too low and have created a staggering pension gap. We measure this gap as the difference between (i) the present value of the annual lifetime income needed to sustain a reasonable standard of living after retirement and (ii) the actual amount of retirement savings (plus the present value of PAYG contributions).[2] Based on this measure, the estimated pension gaps in Japan, Germany, the United States, and France are massive. The investment return needed to close these gaps is around 5 percent, well above the average rate of return of most pension funds in recent years (Reference: Power Point Presentation Chart 1).
Thus, many pension funds need new sources of investment returns.[3] These sources need to be large, because pension funds are the second-largest group of institutional investors, with global assets under management of about $26 trillion (Reference: Power Point Presentation Chart 2).
Hence it is worth exploring alternative asset classes, such as infrastructure investment, including in EMDEs. Pension funds have a natural interest in infrastructure as a long-term asset yielding predictable and robust cash flows, with low correlation to other assets.
One clear aspect of infrastructure is its positive externalities. Well-planned infrastructure not only boosts private investment but also helps reduce the carbon footprint of progress. Since 55 percent of emissions are directly or indirectly attributable to infrastructure, “climate-smart” infrastructure reinforces the climate commitments that countries made in Paris last year, while increasing the overall productivity of the country where it is built.[4] Directing excess savings from advanced economies towards green technologies in EMDEs, which are otherwise likely to become more carbon-intensive as income levels rise, would raise equilibrium interest rates and create long-term income streams. And if investment responds to well-identified demand, it also offers high productivity gains in EMDEs with young demographics. By improving the economic outlook and reducing the risks of climate change, it could also lift confidence and increase aggregate demand in the investing countries over the near term, even if building these infrastructure assets and getting an income stream from them will take some time.
Of course, many pension funds are aware of the benefits from investments in climate-friendly infrastructure. According to the OECD’s 2015 Survey on Large Pension Funds and Public Pension Reserve Funds (covering 77 funds, $7.8 trillion), more funds indicated that they had either established new allocations to infrastructure, or were open to making new or increasing their existing allocations. Of the 23 funds that reported their infrastructure allocation over the period 2010-14, the average allocation increased from 2.8 percent of total assets in 2010 to 3.5 percent in 2014.[5] Most pension funds have a preference for investments in transport and energy infrastructure. But there might still be constraints to accelerating this incipient trend. Funds that reported a separate target allocation to infrastructure remain below targets; this is likely to imply insufficient investment opportunities and, perhaps, insufficient understanding of these opportunities.
Opportunities do exist in some EMDEs and have been tapped by institutional investors—predominantly domestic investors. If you look at investment in the so-called public-private partnership (PPP) space, you see relevant transactions year after year, with increasing values at financial closing. Over the last five years, transportation and energy generation alone have accounted for around $100 billion annually, despite a decline in some regions (Reference: Power Point Presentation Chart 3).
More importantly, there is an attractive pipeline for investments in the coming years. We estimate that there are more than $380 billion worth of investment-ready projects in energy generation and renewables by end-February 2017, in a wide range of countries and regions (Reference: Power Point Presentation Chart 4). Similarly, there is a pipeline of more than $480 billion worth transportation projects at the pre-financial closure stage. While opportunities in roads are most prominent, emerging opportunities in transit, airports, and ports are also worth investigating. These are projects in the pre-financing or financing stages. Some may still take time to be closed. Some need refinements in their business model, and others are just waiting for funding to be fine-tuned and get off the ground. So, yes, opportunities do exist. The question is how to translate these projects into actual investment opportunities, notably in the fixed income space.
Many of these projects are custom-made, although some have issued debt securities. As I mentioned, the behavior of infrastructure debt is a new frontier for many institutional investors. In this context, it is worthwhile to examine the performance of an emerging market infrastructure debt index that Morningstar, an index provider, is building at our request. Interestingly, there is a sufficient number of investment-grade infrastructure bonds to support such an index, which has attractive features. Although its total return over the last 10 years has been somewhat lower than that of a portfolio of non-investment grade emerging market corporates its risk is also lower (Reference: Power Point Presentation Chart 5).
This index can help position emerging market infrastructure in the risk-reward space. Even if an index is not heavily traded at the beginning, it allows asset managers to monitor performance at low cost and use the risk-return information to assess the appropriateness of creating a longer-term allocation to this type of exposure. In our case, the index from Morningstar is investment grade and facilitates comparisons to other asset classes, because its reference bonds are denominated mainly in U.S. dollars. The risk-return chart shows that the total return of the index is comparable to that of corporate bonds (e.g., Morningstar EM Corp Bd T USD), but with lower volatility (Reference: Power Point Presentation Chart 6).
Of course, it is probably still too early for this index to support a passive investment strategy, even if its components have some liquidity. This may happen in the future, if certain problems in the space are solved. For now, I think the most interesting aspect of such indices is the possibility to provide an indicative price, if not a benchmark for the asset class, and also probably helping price issues that may not be very liquid or traded.
