metadata: authors: 0: author: Eichengreen,Barry J.
docna: 0: docna: Financing infrastructure in developing
            countries : lessons from the Railway Age
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Economic Adjustment and Lending,Public Sector Economics,Urban Governance and Management,Public & Municipal Finance,Railways Transport,International Trade and Trade Rules,Municipal Management and Reform,Social Cohesion,Intergovernmental Fiscal Relations and
            Local Finance Management,Public Finance Decentralization and
            Poverty Reduction,Intelligent Transport Systems
teratopic: Finance and Financial Sector Development
abstracts: cdata!: Arguments for financing infrastructure
            development through government subsidies and foreign
            borrowing meet with increasing skepticism.  Numerous
            "white elephants" subsidized by governments have
            strengthened doubts about the efficacy of public finance,
            and the debt-servicing problems of the 1980s have weakened
            arguments for foreign borrowing.  Recent innovative
            suggestions for financing infrastructure investments in
            developing countries have a back-to-the-future quality.  At
            the heart of the nineteenth century debate on financing
            infrastructure development - especially railways - lay
            certain concepts: relying on private finance, encouraging
            the growth of domestic financial markets, and choosing
            financial instruments that minimize the risk of dependence
            on foreign funds.  The author reviews the historical record
            in an attempt to glean lessons for developing countries
            today.  In the nineteenth century, much as in many of
            today's less developed and less liberalized economies,
            not all the informational and contractual preconditions for
            efficient private or commercial finance of infrastructure
            projects prevailed.  In some regions, it was difficult to
            tap investors at home or abroad.  Many countries lacked the
            private institutions (such as universal banks) and public
            ones (such as regulatory agencies) needed to facilitate
            monitoring, to discipline management, and to ensure an
            adequate flow of information to investors.   In places as
            diverse as Canada, India, Spain, and the United States,
            getting enough finance often required that the government
            provide collateral (land grants) and bond guarantees -
            especially where asymmetric information caused credit
            rationing.  The main lessons: exploiting nontraditional
            approaches to financing infrastructure investment requires
            action on two fronts.  First, liberalizing and developing
            domestic financial markets.  And second reforming
            administrative mechanisms that ensure accountability from
            enterprises enjoying government subsidies or guarantees.
repnme: repnme: Financing infrastructure in developing
            countries : lessons from the Railway Age
display_title: Financing infrastructure in
            developing countries : lessons from the Railway Age
listing_relative_url: /research/1994/11/697896/financing-infrastructure-developing-countries-lessons-railway-age
topicv3: Trade m1326924 698,Political Violence and Civil War m1326942 739,Local Finance m1327383 874,Railways m1327400 166,Traffic Management m1583399 4231
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Off of Sr VP Dev Econ/Chief Econ (DECVP)
no_of_pages: 54
author_keys: 0: author_key: 165791
model_extractions: i POLICY RESEARCH WORKING PAPER 1379

# Summary findings

Arguments for financing infrastructure development through gr :rnment subsidies and foreign borrowing meet with increasing skepticism. Numerous "white elephants" subsidized by governments have strengthened doubts about the cfficacy of public finance, and the debtservicing problems of the 1980s have weakened arguments for foreign borrowing.

Recent innovative suggestions for financing infrastructure investments in developing countries have a back-to-the-future quality. At the heart of the nineteenthcentury debate on financing infrastructure development - - especially railways lay certain concepts: relying on private finance, encouraging the growth of domestic financial markets, and choosing financial instruments that minimize the risk of dependence on foreign funds. Eichengreen reviews the historical record in an attempt to glean lessons for developing countries today.

In the nineteenth century, much as in many of today's less developed and less liberalized economies, not all the informational and contractual preconditions for efficient private or commercial finance of infrastructure projects prevailed. In somc regions, it was difficult to tap investors at home or abroad. Many countries lacked the private institutions (such as universal banks) and public ones (such as regulatory agencies) needed to facilitate monitoring, to discipline management, and to ensure an adequate flow of information to investors.

Irn places as diverse as Canada, India, Spain, and the United States, getting enough finance often required that the government provide collateral (land grants) and bond - guarantees especially where asymmetric information caused credit rationing.

The main lesson: Exploiting nontraditional approaches to financing infrastructure investment requires acdon on two fronts: liberalizing and developing domestic financial markets, and reforming administrative mechanisms that ensure accountability from enterprises enjoying government subsidies or guarantees.

- - This paper a product of the Office of the Vice President, Dceclopment Economics is one in a scries of background papers prepared for _World Development Report 1994_ on infrastructure. Copies of this paperarc available free from the World Bank, 18 18 H StreetNW, Washington, DC 20433. Please contact the World Development Report office, roomT7-101, extension 31393 (48 pages). November 1994.

_The Policy Resarch Working Paper Series disseminates the fsndings of uork in progress to encourage the exchange of ideas about development isses. An objective of the series ss toget the fidngs out quickly, even if the presentations are ess than fuily polished. The papers carry the names of the authors and should be used and cited accordingly. The fndings, inetrprerarions, and conclusions are the authors' own and should not be attributed to the World Bank, its Executive Board of Directors, or any of its member countries._ Produced by the Policy Research Dissemination Center
# Financing Infrastructure in Developing Countries

Lessons from **the** Railway Age _Barry Eicbengreen_ Department of Economics University of California at Berkeley Prepared as a backgound paper forthe World Bank's _WorldDevelopmentReport_ 1994 on infrastructure issues in developing countries. I thank Ashoka Mody for guidance and Lisa Ortiz and Andrea Cu for research assistance.
For low-income countres, infrastructure investments have the most allurng benefits but also the most prohibitive costs. Where transoon, communication, and power generation are least adequate, their provision can do the most to boost productivity and stimnate growth. But where income and productvity are depressed by the inadequate provision of infrastructure, the financial resources needed to undewrite infrastructure investments are the most difficult to mobilize. With the lack of infastructure limiting finance and the lack of finance limitng infastructure investment, countres can find themselves in a low-level equilibrium trap from which it is difficult to escape.

Two obvious possibilities for break out of this trap are government subsidies and foregn borrowing. When the social returns to investnent exceed private returns, subsidies can be justified on efficiency grounds. The classic efficiency argument for subsidies applies if a bit of in re investment increases prductivity and profitabilit, iiting a process of self-sustained growth only a fraction of whose benefits are captured by those who finance the initial investment. Even if the returns are appropriable, investment may still not pay when the cost of domestic funds is high, because the supply of savings is low or domestic capital marlkts are imperfect. Investors may then seek finance abroad where its cost is lower. Where all ihese conditions apply government guarantees and foreip finance will be the norm.

These familia arguments for government intervention and foreign borrowing have met with growing skepticism in recent years. The -white elephants- subsidized by governments have underscored doubts about the efficacy of public finance. The debtI~
sevicing difficulties experenced by developing countries in the 1980s have raised questions about the desirability of extenal bonrowing. Both observations encourage proposals to commercialize and privaie infastructure initiatves and to fund them by encougng the deelopment of domestc financial markets.

There is nothing new about either these arguments or these reservations. Ifrstructur projects were pnvately financed and privately constucted in virtually all the regons that began to develop in the wake of Eumpean industialization in the 19th century. (The relaively modest contribution of the fedeal goverment to public works is illustrated for the post-Civil War U.S. in table 1.) At the same time, government subsidies and extenal finance were integral to the proces of i cture investment. ln the United States, to take a prominent example, early railway lines were essentially private undertakigs. But land grants and govemment guarantees subsidized their constuction. Finance was raised abroad, mainly on the London capital markt The cost of many early American railways exceeded their benefits not just in the eady years but in present-value terms, causing the debtors-indluding the states that had guranteed the bonds-to deult, permanrenly damaging their creditworthiness.

