Russian infrastructure A big ship sails far

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1 INDUSTRY REPORT Russian infrastructure A big ship sails far Mikhail Ganelin +7 (495) (ext ) Sergey Vasin +7 (495) (ext ) The expansion of infrastructure is an imperative for the long-term economic growth of any country, but securing sources of funding remains a complex challenge. In this report, we analyze key global infrastructure expansion trends as well as ways and means to fund infrastructure rollout projects in various countries. Our main focus is on Russian transportation, which accounts for 80% of all infrastructure investment in the country. Assuming that the global economy grows at 3.3% per year, GDP will double by The main contributors to growth include a rise in the global population (+20% by 2035) and urbanization (the urban population is expected to increase by 40%), while rapid growth of household income will lead to accelerated growth of international trade and tourism. Under this scenario, global air passenger traffic will double as soon as 2020, air freight will triple, and container shipments will quadruple. In addition, the throughput capacity of most existing transport channels between Asia and Europe is capable of raising cargo turnover on average by another 50%. This increment would clearly be insufficient in case of faster than expected expansion in the coming decades. The minimum need for infrastructure investment to support economic growth is 3.5% of GDP, or $57 trln until 2030 ($3.2 trln per year). However, there is a 20-40% shortfall in infrastructure funding in most countries. State investments in infrastructure total about 65%, but their ability to ramp up funding will be limited going forward due to high debt and budget deficits. The role of private investors, who contribute 35% of infrastructure investment, is conspicuously on the rise. The governments of various countries are working out incentives for investors in an effort to strike a reasonable balance between risk and rewards from infrastructure projects. In Russia, the rate of infrastructure investment averages % of GDP, or roughly in line with the global average. By 2020, infrastructure investment will reach $650 bln ($90 bln per year on average). These funds will suffice for moderate expansion of infrastructure and gradual improvement of its quality, but not in the event of accelerated expansion. Large projects, such as construction of infrastructure for the Sochi Winter Olympic Games, will give way to other no less massive projects, such as construction of the Power of Siberia and South Stream pipelines, expansion of the Baikal-Amur Mainline and Trans-Siberian railways, construction of toll roads under concession terms, and the possibility of deploying the Moscow-Kazan High-Speed Railway with the participation of private investors. According to our estimates, $25-40 bln of private investments will be needed until The bulk of transport infrastructure investment will be directed to road construction (45%), while rail transport will take 20% (including the Moscow-Kazan High-Speed Railway and subway facilities), pipeline transport should account for 30%, while ports and airports will comprise the remaining 5%. Research Department 1 Copyright Gazprombank (Open Joint-Stock Company)

2 CONTENTS Expansion of global infrastructure: exponential investment growth on the way... 3 World poised for higher infrastructure demand... 4 Infrastructure investment needs seen at least 60% higher by Sources of infrastructure funding will resources suffice?... 6 Special infrastructure bourse could be established in Japan... 8 Examples of investment tools used in various countries for infrastructure projects Current status of Russia s infrastructure needs Russia s transport infrastructure: rapid growth or concurrent expansion? Plan of development for transport infrastructure until How will Russian infrastructure be funded and where will the resources come from? Moscow largest investor in transport infrastructure Russian roads: fighting disaster brings noticeable results Avtodor: road concessions promise high yields Glavnaya Doroga Consortium: first completed PPP project in the road construction field Key market players: competition tightens after the Olympics Railway infrastructure: removing bottlenecks and building high-speed lines Higher investment in railway infrastructure is unavoidable Airports: a tasty morsel for investors Seaports: state and business working in tandem Public-private ventures for the expansion of port infrastructure Pipeline infrastructure: Russia s raw material artery Other infrastructure segments Power grid complex Telecommunications Public utilities Appendix Largest construction companies in Russia: main players and trends

3 EXPANSION OF GLOBAL INFRASTRUCTURE: EXPONENTIAL INVESTMENT GROWTH ON THE WAY According to OECD forecasts, global GDP is set to grow at an annual pace of 3.3% per year and double by 2035, amounting to $145 trln. China will overtake the US within the next few years in terms of GDP, calculated as purchasing power parity (PPP), and become the world s largest economy, with GDP surging 2.5-fold by 2030 compared to The GDP of India, the world s third-largest economy, will triple by 2030 in terms of PPP, while Russia s GDP will double during this period, moving from sixth to fifth place among the world s biggest economies. By comparison, the US economy is expected to increase by just 40% over this period, while Europe will expand by 30%. The main factors underpinning growth will be a rise in the population (+19% by 2030) to 8.3 bln, urbanization (the urban population is set increase by 40% by 2030; while its proportion will grow from 52% to 58%), faster growth of household income, as well as further expansion of international trade and tourism. Given the above pace of growth, the load on infrastructure in most countries is set to grow exponentially over the next decade, and its timely development will become the hallmark of steady growth of the global economy. According to estimates by OECD experts, if global GDP doubles by 2035, the volume of passenger traffic during the same period will increase by 2.5-fold, air freight will triple, and container shipments will quadruple. Meanwhile, the throughput capacity of existing transport channels between Asia and Europe could push up cargo turnover by 50% on average, while the effect would wear off within 6-8 years. Given that the design, construction and expansion of large infrastructure facilities will take years, decisions concerning the ways and means to finance them should be made in the near future. Size of GDP vs. country s position in PPP ranking, $ trln Global GDP growth vs. transport sector indicators US CHINA INDIA JAPAN GERMANY RUSSIA BRAZIL GLOBAL GDP PASSENGER TURNOVER CARGO TURNOVER CONTAINER CARGO TURNOVER Source: PWC, IMF Source: OECD 3

