Public-Private-Partnerships and Finance

Patrick Legros*

ECARES, ULB

* Part of work in progress (Dewatripont-Estache-Grout-Legros)

Background• 80-90s:

– Lack of investment in public infrastructures– Declining service quality– Widespread popular support for reforms, including

privatization and creation of independent regulators

• After 1997:– Decline in private investments– Not as much as expected (20% of investments, 10% of

the needs) – Urban better off than rural– WB estimates: India might need to invest 8% or more of

GDP over the period 2006–10 to sustain annual GDP growth at near 8% and replace old capital stocks.

A Map• Debt as a financing scheme may generate a

virtuous cycle at the micro level– Capital flows to PPPs if high expected returns– However, infrastructure projects: LT, demand

uncertainty, political risk, endogenous risk in the provision of quality

– Debt facilitates the creation of incentives – Less endogenous risk => higher returns

• Private financing– Role of decentralization of loans

PPPs

• Literature: costs-benefits of bundling different phases of infrastructure development (building-operation).

• Little attention to the issue of financial contracting (!)

• Important because – Form of finance creates distortions that may undo

potential benefits of PPP contracting (micro level)– Some forms of finance lead to more growth than

others (macro level)

On Some Benefits of PPP• Consider a road project:

– building and operation phases, investment I.• The quality of the road:

– high (little need for repairs) or low (many repairs).• Depends on effort of the builder

– e = 0 (low effort) or e = 0.5 (high effort). – Probability of low quality is 1 if low effort and 0.5 if

high effort.– The builder’s cost of effort is C.

• Revenues at the operation stage– V1 if high quality– V0

if low quality

Investment Made by the State

• Conventional contracting: – builder’s contract separated from operator’s contract:

builder does not internalize the externality of his effort on future revenues: e = 0.

• PPP (bundling) contracting is good: – builder cares about effect on revenues and will do high

effort when its marginal benefit outweighs its marginal cost, or when:

0.5 (V1 - V0) ≥ C

Risk Borne by the Private Parties?

• Why shift the risk to private parties? • Reasons:

– political economy (public accounting rules; “Enronic” tricks)

– Cost of servicing foreign debt– Poor fiscal performance

• In terms of efficiency: same total risk has to be borne?– Not if differences in access to capital market.– Not if endogenous risk is present.

PPP Financing

• Consortium consisting of the builder and the operator (bundling)

• Finance investment of I by equity: keep a share 1 – d of operating revenues, the private investor gets a share d

• Finance by debt of D : if V1>D >V0, repays min(D,V0)=V0 if low quality, repays min(D,V1)=D if high quality.

Debt vs. EquityEquity Debt

Incentive:

do e = 1

Repay

investment

1 01 0 5 .d V V C 10.5( )V D C

1 00 5 .d V V I 00.5( )D V I

1 0 0Same repayment if ( ) ,d V V D V

1 1 0

1 0

but then,

(1 )( )

(1 )( )

V D d V V

d V V

The Form of Financing Matters• Equity (paying dividends to investors) is not

optimal: a debt contract is better.

• Debt is better for effort incentives: Can give less to the builder when V0 and therefore more when V1, for a given expected repayment to the investors.

• Still, when I is high enough, effort will also be low.

Summing Up

• Private financing of projects generates additional agency costs, which undermines the incentive benefits of ‘PPP bundling’.

• These costs depend on the form of financial contracting (e.g., equity vs. debt)– Debt contracting often provides better

incentives to the PPP

Caveat

• Renegotiation– Renegotiation of payment may be more

difficult with a financial intermediary than the state

– Renegotiation matters for all forms of financing

– (soft budget constraint) renegotiation with state may be discouraged with debt

Some other Possibilities

• Foreign borrowing– Exposure to exchange risk– Difficult to service debt since infrastructure is locally

consumed

• Consumer financing (and preferential access)• State

– Taxation-subsidies (tax holidays: most valuable to profitable projects!)

– Direct investment (where are PPPs?)– Guaranteed interest rate

What is Needed for Growth?

• Theories– Legal system (La Porta et al.)– Political institutions (Acemoglu-Johnson)– Financial system (King-Levine, Rajan-

Zingales)

A Detour by China (2)

• Poor legal and financial system

• Corrupt and autocratic government

• Large but undeveloped banking system dominated by four state owned banks.

• Stock market growing fast but still small w.r.t. banking sector

China, India : counterexamples• Growth fuelled by private firms

• (Allen et al. 2005, 2006)

• Main source of financing is “self fundraising” (even for listed and state firms in China)

• Alternative mechanisms to formal governance (reputation and trust. Confucius beliefs?)

• A difference in China: Decentralization of loans to local markets (right to incur debt at local level)– Local governments supportive and participating

Decentralization• Facilitate cooperation at the local level to

avoid fragmentation

• Help the bond market liquidity – reduce transaction costs for secondary

market– Facilitate transparency

0

100

200

300

1998 2003 1998 2003 1998 2003

electricity generation,watts per person

km of paved roads per100,000 hab

Number of fixed linesper 1000 people

India China

World Bank data (Priya Basu presentation oct. 2006)

Infrastructure stocks, China and India

India: Sources of Funds for Firms

Sources of Funds

All Firms

State

Sector

Non-state sectors

Overall

Listed Unlisted SSI SSSBE

Internal 36,3 42,0 33,1 35,0 28,8 6,4 12,5

Capital markets 17,8 12,6 20,9 20,0 22,4 31,2 28,6

Equity 13,3 8,5 16,1 15,7 16,6 29,2 27,7

Debt 4,5 4,1 4,8 4,3 5,8 2 0,9

Banks/Fin.Inst. 15,9 11,5 19,0 19,7 17,3 9,4 -8,7

Others (current liabilities, provisions)

30,0 33,9 26,9 25,3 31,6 53,0 67,0

Years 1991-2004.F. Allen et al. (2006), “Financing Firms in India,” W.B., WP 3975, August 2006