1. Introduction
Rutherford [
1] describes infrastructure as the networks, assets and services that facilitate economic and social activity in the economy. In economic terms, infrastructure refers to fixed and durable assets such as plant, equipment, buildings and civil works that provide the productive framework of an economy. Economic infrastructure is major asset class in most countries and possesses a number of unique investment and financing characteristics:
Assets are long lived, capital-intensive, site and use specific
Assets form part of complex supply chains and in the energy, transport and telecommunications sectors, attract a high level of private sector participation
Revenue is generally stable, indexed and in the utilities sector, demand is generally characterised by low elasticity
Private investment is highly leveraged with long-term, limited-recourse loans or bonds
Projects may be subject to limited competition but pricing is regulated, Regan [
2].
Public infrastructure generates a number of positive externalities that increase a country’s productive capacity, output and growth. It accounts for a significant proportion of the nation’s capital stock with implications for capital deepening, productivity performance, greater diversification in trade and reduced transaction costs. Infrastructure output and pricing is an input for most other sectors of the economy with consequential impacts for the cost structures of other industries and the efficiency of cross-sector supply chains. Studies suggest that infrastructure makes a significant contribution to a country’s gross value added, growth and gross operating surplus, Deole and Gallaa [
3]; Pereira and Andraz [
4]. As an asset class, infrastructure returns disclose a low correlation with other asset classes and leading economic variables such as interest rates, investment, employment, economic growth and exchange rate indicators, Weber and Alfen [
5], and offers an opportunity for diversification in mixed asset portfolios, Peng and Newell [
6]. Infrastructure improves connectivity, lowers transaction costs and fosters the development of production networks and cross-border supply chains. Infrastructure has contributed to the region’s emergence as the fastest-growing regional economy in the world, Bhattacharyay [
7].
In global industrialised economies, infrastructure investment is presently in the range 3.0%–3.9% GDP, McKinsey [
8]; Harrison [
9], although high capital intensity means that around half of all new investment is accounted for by capital retirements or real depreciation of existing capital stock although this varies with the capital intensity, Berlemann and Wesselhoft [
10]; Australian Bureau of Statistics [
11]. In recent years, public investment in industrialised economies has increased for social infrastructure assets such as health, education, corrective services and urban transport in the medium to high-income countries, and inter-regional transport, energy, water and destination transport services such as ports and airports in medium income countries. Data for developing countries indicates most public and private investment is concentrated in the energy, resources and transport sectors and exhibits lower average asset age and capital write-downs than for industrialised economies, Mackenzie [
12]; Project Finance International [
13]. In developing countries, demand drivers include population growth and rapid urbanisation which requires higher levels of infrastructure investment in energy (electricity, oil and gas), roads, ports, rail and urban transport, water and sanitation services, PricewaterhouseCoopers [
14]. In the Asia Pacific, public infrastructure investment in the period 2010–2014 was highest in China (22.5% of gross domestic product or GDP), Malaysia (10.5%), India (7.5%), Canada and Australia (6%), New Zealand (5%), and Korea (4%) although recent data indicates regional average investment levels around 8% of GDP, Ding, Lam and Peiris [
15]; Chong and Poole [
16]; McKinsey [
8].
Infrastructure forms part of complex supply chains and requires long-term planning and financing strategies. In most Asian Pacific countries, the demand for replacement and new infrastructure exceeds the financial capacity of most governments to provide especially in low-income countries with a limited revenue base, high rates of urbanisation and high-levels of congestion in towns and cities. A combination of current account constraints, global borrowing limits and sub-investment grade credit ratings constrain significant new investment in infrastructure services in the foreseeable future, Bhattacharyay [
17]. The challenge for Asia Pacific governments is meeting growing demand for services using a combination of traditional and alternative financing methods and providing appropriate intermediation pathways for high domestic savings. McKinsey [
8] estimates global infrastructure needs of USD57 trillion between 2013 and 2030, equivalent to around 3% of gross domestic product (GDP) annually. The greatest requirements are in the sectors of energy, water supplies and transport services including ports, roads and railways. Regional estimates of the infrastructure investment gap suggest the present global funding deficit is around USD800 billion annually, PricewaterhouseCoopers [
14].