4 JULY 15, 2014 Population growth will be accompanied be an increasing share of urban population, bln people RURAL URBAN Source: United Nations GDP per capita growth WORLD US BRAZIL EUROPE RUSSIA CHINA INDIA TURKEY Source: US Department of Agriculture Increasing infrastructure investments a tested and tried way to stimulate economic growth. Higher infrastructure investments create new jobs in the short term, stimulate economic growth in the medium term, and lower the transport costs of companies while improving the standard of living of households in the long term. According to estimates by McKinsey, an additional 1% of GDP investment in infrastructure will create 3.4 mln new jobs in India, 1.5 mln in the US and 1.3 mln in Brazil. Given the similarity of economic indicators between Brazil and Russia, the number of jobs that would be created in Russia would also match, i.e. 1.7% of the entire economically active population of the country. According to estimates by the Economy Ministry, aggregate investment in Russia s transportation infrastructure yields about 0.3% of GDP growth. In addition, a 10% decline in aggregate transportation costs for all types of goods would add 0.12% to GDP, according to estimates by the Center for Strategic Research. Furthermore, high-quality transportation infrastructure raises the mobility of households, who would be capable of moving with greater ease between areas of cities and regions, for a number of reasons, including the search for employment. This would improve the structure of the labor market, lead to overall growth in household income and ultimately stimulate demand, which is one of the key factors of economic expansion. World poised for higher infrastructure demand The biggest passenger plane in the world, the Airbus 380, which is capable of flying over 800 passengers, executed its maiden voyage in This was the response of the European aircraft corporation to conspicuous growth in demand in the field of air transport and tourism. In 2012, China commissioned the largest hydroelectric generation facility in the world, Three Gorges on the Yangtze River with capacity of 22.5 GW, which is 1.5 times more than the previous world leader, Brazil s Itaipu hydroelectric power plant. Total investments exceeded $26 bln. When the facility was under design, the HPP was expected to provide 10% of China s power needs. However, during the 20 years it took to build the plant, power consumption rose at a mind-boggling pace, and the HPP is currently capable of generating less than 2% of the country s power. By 2017, the largest airport in the world, with a six-runway hub, will be built in Istanbul. The facility will be capable of handling a passenger flow of 150 mln (by comparison, the biggest airport in the world, currently located in Atlanta, is capable of handling 90 mln passengers per year). Turkish authorities are convinced that the new airport will become a major hub connecting East and West, Africa and Europe. The total amount of investments in the project, to be implemented on concession terms, is about $30 bln. 4

5 The 684 km Moscow-St. Petersburg Toll Road, with a maximum speed limit of 150 km per hour, is to be built by The total cost of the road is $10 bln, to be funded through concession agreements with private investors. The need for such a highway has arisen due to a significant increase in freight turnover between the country s two largest cities. The Nicaragua Canal could be built by 2019 between the Caribbean Sea and the Pacific Ocean, with the facility routed through the territory of Nicaragua. It aims to provide an alternative to the Panama Canal, the throughput of which has reached maximum capacity. In 2013, the government of Nicaragua outsourced the concession project to Hong Kong-based HKND Group for 50 years. Construction of the canal is expected to get under way around end The cost of the project is roughly $40 bln, and aside from the canal, the plan is to build two seaports, an airport and an oil pipeline. Infrastructure investment needs seen at least 60% higher by 2030 According to estimates by McKinsey Global Institute, the minimum need for infrastructure investments stands at $57-67 trln from 2013 through 2030 (averaging $3.4 trln per year). This estimate is based on the historical volume of investments in infrastructure over the past 18 years at % of GDP. However, these forecasts fail to take into account faster than anticipated growth of household income and accelerated development of infrastructure in countries where infrastructure is traditionally underfinanced (for example, in Brazil and Russia). Taking into account these factors, infrastructure needs could easily exceed 5% of global GDP ($80 trln), meaning that investment would essentially double compared to the previous period. In the opinion of McKinsey, the aggregate stock of infrastructure assets should amount to an average 70% of GDP in order for it to be maintained in proper condition. The countries where this percentage is lower (e.g. Brazil, Russia, India and even the US) should ramp up infrastructure investments at a rapid pace, while those above that baseline (Japan, China and Germany) have the opportunity to reduce the volume of investments in the coming years. Estimated value of infrastructure assets in various countries as a % of GDP, 2012 JAPAN CHINA GERMANY US RUSSIA INDIA UK BRAZIL 16% 64% 61% 58% 57% 76% 71% 179% 0% 50% 100% 150% 200% Source: McKinsey Investments in infrastructure in various countries: % of GDP ( ) and investment need until 2030 JAPAN EU US RUSSIA BRAZIL CHINA INDIA 5.0% 2.6% 2.6% 3.1% 2.6% 3.6% 3.4% 4.0% 1.5% 4.9% 4.7% 6.4% 6.9% 8.5% 0% 2% 4% 6% 8% 10% Source: McKinsey 5

6 In Russia, the stock of infrastructure assets relative to GDP (61%), while less than the recommended GDP threshold, is still roughly in line with the baseline assetto-gdp ratio of 70%, but is quite close to such countries as the US (64%) and the UK (57%). This is due to the fact that all types of infrastructure are to be found in Russia: highways and railroads, airports, ports, pipelines, power grids (including nuclear), and water supply. Notably, there are not very many countries in the world possessing such diversified infrastructure. A case in point is Brazil, which has excellent highways but hardly any railroads, while many countries have no nuclear power and only a few have such a developed pipeline system. A number of problems in the US, the UK and many other developed nations are due to extensive infrastructure depreciation, as many facilities were built around the middle of the 20th century and therefore are in need of modernization. Global breakdown of investments in infrastructure 17% 29% 20% 8% 42% MOTORWAYS RAILROADS SEAPORTS AIRPORTS ENERGY WATER SUPPLY TELECOMMUNICATIONS 21% 1% 4% Source: World Bank Sources of infrastructure funding will resources suffice? There will not be enough funds for full-fledged infrastructure development in all countries around the world. According to various estimates, the lack of funding in a number of countries reaches 20-40% of their needs. Thus, worldwide infrastructure investment in 2014 should amount to about $2.6 trln (3.6% of global GDP), whereas we assume that no more than $2.1 trln will actually be invested. Investments in infrastructure broken down by regions 2% 2% 19% 12% 5% 5% 7% 3% 13% 17% 15% CHINA JAPAN INDIA NORTH AMERICA EUROPE RUSSIA NEAR EAST LATIN AMERICA OTHER ASIA AFRICA AUSTRALIA AND OCEANIA Source: Gazprombank estimates 6

