Infrastructure Bonds: A New Panacea?
St. Petersburg and Moscow
Russia’s infrastructure problems are legendary. A few statistics can easily illustrate the problem. Canada, with barely 20 percent of the population, has three times more highways than Russia. Half of Russia’s railroad tracks were laid before 1916. Up to 80 percent of railcars and 70 percent of housing stock are decrepit.
But that is only half the problem. Upgrading infrastructure in Russia costs much more than in other countries. Paving one kilometer of highway in Russia costs at least four times more than in China and three times more than in Brazil. Despite abundant, high-quality coal deposits, generation of electricity costs 40 percent more than in Germany. The reasons for the high cost of construction of public works are only too well known – corruption and monopolization.
With much fanfare Russia embarked on an ambitious program to modernize its transportation infrastructure with the adoption of the Law on Concessions in July 2005. Public-private partnerships were touted as a panacea that would permit Russia to finance the most lavish and expensive transportation projects in the world. Work was started on almost 30 major PPP projects. Unfortunately only three PPP projects are creeping forward, although the Transportation Ministry is planning tenders for new projects. Not one of the mega-projects has been redesigned to achieve cost savings, despite the enormous drop in the cost of construction materials and labor as a result of the crisis.
Salans Of Counsel
Rather than change the approach, state authorities who waived the PPP banner for four years, seem to have found a new panacea, Infrastructure Bonds, more typically known as municipal project bonds in the West. There is no doubt that like PPP, infrastructure bonds can play an important role in financing infrastructure development in Russia. International practice shows that infrastructure bonds can contribute as much as 15-20 percent of the cost of large transportation projects. But the key premise in the public debate on infrastructure bonds is that these bonds will be secure and attractive to investors because of state guarantees. One has the feeling of Alice in Wonderland. What about the exhaustion of the reserve fund and the huge budget deficit predicted for 2010? MinFin plans to cover the hole in the budget by the issuance of Eurobonds. However, most economists believe the deficit is unsustainable, and that Russia will not be able to issue a sufficient amount of Eurobonds to close the gap. How then can the federal government credibly guarantee billions of rubles of infrastructure bonds? And if the federal government is unable to issue guarantees, the regions and municipal entities are even less able – particularly in light of falling tax revenues and reduced contributions from the federal budget.
But the beauty of infrastructure bonds is that they can be structured as limited recourse obligations without government guarantees, provided that the law that will be ultimately adopted provides for a tight structure, and the bonds are used to finance economically viable projects. Traditionally a portion of the issuance proceeds are deposited in a reserve fund and revenues from the project go into a sinking fund to pay interest and principal on the bonds. Insurance is used to assure completion of the project, and can also be used to provide “credit enhancement”, i.e., guarantees that project revenues will be sufficient to repay the bonds.
This doesn’t mean that there is no need for government support. The traditional form of government support however, is not a guarantee, but exemption from taxation of the income paid on the bonds to investors. This enables local governments to issue bonds at significantly lower rates, and lowers the overall cost of financing.
One can only hope that before Russia adopts legislation for infrastructure bonds, the Duma will take a fresh look at international experience, and will adopt legislation that does not depend on guarantees that are not likely to be forthcoming to any significant extent. And most importantly, that Russia will abandon the “mega-project complex” and focus instead on economically viable projects structured in the most cost-effective manner. In any case, infrastructure bonds can at best be a portion of the solution to financing Russia’s worn-out infrastructure. Otherwise chances are very high that in four years we will look back on the adoption of legislation for infrastructure bonds as just another wasted opportunity.