How to increase infrastructure investment in the East

One way for Europe to increase its growth rate would be a New Deal on infrastructure investment in the East. Bridging the way out of the crisis by raising capital investment is, of course, also debated in the West and many governments have taken steps in this direction. However, it is the new member states where underinvestment is palpable.

Foto: Creative Commons/ -aphelion

At the same time, putting the Eastern Europeans into the new EU fiscal straitjacket makes it difficult for them to match infrastructure which the West has built over a long time. Even after the destructive ww2 most western countries had well-developed cities as well as railway and road systems. And they added to this stock significantly in the boom post-war years.

The infrastructure gap

Infrastructure means transportation networks (roads and railways) and attendant installations such as tunnels, bridges and parking lots. It also means telecommunication networks, energy distribution installations, water distribution grids and waste disposal installations such as sewage systems and water treatment plants. Finally, the definition of infrastructure as used in economic statistics at the national and international levels usually also include  what is termed social infrastructure, i.e.  hospitals, schools, public administration buildings, etc. As the following table shows, all Visegrad countries are significantly worse off in infrastructure than their Western counterparts.

Tab. 1. The comparison of GDP per capita (in purchasing power parity) and infrastructure development index as put together by the World Economic Forum (the lower the number, the better the infrastructure).

Source: Infrastructure Investment in the Wake of Crisis. Impact of the global economy on PPPs in OECD Countries. PriceWaterhouseCoopers, 2011

V4: mixed crisis trends

The Visegrad countries’ fiscal reaction to the economic crisis has been mixed. In the Czech Republic, the government of Petr Nečas, which lasted from spring 2010 until July 2013, was a notable fiscal hawk. Both its bigger coalition parties had campaigned on the promise of aggressively cutting the public finance deficit. Among other things, this has translated into a plummeting rate of capital expenditure as the table below (tab. 2) shows.

Next door, after an initial surge in the public deficit (reaching 8% in 2009), Slovakia, too, saw significant fiscal consolidation in the short-lived government of Iveta Radičová 2010-12, and this continues under Prime Minister Robert Fico. In terms of the structure of the cuts, these have barely touched social expenditures (already very low by EU standards). There was some reduction in administrative expenditure, but the bulk of cuts targeted expenditures relating to the maintenance and construction of buildings and installations. The government now finances new capital investment practically exclusively from EU structural aid, only adding the necessary co-financing. In addition, it has very low use of multilateral lending. Slovakia has lower per capita access to financing from the European Investment Bank (EIB) than its neighbours in the Danubian region, Austria, the Czech Republic, Hungary and Slovenia. Only Bulgaria and Romania are lower.

Even before the crisis, the country had very low levels of public investment, below the EU average. In fact, as table 2 shows, for years it has been close to spending levels we find in, for example, Germany and the United Kingdom. These, however, are mature economies with well-built infrastructures. They also, unlike Slovakia, finance a large part of their infrastructure spending through vehicles outside of public finance (PPP projects plus, in Germany, funding from the development bank KfW). (Table 2 shows investment in fixed assets, i.e., any assets with a life value of longer than a year, which means computers as well as buildings, rather than purely infrastructure, but this is as close as one gets to infrastructure spending trends in Eurostat databases.)

Tab. 2. General government fixed investment, % of GDP

2005 2006 2007 2008 2009 2010 2011 2012
Czech Republic 4.3 4.5 4.2 4.6 5.1 4.3 3.6 3.1
Hungary 4.0 4.5 3.7 2.9 3.1 3.4 3.0 3.0
Poland 3.4 3.9 4.2 4.6 5.2 5.6 5.7 4.6
Slovakia 2.1 2.2 1.9 2.0 2.3 2.6 2.3 1.9
Germany 1.4 1.5 1.5 1.6 1.7 1.7 1.6 1.5
UK 0.7 1.8 1.9 2.3 2.7 2.5 2.2 2.1
EU27 2.3 2.5 2.6 2.7 2.9 2.7 2.5 2.3

Source: Eurostat

Hungary holds steady. So far it has neither cut nor dramatically increased its public investments. Nevertheless, the government clearly aims to use capital spending to boost the economy. In 2011, it announced a revision of the co-called Széchenyi Plan to boost investment in infrastructure in 2011-14. Currently the government is, for example, seeking ways to revamp and extend its railway network.