7 Breakdown of infrastructure investments by sources of funding FUNDING SOURCES AMOUNT OF INVESTMENTS IN 2014, $ BLN SHARE State budgets and funds 1, % Bank loans % Loans extended by international financial organizations % Share capital of infrastructure companies % Own funds of infrastructure companies % Corporate bonds % Total 2, % The key onus for infrastructure investment falls to the government, which accounts for over 65%. First of all, this is due to the fact that a significant part of infrastructure performs a social function and does not involve generation of revenue (for example, the construction of city roads or water supply systems), and for this reason such projects are of no interest to private investors. In the second place, many infrastructure facilities are still unable to generate high enough returns to interest private investors, so for this reason the state is forced to step in (for example, building airport runways, port dredging operations, or construction of railroads with low freight-traffic density). According to our estimates, budget-funded infrastructure will amount to some $1.4 trln in 2014, and it will be traditionally sourced from tax receipts, excise duties or sovereign wealth funds. That said, we do not expect to see any substantial increase in budget spending on infrastructure in the coming years, since debt and budget deficits are forcing governments to curb spending, including infrastructure outlays. Source: Gazprombank estimates State debt to GDP ratio, %, 2012 JAPAN GREECE ITALY US UK FRANCE CANADA SPAIN BRAZIL INDIA THAILAND TURKEY CHINA CHILE RUSSIA Source: IMF Private investments as equity and debt financing account for about 35% of all infrastructure investment. In 2014, the volume of private investment in infrastructure will amount to about $700 bln, of which 30% ($164 bln) will be raised from infrastructure company profit and equity placements from these companies among portfolio investors, while the other 70% comes from bond issues and bank loans, including those issued by international financial institutions, such as the World Bank, EBRD, Asian Development Bank, etc. 7

8 Equity financing. Equity financing accounts for less than 2% of aggregate infrastructure investment, although investors interest in infrastructure projects is growing from year to year. The number of ad hoc infrastructure funds investing in the shares of infrastructure companies has risen in recent years from zero to over 700. While in 2004, infrastructure funds took in about $2.4 bln, this figure shot up to $40 bln by The return on investment in infrastructure facilities by such funds falls within the range of 10-16%, according to data from Pregin research agency. Special infrastructure bourse could be established in Japan Japan Exchange Group, which runs the Tokyo Stock Exchange, intends to set up a new stock exchange as part of the Tokyo exchange that would specialize in infrastructure investment. This bourse should be up and running by The securities of infrastructure companies and funds are expected to be listed on this venue. Infrastructure funds are often closed, raising money mainly from a limited number of institutional investors. By listing on the new market, they will be able to raise money from a larger pool of investors, including individuals, who are likely to treat them as an alternative to real estate investment trusts. The idea of setting up this bourse is regarded as a major challenge given the Japanese government s goal of reducing infrastructure spending. Japanese airports (Kansai International Airport and Sendai Airport) have already shown interest in this exchange. Moreover, a large number of projects aimed at deploying alternative sources of energy are being worked out in Japan. These projects require private investments and it would be extremely important for them to see this infrastructure bourse get off the ground. It should also not be ruled out that companies and funds from neighboring Asian countries would also be interested in making placements on this bourse. Breakdown by types of investment funds Volume of funds attracted by infrastructure funds, $ bln 42% 13% 2% % INFRASTRUCTURE FUNDS HEDGE FUNDS DIRECT INVESTMENT FUNDS REAL ESTATE FUND Source: Preqin Source Preqin Bank loans. According to Infrastructure Journal, bank loans account for nearly $160 bln per annum. The annual dynamic of loan facilities provision to infrastructure companies is hard to track, though commercial banks have recently been reluctant to provide loans for projects with long payback periods. After the 2008 financial crisis, the average cost of borrowing for infrastructure objects, especially those based in emerging countries, grew 1-2 pps. The requirement regarding the borrowed to own funds ratio rose to 70:30 vs. a pre-crisis 90:10 in order to mitigate lending risks. This caused an increase of the weighted-average cost of capital for an infrastructure project. We do not rule out that the cost of borrowing will continue to grow further due to an increasing number of riskier infrastructure startups in emerging countries. 8

9 Corporate bonds. Debt financing via corporate bond issuance accounts for about 18% of total investment in infrastructure. According to Bloomberg, the overall volume of bonds issued by companies in infrastructure sectors (energy, telecoms, construction) in 2013 stood at $365 bln, of which 25% occurred in the US, approximately 25% in Europe and 15% in China. The bulk of placements are concentrated in the energy (50%) and telecommunications (25%) sectors. The volume of placements in infrastructure sectors has recently soared, which seems attributable to a tightening of lending requirements by commercial banks for longterm infrastructure projects, on the one hand, and the rollout of the QE program in the US that caused a decrease in the cost of public borrowing. We believe the key investors in infrastructure bonds are pension and hedge funds as well as commercial banks. Volume of corporate bonds issued in infrastructure sectors, $ bln Pension savings as % of GDP, Source: Bloomberg, Gazprombank NETHERLANDS SWITZERLAND UK AUSTRALIA US CANADA CHILE DENMARK HONG KONG JAPAN PERU BRAZIL SWEDEN PORTUGAL NORWAY GERMANY THAILAND KOREA TURKEY RUSSIA INDONESIA CHINA INDIA 0% 50% 100% 150% 200% Source: OECD Numerous countries have been recently been striving to arrange public-private partnerships (PPP) in infrastructure development. As a result, the overall volume of private investment under the PPP scheme has almost quadrupled over the past 10 years, to $180 bln in That said, the share of PPP in overall infrastructure investment stands at a modest 8%. Furthermore, the global financial crisis of 2008 halted this growth due to the aforementioned reasons: a reduction of state spending on infrastructure and a tightening of lending requirements by commercial banks. At the same time, the noticeable growth of investment on the part of infrastructure funds pertains to the most attractive projects that can well do without state support. 9