The objective of this paper is to identify the relationship between capital markets, investment in infrastructure and economic growth in the Asia Pacific region drawing on recent literature on these subjects. The paper is organized as follows. The introduction examines the characteristics of infrastructure as an asset class and
Section 2 identifies methods to finance regional infrastructure requirements over the next 20 years.
Section 3 reviews the literature that explains the association between infrastructure investment and economic growth.
Section 4 considers capital markets in the region and initiatives for capital market development, integration and the standardization of market rules.
Section 5 examines the relationship between capital market development and economic growth. The conclusion attempts to summarize the findings of each part and identify future directions for this research.
3. Infrastructure Investment and Economic Growth
Infrastructure has been shown to impact a country’s economic performance in a number of ways. Economic infrastructure contributes to an economy’s productive capacity and output, Calderon and Serven [
51]; Esfahani and Ramirez [
52], multifactor productivity and capital deepening, Mas, Maudos, Perez and Uriel [
53]; Pereira and Andraz [
4], and generates sustainable multipliers of economic activity, Paul [
54]. Aghion and Jaravel [
55] suggest public infrastructure has a positive effect on GDP that is not restricted to the creation of capital stock via economies of scale but is competition enhancing for the economy through the agency of network externalities. Infrastructure is also linked to lower private transaction costs, Baltagi and Pinnoi [
56], adds value to exports, North et al [
57]; Barwise and Dick [
58], and generates positive social returns, Zhai [
59]. Bhattacharyay, (p. 339, [
7]) argues that the big factor behind Asia’s high growth since that late 1980s was rapid infrastructure development that raised economic efficiency in regional countries, improved connectivity between regional economies and enhanced East Asian production networks and supply chains. Infrastructure affects many different industries and needs are determined by contextual factors such as level of urbanization and structure of the economy and both physical and climatic geography play a significant role with different impacts between countries at various stages of development. Evidence confirms that investment in transport services, energy and telecommunications generate highest returns in developing and transitional economies, Ligthart [
60].
The relationship between infrastructure and growth has been difficult to measure with early studies using a static single-equation production function approach showing excessive returns with evidence of diminishing returns, differences in effects between industry sectors and subnational regions over time, and the problem of distinguishing short-term investment multipliers and capital stock accumulation from long-term growth impacts, Regan [
61,
62]. The interest in the relationship between public investment in infrastructure and economic growth commenced with the early work of Aschaeur [
63] who used a production function approach for United States data to identify the elasticity of output for public capital at between 0.34 to 0.39, implying an annual marginal productivity of public capital of around 70 cents in the dollar. The production function approach encountered reverse causation (simultaneity bias) and led to new approaches based on a multivariate static cost function approach and later, dynamic multivariate vector autoregressive (VAR) settings that took into account private sector employment, investment and output in addition to public capital. Subsequent research used financial and physical measures of infrastructure in both developing and developed economies and used VAR analysis applied to multiple country datasets, Pereira and Andraz [
4].
Studies by Warner [
64] showed the elasticity of infrastructure investment of 0.11, Everaert and Heylen [
65] 0.31 and Kamps [
66] 0.22. The relationship with employment was studied by Pereira and Roca-Segales [
67] who identified a marginal product of private investment with respect to public investment of 10.2 equating one million Euro with 129 jobs in the long term, Pereira and Roca-Segales [
67]. Similar studies based on European data report long-term effects of 8.1 (230 jobs per million Euro of expenditure) and marginal product 9.5 corresponding to a rate of return of 15.9% per annum, Pereira and Andraz [
4].
Esfahani and Ramirez [
52] found that the impact of infrastructure investment on growth is substantial when viewed against induced externalities such as the terms of trade, industry structure and specialization, the spatial distribution of industry and the efficiency of investment. Recent research by Ganelli and Tervala [
68] adopted a New Keynesian general equilibrium model to show the welfare multipliers of public investment are positive at 0.8 suggesting the welfare gains of public infrastructure investment if implemented efficiently, could be substantial. Egert, Kozluk and Sutherland [
69] used time series data for OECD countries to establish a positive causal association between infrastructure investment and growth with the impact greatest for sectors offering economies of scale, network externalities and competition-enhancing effects, with growth effects strongest in the telecommunications and energy sectors of the economy, Esfahani and Ramirez [
52].