The goal of this paper is to elucidat the patters of public intervention and external finance. Its premise is that these patterns are consequences of the structal characteristics of markets in countries in the early stages of economic development Government itervention, extenal finance and subsequent dfficuties are all corrlates of the financial market imperfections that give rise to informational asymmetry, morl hazard, and adverse selection, while government policies to overcome asymmetrc information can give rise to the problem 2
Table 1. **Federal** public **works pdires** in the United States, **1866-1iS2** (in **million** of **dollars)**

||1866|1870|1875|1880|1882|
|---|---|---|---|---|---|
|Roadsandcanals|0.1|..|0.1|0.1|0.1|
|Forts, armories, and so on|2.2|1.3|1.4|0.3|0.4|
|Light stations, and so on|1.4|2.6|2.9|2.4|2.4|
|Public buildings|0.3|2.2|8.6|2.8|2.8|
|Rivers and harbors|0.3|3.5|6.4|8.1|11.6|
|Total|$4.3|$9.6|$19.4|$13.8|17.3|

Source: Studensid and Kroos, 1952, p. 165.

Akelof and Romer (1993) refer to as 'looting,- when promoters engage in bauptcy for profit without significant shareholde **r** esistance.' Incomplete information, moral hazard, adverse selection, and looting are not limited to developig countries, of course. But the hioicl evolution of the present high income countries and the parallels between their situation in the 19th century and that of developing countres today suggest that such problems are especially prvasive during the eady stages of economic development.

The remainder of this paper is organized as follows. The first secdon after the introduction introduces some thoretical consideions centering on the interaction between informational asmmetries, moral hazard, and adverse selection. These factors, it is shown, can give rise to credit rationing and account for observed differences across countries in the structure of investment finance. The second section introduces the financial and economic ' This is similar to de problem of managemt divers of profits empaszd by Jlen and Mekn (1976), although in the Aeldof-Ronmr modd it is xacwbated by reductiom inseholdwr mitng imnentvew cau by the govemnt gratee.

3
environment in which firms and governments operated during the 19th century, considering both the nature of risks and the mechanisms used to ameliorate them. The fourth Section descibes the financial arrangements that grew up in response. Evidence is drawn from expeiene with infastructre ivestnents as diverse as turnpikes, canals and docks, tramways, and electrical and lighting systems, though railways command center stage. The railways were the most prominent and capital-intensive infastructure investnents of the 19th century. They forged unified national markets, linked domestc producers to the expanding world economy, facilitted the development of modern high-speed-throughput production tehniques, and provided a hotbed for the adoption of modem management practices. For all these reasons they deserve the promience they have long attracted in histones of economic development3 The ffth and sixth secfions consider two devices used to subsidize infrastructe investmet to attract foreign finance: the govemment guantee and te land gnL They show how these worked to relua the credit-atoning constrait but at the same weakeed the incentive for creditos to monitor managemez± encouaging the lamr to divert resources into unproductive uses. The seventh and eighth sections consider the implications for growth of 19th century infrastructure investments, distinging social from prive returns. The last section draws out the lessons for today's developig countres 2 **Any** attempt to **argue** t importance of raiws must confont _Fogs's_ (1964) conclusion tat the social saving due to rilway constuctin the U.S. wer smimmL Fog.'s figmues consder only socid savings due to fright hage, however, neglecting passeg tffic. And given diff across counties in geography and tpogrphy, wblquet studis have yieded **muhlr etimatos** r **otr** prts of the world Nor do soial sv callations attempt to qafy _p_ the dynamic _dffc emphszd_ by athors as diverse - Jeak (1944). Chadler (1965) md Wlliaso (1974).

4
Theoretical Considerations According to the Modigli-Miller Theorem, investors should be indifferent about the composition of finance. If a firm is highly leveraged (it issues a high rato of debt to equit, investors can offset this by adjusting the composition of their own portfolios. In the simplest model, the structure of finance is irrlevant to investment decisions.

In the real world there are several reasons why this strong resut might not apply, bankruptcy costs being the most relevant to this discussion.3 I their presence, the retuMs to bond- and shareholders are asymmetically distributed. The bondholder cannot ean me than the rate of return specified in the bond covenant but may earn less in the event of de-faUlt.4 iES retU is trncated upward. The equity holder cannot lose more than his stake (assumig lmid liability) but stands to make large prfits in the event of a positive outcome. His return is truncated downward. The riskier a pr*ect, the higher the probability of bankruptcy and subnormal retuns for bondholders, and the highe the probabiity of excess profits and super-normal retns for equity holders.5 In the absence of symmetric information, then, the interests of bond and equity holders diverge, and they may find it difficult to conclude a mutually-Acceptable contra Assume, for example, that the prene r knows the probability of filure but that

**3** See Kaon **(1979) and** Stiglitz **md** Weis (1981). Tax **offecte** the other proi.t ModiMlil-Mer Theorem might not hold.

mso why do 4 **This** sta t **goreg capital** - **due** to **Changes** I interest ratls econoMYwid and po asid incases i bond prices due to pior feirs or occrrce of deaIlt

**T** his aSSue a **gin expcted rate of** retu
purchase of his debt do not. As long as all projects yield the same aeectd return and investors are risk neutral, entrepreneurs with riskier projects will be willing to pay more for a loan.' Since information is asymmetric, adverse sdecdon arises: as the interest rat ris, entrepreneurs with safer projects drop out of the pool of potential borrowers. Moral hazrd results, because by raising the interest rate the lender encourages the borrower to undertake risky vestments. Increasing the intest rate may therefore reduce the lender's expected retun. Asymmetric information thus makes it optimal for lenders to ration credit In this model, credit ratoning is an increasing function of the riskiness of the underlying environment and the severty of balmes to the dissmination of informtaion. The greater the dispersion of returns (the riskder the environment), the greater the risk of bankruptcy and the more likely the compoion of finance will matter. In a world where all retuns are the same, moral hazard and adverse selection cannot arise. And tihe more costly it is to sort projects by probability lass (the greater the informational asymmetries), the more serous the problem of adverse sdlection and moral hazard. Many present-day developing countries are prime candidates on both grounds, be thir volatile economies lack eff ctive financial disclosure requirements and altemative signalling mechanisms. ITe same was true of indust g countries outside of Europe in the 19t century.

Asymmetric informafon, adverse selecto, and moral hazard force entrepreneurs with risky but potentially profitable prqjes to commit their own wealth by subscribing

**6** Since al pr4et **yield** the - **expected** ren, risier **prectsl** (which yield notfing in **ta** _evet_ of **filie) yid** a hie r in the evet of uccea Henc, in the evt of succes mteprus wit risie projecb can afford to pay a higher interes **rtt.**

7 I continu to **assume** a unir expeed rate of **retun.** 6
shares. The grater these problems, the more shar capital will have to be subscribed before debt finance can be obtained.

De Menua and Webb (1987) have shown that the level of investment in this equilibnum will be socially suboptimal. In the first best equilibnru math risk-neutral investors, all projects with expected returns equal to the world interest rate should be undertken But some of these projects will not be financed when information is distributed asymmetrically. The first-best equilibrium can then be restored if the government provides an interest subsidy.

An interest subsidy or guarantee can give rise to other problems, however. Though extension of a government guarantee can relax the credit constraint, it will also remove the incentive for bondholders to monitor firm performance. This perits mt to divert resources to nonproductive uses from which it benefits, (Jensen and Meckling, 1976). In the extreme, promoters have an icentive to engage in bankruptcy for profit. As Akerlof and Romer (1993) show, in the presence of permissive public sector supervison promoters will inflate accounting rates of retUrn rlative to economic urs, diverting the enerprise's resources into their own pockets. If bankrptcy results, govenment, and ultmately, the taxpayer will be left holding the bag. This problem will be most prevalent where govemment overght is lax and where promoters and their confedates attach least value to reputational capital.

7
The Environment for 19th Century Infrastructure Investment Infrastructure investment in the developing countries involves a considerable element of ris This reflects four factors common to such settings: the novelty of the technology, the relatively long gestaton period prior to reaping returns on investment, uncetain prospects for local market growth, and the lack of reputation of aspiring promoters. All four problems were severe in the 19th century.

_Sources of Risk_ Initially, there were few places other than England to which poential invtors in tr e projects could turn for information on required outlays and expected retuns. HEnce, a sngle prominent project like the Erie Canal, so profitably built by New York State in the 1820s, could have a powerful impact on the operation of the capital market' The Erie's success thus set off a canal-building boom that engulfed the mid-Adantic and New England coasts.