10 Dynamic of private investment in infrastructure under PPP schemes, , $ bln ENERGY TELECOMMUNICATIONS TRANSPORT WATER SUPPLY Source: World Bank Breakdown of investment in infrastructure under PPP schemes, % ENERGY TRANSPORT 27% 2% 42% TELECOMMUNICATIONS WATER SUPPLY Source: World Bank The key issue on the short-term agenda to be resolved in order to scale up investment in the sector is finding a reasonable risk-return ratio for infrastructure projects. Investment risks related to infrastructure projects used to be quite high, while their potential returns were modest, thus limiting interest among private investors. Various states are currently offering financing tools to private investors in order to mitigate risks related to investing in infrastructure. In particular, governments are providing guarantees of minimum traffic for investment in transportation, protection for private investment against inflation, and guarantees of minimum payments to investors upon completion of construction. Ahead of the 2014 St. Petersburg International Economic Forum, Ernst & Young conducted a survey regarding the investment attractiveness of Russia s infrastructure. The survey revealed that 68% of respondents cited insufficient guarantees of ROIC as a key obstacle in attracting private investment in infrastructure. The private sector is ready to invest in Russian infrastructure, although it expects government assistance in reaching a required rate of return (at least for the first projects), for instance, through the availability payment mechanism. Types of PPP TYPE OF PARTNERSHIP DESCRIPTION WHO BEARS OPERATING RISKS UNDER PROJECT? EXAMPLES BOT: Build Operate Transfer or ВООТ: Build Own Operate Transfer BTO: Build Transfer Operate ВОО: Build Own Operate O&M: Operations and Maintenance BBO: Buy Build Operate LDO or BDO: Lease Develop Operate or Build Develop Operate A concession holder exercises construction and maintenance (mainly, on the right of ownership) within a set time frame, thereafter the object is transferred to the state. A concession holder constructs the object, to be transferred to state (concessor) ownership immediately after the completion of construction. Thereafter, the object is transferred to operation by a concession holder. A concession holder builds the object and operates it under ownership rights; the time frame is unlimited. Operations and Maintenance: a regulatory body signs a certain service provision and/or maintenance contract with a private company. Buy Build Operate is a type of sale involving reconstruction or extension of an existing object. The state sells an object to a private sector that performs necessary improvements for efficient operation. A private company rents or buys from a regulatory body existing property/equipment, invests own funds in renovation and upgrade, and operates it pursuant to the terms of a contract signed with the State/investor State/investor Investor State Investor State Widely applied in India for road construction. In Russia: construction of a section ( km) on the Moscow St. Petersburg toll road. This type of contract is widely spread in construction of cargo handling terminals at seaports as well as passenger terminals of airports. In Russia: servicing of the federal М-4 Don highway ( km) This type of partnership is widely used in Brazil, where the state arranges largescale privatization of infrastructure objects: namely, motorways, airports and seaports. The Russian example is the privatization of energy assets held in the 2000s. In Russia: Moscow government is currently in talks regarding the transfer of metro coaches (depots) to be serviced and upgraded by private investors. 10

11 TYPE OF PARTNERSHIP DESCRIPTION WHO BEARS OPERATING RISKS UNDER PROJECT? EXAMPLES regulatory body. Turnkey Turnkey construction. State Conventional building contracts. DB: Design Build DBO: Design Build Operate A private company is in charge of design and construction under the project. A single contract is signed for design, construction and operation. Examples of investment tools used in various countries for infrastructure projects China China is the world s largest investor in infrastructure, with the volume of investment over the past 20 years averaging 8.5% of GDP. The bulk of investment is earmarked for motor and railroad construction, as well as energy development. According to McKinsey, the cost of Chinese infrastructure assets stands at 76% of GDP, exceeding the lowest recommended threshold of 70%. It appears that in the coming years there will be a shrinkage of investment in infrastructure to 6-7% of GDP, although it will remain at the highest level globally at nearly $400 bln per annum, or 15% of the world total. Chinese state banks, including China Development Bank, play the key role in financing Chinese infrastructure, with the latter accounting for around half of local investment in infrastructure. Source: Gazprombank Top Chinese banks key investors in the country s infrastructure NAME ASSETS, $ BLN DESCRIPTION China Development Bank Established in 1994 to finance China s infrastructure projects. A 100% stake is owned by the state through the Finance Ministry. Bonds ($800 bln) account for more than 70% of the bank s liabilities and are considered risk-free, as China s Finance Ministry provides guarantees. In 2012, the bank placed $200 bln in yuan-denominated bonds (with a coupon rate of %), or half of China s overall investment in infrastructure. The bank s bonds account for 20% of China s domestic bond market. Local companies and commercial banks are the major buyers of these bonds. Industrial and Commercial Bank of China China s largest bank by size of assets. The state is a controlling shareholder, but some of the shares are publicly traded. Approximately 80% of liabilities are in the form of deposits, while the share of debt in the bank s liabilities stands at below 2% ($40 bln). Around 15% of assets are in the form of infrastructure financing. In 2013, the bank allocated ca. $30 bln to infrastructure companies. China Construction Bank The major source of liabilities is retail deposits (nearly 80% of liabilities), while other types of borrowing account for only 8% ($240 bln). Around 15% of assets ($370 bln) are in the form of infrastructure financing. Bank of China Deposits account for approximately 70% of liabilities, while bonds comprise 15% ($360 bln, of which $280 bln is internal borrowing and $80 bln external). High-speed railways government financing prevails. Over the past 20 years, China has created an extended railway network with a total length of 15,000 km and maximum traveling speed of up to 350 km/h. To support and expand railway infrastructure, state-run China Railways Corporation (the prototype of Russian Railways), which owns the country s entire railway infrastructure, uses various sources of funding. In particular, 40-50% of the total investment needs come from state banks and are guaranteed by the government (China Development Bank, Industrial and Commercial Bank of China, and China Construction Bank), about 40% is in the form of CNY-nominated bonds, and the remaining 10-20% is ensured by provinces through which the railroad will pass. China Railways is the world s largest transportation company, with assets exceeding $600 bln. The company s liabilities total about $460 bln, of which $170 bln are in the form of bonds. To build the section of the railroad, a separate company might be created with a controlling stake belonging to China Railways, while the remaining part will be sold to investors, namely Chinese insurance and construction companies participating in construction of this road. Source: Gazprombank 11