The reaction in Poland has been altogether different from its Visegrad neighbours. The country has maintained strong infrastructure spending throughout the crisis. And in 2012, the government announced the “Polish Investments” programme. The aim of this programme is to maintain capital spending at at least the current levels. This is to be achieved through the recapitalisation of the traditional Polish development bank, Bank Gospodarstwa Krajowego (BGK), and the setting up of an infrastructure investment fund, Polskie Inwestycje Rozwojowe (PIR). Both will be capitalized from state companies to the tune of 10 billion zloty. The aim of PIR is to set up special-purpose vehicles that will directly invest in infrastructure projects, while the increased capitalization of BGK should in turn lead to better credit conditions and increased leverage.

However, attitudes are changing in Slovakia and the Czech Republic as well. In Slovakia, the current government has maintained it achieved relatively good growth rates in 2009-2010, thanks to its first ever road PPP project, the R1 road. In recent weeks, the road-building agency stated it wants to return to PPP projects and the government also announced its first hospital PPP project (the minister of health is supposed to submit a complete proposal by January 2014). It also indicated it wants to build more hospitals this way.

The Czech government started an about turn on its fiscal consolidation policies this spring. By this time, all kinds of stakeholders were seriously worried about a lack of domestic demand, in the wake of miserable growth rates in recent years, which seemed set to continue this year. The government has therefore announced it will ease its restrictive policies. The new president, Miloš Zeman, and his newly appointed caretaker government, along with the opposition Social Democrats argue for strengthening domestic demand with more public investment.

At the same time, they are poised to win the next election, to be held at the latest next spring. At any rate, the Czech Republic is expecting a significant boost to its domestic demand as well as long-term export potential from the imminent construction of new nuclear blocs at the Temelín nuclear power station. Exports should increase not only in the form of electricity, but participation in the project is supposed to open the doors to nuclear projects around the globe to Czech companies that will supply this construction and thus get much-needed references.

To some extent this is also true of the extension of Slovakia’s Mochovce nuclear plant, for which the government is now pushing. In this case, the effect on local demand and innovation would be much less, since Slovakia has very few companies able to supply the sophisticated installations needed for a nuclear power plant. Nevertheless, the boost to at least the local construction industry would be tangible.

Where should the money come from?

So, there might be a budding consensus for stronger infrastructure investment. However, since the eruption of the crisis, the EU has been tightening its fiscal governance mechanisms. This is one of the reasons why governments have so far been shy of stronger capital outlays.

However, there is some respite on that front. In early July, the European Commission announced it will view infrastructure spending more favourably than before when assessing countries’ fiscal positions. Also, the upcoming revision of the EU’s accounting rules (European System of Accounts, or ESA) will provide some room for manoeuvre. And finally, in view of the expansion of nuclear power, the European Commission also just announced it will ease its limits on state aid for nuclear industry.

Still, not only does this not provide for a dramatically improved public investment climate, but three of the governments concerned have their own fiscal straitjackets. Poland and Hungary have constitutional fiscal brakes, as does Slovakia, which fully uses Eurostat’s fiscal definitions in its rules. In addition, an increase in public spending will immediately be reflected in bond market nervousness and consequently higher borrowing costs.

Western countries often built their infrastructure through the use of semi-public bodies, whose balance sheets are fully or partly outside of public finance definitions. Germany has its mammoth Kreditanstalt für Wiederaufbau (KfW). France has its Caisse des depots et consignations (CDC). Italy has Cassa depositi e prestiti (CDeP). The latter two draw part of their capital base from retail deposits. France is now taking further steps. Later this year it will put into operation a large national investment bank, to increase investments in the public interest.+

In addition, Western countries have wide recourse to all sorts of public-private partnerships (PPP). For twenty years, this has been the conventional way of investing in infrastructure in the United Kingdom, with somewhat controversial results. There are doubts whether this type of public procurement has delivered in terms of lower costs and improved delivery dates. However, PPPs have recently been used in other economies, with much more straightforward gains. Germany, France, and even traditionally conservative Sweden today use PPP projects. In addition, Western governments are wooing other kinds of investors in. For example the UK government has now agreed with the largest UK pension funds that these will invest in infrastructure, first railways, later also social housing.

