Longer debt tenors, more domestic liquidity and tighter project legislation. Russia’s sponsors are looking for the same things from their infrastructure market as their counterparts anywhere else. Like anywhere else, pension funds and life insurance companies probably hold the key to better market conditions.

But the pace of development of Russia’s infrastructure PPP sector is picking up. In addition to Saint Petersburg, the first local government to put legislation in place, the Sakha Republic and the Tomsk region have passed PPP laws.

The list of local authorities preparing legislation is also growing – Moscow, Moscow regional, Yamalo-Nenets Autonomous Okrug, Sverdlov regional, Mari El Republic, Krasnoyarsk Kray, and Rostov all have PPP frameworks at different stages of development. And Tatarstan, Bashkortostan, Samara and Novosibirsk say they plan to use PPPs.

Russia has had some PPP successes since 2008 – not least the Pulkovo Airport project in 2010, and financial close on a first true major road PPP, the central section of the St Petersburg Western High-Speed Diameter (WHSD) project, in 2012. But it has not had enough of them to meet the needs of its growing economy.

Even the flagship WHSD project was only partially funded with bank debt – the city of St. Petersburg is funding construction of the 8.7km southern and 26.2km northern sections through government contributions and the issue of Rb10 billion ($280 million) of 20-year bonds, and project financing appeared only on the central section.

The bank and multilateral debt for the WHSD – Rb60 billion from Gazprombank, VTB, both of which were also sponsors, and the State Corporation Bank for Development and Foreign Affairs (VEB), the EBRD and the Eurasian Development Bank – was denominated in roubles. Using roubles minimised currency hedging costs but limited the debt’s tenor to 12 years, even though the concession for the whole road lasts for 30 years and benefits from an annual minimum revenue guarantee.

So while PPPs like WHSD demonstrate major progress in the financial engineering behind Russian infrastructure development, they will not on their own unlock the vast volume of long-term liquidity that Russia will require to meet growing and increasingly urgent demands for capital.

In short, developers and lenders alike believe Russia needs to grow its fledgling market for long-term corporate and government bonds, tap more pension and infrastructure fund investment and develop a true infrastructure/project bond market.

Lack of investment equals lack of growth

Russian infrastructure investment has been, and still is, low given the degree of modernisation required. It accounts for just 4% of GDP (half China’s level), and would be just 2.5% if oil and gas infrastructure is excluded.

The years of underinvestment have begun to take a toll on Russia’s economic growth. While China no longer enjoys double digit GDP growth, at 7.7% it is still over three times Russia’s 2.5%, and Russia has lost an estimated 1-2% of forecast annual GDP growth due to its infrastructure’s inability to meet the demands of a growing economy.

Last year president Vladimir Putin said that the Russian government would invest Rb450 billion from the National Welfare Fund in three major rail and road projects. The three are the modernisation of the Trans-Siberian Railway, the Rub928 billion construction of the 800km VSM-2 high-speed rail line between Moscow and Kazan and the Rb200 billion Moscow Central ring-road project. Putin called for additional private investment in all three projects.

Although the political will to modernise Russia’s ageing infrastructure is in place, and the country has vast oil and gas revenues. But unlike China, which used funding from state-owned banks to fuel its infrastructure boom, Russia needs private sector infrastructure investors and lenders.

In 2007 German Gref, then minister of economics and trade, and now chief executive of Sberbank) put forward a $1 trillion 10-year programme of infrastructure investment. Much of that programme, aside from the Sochi Olympics, has yet to materialise. The 2008 global financial crisis placed more immediate demands on the Russian government’s purse, not least among them the bailout of Rusal.

Gref’s $1 trillion of infrastructure investment over the next decade still stands as the minimum that Russia needs to spend to take a key step in accelerating the pace of economic growth – reducing the rate of capital outflow and increasing the rate of foreign direct investment (FDI).

The impact of Russia’s crumbling transport infrastructure on FDI is significant. FDI into Russia dropped by around $20 billion in 2012, and that number is not surprising given that transport accounts for 25% of the cost of finished products in Russia – two to three times that of an average developed economy.

