Financing Infrastructure in Financial Markets: Why Civil Society Should Be Alert
For the last five years, the Group of 20 (G20) has been weighing proposals to finance the “infrastructure gap” in developing countries: the more than USD1 trillion of additional investment needed to bridge the gap between existing infrastructure and the infrastructure needed in such areas as transport, energy, water, sanitation and internet connectivity to support socio-economic development.
The G20 has leaned towards proposals to attract the savings of institutional investors (mutual funds, pension funds, insurers, etc.), based on the premise that the long-term financing needs for infrastructure development are a fitting match to institutional investors’ need for long-term investment vehicles. However, such proposals have been criticised because this could induce “financialisation”, with all its consequences.
Financialisation: What it is and why it matters
Financialisation has been defined as the increased presence and importance of financial markets, institutions, actors and elites in the economy.
There are three main and interconnected concerns associated with financialisation. First, the greater relative importance of the financial sector reduces, as a counterpart, the importance of factors in the real economy (the sectors that produce actual goods and services). The financial sector is meant to play a mediating role for assets generated through real-economy productive activities, but what happens in a financialised economy is the opposite. The performance of financial markets, especially in the short term, begins to drive the dynamics of the real economy, to the detriment of actual production, consumption and long-term sustainability.
Second, financialisation leads to increasing transfers from the real economy to the financial sector as a growing portion of profits accrues to the owners of financial capital.
Third, inequality increases. As the financial actors’ share of income and wealth grow, so does their ability to influence and even rig policy- and rule-making processes, thus compounding and entrenching inequality.
Financialisation can be seen statistically in the relative growth of the financial sector compared to trade in goods, wages, and other indicators of the real economy. This has been a trend for several decades now. Between 1970 and 2012, the banking sector doubled, measured by loans-to-GDP. Measured by assets-to-GDP, it tripled. In developing countries in the same period, UNCTAD reports that trade openness grew on average 100 percent, whereas financial openness grew 250 percent. (In developed countries, that difference was even more dramatic.) Profits in the banking sector grew from 10 to 40 percent of corporate profits in the developed world. Other authors point to the growing proportion of private debt in the economy as another sign of financialisation.
The phenomenon is not just the result of private-sector financial dynamics: it has been actively enabled by policy measures. One of these is the removal of capital controls, which has facilitated the unfettered flow of capital across borders and the creation and expansion of transnational financial conglomerates. Another is the deregulation of finance, which has diminished state regulatory control of banks (e.g. their size, scale and interconnections), as well as the regulation of non-banking savings and credit institutions, thus facilitating their emergence and growth.
A critical feature of financialisation has been the proliferation of derivatives trading. Derivatives are financial instruments whose value depends upon that of an underlying asset, such as a commodity, stock, bond or currency. This value of the underlying asset can be derived in many ways. A straightforward example of a derivative is called a “forward”, which is an agreement between the seller and buyer based on the expected value of the asset at a future time. “Credit default swap” derivatives are linked to the probability of default on a certain bond. Derivatives may be infinitely varied because there is no limit to the forms that contractual parties might give to their agreement. Derivatives trading is inextricably tied to financialisation because it allows parties to place a “bet” on the underlying asset, regardless of any real-economy reason to do so.
However, financialisation is more extensive than that. Invariably, it needs to diversify to sustain itself: to move into other economic sectors – the public sector, social security systems, housing markets and other spheres of social reproduction – and to reorganise them according to the logic of financial markets. This tendency can be seen in commodities markets. In the early 2000s, financial entities began to treat commodity-based derivatives – derivatives linked to the price of raw natural resources or primary agricultural products – as a financial asset in their portfolios. As this practice grew, commodity prices became more and more divorced from the actual market demand for supply for production and consumption, and more and more dependent on the demand of financial portfolio managers who were willing to hold such derivatives and the willingness of financial firms to supply them – with no intention to produce the underlying commodity.
Long-term investors and infrastructure projects: a good match?