And here lies the answer. Just like the West, the East needs to attract a mixture of financing. There are investment funds around, especially those run by insurance companies, that are interested in long-term investments and historically do not invest much in equities. The best example is the group of funds run by the investment giant Allianz. Private pension funds also traditionally need long-term maturities to match their long-term obligations. In addition, many public pension systems currently generate surpluses which are invested in financial markets. The largest “pre-funds” of this kind exist in France, Ireland and Belgium, each having assets in tens of billions of euros.

Sovereign funds are usually the funds of hydrocarbon-rich locations: Norway, Qatar, Abu Dhabi, Dubai, Saudi Arabia, Kuwait, Russia, Kazakhstan (the last two so far invest only domestically). Alternatively, they are the funds of countries generating significant current account surpluses, which are then reinvested: Singapore, China. For Eastern Europe, the most attractive investor is Norway, whose external investment fund is the largest single investor in European capital markets (it accounts for the whole one per cent of European market capitalisation).

However, there is potential for Arab investments too. For example, last year the Qatari Investment Authority (QIA) announced a plan to invest about 100 million euros in infrastructure projects in Bulgaria. And then there is China, which last year announced a major commitment to investment in Eastern Europe. It opened a special credit line of 10 billion USD for technology and infrastructure investments in the new EU member states, as well as Ukraine and Russia. On top of this, a Chinese company, Cosco, is in talks to invest 1 billion USD into the modernisation of the Croatian port of Rijeka. Hungary received a loan of the same amount for the rail-link between Budapest’s city centre and the airport (the line will be constructed by a Chinese company). Beijing is ready for business. However, it needs more channels for investment, such as the above-mentioned Polish PIR.

Then there are, of course, the traditional investors: the banks. They have mostly withdrawn from infrastructure investment in the traditional markets such as the United Kingdom in the post-2008 liquidity crunch and the demise of the companies traditionally insuring such projects for banks (so-called monorail insurance firms). However, it is clear that when  governments finally start regulating banking more strictly, closing avenues to quick profit found in speculative trading, banks will have to invest more in the “real” economy, infrastructure included.

In order to create room for non-public finance, the countries in question would have to create a detailed framework for PPP projects. These have a mixed and somewhat controversial history in the region. It is not quite clear if the Hungarian highway construction via PPP in the 1990s can be declared a success or not (some economists defend the project, others are critical). The Czech government stopped preparing a PPP project for its D1 highway earlier this year (and there was a similar abortive project in the administration of then -Prime Minister Miloš Zeman in 1998-2002). The preparation of large-scale PPP projects under Slovakia’s first Fico government in 2006-2010 was also widely criticized when the government was not able to clearly explain whether the project would be financially robust.

Nevertheless, there is a clear push for PPP projects at the EU level. The European Commission and the EIB founded the European PPP Expertise Centre (EPEC) to promote responsible PPP financing. Bringing in funds from non-traditional investors who need relatively risk-free long-term return (pension funds, sovereign funds) would go a long way to bridging the financing needs of the countries in the region.

The key is to have proper oversight. If a PPP project is designed by the financing banks or other investors, the chances are it will be more expensive than needed. The danger is there especially if the project is financed on the basis of an availability fee. This means a public authority pays an annual fee to the firm that built and operates, for example, a stretch of road. The investor has every incentive to dictate to the public agency a fee as large as possible, often hidden in complex contractual details.

Therefore, ideally, a country engaging in PPP programmes should have a national PPP unit. This should either be independent with statutes guiding it towards financial prudence, or lodged in the ministry of finance as the guardian of the country’s finances. These units should build personnel capacities to prepare complex financing structures, be transparent in their operations and facilitate a wider professional review of PPP contracts.

