A NON-MARKET STRATEGY FOR ACCELERATING DEVELOPMENT IN PUBLIC INFRASTRUCTURE IN SOUTH AFRICA: A PROJECT FINANCE APPROACH

A NON-MARKET STRATEGY FOR ACCELERATING DEVELOPMENT IN PUBLIC INFRASTRUCTURE IN SOUTH AFRICA: A PROJECT FINANCE APPROACH

In this point of view, we identify innovative approaches to render South Africa a more attractive investment destination for global capital markets, leading technologies and implementation capabilities in the field of public infrastructure. Innovative financial structures are considered as possible strategic contributors to significantly increase the rate and volume of infrastructure financing (and development), commoditising the use of project-specific bonds for capital projects, and a regional exchange for trading modified project bonds for financing public infrastructure.

OVERVIEW South Africa is a leading economy on the African continent. It has a highly sophisticated and mature financial sector, a relatively large and diversified economy, has adopted a world-class constitution, honours property rights and an independent judiciary. Despite the effects of the global economic crisis, the country has grown remarkably since 1994. It has a relatively well developed construction sector and, with collaboration from global leaders in the field, would be well positioned to expand the capacity of the sector if the opportunity arose. The National Development Plan (NDP) published by the National Planning Commission states that to grow faster and in an inclusive manner, the country needs a higher level of capital spending. Gross fixed capital formation needs to reach about 30 percent of GDP by 2030, with public sector investment reaching 10 percent of GDP, to realise a sustained impact on growth and household services. The role of the private sector in achieving this task is essential and although the domestic banking sector may have funding available for a significant proportion of projects, funding alone will not bring with it the requisite implementation capacity. A deeper examination of this challenge reveals that the capacity to implement largescale projects in various sectors cannot possibly be satisfied with only domestically available financial and human resources. Further, systemic factors can now be pointed to a few fundamental issues that appear to compromise the aims of the South African gross fixed capital formation needs to reach about 30 percent of GDP by 2030 National Development Plan, to making infrastructure available for purposes of enhancing economic productivity in a sustainable manner, and for placing South Africa on the trajectory to which it aspires. These include the political will necessary to drive programmes in sectors of high priority, reduce perceived sovereign risks and complete necessary institutional reforms capable of seeing projects through from concept to implementation. This is at the heart of the issue: if the Republic of South Africa has all the necessary governances and institutions flawlessly in place and coordinated, along with comprehensively aligned economic and trade policies geared for investment; would these fundamental inputs be sufficient for realising the extent of productivity and intended growth trajectory? It is contended that this would not be the case. As fiscal revenues continue to decline in South Africa as they have in several other countries, availability of public funds will be insufficient for these capital investments. This is evidenced by the South African Government s intention to spend ZAR827 billion over A PROJECT FINANCE APPROACH 1

the next three years on infrastructure (Budget Review 2013, National Treasury of South Africa). At almost 8 percent of GDP, this is already short of the required 10 percent of GDP advocated by the National Development Plan. Secondly, the required technology, being or having been developed in various parts of the globe and the capacity to undertake this scale of implementation is arguably a constraint at this time. APPROACH A review of the state of global and domestic trends in the financing of infrastructure using the project financing method was undertaken. Key analytical lenses were selected from those relating to the context of emerging economies; including the obsolescing bargain framework, institutional voids and the 4I framework. SUMMARY OF OBSERVATIONS AND PROPOSED INNOVATION Various challenges applicable to the South African context were identified. Using the principles of appreciative enquiry, the positive aspects of relevant South African systems were used to leveraging the system strengths in order to overcome these challenges in theory. Potential options for changing the game were then tested. Key challenges constraining the rate and volume of international infrastructure financing in South Africa, using the project financing method, were tabulated alongside the strengths exhibited by the Republic of South Africa, as shown in the table below. Table 1: Key Strengths and Risks Relating to South Africa as a Project Finance Investment Destination Key Strengths (in no specific order) Sophisticated Financial System Internationally recognised sovereign bond market Functioning and independent judiciary and institutional quality for maintaining property rights Relatively stable policy environment, well respected economic policy team Low risk of expropriation Large and stable African economy Available skills for structuring project finance transactions, and well established PPP Unit in South Africa Well-funded potential financing sources in the form of asset managers and pension funds Key Constraints and Risks Political: Change in government, obsolescing bargain Institutional: Poor planning, inefficient civil service with long lead times, opaque procurement processes, relatively high corruption levels. Weak governance arrangements between policy custodians and implementing agencies. Financing: Refinancing mechanisms necessary (tenor of project financing transactions), currency risk (ZAR is a volatile currency), foreign exchange regulations (repatriation of earnings) Labour: tough labour market with skills shortage Relatively well established and scalable construction sector A PROJECT FINANCE APPROACH 2

