Risks Faced By Infrastructure Projects in Emerging Markets

Infrastructure projects are most needed in developing nations. These are the countries where infrastructure projects are able to create the most growth. This is because the spillover effects of infrastructure projects are felt significantly in emerging markets.

Ideally, emerging markets should create policies that attract more and more foreign investment on to their shores. However, in reality, this is not the case. Emerging markets have a lot of shortcomings. These shortcomings are accentuated during infrastructure projects because of the large scale and size of the investment. This is the reason why institutional investors tend to stay away from infrastructure projects in emerging markets.

In this article, we will list down some of the risks faced by investors when they invest their money in emerging economies.

• Currency Fluctuation Risks: Emerging markets tend to have underdeveloped banking as well as equity markets. As a result, they cannot provide all the capital which may be needed for the development of infrastructure projects. As a result, there is a need to involve foreign investors to fund the project.

  The problem is that foreign investors generally prefer to invest in an international currency such as the dollar or the Euro. However, in most emerging markets, the cash flows are in local currencies. This mismatch often signifies a huge risk for the investors. Since the projects are long term in nature, hedging is also not a viable option. One way to deal with the situation is to involve export credit guarantee institutions of other nations.

  For instance, countries like China do invest in projects and accept the local currency for payment. However, they insist that the contracts for the project be given to Chinese firms. In many cases, this raises costs and hence, may not be the best option.

• Political Risks: Political risks are always present in each and every infrastructure project. However, when it comes to emerging markets, these risks are amplified. In many countries, governments or even rebels disrupt the proceedings of several projects. The disruption could be as simple as not granting permissions for the project. In many severe cases, entire projects have been expropriated by hostile foreign governments.

  There are many corrupt governments in developing countries that know that once the infrastructure project is started, the stakes become very high. The projects cannot simply be uprooted and moved to another location. Hence, such governments try to take advantage of taking maximum money out of infrastructure companies in the form of higher taxes or even bribes! Mechanisms such as investment treaties have been created to mitigate political risk. However, they too seem to have limited applicability.

• Capital Controls: Emerging markets are also known for imposing capital controls. This means that taking the money inside many emerging economies is easy. However, when it comes to taking the money back out of the economy, there may be several restrictions.

  Companies may not be able to return the profits earned to their parent company. This means that the investment opportunities for the cash flow generated are also limited. Limited options translate into lower returns and end up scaring away international investors.

  Also, the problem is that in most cases, capital controls are only put up just before the situation is about to get out of hand. For instance, in Greece, capital controls were stipulated days before the country saw a severe economic downturn.

• Opaque Policies: Emerging markets are known to have opaque policies related to infrastructure development. Sometimes political parties keep the policies opaque and muddled up on purpose. This makes it difficult for companies to comply with the norms. Then, they ask for bribes to overlook the non-compliance. Companies that pay bribes are allowed to work, whereas those that do not pay strict legal action. Apart from being unethical, bribes are also known for having a severe financial impact. Many studies have shown that an opaque policy environment is equivalent to a 33% tax on the infrastructure project!

• Legal Risks: Each infrastructure projects is a cobweb of several interdependent contracts. It would, therefore, be safe to say that the success or failure of a project depends upon the ability of the infrastructure company to execute the contracts. The problem is that in emerging markets, the legal system does not function efficiently. Hence, there is no downside for many rogue parties if they do not honor their contracts.

  The aggrieved parties do not have too many legal options. This is because the legal options may be complicated, time-consuming as well as expensive. Hence, the odds may be stacked against the infrastructure company. This obviously is a huge challenge since no investor wants to end up in a scenario where they have agreed to deliver a project with stringent deadlines but are not able to enforce their partners to hold up their end of the bargain.

  Legal issues can cause severe cash flow problems as it is not common for the payments to be held up because of quality issues or because a certain milestone was not met on time.

The bottom line is that executing infrastructure projects in emerging markets is full of risks. As a result, investors demand a higher return, which raises the cost of the project. It would, therefore, be better to reduce the risks so that the costs can also be reduced and the nation can benefit.