O’Fallon [
70] surveyed the empirical evidence to understand the nature of the relationship between infrastructure and growth. She found that a correlation existed but encountered the causation problem common with earlier studies by Aschauer [
63] and others. The study suggests infrastructure should be viewed as complimentary assets that operate in concert with other human and/or physical capital to contribute to growth. This is consistent with the contemporary view that infrastructure serves as a catalyst for other growth drivers which include effective institutions and a strong market economy, Egert, Kozluk and Sutherland [
71]; Nijkamp and Poot [
72]. However, economies and institutions change over time suggesting that the relationship between infrastructure and growth is dynamic and operates in a different way with various levels of development, Regan, Smith and Love [
73].
A comprehensive review of the literature examining the economic effects of public infrastructure can be found in Pereira and Andraz [
4]. In the Asia Pacific, the relationship between infrastructure and growth has been uneven with considerable differences in levels of market and social development, market structure, urbanisation, incomes and social benefits between regions and countries. Sustained investment in services that improve the productivity of physical and human resources through innovation and technological progress will be primary factors in stimulating growth in any society, Todaro and Smith [
74].
Investment in infrastructure is important and so is the efficiency with which it is implemented and managed. As a component of complex supply chains, infrastructure output has important cost implications for other industries in the economy as a proxy for efficiency at the project and enterprise levels. Efficiency is mainly measured as capital and labor productivity and the efficacy of governance and regulatory frameworks. Institutions play a central role in a developing country’s economic and social development, and programs to attract private investment in infrastructure are more successful when supported by effective market-oriented institutions, Rodrik and Subramanian [
75]. The term institution refers to the formal rules by which a nation manages interaction between individuals and the outside world. Formal institutions are commonly referred to as “the rules of the game” and describe the organizations, policies and administrative frameworks that govern relations between members of society. The institutions that support the market economy include the rule of law, property rights, governance frameworks, an independent judiciary, a central bank, and stable monetary and fiscal policies, Sala-i-Martin et al. [
76]. Market institutions and particularly property rights determine the incentives and constraints that influence economic actions and permit the state, firms and individuals to carry out economic activities that generate wealth and allow the market economy to operate with a reasonable level of confidence and certainty, Acemoglu, Johnson and Robinson [
77]; North [
78].
Property rights in the form of patents and copyright operate to create monopolies for entrepreneurs who invest in research and development, which generally supports high early returns that diminish over time. Recent studies suggest diminishing returns to technology are much greater in our present technology-driven economies than it was in the past. Property rights also create incentives to savings and positive returns to investment and evidence indicates they are a primary driver of savings and capital formation, essential elements of economic development, Baumol, Litan and Schramm [
79]. Acemoglu, Aghion and Zilibotti [
80] identified the dynamics of this relationship over time as a consequence of the transformation of production relationships, the rate of adoption and imitation of technology, and capacity to manage change. A further factor in the dynamic of this relationship is the level of a nation’s economic and social development, Regan, Smith and Love [
73].
Institution also refers to the informal cultural and social rules and norms adopted by society’s social and cultural institutions, which refers to custom and tradition, religious and social conventions and practices. Social institutions contribute to a culturally-embedded willingness to innovate, adopt new technologies, foster a propensity to trade, save and invest, and support a dynamic market economy in the presence of secure property rights, mechanisms to safeguard economic transactions, and pro-market policies, Opper [
81]; North [
82]. Imperfect institutions provide the most significant explanation for the relative poverty of nations, Eggertsson [
83]. Formal and informal institutions are closely related, and formal institutions such as educational policy affect workforce participation, skill levels and a nation’s knowledge capital, Hanushek and Woessmann [
84].
A significant body of research suggests that countries with effective institutions experience greater economic and social development, foreign and local investment, and drive higher growth rates than countries with ineffective institutions, Sala-i-Martin et al. [
76]; Acemoglu, Aghion and Zilibotti [
80]; Acemoglu, Johnson and Robinson [
77]. Conversely, the characteristics of the administration of government that most detract from an effective market economy include excessive bureaucracy in the form of long delays to register a business or obtain visas for workers, red tape and overregulation, corrupt state procurement practices, lack of accountability or transparency in government, and a non-independent or corrupt judiciary, Handoussa [
85]. A detailed analysis of the literature that examines the relationship between institutions and development can be found in Jutting [
86].
