Emerging Markets Infrastructure Project Investment: Issues and Opportunities

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Global investment in real estate and infrastructure projects are on the rise. Preqin’s 2018 Infrastructure Fund Manager Outlook notes that institutional investors have heavily invested in the infrastructure asset class for solid diversification and stable returns. Indeed, the report ascertains aggregate asset under management (AUM) quadrupled from US$99bn to US$418bn over the past decade. The industry is expected to increase exponentially over the next decade. Globally, North America and Europe present the most viable of real estate and infrastructure opportunities. However, a bundle of emerging markets economies follow a close third. Global emerging markets infrastructure investments are currently fueled by Asia Pacific’s growth as opposed to other developing regions. Total deal value for the Asia Pacific amounted to roughly US$50bn over the past five years, with more dry powder allocated to projects within Asia.

Feasible emerging market infrastructure projects usually have a Public Private Partnership (PPP) structure, especially for risk mitigation. As we had examined in US Infrastructure: A Case for Public Private Partnerships, PPPs are beneficial as the private entity internalizes life-cycle costs during the majority building phase of new projects, while the project is listed as public investments on the government balance sheet. Purely public sector projects tend to be inefficient, and have full political risk, while purely private projects may have higher returns, but would not have the accountability of check and balance which sovereign involvement brings. Even so, there are many challenges which investors, financiers, and infrastructure fund managers must take into consideration primarily for emerging markets.

Challenges Faced:

The Macquarie Group is one of the global leaders in asset management with US$356bn AUM, and is considered to be the top global infrastructure finance advisor as at 2017. The Group has dispensed significant pain points and mitigating factors with regards to project investment in emerging markets. Most issues stem from long standing bureaucracy, lack of transparency, corruption, geopolitical and cross border risks. Highlights are follows:

Bid and Post-Bid Processes:

In short, red tape from every conceivable side of the project is challenging at best. Emerging markets tend to have delays in bid preparation, unclear bid guidelines, erratic time to submit request for proposals, and restrictive bid processes which place heavy tariffs on the build-operators of the project. In addition, project ‘hand-holding’ requires higher cost of bid bonds and of additional advisors, planners, quantity surveyors and numerous government officers. In addition, deciding on the best commercial funding structure for the PPP would most likely not be as clear or timely as with developed country projects. For instance, financing default from the private side of the PPP may lead to immediate freezing of project assets, as opposed to debt coverage negotiation.

Terms of Concession Agreements:

Land Acquisition is one of the most troublesome components of the project process in emerging markets. The land surveying, land release, ground approvals and resource rights processes, especially in real estate type transactions, take an inordinate amount of time. The best PPP investment projects that may circumvent this onerous component would be public works and transport type projects, where the government already has clear ownership of the sites in question, with full government use of site resources. Also, there is a huge communication gap in terms of the types of environmental and regulatory requirements needed for all emerging markets projects. As the Macquarie Group states, most delays in their infrastructure portfolio stems from having to backtrack and fulfill regulations that were not mentioned from pre-bid inception onwards.

FOREX Challenges:

Forex issues come in second only to land acquisition challenges in emerging market PPP project fulfillment. This is by no means theoretical as I am currently battling this challenge. In many parts of LATAM & the Caribbean multi-million infrastructure developments are offered a mere US$200.00 a day by Central Banks due to paucity in supply and treasury mismanagement. From an investment perspective, Forex volatility for projects denominated in local currencies may create lower yields due to cross border risks, and hedging for many emerging markets currencies is not available.

Macroeconomic Inefficiencies:

In addition to the Macquarie Group’s points supported above, project developers and financiers know that labor supply, labor quality, labor laws, as well as tariffs on materials, material supplies and weather factors are extremely dictating of successful project fulfillment. Most emerging markets may seem to have a dearth of labor supply. However, educated construction labor may be hard to find, and to keep. Many viable emerging market infrastructure projects that have been fully funded have stalled indefinitely due to a lack of both construction and management labor. Unfortunately with PPPs government policy would require local labor to be sourced, creating a chicken and egg situation.