Leaping the infrastructure gap

The Russian infrastructure market faces range of hurdles, both domestic and international, and is at different stages of circumventing them.

They include global competition for funding; the dearth of local banks able raise foreign currency debt at medium- to long-term tenors at a cost of funds competitive with foreign banks; the small number of domestic banks able to lend long-term in roubles (only Gazprombank, VTB, VEB and Sberbank are regular project lenders); and a lack of transparency and weak legislation.

The global competition for both private and development finance debt for infrastructure projects has become more intense since 2008. Russia now faces competition from both developing and developed markets for infrastructure funding.

According to the Organisation for Economic Cooperation and Development the level of global investment in infrastructure needed to meet demand should equal 3.5% of global GDP – around $70 trillion – in the period to 2030. Up to $25 trillion of this will have to be financed from extra-budget sources.

In Europe, demands for European Investment Bank, European Bank for Reconstruction and Development Bank and export credit agency support for infrastructure continue to rise as cash-strapped European governments attempt to rekindle economic growth through infrastructure development.

EU projects come with lower political risk, greater financial transparency, more asset security, and conformity to international project finance standards. They usually move more quickly towards financial close, unlike several Russian projects, whose costs have climbed sharply in the years between forecasting and funding. The most recent example is the infrastructure associated with the Sochi Winter Olympics.

Corporate governance and the legal regime in Russia remain concerns for some investors. It is difficult to put together a lending syndicate under Russian law because security cannot be shared among lenders with the same ranking. Pledges of accounts are not effective, as it is legally impossible to prevent a borrower from making a withdrawal from an account it owns, even if that account is pledged.

As a result the documentation for most major projects either uses English law where possible, or features bespoke Russian workarounds that may or may not meet international project finance standards. Either way, the. lack of a standardised approach increases transaction costs.

But Russia has some qualities to recommend it as an infrastructure investment destination. The returns on Russian infrastructure projects can be very appealing, and some bankers’ estimates of past projects’ internal rate of return are as high as 25%

Risk premiums attached to Russia are around those of Turkey, which has a booming infrastructure market. Five-year credit default swap spreads on government bonds are substantially cheaper than those of Italy, Spain, Portugal and Ireland, and Russia is widely perceived as moderate risk. Consequently, the cost of financing Russian infrastructure should also be around that as Turkey and benefit from the same lending appetite.

Bond market development

And most significantly, Russia’s bond market is developing into a potentially major source of locally denominated long-tenor debt. To date, Russian infrastructure bonds have not been the non-recourse project bond issues typical of European and Middle East projects. Russian infrastructure bonds have either been corporate, municipal or sovereign-backed.

But the maturity on these issuances is lengthening, creating a more useful yield curve. Recent offerings from Russian Railways, for example, have given investors the opportunity to buy 30-year corporate rouble debt for the first time. And Putin’s administration is actively encouraging pension funds to move into this relatively new market.

The typical pricing on these new infrastructure bonds is 100bp over CPI, making them both attractively priced, compared with typical Russian sovereign bonds, and inflation-proof.

Analysts expect issuance to increase markedly following a series of financial market reforms, including the creation of the Russian Central Securities Depository (RCSD) and access to international custody and settlement providers such as Clearstream and Euroclear.

As the Russian bond market liberalises, international investors are expected to become much more active in the domestic bond market and, by extension, more influential in how infrastructure financings in the capital markets are structured.

New funding markets for Russian infrastructure bode well for the upcoming project pipeline. In roads, state highway operator Avtodor either is, or will be, tendering the M1 Moscow Minsk, two sections of the Moscow-St Petersburg toll road, the M4 Don concession and a heavy goods vehicle tolling system project.

Avtodor has also recently shortlisted two bidding groups on the Rb56 billion Lena Bridge PPP near Yakutsk. The two are Yakutskaya mostostroitel’naya kompaniya (comprising Chinese Railway Construction Company/Stroygazconsulting/ NPO Mostovik/Russian Direct Investment Fund) and Transportnye Kontsessii Sakha (Northern Capital Highway/VTB Bank/VTB Capital/Istner).