12 According to an infrastructure report prepared by Ernst & Young, from 1997 to 2007 China conducted a six-stage campaign to increase train travelling speed. As a result, construction of tunnels and bridges allowed for more declivity, the turning radius was reduced and continuous welded rails were laid. In 1997, the total length of high-speed tracks, where trains could pick up speed over 160 km/h, stood at 752 km. By 2007, their length was increased to 14,000 km. Following extended discussion among experts on which type of high-speed train to choose traditional or maglev in 2006 the PRC s State Council chose the former (HSR). The next stage was the development of the high-speed train series CRH (China Railway High Speed), which ensured a further increase in travelling speed. In 2004, the Railways Ministry announced a tender to supply 200 high-speed trains that could conduct transportation services at a speed of over 200 km/h. Applications were filed by such large companies as Alstom (France), Siemens (Germany), Bombardier Transportation (Germany), and consortium of Japanese investors headed by Kawasaki. As a result of the tender, contracts were signed with Alstom, Bombardier and Kawasaki, while Siemens was not among the winners, as it refused to lower the price for the trains and technology transfer. The following year, Siemens reduced the price, which allowed it to win the tender to supply 60 trains to conduct transportation service at a speed of 300 km/h. Each foreign manufacturer adapted the supplied high-speed train to China s unified standards. Train assembly was performed either jointly or with the assistance of Chinese manufacturers. Thanks to technological cooperation, Chinese engineers were able to design their own high-speed trains, based on trains made by foreign manufacturers. Chinese trains carry passengers from Beijing to Shanghai (1,463 km) in less than six hours, i.e. twice as fast compared with previous-generation trains. High-speed trains also allowed an increase in carrying traffic, resulting in higher capacity for the railway transportation system. As high-speed trains used the same tracks as freight trains, the only way to further increase the speed and capacity was to build high-speed lines for passenger trains. Recently, China launched a campaign to build dedicated high-speed tracks for passenger transportation. Toll roads private financing prevails. China embarked on active construction of toll roads in the early 1990s. The total length of toll roads currently approaches 100,000 km, linking all provinces and major cities in China. Total investment exceeded $260 bln ($2.6 mln/km). China's State Council and the Transport Ministry approve projects and construction standards, while their implementation and financing is performed by the administrations of involved provinces. Originally the provinces financed up to 90% of road construction from their budgets and through loans. Once construction is completed, the toll road is incorporated into the capital of a new company, the shares of which are placed on an equity exchange among international investors. Administrations spend the received money to build a new road. Thus, currently about 45% of road construction funds are self-raised, namely through the sale of shares via IPOs and cash flow from existing toll roads. The remaining 40% of the investment is still provided by provinces (through loans) and only 15% comes from the federal budget. Currently more than 15 such companies with a total market capitalization of $53 bln ($115 bln inclusive of debt) are trading on the Hong Kong Stock Exchange. Their distinguishing features are high margins (EBITDA margins of 40-60%) and solid dividends. The average P/E multiple of these companies for 2014 stands at around 10.0x, which is close to the average of Hong Kong s Hang Seng Index. 12

13 China s publicly-traded companies owners of toll roads COMPANY TICKER MCAP, $ MLN. EV, $ MLN FREE FLOAT CHINA COMMUNICATIONS CONSTRUCTION 1800 HK 10,361 25, % CHINA RAILWAY CONSTRUCTION 1186 HK 9,227 18, % CHINA RAILWAY GROUP 390 HK 9,181 30, % JIANGSU EXPRESS 177 HK 4,698 5, % ZHEJIANG EXPRESSWAY 576 HK 3,941 3, % SHANDONG HI-SPEED CH 2,277 4, % SHANGHAI TUNNEL ENGINEERING CH 2,142 4, % SHENZHEN INTL HOLDINGS 152 HK 2,090 4, % HOPEWELL HIGHWAY INFRASTRUCTURE 737 HK 1,474 1, % SICHUAN ROAD&BRIDGE CH 1,373 3, % SICHUAN EXPRESSWAY 107 HK 1,255 2, % SHENZHEN EXPRESSWAY CH 1,163 2, % JIANGXI GANYUE EXPRESSWAY CH 1,045 2, % ANHUI EXPRESSWAY 995 HK 1,037 1, % FUJIAN EXPRESSWAY DEVELOPMENT CH 932 2, % YUEXIU TRANSPORT INFRASTRUCTURE 1052 HK 850 2, % Total 53, ,400 China s high-speed railroads financing breakdown China s toll roads financing breakdown Source: Bloomberg 40% 10% 45% 15% 40% 40% STATE BANKS BONDS REGIONAL BUDGETS STATE BUDGET BORROWINGS INTERNAL FINANCING (IPO, CASH FLOW) Source: World Bank Source: World Bank India Over the past 20 years, India s investment in infrastructure has averaged 5% of GDP, which was insufficient given the country s average annual GDP growth rate of 7%. Under the new five-year development plan ( ) the Indian government has decided to double the amount of investment vs. the previous plan to $1 trln, or $200 bln annually (10% of GDP). The bulk of investment will focus on transportation (35%), utilities (34%) and telecommunications (17%). This is the most ambitious plan to stimulate the economy among developing countries, although it is unlikely to be fully implemented due to a shortage in funding of about $300 bln. The Indian government plans to provide 53% of the required investment, 25% of which will be covered from the state budget ($250 bln), 11% will come from extra-budgetary sources, and 17% through public borrowings. The remaining 47% is comprised of private investment, including 13