We need a more focused pan-European approach

What would also help would be a good pan-European framework. The EU’s Growth Pact, passed in June 2012, goes some way. It has provided for increased capitalization of the EIB to pump extra lending to Central and Eastern Europe. Another aspect of the pact are European project finance bonds. Implemented by the European Investment Bank, they will pool investments and spread risk and therefore decrease the cost of finance. This is a step in the right direction, but the EU must find ways of extending the programme to cover smaller infrastructure projects, not just the large pan-European schemes.

Why has investment not been higher in the EU so far? For reasons of complex political economy, governments have focused on deficit-cutting measures. This is based on the argument that the economic crisis has been caused by too much public debt. Some government deficit control at the EU level is admittedly needed, but in reality, it is the private, not public, debt that had ballooned in the years before the crisis erupted. Spending cuts have generally been popular with the middle classes, who feel they have been subsidising the less well-off too much. There is a strong financial lobby behind this policy as well. Naturally, financial investors don’t like the idea of either debt write-offs or inflationary spending that would hurt the value of current financial holdings. Also, psychologically, “tightening the belt” injects a sort of moral imperative into the political process. And last but not the least, the beauty of this recipe is its simplicity. This is also something that is valuable in political battles.

However, a few years into the crisis, with a growing number of economists pointing out austerity does not lead to renewed growth and with cuts beginning to hurt the middle classes, the environment is admittedly changing in favour of more decisive government action. As mentioned above, this is evidenced by, for example, new infrastructure programmes in the United Kingdom or France’s establishment of a large national investment bank.

Of course, investment schemes are, by their nature, at the crossroads of many economic and social controversies. Not everybody wants more concrete in their landscape. Some prefer railways, while others demand more roads. Nuclear or coal-fired power plants are targeted by green activists, while policies to support renewables can be just as controversial, especially for their cost. There is no simple solution to these conundrums. What we need is an informed, democratic debate on the value of each type of investment.

Similarly, the question of whether to finance infrastructure dominantly from public sources or whether to involve private capital is far from settled. Partly this is an accounting issue. Many economists have been pointing out that investment (and education) should not properly be classified as expenditures, since they create assets (in contrast, buying a fixed asset is a cash outflow for a private firm, but it enhances its balance sheet). That would pave the way for more generous investment. But so far, there does not seem to be a consensus on such a far-reaching step.

Nevertheless, it is possible to create solutions where spending is kept off public accounts. The Germans and the French have been doing this for years through their investment banks, and influential figures are calling for a proper national investment bank in the UK as well. This has been advocated, among other, by Lord Skidelsky, the political economist, who has also called for similar action at the EU level. Another option is PPP projects. These have their own controversies. As said, they need to have proper government oversight and be structured in such a way that they properly spread the risk and cost between the private investors and the public sector.

The third sets of concerns tends to be strategic. Who will end up owning infrastructure? This is a valid concern, but should not be exaggerated. Firstly, PPP projects tend to be of build-operate-transfer (BOT) variety. This means investors don’t acquire facilities for good and governments usually retain a strong regulatory leverage on how the assets are used. In fact, it is conceivable for many projects to give investors a more or less purely financial role, by investing through bonds. The same goes for any potential fear to let non-European investors in. They cannot endanger the strategic interests of the EU, which is the biggest economy in the world, as well as a military power.

So, as the crisis progresses, the political appetite for infrastructure investment is growing.  The problem is that progress is too slow. And that goes especially for the new member states, where investment is most needed. Building on the 2012 Growth Pact, the EU should now work in a more focused way to bring long-term finance to Central and Eastern Europe. This should mean providing joint borrowing programmes that will pool private investments and therefore decrease the cost of capital and increase multilateral lending. In their turn, governments in the region should build frameworks for infrastructure projects. Investors need to see credible country- and regional-level development plans, viable projects and financial vehicles for their investments. Everybody will benefit. The new member states need dramatic infrastructure improvements. And given how large their needs are, this type of spending will give a significant growth boost to all of the EU.

Juraj Draxler

Juraj Draxler

is Associate Research Fellow at the Brussels-based think-thank CEPS, and lecturer at the Anglo-American University, Prague. He has authored and co-authored several reports contracted by the European Commission on social policy and labour market regulation.