Many of the technologies involved were new and unfamiliar. The costs of building a canal connecting Bufflo with take Erie or crossing the rolling English countryside provided limited guiance to those seeking to estimate the costs of surmountmg the higher mountans of westen Pennsylvania. It is no coincidence, then, that the canals of Pennsyhlania and Maryland turned out to be more expensive than anticpated and were never profitable. Similarly, information gleaned from experence with canal building was of limited use at the

**S** The Canal wa completed in 1525 at a total coSt of $11 million, $3 million of which cne from curent source and $8 million of whi came from long-tem loss. It was able to mee current inteest paymnut on the debt in itg first year of operation and was paid off fully within ten yea.

8
outset of the railway age.9 Though even in Europe only incomplete information was available regarding economic conditions, the problem was most severn in overseas regions of recmt Eiuropean setement. For regions like the North Ameican West that had onily rcentdy appeared on maps, not even geography could be tkn for granted: one writer recalls a dinner in London where a British investor asked an American visitor whether Cincinnati or Ohio was the' larger city.

The amount of traffic a railway would attact was contngent on the economic development of the adjoining region, which depended on inponderables such as the fertility of the soil, the reliability of rainall, and the exotent of mineral reserves. -Want of local knowledge' was cited in 1852 by the chairman of the Madras Company as an obstacle to atacting exnal finance for railroad building in India.'° Wher the volume of traffic ultimately depended on fte ectent of mineral deposits, uncertainty about reserves posed a fomidable risk; North Ameican railways were built or not built on the basis of crude forects of coal or silver deposits. Where land had to be setded, dleared, and irrigated before it could be fanned, many years might be required before the picture was claified. Cnadian railway building peaked in the final decades of the 19th century but significanty stimulated wheat production (and rail traffic) only in the second decade of the 20th century.?' Even where setment was no at isue, years might have to pass before ' It war mimilarly problematic to extrpolte from expeienc with gas-hintinglmp to detemine the costs ad benefits of eleCtifiCAtioc.

0ocpherm (1955, Lp1SO).

A-nkli (1980, p.260 _adptwim)._ 9
economic activity and the volume of traffic responded. An Indian official in 1846 cited the long gestation perod before profits could be expected as a particular impedimen **t** o railway investment'<sup>2</sup> Foreign mvestors could be discouraged as well by uncertainty about political stability. The hesitncy of foeig investors to place ther fnds in the United States lingered into the 1870s, well after the conclusion of the Amenican Civil War. The unfortunate name given to the 1857 rebellion in India ("the Mutiny') represented a persistent impedinto borrowing.'<sup>3</sup> Along with the economic prospects of the project, it was necessary to evaluate the promoter undertaing it Recently settled, sparnzly populated areas were prme locations for fly-by-night operators. Promoters could strike sweedteart deals with constructon companes, siphoning off the resource of the project and saddling it with an insupportable debt burden. This danger represented a lear impedimen **t** o investment.

# _Mewas of_ **_Reducing Risk_**

An obvious way of reducing these risks was to exploit the informational advantage possessed by local inrestors. Countries with precious industial and commercal development could possLbly fmance infrastructure investment through a limted partnesip of wealthy reidents who were well informed about local prospects. Early tumnpies, canals and railrads had modest capal requments compared with the long-disance rail lines that

**MsPhccn** (1980, pp. **180-1** 1). "3 **M dcPheco** (1955, p.lIC).

10
would follow. A locally-based limited partnership might therefore suffice to raise the

# requisite capital.

New England, the center of American textle manufactring and hence of Ameican industry in the early 19th centuy, illustates the point. The growing number of small industrial towns provided a fertle field for short-haul railroads.<sup>14</sup> New England was also the center of American commerce, shipping, and whaling. Important Boston traders specialized in the China trade, through which they learned how to use entrepreneurid **a** l nd manageial tecnques to overcome long spans of tie and distance.'<sup>5</sup> Much New England railway finance was raised in the same way that the region financed its textile mill, namely by relying on family, fiends, and personal contacts. Where contract enfo was problematic and information was diffilt to verify independenly, the markets made beavy use of such links.' Friends and associates would vest their confidence in iddual finaniers with reputations for honest dealing who signalled tieir commitment by putting their own funds at risk?<sup>7</sup> The danger of looting by fly-by-night opators was corepondingly reduced.

The great majorty of early American railway shares were subscribed by relaively sphisticated local manufcturs, farmers, landowners, bankers, merchants, and contractors. Not only did these indivduals have superor access to information, but they stood to benefit

> **14** Chandlr (1954, **p.25S).** Johnson and Supple (1967, p.30).

16 For detais, ae Lamuxea (1986).

> **17** Raidis (1988, p.<sup>2</sup> 10). As Jobnon **mnd** Supple (1967, p.338) put **it,** *investurt **tened** to **be** a cumulative al process in **ma** enviroment **lading** an impesonal **national** _nwcyn_ **_m -ke_**

11
the eteaites associated with ithe constuction of transporion links." Many early syndiates were led by textile producers seeking roads that would serve their mills and Boston merchants loolkng to railroads as a link wuffi the hinterland market and the Great Las.

This model was difficult to generalize, however, because the captal requirements of early nilways were more modest than the successors and the funds available in New England ecceeded those of other developing regions, which had to seek extrnal finance. Railway shares and bonds tended to be traded in distant market before such trade developed in the liabilides of manufcturing and commercial concemns. Manuf used more eotic technologies, and commercial undertkngs had less tangble forms of capital (receivables, for example). This required greater sophistication of investors. It was more strightforward to compare the costs and quality of raiload construction taversing similar terains than the intangible informational capital of a mercantile company. The railways were thus among the fist enteprs to access eternal finance on a significant scale. As eary as the 1830s, a number of railway lines around Philadelphia and several lines in Virginia and North Carolina were able to market bonds in London.' The pattern perdsted: as late as 1914 railway bonds accounted for perhaps half of all outstanding foreign investments in the United States.2

**Pai (1984, p.156). " Bain** (1988, p.211). **Adler** (1970, pp.l1-ll). **Woodruff (1967,** p.119).

12
In tem of accessng external funds, railroads benefitted from the fict that some of the knowledge needed to evaluate project risk could be tansferred across space. External finance of British raiways was rlatively well advanced; the experience of British investoss heped them to evalte the prospets of Ameican lines.?

Notwithstanding these advantages, extemral investors were sill andicad by incomplete information? This led them to shun common shares. Prior to the 1850s foreign investors underwrote U.S. railways primarily by purchaing government bonds that were issued to hdp finance railway construction. Only New Englanders invesdng in westem and southern railways were inclined to purchase securites issued by the railways tbemselves. Boston began in the 1840s to invest in the roads of the U.S. South and West hrough personal contacts. Railroad men comig to Boston contated merchnts who had invested previously in local railroads. The promoters invested their own money, signalling their commitment, "and taked fiends and close buiness acquaintances into **aling** _shara_ in **it.'2** Long-fl relations between weter promoters and Boston mercants and between the merchans and thir personal tacts provided a reliable conduit for information about investment prects and their promoters.

Luring overseas investors required , inrmediation of spedaizd institutons that had grown up in the London market issue houses, prvate banks, bill brokers, and financial

# **22skin** (1988, p.22.

2 I **r** to **textndm rter thu foumi*' investo for two rasos.** Firt8, coutis **suckh a Chad ad India whh were not idepmndet rlid n externa finace rom &e colonial cater, Gre Brita Send, lat deveopig regos i contnentul** ec_ **lk. Wested Undited Ses reiod a anoa fiance, frm alier developing regns such s** New **England Nichols** u Bildle **and** oder **merchs anld banks. plyed** a **similr role i Phbiadpb. Candler (1954,** p.259).