14 15% from investors own funds and 35% through borrowing. However, so far the confirmed size of private investment amounts to ca. $300 bln. China has offered India financial support and is prepared to invest the $300 bln shortfall in the country s infrastructure. China is apparently interested in engaging its construction companies, equipment and materials. However, the Indian government is in no hurry to accept the proposal, as a number of infrastructure sectors are considered strategic (telecommunications, utilities) and do not allow Chinese capital. Sources of funding implied by the plan ( ) Confirmed non-budgetary sources of funding ( ) 33.3% STATE BUDGET 3% 25% COMMERCIAL BANKS 14.8% NON-BUDGETARY FUNDS 8% NONCOMMERCIAL FINANCIAL INSTITUTIONS PRIVATE INVESTMENTS EXTERNAL BORROWINGS 16.5% 10.6% 24.8% GOVERNMENT BONDS INVESTORS' OWN FUNDS 22% 42% INSURANCE COMPANIES EQUITY FINANCING Source: Deloitte Source: Deloitte Potential non-budgetary sources of funding for Indian infrastructure under the five-year development plan until 2017 include the following: Commercial banks. They could invest about $120 bln over the next five years, accounting for 12% of the total investment required and 42% of all currently available private investment. Non-bank financial institutions ($64 bln; 22%). India has many specialized nonbank financial corporations, targeting infrastructure investment. They are India Infrastructure Finance Corporation (IIFCL), National Highways Authority of India, Rural Electrification of India, Power Finance Corporation (PFC), and Indian Railway Finance Corporation. Insurance companies ($1 bln; 3%). Insurance companies that are not involved with life insurance business are obliged to invest no less than 15% of their assets in Indian infrastructure. Key infrastructural financial organizations in India COMPANY DESCRIPTION CAPITAL STRUCTURE India Infrastructure Finance Company Limited (IIFCL) National Highways Authority of India (NHAI) Power Finance Corporation Rural Electrification Corporation Limited A state-owned corporation established in 2006 to support infrastructure projects. The company participates in infrastructure projects as a co-investor, offering direct financing or providing guarantees to improve the credit quality of infrastructure bonds. The company also takes part in implementation of over 200 projects with a total value of $77 bln. Government agency for road construction and management. State-run corporation that was specially created in order to attract investments to India s electric power generation sector. State-run corporation specially created to attract investments into India s power grid assets. The company s assets stand at $5.8 bln. The total value of bond placements amounts to $4.9 bln with a coupon of %. In 2013, the company issued loans and guarantees in the amount of $1.9 bln. The company s bonds are not state-backed, although its ratings are at the sovereign level. The state budget is the main source of financing for the agency. At the same time, the regulator has a small number of public loans totaling $2.5 bln carrying % coupon rates. The Indian government owns 73% of the company s shares, while free float accounts for the remainder. The company s MCap stands at $4 bln. The overall number of loans (mainly public) stands at $24 bln with coupon rates ranging from %. The Indian government holds 65% of the company s shares with the remainder in free float. The company s MCap stands at $5.5 bln. Public loans 14

15 COMPANY DESCRIPTION CAPITAL STRUCTURE Indian Railway Finance Corporation Infrastructure Development Finance Company Indian Leasing and Financial Services Indian Railways 100%-owned subsidiary. The company attracts cash from the market to finance the purchases of equipment for subsequent lease to the parent company. The company was established in 1997 as a government agency for financing various infrastructure sectors. Sometime after that, the company turned into a joint-stock company and offered its shares on the stock exchange. The company was established in 1987 by the central bank of India and a number of other state bodies. Later, Life Insurance Corporation of India, ORIX Corporation (Japan), and Abu Dhabi Investment Authority also became the company s shareholders. The company attracts investment in India s infrastructure facilities. It also builds and manages highways, energy facilities, ports, city infrastructure, and water delivery systems. taken out by the company total $18.7 with coupon rates ranging from %. The company s total assets stand at $12 bln, of which $11 bln are in the form of public offerings. The company s total assets amount to $12 bln. The government owns 17% of the company s shares, while international investors hold the remainder. Total investments stand at around $25 bln. The major shareholders are Life Insurance Corporation of India (25.34%), ORIX Corporation (23.00%), Abu Dhabi Investment Authority (11.09%), Central Bank of India (8.34%), State Bank of India (6.98%), and ILFS Employees' Welfare Trust (13.65%). In addition, the offerings of infrastructure bonds, the incomes from which are not taxed (tax-free bonds), are widespread in India. The government sets an annual limitation on such offerings. For example, the government allowed non-banking financial corporations to issue only $9.2 bln in tax-free bonds in 2014; while private investors were allowed to issue about $5.0 bln. Moreover, the government sets tax holidays for infrastructure companies for a period of up to 10 years. Source: Gazprombank estimates Total ivestments in India, $ bln Investment structure in India % 9.0% % 80% 70% 60% 50% 40% 30% 20% 10% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% % 0.0% HIGHWAYS RAILWAYS PRIVATE PUBLIC % OF GDP Source: IBEF Source: IBEF Railways. India has the world s fourth-longest railway network. Daily passenger traffic via this network amounts to 30 mln people (vs. about 3 mln passengers travelling via Russian Railways network per day). In 2013, Indian trains carried about 1.0 bln tonnes of cargoes (vs. 1.2 bln tonnes in Russia). State-run Indian Railways owns the entire railway infrastructure. The new government development plan for envisages that investments in railway infrastructure will increase by 2.5 times to $100 bln. However, investments for 2014 are planned at $12 bln, which is comparable with Russian Railways capex. About 40% of the company s investment is financed by the state budget, 30-35% is allocated from company s net income and borrowing, and the remaining 25-30% is attracted from additional sources, including around $1 bln from private investors. Indian Railways includes a special investment unit called Indian Railway Finance Corporation, which focuses on attracting private investment. The unit s assets amount to $12 bln. The investment company mainly uses the attracted funds to finance the purchases of locomotives and rail cars, which are subsequently leased out to its parent company Indian Railways. In early 2014, the company placed several bond tranches denominated in Indian rupees totaling about $5 bln. The maturity of the bonds was set at years and the coupon rates ranged from %. That said, these 15

