Are cash-rich pension funds the answer to financing Asean’s massive infrastructure upgrade?
By Eddy Sunarto
Over the next decade, the largest capital investment in Asean integration will be made since the bloc’s inception in 1967. According to the Asian Development Bank (ADB), no less than $600 billion will be required to address Asean nations’ infrastructure problems – a staggering $60 billion a year.
Given the recent rapid ascent of the region’s economies, the need for infrastructure investment comes as no surprise to anyone, least of all the Asean member countries. The idea for the Asean Infrastructure Fund (AIF) – established to focus solely on financing infrastructure investments in the region – was hatched as early as 2006, but was only formalised in 2012.
The AIF was initially capitalised with $485m of equity investments from Asean member states and the ADB, and has formally stated that it will commit $13 billion in infrastructure financing up to 2020. Though this falls far short of what is required, it is a step in the right direction after decades of neglect of public works across the region. For example, after flooding in January this year, Jakarta admitted that its sewerage system has not been upgraded since Indonesia gained independence from the Dutch in the 1940s. Similarly, Thailand’s infrastructure development has mostly been neglected over the past decade.
In addition to the AIF, Thailand and Indonesia in particular have aggressively ramped up their respective infrastructure spending budgets recently. In March, the Thai cabinet approved a $70 billion infrastructure budget over the next seven years that will allow the Thai Ministry of Finance to issue long-dated bonds. Indonesia, on the other hand, has acknowledged the need for $150 billion of spending over the next five years to build power plants, shipping ports and thousands of kilometres of roads to connect its vast archipelago. In its recent 2013 budget session, the Indonesian parliament approved a 15% increase in infrastructure spending, an additional $22 billion, for 2013.
Funding gap
It is unclear at this stage how the AIF or the individual sovereign governments will fill this apparent gap in capital investments over the next few years. It is obvious, however, that much of the funding will have to come from the region’s foreign exchange reserves, which currently stand at an unprecedented high. According to the latest figures, Asean Five – the five largest economies in the region – has a combined reserve of almost $800 billion, which will allow Asean to keep equity ownership of the infrastructure projects within its member states as much as possible. Asean can also tap into the region’s banks and unlock billions of dollars in private savings through bank loans. Experts have argued, however, that financing long-term infrastructure projects with bank loans is not ideal because it leads to a liquidity mismatch as most banks fund their long-term loans with short-term deposits. In this respect, governments will be disinclined to use bank loans as a funding mechanism and risk destabilising the system. Furthermore, with the impending introduction of the Third Basel Accord in 2013, which penalises banks for holding long-dated illiquid assets, it is unclear how far the banks themselves are willing to channel their funds into these projects.
By far the most sustainable and viable source of long-term funding for the AIF and individual governments will be debt issuance. In this way, the AIF can participate in the cheaper capital markets and attract both domestic and international investors through the sale of long-term bonds. This will allow cash-rich institutions like pension funds and insurance companies to provide the necessary funding.
Attracting pension funds
Pension funds, due to their relatively strict investment mandate, have historically invested in ‘low-risk’ fixed income assets such as money market deposits and government bonds. These restrictions were considerably relaxed by many governments in developed nations in the wake of the 2008 credit crisis, as a means to attract funds into public spending programmes. As a result, many pension funds in Europe and the US began to reallocate some of their asset holdings into government-backed infrastructure bonds. This investment proved to be a perfect fit for the pension funds due to the duration matching on both sides of the balance sheet – long-term infrastructure bond assets funded by long-term liabilities in the form of pension contributions. According to the latest figures, approximately 40% of all infrastructure asset class in the developed world is currently financed by pension funds.
In the long term, the viability of financing infrastructure projects in Asean will depend heavily on tapping the resources of pension funds and insurance companies.
Donald Kanak, chairman of Prudential Corporation Asia, emphasises the need to encourage individuals in Asean countries to switch their savings from short-term bank deposits to long-term pension and insurance investments.
“Financing most infrastructure needs with domestic savings is well within the reach of Asean as a region,” he said. There are two keys to that. First, to encourage more domestic savings to flow from deposits into long-term pension savings and insurance products; second, to further develop long-term debt and equity capital markets nationally and regionally.
“Considering that Asia is ageing about three times faster than the West did, there is an urgent need to grow the pool of insurance and private pension assets in most Asean countries to provide income for millions of retirees in the future,” Kanak added. “Insurance and pension assets across several Asean markets – covering Malaysia (insurance assets only), Indonesia, Philippines, Singapore and Thailand – in 2010 were only 18% and 32% of GDP respectively, whereas in the UK those numbers are 157% and 168%. Building up the pool of long-term savings, rather than a burden, will become a major source of investment in long-term sovereign debt and capital for investment in businesses and infrastructure – in other words, the savings for Asia’s greying will finance Asia’s growing.”
There are, however, a few regional-specific obstacles that have to be overcome. The most obvious sticking point is the issue of credit risk, and whether these bonds can achieve investment grade status. Investment grade rating is imperative and the primary criterion for attracting pension funds. To overcome this obstacle, it is envisaged that the ADB, as a triple-A institution, will act as a guarantor to any debt security issued by the AIF. Furthermore, while the average individual country rating tends to be low, collectively the region has a good credit history. Apart from Indonesia’s debt restructuring during the 1998-2002 Asian financial crisis, no other Asean countries have defaulted on their debt obligations, which will be one of the selling points for would-be investors.
The local currency bonds sector will also be hoping to attract investments from pension funds. According to the ADB, the local currency bond market – for governments and corporates – has grown substantially in recent years. Latest figures indicate that the total bonds outstanding in the region rose to $6 trillion as of September 2012, an 11% increase from the year before. This is set to increase even further over the coming years as the infrastructure bonds come into the market. Government bonds issued by Indonesia, for example, have been in high demand and regularly oversubscribed at auctions since Fitch and Moody’s awarded investment grade status to the nation’s sovereign debt.
If Asean is to take its development to the next stage, it is critical that it broadens and harmonises its capital markets in order to attract private investments. Asean nations must work together fast to integrate the bloc’s disjointed capital markets and create a robust bond market. Securities regulators across the region must also work towards a common legal jurisdiction for securities documentations to facilitate a smooth entry for international investors like pension funds. As the Asean Economic Community – set for 2105 – draws closer, the race is on for each member state to become the regional transport hub. It is only through attracting outside investments that this can become possible.
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