Effective institutions have been shown to influence the organization of production, reduce transaction and production costs, provide an enabling environment for competition and information flows, and play a central role in the way in which societies distribute the benefits and the costs of economic development, North (p. 19, [
82]). Acemoglu, Johnson and Robinson [
77] argue that institutions matter because they shape the incentives of key economic actors in society. Institutions can improve a nation’s productivity and factor accumulation, Hall and Jones [
87] and are a factor in the rate of FDI inflows, Benassy-Quere, Coupet and Mayer [
88]. Ho et al. [
89] studied foreign direct investment in Brazil, South Africa, Russia, India, China and Malaysia between 1977 and 2010 and found infrastructure, economic freedom, interest rates and market size were important determinants of inbound flows. Busse and Hefeker [
90] show that government stability, law and order, government accountability and quality of the bureaucracy are significant determinants of FDI. State support for market-oriented institutions that encourage investment in physical and human capital, encourage capital market development and permit capital transfers generally reduce investor concerns about political risks such as state expropriation, unilateral withdrawal from long-term contracts, and the enactment of discriminatory laws, taxes and regulations. The evidence suggests that nations with effective market institutions generally invest more in infrastructure and human capital and will use these factors more efficiently to achieve a greater level of income, North [
78]; Jones [
91].
The relationship between institutions and infrastructure development is different between Asia Pacific countries in several respects. First, the nature of infrastructure requires that government agencies and policies also play a central role in the planning and approval of projects and particularly, the coordination of government agencies with overlapping jurisdictions. The coordination role of the state assumes greater importance with federal constitutional systems and with nations in which provincial and municipal administrations provide the greatest share of infrastructure services.
Second, infrastructure is not a stand-alone asset but a networked supply chain, the efficiency of which depends on its weakest link, Williamson [
92]. For example, a new port facility will operate to the capacity permitted by the road, rail and other transport systems that service it. Investment in new services requires complimentary investment and/or upgrading of support services. For government, the challenges include sourcing the capital for basic infrastructure, long-term planning, coordination of state agencies, and integrated approval and regulatory processes.
Third, institutions are essentially
sui generis and endogenously determined by the political, economic and social forces at work in each nation, Haggard [
93]. Institutions that may prove effective in one country may not prove effective in another and different approaches will lead to different asset allocation decisions, Acemoglu, Johnson and Robinson [
77]. There is also evidence that the role of institutions may differ over time with factor-driven economies at relatively low levels of development deriving greater foreign direct investment and infrastructure spending than countries further along the development path, Regan, Smith and Love [
72].
Fourth, the capacity of government to provide the capital needed for both economic and social infrastructure is limited. Fiscal pressures, a reluctance to increase the tax burden and high levels of public debt provide impediments to greater public investment in the future, OECD [
43]. In 2015, public capital investment in OECD countries averaged 5% of GDP, which remains a benchmark for industrialised nations, Stevens and Schieb [
94]. As mentioned earlier, there are significant differences between Asia Pacific countries with China (22.5% GDP), Malaysia (10.5%) and India (7.5%) contributing more than the regional average of 6.4%, PricewaterhouseCoopers [
14].
Private investment has increased in recent years to around 10% of public capital spending in OECD countries and even greater levels in developing nations and is a policy option for government to increase future infrastructure spending to around 7% of GDP. Private investment on any scale requires new complimentary institutions such as new procurement policies, governance and contract management/regulatory frameworks and agency capacity-building to develop the skills necessary for managing this type of investment.