Solutions Presented:

Emerging market project development, financing and investment fit in with high risk, high reward appetite. Yet as we mentioned before prudent infrastructure investments give solid returns and add practical diversification to portfolios. Therefore emerging markets project financing and investments are not to be avoided, but to be mitigated. Successful project investment takes a great deal of sovereign and macroeconomic research, whether per project or via an infrastructure fund. The Macquarie Group pinpoints several requirements needed for investor comfort when it comes to infrastructure investing, and especially for emerging market conditions.

  1. Stable Political Environment:

    Note that a stable political environment will not mitigate red tape. However, mitigated political risk allows PPP projects to be safeguarded against event risks such as coups, and freezing of foreign investments.

  2. Stable Economy with Growth Potential:

    Overall a stable economy with high credit rating gives comfort of low default risk. However, it is necessary to delve further into macroeconomic variables such as labor and capital intensive predilections. Does the country have stringent union interests? Does the country’s labor have the educative capacity to cost effectively get PPP projects done? Are there punitive tariffs on capital intensive projects? It is necessary to ensure the emerging market country accounted for PPP infrastructure projects in its annual budget, broken down by sectors such as transport, seaports, utilities etc.

  3. Open and Transparent and PPP Bid Process:

    Is the country’s public procurement and bid processes in line with international standards and policy frameworks? What is the track record of successful PPP projects in terms of pre-bid to completion timeline? It is necessary to be in close contact with the country’s department of public works, transport and infrastructure to get a detailed log of such a track record before investing in any project, or in any fund.

  4. Stable Financial Market:

    This one is tricky for actual returns, especially as most emerging market projects are structured in local currencies. If investing in an infrastructure fund, the risk is mitigated. If there is direct investment in the PPP project, the risk is heightened, no matter how stable the financial market is. And don’t be fooled by oil-based emerging market countries. One would believe that such countries would have strong cross border Forex capabilities. However, if the projects are non-energy infrastructure, FX paucity and volatility can still be an issue. It’s necessary to examine the country’s central bank and its monetary policy beforehand.

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Understanding and dealing with bubbles – a review of the state of the art

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Take a close look around you. There seems to be today bubbles boiling up everywhere.

There are bubbly stock markets like India, Brazil, and the U.S. Lots of bond bubbles: U.S. Treasuries, U.S. corporate bonds, global bonds in general, subprime auto bonds.

There’s talk of a bubble in the international art market, solar energy, venture capital, lithium and U.S student loans. Another looming one is the bitcoin bubble too.

There’s also evidence of real estate bubbles around the world: Vancouver, Auckland, Sydney, Toronto, San Francisco and London, for starters. There’s a reported bubble in “nine-figure real estate listings.”

Chinese bubbles are a class of their own: Real estate, iron ore, cotton, garlic, eggs and soybean meal are some recent ones. Of course, China’s stock market bubble burst last summer.

Then there is discussion of “the mother of all bubbles” also known as “the everything bubble,” which infers that a global debt bubble feeds all the other bubbles. With so many bubbles, it’s hard to keep track.

Possibly a Bubble ETF is needed, composed of the many bubble markets, so that there’s an efficient way to track and trade the world of bubbles.

Yet, despite the fact that speculative bubbles are popping up everywhere, it can often be hard to tell you’re in a bubble until it pops. It would help to know how to tell a bubble is forming.

Luckily there are about four centuries’ worth of speculative bubbles to study for answers.

The first widely known and the most famous market bubble of all time was Tulip Mania, which occurred in Holland in the early 17th century. The Dutch became enamored with tulips that had flaming colors on their petals. They coveted the bulbs that grew into these unique tulips.

As demand for the bulbs increased, along with their value, a market in tulip bulbs developed. As word of profitable speculation spread, more people piled in. Prices moved continuously higher.

Then from December 1636 to February 1637, the price of premium tulips surged by 200 percent. At the height of the mania in 1637, the market price of a single prized bulb was sufficient to purchase one of the grandest homes on the most fashionable canal in Amsterdam – when that city’s homes were among the most expensive in the world.

Needless to say, these prices were not an accurate reflection of the true value of a tulip bulb. In February 1637, buying tipped over into selling, and a domino effect of cascading lower and lower prices took hold. Speculators saw that they had spent vast sums to buy plants that were little more than glorified onions, and liquidated their tulip bulb holdings without regard for price. As wealth evaporated, pandemonium engulfed Holland. A deep economic depression followed.

