Why Isn't Investment Already Taking Place?

August 11, 2009

Here’s a common objection to the logic behind the proposal for building charter cities in poor host countries:

If investment in urban infrastructure can really generate win-win benefits for investors and residents of poor countries, why isn’t it happening already?

To see why, start by picturing a familiar long-term investment. Imagine that a lender (an insurance company perhaps) wanted to do a long-term deal with a borrower (someone who takes out a 30 year mortgage to build and live in a home.) If all the borrower can do is make a personal promise, the loan will never take place. Even if the borrower is very concerned about her reputation and always sticks to her word, the lender might reasonably worry about being repaid. If the borrower dies, for example, she can’t be sure that her heirs will stick to her promise.

The leaders in many poor countries face the same problem. They can’t control what future political leaders will do in 5, 10, 20 or 30 years. No one knows if future leaders will enforce the terms of any agreement entered into in good faith today. Residents want to pay for infrastructure. Investors want to earn a return by supplying it. Leaders want the deal to be done. Nevertheless, the investment does not take place.

In a country like the United States, mortgage lending can take place because borrowers and lenders can rely on a neutral third party, the court system, to enforce the terms of an agreement for decades into the future. A partner country can do for a country with excessive political risk what the court system does for the United States. They can act as a third party guarantor of an agreement between investors and residents.

The risk that a future government will breach the terms of an agreement is called political risk. An investment in a piece of infrastructure such as a power plant or an airport requires a large initial outlay and pays returns for decades. An investor who contemplates an infrastructure investment in a country with political risk has to take account of the chance that after the initial outlay, the local government will deprive it of a chance to earn the return. An investor who might be willing to accept a 10% rate of return in a country with no political risk might require a 20% or 30% rate of return to invest in a country with an unpredictable legal and political system. Some investments, oil wells for example, can generate this kind of return, but rates this high kill most infrastructure projects.

Political risk is like the worst kind of tax. It stifles valuable economic activity without raising any revenue for the government. By providing administrative oversight in a charter city, a partner country can help a host country remove this tax.

This post originally appeared on the NYU Stern Urbanization Project’s blog. To read the original post, click here.