US infrastructure has drawn significant attention globally as a potential home for outbound Foreign Direct Investment (FDI). Several early projects, however, have generated concerns about the surprising level of “political risk” to investors in American projects. I suggest that in the US infrastructure capital market, political risk, in the true meaning of the term, is a myth.
Political risk is a specific term used by cross-border investors to describe the cluster of risk around political conditions such as revolution, civil unrest, war, expropriation, repudiation of contracts, and similar acts and events that may occur around an unstable government or a government that does not respect private property or contractual rights, particularly the rights of foreign owners or contractual counterparties. There is a wide variety of insurance coverage, known as Political Risk Insurance (PRI), to address these sort of risks but these products are not generally available for investment in the United States because, in short, there are no such risks in the United States, at any level of government, federal, state or local.
There may be a local government somewhere that may try to pull a fast one in a particular instance, but the court system, even the local court system, will address that and, while the US court system is far from perfect and it may even take an appeal or two, there is no widespread experience of foreign investors being “home cooked” -- the term used to describe the risk of a local court exhibiting a bias to the local party to a dispute -- as is often the case in other national jurisdictions.
“In the US infrastructure capital market, political risk, in the true meaning of the term, is a myth.”
Why then the myth of political risk in the US, indeed, even a perception of a high degree of political risk? This is due to two features of the US infrastructure market that have confounded foreign investors since the heightened interest began. One is a particular US legal issues and the other is the result of the unfortunate history of several transactions.
The legal issue is well understood by the US market. In many states, government is restricted by constitutional law from contracting beyond one year. Hence, most contractual obligations are “subject to appropriation” and therefore future payments are legally avoidable. This is known as an “appropriation risk” and it is treated by the US capital markets as a credit issue, not a political risk. There is much written on this topic and the global market is coming to understand this historical twist on American state and local sovereign credits.
Much more troubling is the history of failed procurements in the last few years. This is best understood by first considering how a high risk emerging market nation would bring a project to market. Country X would run a tightly managed procurement at global best practices standards in order to attract significant interest to its higher risk project. Later, the government may be overthrown but hopefully the investors will have PRI to hedge against that.
“Given that bidders may spend several millions of dollars preparing a bid, this risk, what I call “risk of politics,” is very real in the US market .”
It is highly, highly, highly unlikely that a US government unit will meaningfully default on an executed contract as a result of say, a coup d’état. However, many US state and local governments have led procurements at less than best practices standards and have allowed politics to interfere with outstanding procurements resulting in significant financial losses to the bidders. Given that bidders may spend several millions of dollars preparing a bid, this risk, what I call “risk of politics,” is very real in the US market and has the potential to meaningfully dampen the interest of foreign capital in US procurements.
All markets have established norms. It is unlikely that a state or local finance officer would approach the municipal bond market with the expectation that the market’s practices need not apply. Advisors would quickly observe that non-standard structures could result in less than optimal pricing. The market for investment into infrastructure assets is no different in that regard. It is a global market and its participants have certain expectations about process. The reality of process risk certainly is reflected in pricing and risks tainting what should be the most risk-free market in the world.
This article originally appeared in the Summer 2012 issue of American Infrastructure.