The role of institutions is to mediate the relationship between infrastructure investment and output activity whilst providing the legal and incentive framework that encourages investment and growth, Esfahani and Ramirez [
52]. Incentives and the efficiency with which infrastructure is managed over long-term incomplete contracts are drivers of national competitiveness. An additional factor is the efficiency of infrastructure management. Hulten [
95] has argued that it is not the quantity of infrastructure that a government has but the efficiency with which it is used. The study compared the growth experience of East Asia and Africa and found that over one-quarter of the differential growth rates between the two regions could be attributed to the effective use of infrastructure resources. More recent research collaborates this finding, IMF [
18]. A comparative analysis of high and low growth economies found that 40% of the growth differential was due to the efficiency effect making it the most important factor in differential growth performance. Warner found public investment had limited impact on long-run growth due in party to weak or circumvented project appraisal selection and management procedures, Warner [
96]; Gupta [
97]. Moreover, efficient institutions are necessary to manage the selection and efficient implementation of public infrastructure programs. Banerjee, Oetzel and Ranganathan [
98] examined a panel of 40 developing countries between 1990 and 2000 and found that private participation in the sector is improved where the host country protects property rights and runs an efficient bureaucracy. An earlier study of 83 developing countries between 1984 and 2003 made similar findings and added political stability, law and order, internal and external conflict, corruption and ethnic tensions as factors, Busse and Hefeker [
90].
Brenck et al. [
99] studied countries in central and Eastern Europe that were recent additions to the European Union, and candidates for membership of the European Union and found a low level of private infrastructure investment. The explanation for this was found to be an unfavorable institutional environment. There is a view that the institutions most conducive to investment and particularly private investment are those that support a market economy such as an established capital market, satisfactory ratings in ease of doing business criteria, free movement of foreign exchange and a judicial system with low levels of corruption and speedy determination of civil matters, Nabi and Suliman [
100]. Egert, Kozluk and Sutherland [
71] examined the relationship between infrastructure, growth and institutions in 26 OECD countries between 1975 and 2006. The study found that policy frameworks with a robust decision-making process, rigorous investment evaluation and selection, and which encouraged market competition were most appropriate for delivering growth and attracting private investment.
Institutions also need to adapt to changes in economic development. What are appropriate institutions today may not be optimal in the future and what works in one institutional context may not work in another. Acemoglu, Aghion and Zilibotti [
80] examined the dynamic properties of institutions as countries transition from factor-based economies to greater innovation and technology in which manufacturing and service industries assume a greater share of GDP. The willingness to adapt institutions to new circumstances on the path to economic development explains the rapid transformation of the high-growth economies of North and East Asia in the second half of the 20th Century, Studwell [
101].
5. Capital Market Development and Economic Growth
A strategy of ASEAN, the Asia Pacific Economic Cooperation forum and the East Asia Forum in the past decade has been improvement in the integration of capital markets in the Asia Pacific region the focus of which has been the relaxation of foreign ownership and investment rules and greater openness for capital movements. However, as explained above, structural reform has not matched market development in many of the transitional economies in the region, the pace of regional market connectivity has been slow and significant challenges remain including the low rate of conversion of domestic savings to capital market supply, improved intermediation to raise growth in intra-regional trade, improved capital market innovation and overcoming institutional resistance to greater levels of transparency and governance, ASIFMA [
102].
The importance of capital market development in the region cannot be understated. The literature identifies an association between capital market development and economic growth, Zhuang et al. [
124] although as with other drivers of growth, such as public investment, there is evidence of two-way causation in the association, Robinson [
125]; Acquah-Sam [
126]. Research using cross-country data and advanced econometric techniques confirms that countries with efficient capital markets experience stronger growth than those that do not, King and Levine [
127]; Levine [
128]; Zhuang et al. [
124]. However, this does not occur in isolation and the strength of the association is determined by a number of endogenous conditions of which the most important is effective institutions which have been shown to influence the organization of production, reduce transaction and production costs, provide an enabling environment for competition and information flows, and play a central role in the way in which society distributes the benefits and the costs of economic development, North (p. 19, [
82]). Acemoglu, Johnson and Robinson [
77] put the case that institutions determine the incentives of key economic actors in the economy. Institutions may also improve a nation’s productivity and factor accumulation, Hall and Jones [
87], and research shows that government stability, law and order, accountability and the quality of the bureaucracy are significant determinants of foreign direct investment, Busse and Hefeker [
89]. Institutions also play an important role by providing prudential supervision of banks and non-bank financial institutions, Lin [
129], corporations and securities regulation, accounting and audit standards, and laws dealing with insolvency and compliance with capital market trading rules, Stiglitz [
130]; Zhuang et al. [
124].