In light of the strengths and weaknesses identified, consideration of the analyses using the framework for spotting institutional voids, the 4I Framework for describing the nonmarket environment and the opinions of respected authorities, it is contended that financial structuring innovations combined with project financing could positively contribute to realising a step-change in the rate of infrastructure development in South Africa. Furthermore, it is contended that this approach will not extend the magnitude of risk exposure assumed by the state. Given the relative sophistication of South Africa s financial sector, the issuance of infrastructure project bonds for raising capital is recommended. In the African Development Bank s publication on the subject of the conditions necessary for infrastructure project bonds in Africa, it is clear that South Africa leads South Africa stands out in the region in terms of local market liquidity, capital market development and experience with project finance. Although it is noted that issuing standard infrastructure bonds would not by itself facilitate the intended result. Various adjustments to the bond instrument are suggested in order to address the key constraints and risks tabulated in Table 1, above. Additionally, it is generally agreed that a second important innovation would be required for substantially increasing uptake and liquidity in project-financed infrastructure investments in South Africa. The second recommendation is that a regional exchange be established for purposes of issuing, tracking and facilitating secondary trade in infrastructure project bonds. It is suggested that initially, the exchange be restricted to markets in Sub- Saharan Africa. The founding, nonnegotiable rules to the exchange, at a minimum and in addition to good governance practices related to these institutions, are recommended as follows: All countries issuing bonds via, or trading their instruments on the exchange, will comply with a jointly agreed set of rules, in the form of a sovereign subscription agreement; In facilitating good governance on transactions the exchange will be entitled to take punitive measures against non-complying members; Any instrument issued by a sovereign for trade on the exchange, will be backed legally and directly by the central revenue fund of the issuing sovereign, in respect of financial obligations associated with the financial instrument; A specified minimum proportion of infrastructure project bonds issued on the exchange should be subscribed by a DFI or public pension fund from the issuing country. These subscriptions cannot be traded, except to another local qualifying institution, for the entire tenor of the instrument; All sovereigns will make international political risk cover available (preferably issued by the Multilateral Investment Guarantee Agency or similarly non-partisan organisation); All project documents associated with projects where bonds have been subscribed, should be lodged internationally, with recourse available through an international and objective body (possibly the A PROJECT FINANCE APPROACH 3

International Court of Arbitration and other similar organisations); Subscribing countries should be encouraged to publish their infrastructure plans, register the project procurement phase and publish progress via the exchange; and Countries should be encouraged to receive unsolicited bids via the exchange and systematically conclude them in a predefined and predictable manner. It is important to note that the exchange would only serve as a transparent market, and platform for raising finance and trading infrastructure project bonds and similar instruments. It is not recommended that the exchange be used as a mechanism for regional integration, i.e. that countries should share risk in any way whatsoever. Table 2 below, shows the mitigation features inherent in the design of a system which offers the potential of attracting substantially higher rates of project financing investments than seen before, in South Africa. Table 2: Designing for Investment Attractiveness and Risk Mitigation Key Risks Political: Change in government, obsolescing bargain Mitigation Features (South Africa) Co-financed with local DFI s Political risk cover built into instrument Returns guaranteed by the Revenue Fund of the issuing country Regional platform offers international visibility of sovereign obligations International lodgement of project documents and access to international arbiters to resolve disputes Institutional: Poor planning, inefficient civil service with long lead times, opaque procurement processes, relatively high corruption levels Financing: Refinancing mechanisms necessary (tenor of project financing transactions), currency risk (ZAR is a volatile currency), foreign exchange regulations (repatriation of earnings) Publication of National Infrastructure Plan Decouple financing from implementation this allows the state to access the best possible project financing offer via the exchange. Traditional bids presently combine implementation and financing substantially complicating the state procurement process Predictable method and transparent platform for receiving unsolicited funding bids, and processing these in an orderly manner Banks subject to liquidity requirements, governances and regulations can subscribe in these long-tenor instruments and trade them early in this liquid market, to remain within their preferred investment horizons All bonds should exhibit both fixed and variable income components fixed component to assist in reducing currency risk (possibly benchmarked against T-bill rates of issuing country), and variable component of project cash-flow stream in accordance with project documentation A PROJECT FINANCE APPROACH 4

Conclusion South Africa is a leading economy on the African continent, with several challenges and huge potential. Practical challenges standing in the way of large-scale private sector infrastructure investments (in addition to varying perceptions of political risk) have been identified as institutional weaknesses ranging from weak planning and structuring competencies, unduly long lead times for decisionmaking, relatively opaque administrative processes and the perception of policy uncertainty. These institutional challenges are recognised as characteristics of a young democracy and; as an area that should receive considerable focus until resolved. The application of the selected non-market analytical frameworks have yielded further central findings which suggest that increased use of project infrastructure bonds and creation of a liquid market for trading these could positively contribute to accelerating infrastructure development in South Africa over the short-tomedium term, by mitigating risks and challenges experienced by various stakeholders. The aim of these innovations are to reduce risks for all parties concerned, as far as possible, in addition to reallocating risk appropriately amongst the financial institutions, project implementers and thesovereign. It should be emphasised that the introduction of project infrastructure bonds and a secondary market for trading these instruments do not negate the need for well capacitated institutions functioning in concert with each other. It is suggested that they are undertaken as distinct initiatives, in parallel with one another. Finally, it is further recommended that future research explores more deeply the regional, both geopolitical and economic, implications of implementing these proposed innovations. Economic policy, particularly those related to international investment and taxation would also have to be given due consideration. The importance of regional coordination on these policy areas may well be amplified if maximum value is to be extracted, for all stakeholders concerned, from this approach.

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