16 bonds were not subject to income tax. In addition, the Indian government is allowing an increasing number of private investors to take part in projects for the construction of railway infrastructure facilities, i. e. depots, storage facilities, railway stations, and even special separate rail lines approaching ports in order to speed up the elimination of existing bottlenecks. Construction of the Western and Eastern railway corridors with a total length of 3,300 km is now one of the main infrastructure projects in India. The implementation of this project is to be completed in 2017, and should increase cargo turnover throughout the country. Total investments in the project amount to $16.7 bln. Highways. India has the world s second-largest highway network (4.7 mln km). More than 60% of cargoes are carried throughout the country via highways. The development of a highway network is one of the top priority tasks of the Indian government. Under the public private partnership, over 50% of private investments are allocated for highway construction. The bulk of investments are conducted under the build-operate-transfer principle, which envisages a private investor (or consortium of investors) building a road and using it for years, with the investor eventually returning the road to the government. The Indian government supports investors by allocating special grants for road construction (up to 40% of the project value). The Indian government also awards infrastructure projects with 100% tax holidays over the first five years and 30% holidays for the following 30 years. Brazil The Brazilian experience of attracting private investment to the infrastructure sector is quite interesting, although it still cannot be recognized as very successful. Since the mid-1990s, the country s authorities have demonstrated their commitment to mass privatization and concession of infrastructure facilities. As a rule, an investor that is ready either to pay the maximum price for an asset, or to set the minimum tariff for use of the infrastructure, is selected as the winner in the privatization of roads, airport and postal terminals. However, Brazil s infrastructure sector is still poorly developed. The country was ranked 114th out of 148 countries rated by the Global Competitiveness Index (GCI), and total investment in Brazilian infrastructure does not exceed 1.5% of GDP. The main problem involves the high political and economic risks and quite low returns on investment (ca. 6%). The country suffers from complex and lengthy bureaucratic procedures, which considerably impede the implementation of infrastructure projects and decrease returns on private investment. Projects involving the construction and management of highways and railways offer low returns on investment. However, investment in airport and seaport infrastructure remains quite attractive. For example, the Singapore port operator Changi and Brazilian construction company Odebrecht recently offered $8.2 bln on the tender to get the airport in Sao Paulo in concession, which is four times the initial price of the tender. In contrast to China and India, Brazil suffers from a lack of government bodies that support and attract investment in the infrastructure sector. The Brazilian Development Bank is the only such organization with assets exceeding $300 bln. However, the efficiency of the bank s efforts to develop the country s infrastructure sector is unclear, as the bank also supports other branches of the economy, i. e. social, education, and healthcare sectors, small businesses, environmental projects, etc. Each year, the bank invests $80-90 bln in the Brazilian economy, of which 35-40% is comprised of investment in infrastructure projects. A few years ago, in an effort to attract more private investment to the infrastructure sector, the Brazilian government set the terms for an offering of special infrastructure bonds, which must meet the following criteria: The funds raised via the bond offering must be only used to finance the company s investment program; 16

17 The minimum maturity is four years; The bonds carry a fixed coupons or coupons linked to inflation rates; The bonds can be redeemed ahead of schedule no earlier than two years after the bond issuance; Proceeds from the bonds are not subject to tax (earlier the income tax stood at 6%). The Brazilian government expects that the bonds will generate up to 10-20% of total investment in the infrastructure sector. However, Brazilian companies still unwillingly use infrastructure bond offerings as a low-cost way to attract investment, since such borrowings remain expensive. Only a few companies have thus far placed infrastructure bonds with inflation-linked coupons ranging between %. US According to the American Society of Civil Engineers (ASCE), US demand for investment in economic infrastructure amounts to about $3 trln for the period through 2020, or more than $400 bln annually. However, because of efforts to reduce the country s budget deficit, the planned investment (both public and private) in the infrastructure sector turned out to be far below the real needs standing at $1.8 trln through 2020, or around $220 bln annually (less than 2% of GDP). The decrease in investment in US infrastructure is a matter of great concern in that country. Some experts believe that capital that was earlier withdrawn from the country could become an additional source of investment in US infrastructure. Lawmakers have suggested exempting capital returned to the country from taxes, while obliging to invest these funds in US infrastructure bonds. The bulk of investment will be shared between two infrastructure segments highways (61%) and energy (36%). Highways. Road construction and reconstruction is financed through the Highway Trust Fund, mainly replenished with proceeds from fuel excises at a level of 18.3 cents/gallon. The fund s annual income stands at around $45 bln, but these proceeds fail to cover its expenses. The major issue is that given the flat level of inflation, excises have not been raised for the past 20 years, while the growing number of cars has been accompanied by diminishing fuel consumption, which has a negative impact on the fund s financials. Each state is entitled to set its own fuel levy in order to arrange financing of regional roads. Alaska has the lowest size of 26.4 cents, while New York enjoys the highest rate of 69.6 cents. US fuel levies average 48.8 cents, or 13.3% of the average retail price of a gallon of gasoline. Railways. The particularity of the US railway infrastructure is that the segment is wholly owned by private railway operators, who mainly focus on cargo transportation (53% of total turnover throughout the country), while passenger transport accounts for a minimal share. 17