The association is also affected by the relative level of development of capital markets, Alfaro et al. [
131]; Azman, Law and Ahmad [
132]. Alfaro et al. [
131] used cross-country data between 1975 and 1995 to show that countries with well-developed financial markets gain significantly from FDI providing an explanation for the high share of FDI that flows to developed economies, ADB [
108]. FDI has also been shown to have a positive and statistically significant effect on economic growth in developing countries, Levine [
128]; Agenor and Montiel [
133]; Zhuang et al. [
124]; Alfaro et al. [
134]. However, capital market development is not an even process across developing countries and is affected by financial intermediary development, Beck, Levine and Laoyza [
135], stock market liquidity and banking sector development, Levine and Zervos [
136], and given levels of economic development, Mavrotas and Son [
137].
Capital markets provide benefits for government and the private sector in emerging economies by enabling the trading, diversification and management of risk, Levine [
128]; provide capital for infrastructure investment, Claessens and Feijen [
138]; provide information and liquidity for investors and facilitate capital market integration, Bekaert and Harvey [
115] and provide an entry point for institutional investors, Economic and Social Commission for Asia and the Pacific [
139]. Well-developed capital markets may provide greater flexibility to manage debt maturity and currency risk, and provide more efficient risk allocation with downstream impacts for economic and social development. It is therefore an integral policy option for government in developing and transition stages of development as part of wider reforms designed to improve trade, economic openness, and the effectiveness of government’s fiscal, monetary and exchange rate policies.
Domestic capital markets enable government to issue bonds to finance fiscal deficits, harness domestic savings, and reduce dependence on foreign borrowings carrying exchange rate risk. Long-term bonds provide a benchmark for pricing long-term debt and inform monetary policy by providing a yield curve and information to assist the conduct of monetary policy.
For government, capital market development assists macroeconomic stability by enabling government to finance deficits with local currency bond issues, by helping to bridge the gap between savings and investment, and providing instruments for management of monetary policy. Diversified capital markets may also improve the efficiency of capital allocation and facilitate greater dispersion of unsystematic risk in the economy. For local firms, capital markets provide options for the long-term finance, lower cost of capital and more options for the management of interest rate and maturity risk with long-term and capital-intensive assets such as infrastructure. For investors, local markets bring liquidity, market access, assist portfolio diversification and provide information about their investments and the market not otherwise available to private investors. Capital markets in emerging economies are an important institution and one that is positively associated with measures of economic development, Nowbutsing and Odit [
140]; Laeven [
104].
Capital markets also remove investor and borrower dependency on banks by introducing competition and providing alternatives for institutional investors. From an institutional perspective, market development also introduces market discipline at two levels. Firstly, reforms to improve regulation and oversight of corporations in matters of corporate reporting, disclosure, and governance. Moreover, strategies to improve connectivity between markets, countries and regions requires coordination of regional regulatory frameworks and standardization of compliance requirements such as common accounting, documentation and liability standards, listing rules, margin requirements for e-trading and centralized clearing arrangements. Secondly, project finance for infrastructure projects permits lenders to impose and enforce covenants under loan agreements such as loan security and debt service coverage ratios, reporting and disclosure requirements, and step-in rights in the event of breach of loan covenant by the borrower.
Laeven [
104] identified a positive correlation between market development and the size of the banking sector, bond and equity markets. Market sophistication in the form of over-the-counter (OTC) interest rate and foreign exchange risk management instruments are more effective in the presence of a large bond market, financial openness and large volumes of external trade, Mihaljek and Packer [
141]. Development of markets is also correlated with FDI flows which also have been shown to make a contribution to an economy’s long-term growth rate, Agenor and Monteil [
133]. Financial market development in the presence of trade openness is associated with technical innovation and wider use of financial derivatives for interest rate and currency risk management, Zhuang et al. [
124].
Unlike other regional capital markets such as North America, Australia and New Zealand, and the European Union, as noted elsewhere, no single Asian authority is positioned to drive, coordinate and provide a road map for structural market development and greater uniformity in capital markets, suggesting the roadblocks to market development must be addressed under the regional economic, trade and financial market organizations of the region including the Association of Southeast Asian Nations (ASEAN) and the various economic and trade forums of the region including Asia Pacific Economic Cooperation, the Asia Economic Forum and the East Asia Forum.