With this in mind, we come back to the trillion-dollar question of the infrastructure gap and G20 proposals to seek funding from institutional investors with long-term horizons. While these are put forward as an antidote to the short-termism associated with financialisation, they also tend to equate institutional investors with long-term investment strategies. This is unwarranted. In practice, even pension funds and insurance companies are using the services of asset management firms that are motivated to deliver good short-term results in a competitive market in order to achieve higher profits for themselves. A recent survey of asset allocations of pension funds in OECD countries revealed that their “alternative investments” – where infrastructure assets usually fall – are primarily done through funds or “secondary intermediaries”, such as infrastructure funds, hedge funds, private equity funds, and even funds of hedge funds and private equity funds of funds.
Along similar lines, the G20 proposals assume that long-term investors will not expect higher-than-average or unreasonable returns. But even where this is true of the asset owners, it is only logical to assume that the more intermediaries are involved between them and the final projects in which their funds are invested, the higher the need will be to achieve superior returns in order to satisfy the asset owners’ expectations and ensure the intermediaries’ profits.
The distance between asset owners and the final projects also opens an opportunity for unscrupulous arbitrage (simultaneous buying and selling on different markets or in derivative forms to exploit price differences) between the true risks of the projects and the perceived credit risk of the financial assets built upon them. This could grow particularly problematic in the proposed “pooled investment vehicles” that would combine the revenue streams of a number of public–private partnership projects. The mortgage-based securities that helped trigger the global financial crisis in 2008 provide an apt illustration of the potential consequences.
The question is: Will infrastructure-based assets, which are more novel than mortgages and where due diligence is exponentially more difficult, create new opportunities for intermediaries to generate short-term gains at the expense of asset owners’ exposure?
Unfortunately, current regulation offers little comfort. Commenting on the G20/OECD High-Level Principles of Long-Term Investment Financing by Institutional Investors, the Trade Union Advisory Committee for the OECD demanded that they provide further guidance on matters such as asset managers’ capacity and duty to act in line with asset owners’ objectives; prevention of conflicts of interest, and duties to act in the interest of ultimate beneficiaries and owners; and asset managers’ contracts. The Principles, in their final draft, left those issues to pension funds to negotiate by themselves. More recently, the OECD produced more than 400 guidelines to develop the Principles, now endorsed by the Group of 20. In spite of this abundance, the guidelines retain an almost exclusive concern with the responsibility of asset owners and have nothing to say about public-interest regulation of asset managers.
Relevance for human rights and other public interest agendas
For civil society agendas in support of sustainable development, human rights, and accountable and participatory governance, the increased involvement of institutional investors in infrastructure projects raises a number of issues. These can be grouped in three categories.
The first category includes concerns that are common to all forms of financialisation, and have been addressed above.
The second category is tied to the nature of institutional investors and the nature of infrastructure. There is an inherent tension between the interests of institutional investors to pursue high risk-adjusted returns and the interests of citizens and taxpayers in the countries where the infrastructure is to be built. Precisely, the characteristics that are beneficial to asset managers are detrimental to users, consumers, taxpayers and citizens. For instance, infrastructure providers can hike up tariffs if their costs increase, which will obviously have an impact on peoples’ access to services, especially for low-income users or where no alternatives exist. Similarly, publicly backed guarantees protect investors against risks such as inflation, exchange rate hikes or limited demand. For taxpayers in the host country, these guarantees represent liabilities that, should they materialise, will bear on future budgetary periods. These problems are exacerbated by the systematic tendency of contracts to overstate future demand and understate costs.
Other advantages to investors are revealed in the kind of policy proposals that make infrastructure projects “bankable”. To improve their “investment climate”, governments are advised to freeze regulatory protections for labour and the environment, to strip citizens of protection against having their land seized, and to criminalise public assembly or protests against harmful projects. The Guidelines on Contractual Clauses of Public-Private Partnerships, which the G20 recently commissioned from the World Bank, presents clauses that go even further to favour investors as a desirable norm.