13
investment companies. (The importance of these various institutions is summarized in table 2.) In the 1820s and 1830s Brtish investors purchased American state securities and canal bonds recommended by Samuel Gurney, the Quaker bill broker, and American Joshua Bates, managing partner of Baring Brothers from 1825 to 1864. Ihe head of a British investnent banking firm like Barings would only occaionally visit the region in which the investment took place but retained an Ameican agent to monitor developments. Here, too, peronal contacts mattered: Barings replaced its furst American agent, T.W. Ward, with his son, Samuel Gray Ward.

Table 2. roportion of Overseas New lhsues lItrodued by the Main Type. of lisuing H}ues, 1W70-194

||Official<br>ad wemi-<br>official<br>agenciets|Private<br>banke|Joit-stock<br>bank|ov0a<br>ban and|Companis<br>vi thir<br>bankss|Oher<br>**nmi**|Totll<br>anwunt<br>insed<br>**(finiin)**|
|---|---|---|---|---|---|---|---|
|1870-74|1.8|53.0|4.4|9.6|18.2|13.0|390.6|
|1875-79|14.5|36.5|0.8|24.7|13.0|10.5|149.2|
|1820-84|6.7|38.5|3.3|14.1|26.7|10.7|355.3|
|i8S-89|9.9|43.7|5.3|7.5|26.1|7.5<br>|479.2|
|1890-94|10.4|46.4|9.0|8.8|19.6|5.8|349.6|
|1895-99|8.7|25.1|11.2|20.3|25.2|_9.5_|359.6|
|1900-04|27.4|19.2|17.8|14.4|16.7|4.5|258.2|
|1905.09|10.3|32.7|12.2|22.4|18.7|3.7|509.9|
|1910-14|8.3|35.2|17.4|18.8|17.5|2.8|783.8|
|1870-1914<br>Tota|9.8|37.2|10.3|15.4|20.5|6.8|-|
|amount||||||||
||_(u)355_|1,354|371|562|746|248|3,636|

# a. For exaalplc, merchin bank=r

- b. Conqpising: invsuent trut (£23n uUion); finance, lund, aLnd prapediy comies (£18 nil ion); specid purpose syndicat (Mi mllIion); issuc hou with stDck exchane connections (222 miDlion); companics a ueir own iBsuers (13nmiion); and mnellaaeous isuers _(fL31_ nmilo).

- Source: Bsed oc a table prepard by W.A. Brown publshed in 7h _Econovi_ (November 20, 1937) and rprinted in Balough, 1947: 233.

The leading **invesment** houses **spedcalid** in **recommending only the hihst** quality foreign bonds. To **signal** their **cotment** to this advice, they bought **the** same bonds for 14
their own portfolios. Typically, these were bonds of roads backd by ste government credit or bonds that were partculary well known and long established. Many British investors limited their purchases to a few large eastern companies for which infonnation problems regarding western companies were least severe.?

Other Europeans (mainly the French, Swiss, and Germans) invested more widely but conducted le business with European-based intermediaris like Barngs, relyg instead on American investment houses. Rather than paing them up with mstitutonal partners m the home country as the British did, these Europeans dispatched to America a representative to examine the prospective investment in order to ascertain e value of the securities.26 The immigrnt community fonned another conduit for information. Specialized publicains such as _The Amerk alrd Jown_ and _Poor's Mwwaf tae Rairoads of the United Sates_ also provided information for investors. From the 1860s, Brtish investors organized _thmselves_ as the Council of Foreign Bondholders and te English Associatin of Amidcan Bond and Shacholders to collect information on arrears and negotate th debtors. Protective or ons were established also in France, Germany, and Holland27 Though most American **railway** bonds were sold privately, a sewndary market **in** these securities had sprung up by the 1850s. Increasingly investors turned **their** attention from bonds to common shares. Stocks were not marketed by the usual issuing agencies; they 2 Adler (1970, p.66-67).

' AdIer (1970, p-<sup>47</sup> ).

**2'** On the operations of the Council of Foeign Bondholders, soe Eichgrc and Portes (1989). Wiins (1989) motes that tie newspaper files of the Coumcil include 25 volumes devoted to American **raiways**

15
had to be obtained from American railway offices in England or, more commonly, from jobbers ancl dealers who purchased blocks in the U.S. for sale in Europe. itially, only the most reputable issues were traded on the London Stock Exchange. Their numbers grew quickly, however. The directors of the Exchange provided only a weak filter for dealing with problems of asymmetdc infor'natioBn "Before 1914 the Stock Exchange made no attempt to restrict or control in any way the right to deal in any security, whether British or foreign....it was in general more concemed with aementto ensure a reasonably free market in the securities than with the intrinsic merts of the company or with the adequacy or accuray of the infonnation provided."22 The Exchange's ability to restrict entry was himted by competition from provincial exchanges and outside brokers and bucket shops. From the **mid-1880s** _The Economist_ began to publish quotations for American rails not listed on the London Exchange but nonetheless extensively traded.?

In addition to personal contacts and specialized investment brokers, foeign investors relied on the signal of hiird-country management A substantial share of late 19th century British investment in Lain America was in enterprises controlled by Americans and Canadians. North American investors faced the same risks as their Britsh counterparts but, enjoyed advantages of proximity especialy in the cases of Mexico and Panama (still officially Colombia). Prior U.S. and Candian borrowing had established links with the London market that could now be used to channel information from Latin Amenca back to Bntain.

Pidsh (1951, p.4).

Adler (1970, p.158). Trading an other European exchanges was active as well. As ealy 1875, 63 U.S. railway ises were **listed** on the Amstrdam Exchange. Wilkins (1989, p.202). U.S. railway es were also actively traded in Berlin, Paris, Geneva, Zurich, Basle, Brussel, and Antwerp.

16
The involvement of Americans and Canadians with whom British investors had long-term relationships maximized information capital and prevented British foreign investments from being looted. Bntish investors took shares in Canadian-controlled public utilities, tramways, and railways throughout the Westem Hemisphere. On the eve of World War I, Canadiancontrolled enterprises represented more than half of all British portfolio investment in pnvate industry in Latin America and nearly half of all British public utlity capital invested there.<sup>30</sup> Risk could remain even where information was not a problem, given the uncertain prospects of the regions of recent settlement. Large investors could eimiate the unsystematic component of this risk by holding diversified portfolios of railway bonds. British, German, Russian and Canadian insurance companes, which invested heavily in U.S. railway bonds, could follow this strategy. So could English and Scottish commrcial banks, many of which held substantial portfolios of American railway bonds,5' Similar oppornities were offered to smaller investors by investment trust companies, the equivalent of modern mutual funds. Most of the early trusts were unincorported. Shares were typically issued in £100 denominations. The first investmen **t** rust, the Foreign and Colonial Govemment Trust established in London in 1868, spawned a number of imitators. In 1873 its five tustees founded the first trust company devoted solely to investment in American railway securits. Some tmsts followed highly conservative investment stategies, investig exclusivelyn high grade bonds, while others branched into more speculative activities like

- Stoe (1977, p.715). 31 See Goodbt (1972).

17
the underriting business, floating railway securities themselves.

# Patterns f Infrsructure fmuance

These institutional structus, superimposed on an environment of asymmetrc information, yilded a predictable pattern of ifrastucture finance. Not every piece of infrastructe was financed in the same way, but the exepdons to the pattern and the distinctive features of the proects with which they were associated yield useful information on the operation of contemporary markets.

Early infruc investments were almost always financed locally?' Residents had the most complete Imowledge of local economic prospects; local finance, by liniting asymmetrc information, minimized problems of adverse slection and moal hazard. Local residents had lonterm riosips with the promoters, whose reputatonat capital would have been put at risk by looting.

Not surprisingly, then, early New England railways were financed almost entirely out of equity.? Significantly, however, these projects we relatively modest, only connectig Boston with Portsmouth or Providence. A more ambitious railroad built in the late 1930s and early 1940s, the Westem Railroad linking Boston with Albany, had 2000 stokholders, more than half of whom were located in Boston. Only 17 percent had 100 or more shares as Plait (1984, p.128 **_audpwsim)_** insists on his fict. Johnson and Supple (1967, p.36).