But there is more work needed to accelerate the expansion of investment in EMDE infrastructure in a way that supports the paradigm shift in development finance I mentioned earlier. This is why multilateral development banks are adopting new instruments and policies to involve the private sector as both financier and implementer of investments to support development outcomes and foster sustained economic growth, social inclusion, and environmental protection.
This approach promotes the judicious use of scarce public and concessional resource based on lessons learned in the last 20 years of private investment in infrastructure. We recognize the three angles from which the private sector participates in infrastructure: i) the proportion in which consumers of the service will pay to ensure the cost recovery of the investment, ii) the role of the private sector in controlling and operating the assets and implementing the investment, and iii) the scope of the private sector financing the investment. Mobilization is reflected in the third angle, and we will try to maximize it—giving priority to mobilizing private sector resources when this is possible, recognizing the importance of the two other aspect to the success of the endeavor. The participation of resources will probably vary across sectors and geographies, and the adequate social balance should be ensured. But cost recovery through service charges, government support, or concessional resources is essential, to ensure the adequate return to investors.[6] The approach relies on our ability to also address the needs of host countries using different instruments, i.e., influencing their business environment by promoting reforms where necessary, and by developing financial solutions, such as guarantees at project levels or at portfolio level, while observing principles of efficiency and equity. That is the way to to align the risk capacity of private investors with the realities of these markets. That’s a good use of scarce public resources.
The following actions will help facilitate capital flows to infrastructure investments in EMDEs:
· Helping governments develop a favorable legal environment, prepare projects, and structure programs that are attractive to long-term institutional investors. That is the objective, for instance, of the Global Infrastructure Facility (GIF), which the World Bank created with the help of donors and in partnership with other multilateral development banks. As part of the GIF, we disseminate information about government investment programs as well as about the role of instruments such construction insurance to expand the appetite for greenfield projects. These actions will help bring to the market the pipeline I showed before, which includes projects of varying levels of preparation and economic viability. Helping in the origination of robust projects is an important role of multilateral development banks.
· Second, we are exploring ways of risk-sharing with the private sector so that public resources can be targeted more effectively. We know that traditional lending is not enough, and we are working to scale up guarantees and new instruments. We are also developing innovative new structures to involve the private sector in transactions. An example is 欧美日b大片’s 2.5 billion-dollar Private Sector Window (PSW), which I mentioned already. The PSW tackles some of the most difficult issues in developing economies’ investments, such as exchange rate risk from local currency debt, and the challenge of managing these risks to match fixed-income expectations. It is not easy to fully address direct or indirect exchange risk in infrastructure projects, because immediate pass-through of exchange rate fluctuations to consumers is hard to achieve. Alternatives may exist, however, to protect patient long-term capital.
· Third, we are supporting the development of local capital markets because they are an essential element to provide confidence and liquidity for foreign investors, notably portfolio investors. They also foster the deployment of domestic patient capital from local pension funds.
To conclude, there are many reasons why investing in countries with young populations can be an excellent way to reduce the pension gap in advanced economies. But the issue of risk appetite and capacity is real and should be treated also from the angle of efficient fiscal expenditure. Ensuring the development of local capital markets in hosting countries is a good strategy. But using public resources from advances economies to creating opportunities for deploying excess savings by helping address certain risks in EMDE investments can be a good fiscal policy. And MDBs can be an effective instrument to implement it, not only by using their balance sheet, but also by helping improving the business conditions in hosting countries and the level of disclosure and information in this space. This is today’s challenge—and of course Europeans are familiar with the so-called “Juncker Plan,” which is underpinned by the same objective of mobilizing commercial finance. I am confident that the approach I have outlined can be scaled up to EMDEs, and that mobilization strategies.
Thank you very much for your attention and the opportunity to share these thoughts with you today.
[1] Klein, Robert, 2016, “The Pension Gap Epidemic,” The Geneva Association, October (Zurich: International Association for the Study of Insurance Economics).
[2] Marin, Richard A., 2013. Global Pension Crisis: Unfunded Liabilities and How We Can Fill the Gap (John Wiley & Sons: Hoboken, NJ).
[3] Similarly, a decline in the funding status could also precipitate abrupt portfolio rebalancing away from higher-risk alternative assets.
[4] There is a global commitment for action, especially in building low carbon infrastructure. On December 12, 2015, the Paris Agreement was adopted by 195 governments, signaling an important milestone in the global fight to combat climate change. Since then, 190 governments have committed to concrete action to reduce their greenhouse gas emissions.
[5] Target allocations amongst the funds with dedicated infrastructure exposure ranged from under 1 percent to over 20 percent of total assets.
[6] For example, about 50 percent of infrastructure investment could theoretically be financed on a commercial basis. However, the actual share of private finance is estimated to be “only” about 20 percent; this suggests ample room for private capital to take on a more substantial role infrastructure investment.
