Building the Case for Investing in Quality Infrastructure in Asia
Published: 28 June 2021
Smart planning and spending improves public services and raises productivity, attracting more private capital and labor and sustaining growth.
Infrastructure is good for economic development. But infrastructure is also built in pursuit of goals other than growth, including promoting social equity, environmental improvement, public health, and even political goals.
The existence of tradeoffs between competing goals means infrastructure planning and investment inevitably requires political choices. It is useful to model these relationships and better understand the benefits to inform policy makers about investment decisions.
Why invest in infrastructure?
Investment in public infrastructure could lead to benefits and to more investment. A virtuous circle is created when there are positive, mutually reinforcing interactions between public investment and economic development. When one increases so does the other.
Vicious circles can also exist. Underinvestment can harm development.
Three of the many concepts of virtuous circles are the trade model, which is about connectivity and lower costs driving growth; fiscal model, which is about investment leading to growth that increases revenue; and socioeconomic model, which is about productivity and complementarity driving investment. All three are windows on the same processes.
The socioeconomic model of a virtuous circle relies essentially on increasing efficiency and positive feedback loops. There are many reasons infrastructure is expected to complement private capital and raise productivity. Output comes from making efficient use of labor, private capital, and public infrastructure as inputs.
Figure 1: Socioeconomic Framework
Infrastructure spending provides a direct demand stimulus for growth. But if public capital is complementary and raises productivity, it also increases returns to capital and thus further induces private investment and attracts more labor through both higher wages and lower prices. The consumption benefits of better services and environments are not just amenities, but they also raise productivity.
And finally, there is the increase in tax revenues to finance more infrastructure.
Naturally, we would like to know if these effects can be estimated as that information would be useful for planning and investment decisions.
Evidence from econometric studies
Recent evidence, mainly from OECD countries, estimates the effects of increased investment of 1% of the gross domestic product (GDP) in public infrastructure. This produces output elasticities of 0.4 in the same year and 1.5 over 4 years, meaning a dollar today raises output by $1.50 over the medium term. Private investment increases at the same rate as GDP, suggesting that public capital does not substitute for private investment but crowds it in. Employment increases by 10% to 30% of the investment in the short term and the public sector debt-to-GDP ratio falls by 0.9% in the same year and up to 4% of GDP over 4 years. These suggest that economies grow more than the spending required to increase output and possibly also that governments use their increased tax revenues to pay down existing debt.
The evidence from developing economies tells a similar story but is much more variable. Economies with a lower initial stock of infrastructure may have higher returns because simple fixes can have big effects, while economies with a higher initial stock may grow slower as marginal returns tend to decrease once networks are complete. However, typical analysis does not include the kind of growth effects explained in this article, and if they could be estimated, the results are profound.
Infrastructure projects supported by the Asian Development Bank (ADB) and the World Bank have over the long run demonstrated average economic rates of return ranging from about 10% to over 20%. But the implied rates of return from output elasticities are much higher, suggesting that conventional analysis does not capture the full magnitude of effects from growth. Real rates of return could be an order of magnitude higher. The implications for tax revenue are thus positive for debt sustainability but only if funds are spent on the right infrastructure.
A few aspects about the effects of investments in public infrastructure can be generalized. Different industries experience returns. Manufacturing, for example, benefits more than services. Different infrastructure produces varying results with transport tending to produce the highest elasticities. Geography matters as larger areas experience stronger results, suggesting wide positive spillovers.
There is a time lag for benefits. Longer time periods produce higher elasticities. And public investment efficiency, meaning how much extra infrastructure services are obtained for each additional dollar spent, has a strong effect on all these benefits. In other words, spend more but also spend better.
As mentioned earlier, economic growth and increased tax revenues have clear implications for fiscal space and debt sustainability. In short, the investment can pay for itself.
How much should Asia spend on infrastructure?
A 2017 study of ADB estimates that developing countries in Asia and the Pacific should invest $26 trillion to meet the Sustainable Development Goals by 2030 or about $1.7 trillion per year. This is needed to maintain the growth momentum, eradicate poverty, and respond to climate change. However, the region invests only an estimated $880 billion in infrastructure per year, which is just above 50% of the need.
Figure 2: The Asian Infrastructure Gap
A sample of developing countries show that national investment in infrastructure ranges from 7% to 1.5% of GDP. It should be noted however that investing roughly the same percentage of GDP can achieve different results.
Figure 3: Infrastructure Investment Varies across Countries
To close the infrastructure financing gap, private sector investment has to grow dramatically.
Now some sectors are more attractive to private sector financing, such as telecommunications and energy. Transport is respectable but needs to catch up, while water and sanitation attract little private investment.
However, with few exceptions, private sector participation in infrastructure is limited and declining in both value and number of projects over the last 10 years. There are a few reasons for this, including poor deal structuring, unsupported legal and regulatory frameworks, the lack of consistency and prioritization of private sector projects, and uncertainty and transparency associated with bidding processes.
Yet, there is hope. Some of the most important partnerships that can be formed with the private sector are those with institutional investors for long-term finance. Figure 4 shows why these seven categories of institutional funds represent a total of over $80 trillion in assets. Pension funds alone are a size equal to one-third of the investment gap, but they have only 1% of assets invested in infrastructure.
Figure 4: Role for Institutional Investors
The pool of resources for infrastructure financing is potentially much larger than what current public sector planning anticipates. Attracting such investors involves converting projects and portfolios into an asset class. There is a lot of work to do on this, including dealing with tenor mismatch, liquidity concerns of infrastructure investments, construction risk, currency mismatch, and creditworthiness of borrowers. But this is where multilateral development banks like ADB and the World Bank come into the picture.
How can the region close the infrastructure gap?
Countries must put in place policies to attract better projects and more finance. First is to develop high-quality pipelines of investment-ready, high-priority projects with experienced procurement and delivery capacity and clear service and commercial objectives with appropriate risk allocation and potential returns.
Second, make these project pipelines more attractive to private sector participation by improving the investment climate, strengthening capital markets, and attracting new investors and sources of finance.
Third, countries need better project planning and development. Part of this has to do with ensuring that plans and implementation are fully aligned with the G20 principles for quality infrastructure investment and promoting such standards through partnerships. In brief, these principles promote good governance, job creation, social environmental safeguards, alignment with national development strategies, and effective resource mobilization, including private sector participation.
Infrastructure development is good for countries and more is needed. Here are the key takeaways from this discussion.
First, investment needs in Asia and the Pacific are huge but so can be the returns. Splurging on debt is not justified, but smart spending is. Economic assessments can help.
Second, closing the financing gap requires full mobilization of all sources of finance. While the public sector will continue to bear about half of the burden, the private sector has an important role to play. Policy and regulatory regimes need reforms to start crowding in private funding.
Third, a major objective must be to unlock access to institutional investors. That means a welcoming public–private partnership (PPP) environment.
Fourth, governments must create a stable environment for high-quality project development, including operations and maintenance, to generate higher quality infrastructure services.
And finally, cooperation between governments, multilateral institutions, and private finance is the key. If we can get these partnerships right, we can maximize the availability of funding to meet the challenges of the infrastructure gap.
This article is adapted from a lecture delivered at this year’s inaugural ADB Lecture Series at the National Graduate Institute for Policy Studies in Japan.
Asian Development Bank. 2017. Meeting Asia's Infrastructure Needs. Manila.
R. Guild. 2019. How Quality Infrastructure Investment Sparks a Virtuous Circle of Benefits. Asian Development Blogs.
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