Tulip mania established a pattern that has since been repeated over and over in speculative bubbles ever since. Despite advances in economic theory and the increasing sophistication of markets, market bubbles, and human psychology, haven’t changed much since the 1630s.

In 2008, Jean-Paul Rodrigue, a Canadian transportation scholar, conducted a study of the history of bubbles, and published a model of bubble stages:

  1. Stealth Phase. The initial bubble stage is where a new market opportunity, or paradigm, is cautiously recognized by early smart money investors.
  2. Awareness Phase. As market prices rise, more investors are attracted to the new investment story. The media begins to cover the story, adding to the momentum, and investors become increasingly interested – and increasingly less sophisticated.
  3. Mania Phase. Now everyone notices the rising prices. The media is touting “the investment of a lifetime.” Price becomes detached from underlying economic reality. Euphoric, irrational investors project recent price gains into the future. Enthusiasm spreads like a contagion between investors. A feedback loop ensues – rising prices amplify stories that seem to justify high valuations, which attract an ever increasing number of buyers.Even cynical traders join the buying, expecting to sell to “greater fools.” Price gains become nearly parabolic. Paper fortunes are made. Greed rules. Meanwhile the smart money is selling to the dumb money.
  4. Blow-off Phase. At some point buying abates and a paradigm shift slowly – or sometimes quickly – unfolds, as market participants realize something has changed. Sellers now find few buyers and prices fall quickly. Leveraged speculators face margin calls and are forced to sell. The decline becomes a crash.

Everyone now views the market as “a house of cards,” and prices plummet at a rate much faster than when the bubble was inflated. Often, prices fall below pre-bubble levels. The market becomes universally hated. But eventually the smart money starts buying again, recognizing the  panic has created an opportunity to buy assets at bargain prices.

This classic bubble pattern is apparent in the most notorious bubbles of the modern era, including some very recent ones.   Another example is the Shanghai Composite index just last year. Starting in August 2014, the index gained 125 percent in 10 months. This was fueled in part by easier margin lending rules, which allowed Chinese investors to borrow more to invest.

This amplified the speculation and buying, so prices kept going higher. Thinking that buying stocks was an easy way to make money, less sophisticated investors entered the market and mania ensued.

But eventually the bubble popped. Investors realized stocks were way overvalued and the market collapsed and fell 32 percent in less than a month.

Over 400 years of market bubbles have shown a recurring pattern: A smart investment idea gains a following, and prices rise. The media discovers the story, ever more investors join in, becoming increasingly excited, and prices rise even more. Valuations lose connection with economic reality. Sooner or later the bubble bursts, prices crash, and many investors are ruined.

With potential bubbles in so many different markets across the globe, it’s a good time to study this historical pattern. Knowing what stage a market bubble is in can help you avoid taking a bath when the bubble pops. And bubbles always pop.

Learning to control the emotions that can cause us to get caught up in market bubbles is also important.

Next bubble?

I am afraid the next bubble will be due to cheap money…

Ever since the Fed (and other money printing entities throughout the world) started to print money at record pace after the 2008 crisis, there has been a lot more money in the economy.

What the central banks were trying to do (and it has worked a little) was stimulate economies by injecting money into industries that were hanging on by a thread.

Unfortunately, this has caused many assets to be inflated in price because of the larger volume of dollars (or whatever currency you use) in the market.

This large volume of money allowed people to pay higher prices for things like homes, businesses, cars, education, or really anything that can be bought with borrowed money.

As we continue down this road of more money printing, we are just like a drunk at the bar, who is drinking more and more. We think we are getting better and better at dancing all over the tables, and hey, maybe we are! But… the next morning we are going to have a mean hangover.

So, anything that is financed through borrowed money is at risk of being in a bubble. Real assets that cannot be financed are the few things that wealthy people will start transitioning into as this bubble gets larger. Things like metals, art, collectibles or foreign real estate.

Given the current state of our economy, the only thing worse than a new bubble would be its absence.

Now you know….

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