Yet a third category of concerns stems from governance arrangements. Technical and, especially, financial support for infrastructure project preparation activities are provided by multilateral development banks (MDBs) through project preparation facilities (PPFs). The overarching goal of PPFs is to set up a project to the point that it attracts sufficient interest from other investors. In the World Bank’s version, called the Global Infrastructure Facility, private investors are brought in as “advisory partners”, essentially sharing the decision-making platform with the Bank. Representatives of civil society, consumers and other groups that would be affected by the project are conspicuous in their absence. With the G20 calling for MDB-based PPFs to “maximise their capacity to… collaborate with the private sector”, one has to wonder whether the World Bank’s facility is an exception or has set the standard that others will seek to adopt. If the latter, what does this mean for publicly accountable governance of infrastructure development?
“Reforming the investment climate” – perhaps entailing the kind of measures mentioned in the second category of concerns – is identified in many assessments as part of effective project preparation, and it is likely that development banks will use their muscle to promote such reform. If this requires changes to laws and regulations in the host countries, what will safeguard transparency and accountability to citizens?
All of this does not justify a blanket scepticism that institutional investment in infrastructure development can become the win-win situation that the G20 posits with such fervour. But to do so, the tension between the interests of institutional asset owners and the interests of end users should be reconciled in a balanced way and not driven by the interests of profit-seeking financial intermediaries. For example, the use of domestic pension savings to finance domestic infrastructure can actually make development less dependent on foreign inflows and thus more likely to buttress national development priorities.
What can civil society do?
There are a number of regulations and measures that civil society could promote in order to safeguard and mitigate concerns presented by the involvement of institutional investors in infrastructure development.
In states that are home to institutional investors, financial regulations should require them to safeguard human rights and the environment as well as provide effective remedies for violations. Such obligations should be explicitly embedded in the fiduciary duty of asset managers, not just asset owners. The regulations for listed and non-listed companies should also include requirements for corporate disclosure on human rights, environmental and social issues. Specifically, corporations could be required to disclose: the measures and mechanisms they have in place to prevent such hazards and to identify and consult with potentially affected communities before financing projects; any ongoing process of identification or consultation with affected communities; the outcomes of any process that has come to closure during the reporting period; and the remedies available to the affected people, in compliance with Pillar 3 of the UN’s Guiding Principles on Business and Human Rights.
In states that are hosting infrastructure projects (whether or not they coincide with the home of the institutional investors), it is crucial to demand that they have in place conditions for transparency and accountability, such as timely disclosure of contracts under negotiation, and mechanisms for both ongoing citizen involvement and parliamentary scrutiny of contract negotiations and performance. General institutional checks and balances are equally important, such as a functioning judiciary, a framework for whistleblowers, and press and civil society freedoms (of assembly, petition, and so on). These are at least as important as the “business environment” that investors so much insist upon. Rules to ensure the private sector reaps its rewards only where it is actually taking a risk (rather than, for example, eliminating risk through unaccountable budgetary processes) should be applied. One example is the “Ryrie rules” that were used in the 1980s in the United Kingdom.
Public financial institutions that engage with institutional investors in co-funding projects should strengthen their safeguards and requirements for human rights and environmental impact assessments. They should understand these not as administrative boxes to tick but as empowerment tools for the communities that “development” projects aim to “develop”. Communities are in a great position to uphold the highest standards for disclosure of contracts and transparency, and should not hesitate to do so.
Finally, and not least, there are actions to undertake with the institutional investors themselves, such as securing voluntary commitments from them to report on sustainability and responsibility standards and their compliance, and to subject themselves to reviews and audits. This could include third-party certification requirements. At the moment, voluntary standards in the financial sector is essentially a “no man’s land” where any firm can claim to uphold any standard, without the risk of having to stand up to external verification.
Support for voluntary commitments is growing among investors as they begin to understand that neglecting human rights and sustainable development issues may ultimately bear long-term financial costs. But it is crucial to remember that such measures do not replace legislated regulations that express a principled commitment to human rights and sustainable development, beyond any concern for financial returns on investment.