18
of 1841.4 Anote example is the early Spanish railways, Which wee financed domestcally from the 14Os. Although foreign financiers, eneneurs, and gine took part, te major share of capital was Spanish.35 The undedeveloped state of markets could, however, pose an obstacle to mobilizing local finance. One example of the difficulties presented by imperfect commodity and capital marbet was the attempt to market bonds for the StL Lawrece and Atlantic Railway in Canada in the 1840s. Some of the Canadian subscriptions were paid in the form of pork and eggs for the sustenance of construction gangs, since many farmers lackd cah. Certain early U.S. railways similarly took subscriptions in the form of labor and materials?

These early railways were short and cheap and hence had relatively modest capital requirements. The transition from turnpioes to canals and then to long-haul railways over me made it necessary to raise more funds than could be mobilized locally. Extemal finance was not a substitute for local finance; rather, it was a supplement Locals still needed to put up capital as collaten! ;n order to mdicate twilingness to put fteir money where their mouths wer Extenal invest could th be assured that those in the best position to assess the needs of the project and monitor its progress and the actions of its prmotes would in fact do so.

Externl finance for inftrastucte investment might come from more advanced areas within the same country, as in the case of New England's investments in the U.S. South and 34 To cona the roed from the sate line to Albay, the city of Albay subscribed the ei capitl dock, paying for it with city bonds Johnson and Supple (1967, p.<sup>43</sup> ).

's Wais (1974, p.159).

Eastebrook and Aitkon (1961, p.297); Cleveanmd and Powell (1912, p.30).

19
West. Where advanced regions did not exist and e capital requiremts of the proect exceeded the resources that could be mobilized elsewhere in the country, promoters and governments engaged in borrownng overseas. Where as the short, cheap Spanish railways of the 1840s were heavily financed by local interests, their more ambitious successors, such as the Norte and the M.Z.A., found about half of their capital in France.37 The financial instruments employed varied with economic and geographical distance. Nearby lenders, such as New Englanders lending to the American West, often purchased common stock because personal and business contacts provided a reasonably reliable flow of information. Some of the short, inexpensively-bui **l** t ines of cental New York were able to supplement local subscnptions with sales of stock in New York City.<sup>3</sup> A substantial block of shares in Canadas Welland Canal, built in the late 1820s and 1830s to ircumvent Niagara Fails and open Monteal to westen trade, was .purchased by a group of ivestors in New York State. This was the only Canadian canal which attracted significant foreign investment; prommity to New York and the stae's xperence wnth the Eie Canal played a facilitating role.' British investors in American railways, whose economic distance was reduced by institutions such as investnent houses and stock brokers, often prefered stock as welL40 3 Pla (1984, **p.129).** 3 Trading in these sres played a central role in early development of die New Yok Stock ExchangeL Chandler (1954, p.254).

3Ulnimately, revenues proved insufficient to pay for mmienauce. In 1837 the provincial goverment took effective control of the canal and formal ownership passed to it in 1841.

' Estimatn for years around the end of Ihe prewar perod nonethless suggest that the majority of **Bnrti** investments **in** Am rails took **the** form of bonds. **See** for example Lewis (1938), who suggests **tbat** the value of British holdings in bonds, aound 1914, **was** two and **aneaf** times the value of **shares.** 20
Otiers more typically invested in bonds, which were less risky than the residual claim of common stock." Ambitious infrastructure projects such as long-haul railways relied primarily on bonded debt. A very few railways, for example certain early southern lines, were able to issue stock, but these relied on the municipal guarantees of cities like Charleston and Savannah.42 In the case of Spain, foreign investors avoided stock, despite the fact it was widely taAded in Barcelona. Common stock represented only 40 percent of Spanish railway capital as of 1864.

American railway bonds could run 30, 40, 50 or even 100 years to maturity.<sup>0</sup> They were secured by mortgages on the raiiroad's property or enjoyed a government guarantee. Many lines issued bonds that could be converted into stock at te holder's option. With time, this "long-term convertible mortgage bond' became the standard investment vehicle for American railways." According to Adler (1970), all but one of the Anerican railway issues that found favor in London before 1852 were convertible bonds.

One of the extra risks faced by foreign investors was that posed by exchange rate fluctuatLons. mlustrations from the United States occurred in the suspension priod during and immediately following its Civil War and in the 1890s, when doubts about the stability of the dollar exchange rate resurfaced. Latin American countries xpienced even more Other contpoy estimats put the ratio n high s nine to one. **See Wi** (1989, _p.725)._ 4' Chndler (1954, p.<sup>2 48</sup> ). As Jacob Schiffof Kohn, Loeh put _dto_ point in 1913, stoks go wrong more rquently than bonda' Cited in Wilkins (1989, p.725).

I Chamdler (1954, p.250-251). More infimation on govenmet guarantees folows in the next 4 **Wilcins** (1989, **p.725).**

**_Chandler_ (19S4, p.250-251).**

21
frequent bouts of exchange rate instability. A few well-established railways of tie eastern United States, such as the New York-Wilmington lines and the Pennsylvania coal roads, were able to issue sterling bonds. Lower interest could be offered on those bonds because exchange risk was absent.Y Thus, once the Michigan Centra had proven its viability, it was able to issue six percent sterling bonds rather than eight percent convertible bonds.<sup>6</sup> But this was feasible only for railways with steady incomes and ample reserves.

The problem with relying on bonds, as foreign investors in infrasucture project did in the second half of the 19th century, was that, in tie prevailing environment of imperfect information, adverse selection and moral hazard incrased with leverage. The portfolio of project contempling debt finance grew riskier as the intrest rate rose. Promoters had an incentive to take on excessive debt (to water their stock), because they stood to make huge profits through leverage if they succeeded but could lose no more than thi equity stake if they failed.

Contemporaries consequently complained that many worthwhile investment projects could not raise exal finance. This credit rationing created an obvious argument for government intervendon.

# _Govemmnm Guarantea_

'When great schemes of public utility are brought before the country," wrote _7he E7onomit in_ 1858, 'it is natural that the Government should extend its aid to such < Some also issed gold bonds, inte ad pnncipl an wlich was payabe n gold Adr (1970, p.SS-56.

22
enteprises."7 The prei was that the social benefits of such project might exceed the private returns.A Promoters employed this argument to their advantage, emphsizing the benefits to society at would result from the successif completion of such investments. In the case of infrastructure investments, government aid took the form of outight subsidies and aid in ldnd (often fianced by the issue of bonds daignated for the pupose or the earmarling of revenues) and guarntees of interest on bonded debtY In Spain, the railways received subventions from the government as wel as tax ecemptions and trff **ConlcCSls** on imported raiL Canaian govermments borwed $20 million for canal purposes in the 1840s alone.' In the United States, of the US$195 million allocated to canal construction between 1815 and 1860, US$121 was spent by state govenments, only $74 million by private companies<sup>5</sup> l State and local governments were also fundamentl subscribers to the securities of the early Ameican railroads. Prior to 1840 nearly all the great est-west projects-both railways and canals-were financed by public bonds. In the case of the Western Railroad Corporation of Massachusetts in the I0s, for example, the Commonwealth of Mahus took a one-third partnrship in the railway, which k finaced by floating state paper in London.' The State of Ohio subscribed one share in its state's railroads for every two shares purchased by private investors. The costs of these 47 Cited in _M1 &nJs_ (1955, p.181). **s'** I report some of the evidnce asn priva and soda rn:tu below. **4** Anoter form of aubaidy, _the_ land gran, in the subject of the next macdon. :e Jm (1938, p.204). **£** _Crsmner_ (1960, _p.558)._ 8 Plait (194, p.156).

23
projects were said to be too great and their profits too uncertain to attct adeqate private capital.' Only thie early North-South railways and the Pennsylvania coal roads were paid for largely by bonds of private coxporations. These lines were shorter and cheaper to build and more certain of regular traffic.

