In 2019, Indonesia’s Ministry of National Development released a $412 billion infrastructure investments plan to construct power plants, mass transit, and airports. Indonesia’s President, Joko Widodo, has made infrastructure projects a priority for his administration, recognizing the demand for improved infrastructure due to Indonesia’s current and projected economic expansion.
As economies and populations grow, infrastructure development must grow at a corresponding pace, leading to these escalated projections of infrastructure investment needs. Failure to achieve growth in the infrastructure sector threatens economic growth and, by extension, populations’ ability to benefit from its country’s investment of its other sectors. Infrastructure can boost an economy’s growth both directly, by creating new jobs, and indirectly, by facilitating travel, shipping, and access to utilities. And the greater a country’s growth is expected to be, the more infrastructure investment is required.
The Infrastructure Investment Gap
The World Bank in 2017 estimated Indonesia’s infrastructure investment gap (the difference between actual projected investment and required investment) to be $500 billion over five years. While Indonesia has made progress closing the gap, it still requires significant investment from public and private sectors. While Widodo’s government aims to fund 40 percent of its ambitious infrastructure plan, the rest must be funded by other sources: 25 percent through state-owned enterprises and the remaining 35 percent from the private sector. But private infrastructure investment has been historically difficult to incentivize, and often lags the amounts required.
This lag can be attributed to several factors. One factor is the size of up-front investments required to undertake an infrastructure project. This initial capital requirement is not feasible or desirable for potential investors. Another factor is the relative risk of investing in infrastructure. A third factor serving as a barrier to sufficient infrastructure investment is that the returns on infrastructure investments are often realized in the form of positive externalities – benefits to society, rather than private gains to the investor. The challenge is to develop investment vehicles that manage the inherent risks of funding infrastructure projects.
Compact Development for Infrastructure Projects
A solution that has generated widespread support is compact development. The Millennium Challenge Corporation (MCC) has championed this approach to infrastructure development as a rigorous, results-oriented form of assistance, that complements existing development funding. Indonesia has been a beneficiary of this approach, under a $474 million compact between 2013 and 2018, and is currently developing a subsequent compact. Due to the unique characteristics of MCC compacts, Indonesian infrastructure can benefit from this approach to funding.
Under a compact, countries receiving assistance are selected for large-scale grants, distributed over a period of five years to address the country’s economic constraints to growth. Infrastructure projects benefit from compacts, not only because of their size and scope, but also because compact development is a rigorous process that leverages qualitative and quantitative country- and sector-specific data to increase the likelihood of successful outcomes. Due to the inherent risks of private sector investment in infrastructure, these mechanisms serve to counter the factors contributing to historic underinvestment.
Eligible partner countries are selected for participation in compacts based on three criteria intended to assess the stability of the business environment for investors. The first is a rating based on policy indicators, assessing the country’s record on political rights, civil liberties, economic freedom, and corruption. The second criterion is the probability that the MCC investment will result in poverty reduction and economic growth. The third selection factor is MCC funding availability. This selection process was crafted to prioritize investing in nations with high expected returns, serving to reduce the inherent risks of investments.
The other component of compacts that lowers investment risk is the compact development process itself. Compact development is comprised of five phases that serve to lay a rigorous groundwork for private sector investment in infrastructure. Each phase is a lengthy collaboration between MCC Compact Development Teams and stakeholders from both the public and private sectors of a country. This ensures that projects selected to be funded via compact are tailored to a country’s specific needs and have buy-in from a broad spectrum of stakeholders.
Complementary Investment Approaches
Since compacts target long-term sustainable goals, eligible countries are encouraged to increase private sector contributions through a broad range of financial instruments aimed at increasing expected returns and lowering risk to investors. As a country eligible for a subsequent compact, Indonesia benefits from exploring multiple financial tools for decreasing risk to investors.
Guarantee instruments are one type of tool that may help incentivize private infrastructure investment. Guarantees are financial products that consider various sources of investment risk and reflect them in expected cash flows. If risks are properly studied, understood, and weighted in the assessment of expected cash flows, guarantees can mitigate investor risk by enhancing the creditworthiness of a project. Guarantees and other catalytic first-loss capital (CFLC) tools (including grants, equity, ad subordinated debt) lower investment risk by increasing credit worthiness of recipients.
Matching grants to small and medium-sized enterprises (SMEs) have been used by organizations such as the World Bank to provide short-term subsidies through its International Development Association (IDA) fund. These subsidies aim to build private sector capacity in poor developing countries, targeting industries such as agribusiness, fisheries, tourism, and rural development. Matching grants have been found to have positive outcomes in terms of building technical knowledge, procurement skills, and enhancing management knowhow. Reporting by the Trade & Competitiveness Global Practice suggested that these outcomes are linked to the monitoring and evaluation, local knowledge, and tailored approaches developed for projects. Since these are features of MCC compacts, matching grants have a high potential of benefiting infrastructure development work.
Another financing approach to boost private sector engagement in development projects is Results-Based Financing (RBF). RBF instruments link funding to outcomes. In recent years, impact bonds (contracts that provide funding based on performance) have been successfully leveraged for projects including water utilities, renewable energy, and telecommunications. Impact bonds and other RBF mechanisms establish an agreement between investors, service providers, and “outcome funders”. Investors provide capital up front to service providers to develop a project. If agreed-upon outcomes are realized, the “outcome funder” (a government or other third party) repays the investment at a premium. This approach incentivizes positive outcomes as well as private investment in potentially risky projects. RBF tools should be used with compacts; the approaches are compatible due to the focus on measurable outcomes, private investment incentives, and risk reduction.
WBD’s Approach to Infrastructure Finance
The South Asia transportation technical experts at WBD can help donor agencies and their partner countries develop sustainable, transparent, and high-quality infrastructure in Indonesia and across South Asia. We perform initial landscape mapping of planned infrastructure projects and provide targeted technical assistance to priority infrastructure projects. Our development finance and private sector engagement experts can offer access to innovation financial products and lower the risks for financial institutions to lend to businesses, individuals, and small enterprises.
Author: Adriana Weiss, Senior Associate at WBD, is an investment finance professional, engaging with the firm’s Economic, Procurement, and Business Analysis award with the Department of Defense, Defense Information Systems Agency.