1. Public-Private-Partnerships and Finance Patrick Legros* ECARES, ULB * Part of work in progress (Dewatripont-Estache-Grout-Legros)

2. 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.

3. 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

4. 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)

5. 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 –V 1 if high quality –V 0 if low quality

6. 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 (V 1 - V 0 ) ≥ C

7. 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.

8. 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 V 1 >D >V 0, repays min(D,V 0 )=V 0 if low quality, repays min(D,V 1 )=D if high quality.

9. Debt vs. Equity EquityDebt Incentive: do e = 1 Repay investment

10. 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 V 0 and therefore more when V 1, for a given expected repayment to the investors. Still, when I is high enough, effort will also be low.

11. 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

12. 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

13. 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

14. What is Needed for Growth? Theories –Legal system (La Porta et al.) –Political institutions (Acemoglu-Johnson) –Financial system (King-Levine, Rajan- Zingales)

15. 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

16. 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

17. Decentralization Facilitate cooperation at the local level to avoid fragmentation Help the bond market liquidity –reduce transaction costs for secondary market –Facilitate transparency

18. World Bank data (Priya Basu presentation oct. 2006) Infrastructure stocks, China and India

19. India: Sources of Funds for Firms Sources of Funds All Firms State Sector Non-state sectors Overal l ListedUnlistedSSISSSBE Internal36,342,033,135,028,86,412,5 Capital markets17,812,620,920,022,431,228,6 Equity13,38,516,115,716,629,227,7 Debt4,54,14,84,35,820,9 Banks/Fin.Inst.15,911,519,019,717,39,4-8,7 Others (current liabilities, provisions) 30,033,926,925,331,653,067,0 Years 1991-2004. F. Allen et al. (2006), “Financing Firms in India,” W.B., WP 3975, August 2006