Subsequent investigations are consistent with the view that railways trw off positive extenalities. Fogel's (1960) study of the Union Pacific Rairoad in the United States, for example, estimated that the social return averaged 30 percent per annum, two and a half times the private return.' Yet it was far from clear that pnvate entrepreneurs were unable to capture thcse exteralties. Adjoining lands whose productivity and value were enhanced by investment in a tunpike, canal, or railway could be and often were purchased by the pmmoter of the ifrstructure project Textile mills and mercantile enterpises whose profits were boosted by infrastructure investments that provded a steady supply of raw materials to the factory and finished products to the market could be and oftn were owned by those who organized infrastructure projects. This ability to internaliz **e** xternalities clearly weakeed the case for subsidization.

A second justfication for government intervention was to offset information asymmetries and capital market imperfctions. Even if social retums could in principle be captured by investors, incomplete information that resulted in credit rationing might prevent them from doing so. Though this rationale receives less attention in the literature, it provides an explanation for the form taken by many subsidies: interest guarantees on 5 Chandler (1954, p.249).

**56** Fogel (1960, p.106). I return to this issue of social retuns in the section an social impact

24
government bonds.<sup>55</sup> This device was prevalent wherever canal and railway construction took place. In India, for example, if a company did not attain a minimum rate of reurn (about five percent, at the time) it received compensation for the difference from the Govemment of India under the terms of "the guarantee." The interest clause in the bond covenant was backed by the govemment's full powers of taxation. All of India's early railways, including the important lines running inland from the pOrt cities, were built under the guarantee. The less certain the local economic prospects, the more powerful the effects; government guarantees were therefore particularly effective in attacting foreign investors. The motives of the British investors can be explained almost entrely in terms of the five percent guarntee of interest offered by the Indian Government," as one Indian historian concluded." Without the guarantee, infrastructure projects were impossile to finance.? Once the guarantee was provided, however, Indian railways had no difficulty in accessing the widest possible marlkt. The Indian bonds bore interest rates several points above those offered on Brtish consols and were regarded as perfectly safe. Investors included conservative widows, banisters, clergymen, spinsters, bankers, and retired army officers.

In Canada, canal projects in the first half of the 19th century received government M If credt rationg **was** he distortci, **then s** intmmst gaua (or susdy-this section) was the firt-best fom of intervenfios. If positive extenzalities were the distordon, m conrst there would be no argumet for iterveng in ways that might affect _tie fir's_ capital str.

" Miphbeson (1955, p.180).

**5** Because the North Bengal Company was refsed a guarantee, it was unable to **begin constuctioa** and ali deposits were tmed to shareholders.

25
guarantes under ffie aegis of the British Colonial Office? Before 1849, attemptS to build railways in Canada had foundered as a result of difficulties in aising capital. That year the leglature passed a scheme for govemment guarantees of interest at a rate not over six percent on half the bonds of any rAilway over 75 miles in length, provided that half the railway had already been built.' Once the guarantee was secred, Canadian railways were able for the first time to attract significant amounts of foreg finance, mainly through the participation of a few large Boston and New York capitalists already experenced in rilway building and management.

The Grand Tunk Pacific, in its fte the single laqest investent project undertaken in Canada, mlustates the financial structue that might resuLt On the pairie secto from inmnipeg to Wolf Crek, Alberta, the government guatanteed thr percetnt bonds for first mortgages in the amount of $13,000 a mile. On the remainder it guaranteed similar bonds for 75 percet of the total construction cost. Moreover, for the fit swen years the government paid the intest on the bonds it guaranteed.'0 The imporance of guarantees grew with the cpital requm ts of the project. Canada later began the construction of not one but three transcontinental ailways, for which considerable amounts of foreign capital were imported (see tables 3 and 4); Glazebrook (1938) concluded that not even one could have been built without govemment garantees.

leaks (1938, p.199).

s Etebok mud Aitkca (1961, p.298).

* For debits, we ANki (1980).

26
Table 3. Disttibulion of Total Flow of Capital to Canada, 1900-1914, (millions of dollams)

||AR1<br>countries|Grea<br>Bnitaia|Unite<br>Sutesw|torw<br>countries|
|---|---|---|---|---|
|MeipFal_govew__|260|200|60|-|
|Rtairoads|767|670|_S0_|47|
|Jnduatrial|630|420|180|30|
|LandSId finber|305|80|145|80|
|Mining|125|65|60|-|
|Insumnco|a2|32|_50_|-|
|Other|198|111|81|6|
|Totl|_2,546_|1,753|630|163|

Source: Buckley 1955, p.90.

Table 4. Gross Construction Outlays in Major Tansport Mdds in Canada, 1901-1930

|Period|R-ailways|<br>Hlighways<br>Can|als and harbors|Total|
|---|---|---|---|---|
|||V*luo (milhons of dollars)|||
|1901-05|124.3|3.3|32.1|159.7|
|1906-10|380.7|11.7|48.0|440.4|
|1911-15|537.4|38.5|93.7|669.6|
|1916-20|_252.5_|39.4|59.7|351.6|
|1921-25|253.2|100.4|109.8|463.4|
|1926-30|389.4|172.4|138.2|700.0|
|||P}etage<br>distnrbution|||
|1901-05|77.8|2.1|20.1|100.0|
|1906-10|86.4|2.7|10.1|100.0|
|1911-15|80.3|_5.7_|14.0|100.0|
|1916-20|71.8|11.2|16.9|100.0|
|1921-25|54.6|21.7|23.7|100.0|
|1926-30|_55.5_|24.6|19.7|100.0|

Source Buckldy 1955, p.<sup>3 2</sup> .

27
Government guarantees were not an unnitigated blessing. While they helped railway promoters surmount the problem of credit rationing created by asymmetric information, they also removed the incentive f.or investors to monitor management performance. Investors no longer stood to lose-or to lose as much-if promoters and their confedeates diverted resources from productive uses. This gave the latter an obvious incentive to negotiate sweetheart deals with those responsible for construction and supply in order to channel funds into their own pockets. Because many infrastructure projects were one of a kind, the practice was readily disguised. Reasonable costs of idiosyncmratic projects like railway and canal construction are intnnsically dificult to ascertin. Many partners in such projects were only tempoarily involved and thus had little reason to be detered by potential damage to their reputations as promoters. Meanwhile, only those ultimately responsible for the financial liability-or more precisely, their elected reesentatives-had an incentive to monitor such activity. Guarantees therefie could (and did give rise to lootng. The prevalence of looting is difficult to verif, given the problem of definitively establishing minimum feaible constuction costs. Yet the correlation between cost inflation and bond guarantees for 19th century infstrucure investment is suggestive. Again, Canada's Grand Trunk Railway illustates fte point. Reall that the Canadian govement guarnteed first mortgae tree percent bonds in the amount of $13,000 a mile on the praiie section and that it guaranteed similar bonds for 75 percent of the total constrcon cost on the remainaer. Almost immediately the company found itself unable to pay interest on its bonds. To a large degree its problems reflected "unanticipad cost of constuction."" B **Eastbweok and** Ait= (1956, p.309 **and** _passim)._ 28
Contractors pressed for the construction of new links to the railways of New York and Michigan rather thn the use of existing lines. In 1851 Czowski and Company, a contracting fimn run by former directors of railways with connections to the Grand Trunk, was awarded the contacts for the construction of these lines. The contractors received their pay in cash, mand the indvidual members of the firm realized sizable fortunes."2 In contrast, British contractors who were dealt with at arm's length received less generous compensation. Overall, construction costs proved much higher than expected. Existng lines were added to the network for 'inflated' purchase prices. Operating e ses in the first ten years ranged from 58 to 85 percent of gross receipts instead of the forecasted 40 percent that was tpical _of_ other railways. All this is consistent with the predictions of the Akerlof-Romer model-that unlimited govermnent guarantees extended to relax credit-rationing constraints weaken the effectiLeness of corporate control if they are not accompanied by effective public sectr oversight and regulation.

Land Grants Another form of govenment intervention was land grants. These can be justified on exality grounds; ceding adjoining land to railways and canals allowed promoters to nternalze many of the positive externalities trown off by their investments. An alternative and arguably more accurate interpretation is that land grants corected capital marlkt imperfections in the same manner as interest guarantees. They provided collateral that could Eaebokand Aid (1965, p.310).