18 SWITZERLAND HONG KONG FINLAND FRANCE GERMANY JAPAN CANADA USA SOUTH KOREA MALAYSIA UK AUSTRALIA TURKEY CHILE ISRAEL THAILAND KAZAKHSTAN UKRAINE CHINA INDONESIA INDIA RUSSIA PHILIPPINES PERU ROMANIA BRAZIL ARGENTINA VENEZUELA JULY 15, 2014 CURRENT STATUS OF RUSSIA S INFRASTRUCTURE NEEDS In 2013, Russia ranked 93rd among 148 countries by the quality of its infrastructure in the rating of the Global Competitiveness Report , which is calculated by the World Economic Forum (up eight positions compared to the previous year). Incidentally, this rating is based on the opinions of entrepreneurs who do not always have a clear picture of the actual status of the quality of infrastructure in the country. For example, oddly enough Russia ranks 138th in terms of the Road Quality Index, coming between the Republic of Chad and Yemen, which seems ridiculous. By the quality of its railroads, Russia ranks 38th, trailing such countries as Finland (6th) and Singapore (10th), countries where a railroad system barely exists. Moreover, in terms of overall quality of infrastructure, other CIS countries, including Kazakhstan and Ukraine, rank considerably higher than Russia in 64th and 70th position, respectively. Given that this index is overly subjective and does not reflect the actual status of infrastructure, we believe that the country s dynamics in the index over a number of years is of greater relevance, as it is capable of a capturing trends and conveying changes in the quality of infrastructure. Russia's position in the rating of countries in terms of the quality of infrastructure Source: World Competitiveness Index Changes of Russia s position in the rating of infrastructure quality RUSSIA 2008 RUSSIA 2012 RUSSIA 2013 CHINA 2013 BRAZIL 2013 INDIA 2013 Overall quality of infrastructure Quality of roads Quality of railroads Quality of seaport infrastructure Quality of airport infrastructure Source: World Competitiveness Index 18

19 Russia s infrastructure investment needs total at least 4% of GDP. Large-scale investments are required in virtually all infrastructure segments, including highways and railroads, power grids, water supply, telecommunications, ports and airports. According to estimates by McKinsey, Russia spent an average 3.4% of GDP on infrastructure from 1999 through This figure is broadly in line with our own estimates. By comparison, global infrastructure investments during this period averaged 3.8% of GDP (3.1% in developed countries and 5.5% in developing countries). However, going forward the volume of investments would have to be raised to at least 4% of GDP in order to maintain domestic infrastructure in good shape and secure its harmonious expansion in line with GDP growth. Thus, assuming that average annual GDP grows by 2.5% until 2030, the total need for infrastructure investments in Russia during this period would be RUB 60 trln ($1.7 trln), or about $100 bln per year. Planned infrastructure spending in Russia will be about % of GDP until In order to assess the magnitude of planned infrastructure investment in Russia, we analyze a large number of federal target programs spearheaded by the RF government, Russia s transport strategy until 2030, federal spending and regional infrastructure budgets, as well as the investment programs of natural monopolies (Gazprom, Transneft, Russian Railways), and of companies that invest in infrastructure (mainly in power engineering and telecommunications). On the basis of these documents and our calculations, about % of GDP will be spent on infrastructure projects or RUB trln per annum ($ bln), roughly on par with investments by large developed countries. Infrastructure investments will reach RUB 22.5 trln, or about 2.2% of global infrastructure investments by These resources should suffice for moderate expansion of domestic infrastructure (including highways and railroads), to raise its quality and efficiency, but would not be enough for accelerated expansion compared to Russian economic growth. For this reason, many infrastructure restrictions will remain in place in the country. A distinguishing feature of investments in the Russian economy is the large proportion of spending on construction and servicing of pipeline transport. The main investors here are Gazprom and Transneft, which will sink at least RUB 800 bln per year into infrastructure by The structure of Russia s infrastructure spending, as is the case in most countries around the world, is dominated by investments in transportation infrastructure (55%), mostly for the expansion of highways (45%), whereas pipeline transport investments come second with a proportion of 25%. The other 20% includes investments in telecommunications, power grids (investments in generating assets are not classifiable as infrastructural according to our classification) and public utilities (mainly water supply; housing maintenance and repair are also not regarded as infrastructure investments). The RF president and government are aware of the importance of raising infrastructure investments, since this is one of the key factors stimulating economic growth in the country. Specifically, the president tasked the government with expanding infrastructure in a number of areas over the coming decade, as follows: Double the construction of federal highways from 2013 through 2022 compared with Expand the total length of federal highways compliant with statutory requirements and transport operating standards to 44,000 km (83% of total infrastructure). Increase the aggregate cargo handling capacity of Russian seaports by 302 mln tonnes (port capacity currently stands at 800 mln tonnes). 19

20 Estimated key directions of investments in Russia s economic infrastructure (less VAT), RUB bln E 2015E 2016E 2017E 2018E 2019E 2020E Transport (less pipes) ,390 1,572 1,346 1,576 1,912 2,037 1,894 1,775 1,760 % of total 39% 37% 52% 55% 49% 51% 55% 56% 56% 56% 58% Pipes % of total 33% 37% 24% 23% 28% 28% 25% 25% 25% 24% 22% Power grid system* % of total 11% 12% 11% 10% 10% 9% 8% 7% 6% 7% 7% Telecommunications % of total 15% 14% 13% 12% 13% 11% 10% 10% 10% 11% 12% Public utilities** % of total 1% 1% 1% 1% 1% 2% 2% 2% 2% 2% 2% Total 2,083 2,696 2,687 2,875 2,774 3,106 3,453 3,615 3,356 3,147 3,057 As % of GDP*** 4.5% 4.8% 4.3% 4.3% 3.9% 4.1% 4.2% 4.0% 3.4% 3.0% 2.8% Source: Gazprombank * we do not include power generating assets in infrastructural investments ** we consider mainly investments in water supply, but not in house repairs *** declining investments to GDP ratio after 2018 is attributable to completion of large-scale infrastructural pipelines, although we do not exclude the likelihood of emergence of new projects Russia s transport infrastructure: rapid growth or concurrent expansion? The vast expanse of Russian territory clearly reveals the need of households and companies for advanced and reliable transport infrastructure. The country s total territory is equal to 17 mln km 2, with the maximum length from West to East reaching about 10,000 km (by comparison, Canada, the world s second-biggest country, is about half as big). By virtue of the large distances and export orientation of the Russian economy, the proportion of transportation expense in the cost of production of some companies can reach 30%, which means that having an efficient transport system makes these companies competitive on the global market. In terms of the Logistic Performance Index, Russia ranks 94th among 155 countries. This index is tracked by the World Bank, which factors in the quality of transportation infrastructure, customs procedures, ease of delivering consumer goods, and a number of other criteria. The mobility rate of Russia is also considerably lower than in developed countries, and this is a key factor in the expansion of employment and tourism, growth in income and spending, and, consequently, the overall economic development of the country. 20

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