29
be used to back bonded debt. Land grants were pticualy attave to governments for which interest guarantees implied ffie imposition of hily distortionary taxes.

Bonds baclkd by mortages on land had minimal bankruptcy costs compared with other bonds. Interest and principal owed to the prmary creditors could be paid off trough land sales in the event ta the investment project failed. The loan was filly collatelized, mitgating the problem of moral hazard and adverse selecdon that otherwis give rise to credit rationing.'<sup>3</sup> This role of land gants is reflected in the fact that the only American railroads that were able to issue regular bonds as opposed to convertible issues received land grants." These secues were issued separately from the other bonded debt of the enteprise. Altematively, receipts from land sales could be mortgaged, as in the case of the Atchison, Topeka, and Santa Fe railroad, which issued "land income" boads. This bacing was especialy attrctive to foreig investors for whom monitoing and information gathering was least practicaL In principle, the land gants offed **to** railways in North America and lsewhere were m strictly limied scope. Compared to an unlimited guarantee, this should have done less to discourage monitoring by outside investors. But railways receiving land grants that subsequently ran into diffculties were often extended inteest guarantees and other forms of subsidization. In practice, then, the negative side effects of land grants were no less pronounced than those of bond guarantees.

0 **_At_** least this was tre of early mortgagp bads. Susquently some pwmost isued coiatmuI tru mortgage bonds tat were seued not by real popety but by the docks and bonds of otls compis. See Bryant (1971) for detabs.

* Adle (1970, p.54-55).

30
The land grant policy was taken to an extreme in North Amenca. Approximately 150 million acres of land was granted to western U.S. railways between 1850 and 1870. The policy was di nued in 1871 (coincidentally, the same year it was adopted in Canada). The Canadian House of Commons described land grants as a wray of subsidizing ailway constuction without having to rAise the rate of taation. (Defaults on guaranteed bonds in the 1850s and 1860s had led to a painful drain on govenmment revenues.) Initially land was granted in alternating blocks twenty miles deep and six to twelve miles wide, one going to the railroad, the next reserved for ffie government Collateal was most valuable in places with the least adequate information and the greatest potential for moral hazrd and adverse selection. In India, for example, the govemor-geneal recommended in 1846 that the East ndian Railway Company be given land and a capital guarantee for a railway to rua from Calc up the Ganges, a venture too speculative to be supported by pnvate subscriptions alone. Parliament considered the question, concluding that if the East India Company was going to give subsidies to any railway, pref ence should be given to one that would benefit cotton. After months of discussion it was decided to give land and interest guarants to severfal **Upal** lines."'<sup>5</sup> The U.S. land grant policy has been stued in devil. Fishlow (1965) esfimates that the land subsidy amounted to roughly five percent of total U.S. railroad investment during 1850-1880. Other authors (such as Mecer, 1969, 1972) come up with smalle numbers. If the land was used to fully colralim a comparable amount of borrowing, a

**JPnk** (1938, p.210).

31
railway's credit constraint would be relaxed only slightly. This conclusion may be misleading, however. Land grants were not uniformly distributed across the rilways constructed in this period. They were concentrated in the period 1865-70 and were received disproportionately by certain roads, including the first transcontinental lines, the kind of risky investments that might otherwise have found it difficult to secure adequate funding. Mercer concludes that many land grants were wasted; they were given to railroads th would have been built in any case. He bases this presumption on the finding that the private rate of return exceeded the return on alterative uses of funds-hi other words, at the railways still would have wanted to borrow at the prevailing rate. An asymmetric information perctive casts doubt on this conclusion, because it implies that some railways denied land grants might not have been able to access external finance at any price.

Social **Ipact** 19th centuy infiastructure projects dramatically reduced the costs of communication and tanspor (see table 5). The ontribution of external finance to project completion varied according to the wealth of the indigenous populadon, the density of setlement, and the ability to mobilize domestic resources. In the United Staes the majority of infras investment was financed from domestic finds. (Even there, foreign investmt could be important for certin citical sectors, such as railroads, as table 6 illustrates.) In Africa, at the other extreme, the largest share was financed exteally, especially for expensive prects such as railroads.

32
Table S. **Cot** of **Inland Transport** in Selected Countries, 1801-1960 (i US **mnts** per daort tonuzile)

||**United**<br>Kingdom|**Frnmco**|**United**<br> <br>**Stat**|**Ausualia**<br>**(Now**South Wales)|**India**|**Japa**|
|---|---|---|---|---|---|---|
|Road|||||||
|1800-20|18-29|-|30-70|-|-|-|
|1830s|13-22|5-11|12-17|-|12|-|
|**1860s**|-|-|-|13'|(s)b|-|
|Early l9th**centz**|**s-r**|24|(1.7-3.4)'|-|-|-|
|Rdaway|||||||
|1850|**(3-S)**|2.2'|(4.1)9|-|_|_|
|1880|2.4"|1.7|1.2|**4.1**|2.0'|-|
|1900|2.0|**1.3**|0.7|2.3|0.9|0.9|
|1920|2.2|1.2|1.1|1.4|0.8|1.0|
|1938|2.3|**1.7"**|1.0|**2.0**|1.0|0.7"|
|**1950**|2.2|2.1|1.3|1.6|1.0|0.8|
|1960|3.3|2.5|1.4|3.6|**1.1**|1.6"|

Note: Road and **canal figures a mosdly** approximate. Bracmts denote incomplete figures. Railway figues refer **to** averag receipts for goods carded by rail **and** are **fiom the** following **dates** onwards: **UK** 1820, **France 1850,** USA 1870, Australia (New South Wales) 1870, india 1900, **Japan** 1890.

1871 figure **'New** York **State** rilway. b 1861-2 fig=ue **for Cotton only** 1885 figure S **SeeWJ** acm -die _ACan_ route, 1830-50

**J 1874 fgure I** lncrase m 1938 **pary** accouted **for** by ew **method** of

Yorksire d **Iancasbie** railways for 1852-3 **193-7 fig** '1851 figure **A proximate** Source: Woodruff 1967, p.253.

In Asia, external finance was relatively small and unevenly distributed. Certain sparsely populated countries such as Malaya received large amounts of foreign investment per capita, fincing almost all of iheir infrastructure out of foreign fund. India, operating under the guaantee, received disportionate quantities of foreign investment. Most castes **had** a background unfavorable to financial involvement; hence Indians **provided** relatively little capital for these enterprises, concentratng instad in small-scale trading ventures.

33
According to data cited by Woodruff (1967), on the eve of World War I wme th-quarters of recorded investments in India had been financed by foreign investors, two-tirds of which were devoted to the railways.

34
Table 6. Estimates of Long-term Foreign Investment<sup>in the United States, 1853-1874 ($US miflions)</sup>

||||Governent|||||Pri|vae Sector||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
|Datw|Totdal|Podae|State|County/<br>city|Bank|Canal|Riroads|Isurance|Minig|Manufauing|Utilities|Other|
|1853<br>1854|22.2|27.0|111.0|21.5|6.7|2.5|52.1|0.4|0.7|0.1|0.1||
|1856<br>1859|241.0|15.0|111.0<br>40.0|21.5|6.7|2.5|82.9|0.4||||1.0|
|1861, Jan.<br>1863|444.0<br>200.0||||||100.0||||||
|1864, Mar.||150.0|||||||||||
|_1865,_Mar.<br>16S, Jue||320.0|||||||||||
|<br>1866|600.0|350.0|*-150.0o||||100.0||||||
|1867||486.0|||||IS0.0|||||21.0<br>|
|1868|938.0|700.0|60.0|||7|243.0||10.0|||25.0|
|1369|1,390.5|1,000.O|100.0|7.5||5|||||||
|1871||845.0|||||||||||
|1872|1,.0||||||||||||
|1873|1,S00.0||||||||||||
|1974|1,500.||92.9||||390.0||||||

Souc: Wikins 1989, p. 91.

35
FoMign investment played a smaller role in China and Japan. I China it was oncentratedin British-owned businesses, mainly trading companies, in tie Shanghai area. Only one-seventh of Brits funds went into transport, most of it was devoted to shipping. The French contribution to infrastructure was more important: French capital financed railways connecting French Indo-China with China and penetrating into China's inteior. About one-tird of foreig investment in China as of 1913 was devoted to transportation. Japan was essenfially cosed off to foreign investment prior to 1900. Only therafter did the government begin to float bonds on the London markt to defay the cost of its wars with China and Russia and to help finance public utilities, including railroads.

Europan investment in Afica was driven by strtegic as well as commercial motives. ITe fonmer, eptomi by the French-financed Suez Canal, dominated in North Africa, while the latter was the driving force to the continent's south. There, Europan money financed railways and ports to open up the interior, with its diamonds and gold, and to exploit opportunities for plantation agcultue. French fimds, attrsted by government guarantees, financed the construction of railways and porU in Tunisia, Algeria, and Morocco (where Spanish money was also important).6" Exena funds also loomed large in Austrlia and New Zealand, both bause the counis wer sparsey populated and because the colonial connection helped to overcome information problems and other rsk Bnrtsh investors financed rually all of New Zealand's pre-1913 pubLic worls, including the railway and harbor systems. Population increased more rapidly in Australia, fcilitating some domestic fiance of pubLic works. But much infrastructre investment, in railways, ports, and urban public works, was financed through borrowing in London, particularly before 1850 and after 1880. Recent studies of latin Ameica (for example, Stone 1977) have produced a deailed picture of I A few loans wero mised directly from govenmet agencieasuc dae Caim del Depots. For dtails, see KEuak (197).

36
the varied infrstuture projects financed out of foreign funds. As of 1914, some two-irds of European funds had been used to develop infrastructure, including ports, harbors, wharves, and power and water supplies. More than **t** -quartrs of Argentina's extensive railway system was financed by foreign funds, for example. Like that of the United States, the Latin American experience disproves the idea that a current colonial connection was needed to secure access to overseas funds. As one historian wrote in the 1960s,<sup>T</sup> here are few major public works in Lain America today which do not owe thdir 19th- or early 20th-century origins to a decision made by one of the financial houses of London, Pars, Berlin, Madrid, or Lisbon."'> All this paints a pictre of foreign infrastructure investment having a favorable influence on economic development Analysis would not be complete, however, without mentioning negative aspects of the process. a g Peronist criticism of Britsh railway investments in Argenfina, Jenks (1944) wrote, 'The lines were so located that they did not **facilitate** communication **between** interior areas except by way of Buenos Aires. They were operated substantally as unregulated monopolies. Railway rates were high; they were unresponsive to local needs; they discriminated against nascent local dustries and ruined existing competitors. lhey actively opposed highway construon, except for feeder purposes. Employees were indifferent to passengers and shipers. There was insufficient rolling stock to handle traffic eipeditiously." Such critcisms were by no means uncommon elsewhere, as demonsUaed by Popult complaints about the stuchme of U.S. feight rates in the 1880s and 1890s. Arguably, howver, these problems were more severe where foreign fenance was more extensive and entailed foreign control. Jenks compares the effects of foreign investment in the growth and operation of railways in the Unied States l Woodruff (1967, p.124).

37
and Argenina. In fte U.S., foreign finance merely supplemented domestic funds. Foreign investors rarely acquired majonty sta and operating control." Railway management was highly responsive to local economic conditions. An efficient and reliable railway system facilited the emergence of massproduction manufactuig techniques, notably including moden methods of inventory control, in the late 19th century.P But in Argentina, foreign finance dominated, British control of railways was often complete, and management-down to the stationmasters and engineers-was almost exclusively English. The design and operation of infrastructure projects was consequently less responsive to "local needs."

# Private Returns

The preceding discussion of the economic effects of foreign investnent provides no guidance for estimating private returns. Where investment in infrstructu created positive externalities that were not easily capured by investors, private returns could fall short of social benefits. Where opporunmities for price discrimination and predaory pricing were exploited by foreign-owned or foreign-controlled enterprises in contrast, private retuns to the investor might exceed benefits to ffte recipient country. The qualitative liteature on reign investment in the late 19th century does not speak clearly to this question. It is replete wit tale of filed projects and disastrous investments-all cases with low returns on purchases of common stowc A prototypical case is the Canadian Grand Trunk Railway, The main exceptions occuned in the wake of defult, when representatives of forign bodloldeas migh demand effective contol of mmagemenL In addition, certain Briish baning hous had impornt influenco on See Wilkins (1989, p.209, 218 _andpassin),_ who reports examples such a the St. Lotis and Irn Mountain Railroad, m which Barings acquired a lage stake, promping Thomas Bauing at one point to go to te TUnited Sates in an efort to chane the company's mgement

* **For** details, **see** Chzndler **(1910).**

38
whose financing was described in the section on government guarantees. Despite successive reorganizations extending over the second half of the 19th century, the Grnd Trunk was not able to pay a single cent of interest either on its common stock or on the preferred shares into which the orginal debentures were converted in 1862. By 1865 Grand Trunk Shares were selling in London at 22 percent of par."7 Nor were defaults and losses on bonded debt uncommon. "Many American rairoads had been financed almost entrely by bond issues, and in consequence had experenced great difficulty in avoiding bankruptcy and receivership during periods of low earnings.'<sup>71</sup> Not even government backing guaranteed security; U.S. states that backed bonds for financing infrastructure investments defaulted in the 1830s and 1840s. The same was true of French and German loans to the Greek and Turkish governments and of British loans to the City of Buenos Aires, all undertaken in part to fund infastucture investments (Fishlow, 1985).

The returns on overseas investments have been studied most systematically for Great Britain. (The distribution of British overseas investments in 1913 is shown in table 7.) Edelstein (1981) tacks a sample of Brtish equities and debentures (bonds) over the period 1870-1913. His sample is comprsed of first- and second-class publicly traded securities. He finds that Bntish foreign and overseas equity investments consistently outpaid equity investments in the same sectors domestically. Equity investments in Indian, atn American and U.S. railways yielded a higher return than British investment in domestic railways. Investment m foreign and overseas gas works consistently yielded a higher return hn investment in gas companies at home. After 1886 investment in foreign and overseas telegraph and S **See Jo** (1938, p.202-203); **Easbbroo** and **Aike** (1961, p.317). **Easterbrook** md **_Aitke_** (1961, p.432).

39
telphone companies outpaid investments in compefing domestic companies. Retums on investment in forign and overseas twnways outstripped those on domestic tram companies after 1876. Much of this diffeece is plausibly attributable to the greater riskiness of foreign and overseas investment, as Edelstein demonstrates. But for investors able to diversify away the unsystematic risk assciated with pardcular foreign invesments (rough reliance on investmen **t** msts, for example), t foreign equity premium clearly sufficed.

Table 7. Brilish Overseas hnvstnemt i. Publidy-isseud Securifies, Deemuber 1913

||_£millon_|Percent|
|---|---|---|
|Goemmet<br>amd mmicipa|1,125.0|29.9|
|Dominion and coltnia govemnuIs|675.5|17.9|
|Foragp goverant|297.0|7.9|
|Oveuseau micipaliiies|152.5|4.1|
|Rawaya|1,531.0|40.6|
|<br>Domio<br>amd colonia xaaiwyw|306.4|8.1|
|<br>Indian railways|140.8|3.7|
|United State mailways|616.6|16.4|
|Other fbreig naifay|467.2|12.4|
|Oter public utilities|185.1|_5.0_|
|Elctric liHt and power|27.3|0.7|
|Gas and wateworks|29.2|0.8|
|Cans ad dock|7.1|0.2|
|Tramways|77.8|2.1|
|Telegpbs and tephon|43.7|1.2|
|Commerce ad induy|208.5|_5.5_|
|<br>CoaL imo and ted|_35.2_|0.9|
|Breweries|18.0|_0.5_|
|Other conuercia and industra|155.3|4.1|
|RaW Materas<br>|388.5<br>|10.3|
|Mines|_m.2_|7.2|
|Nitrat|11.7|0.3|
|Oil|40.6|1.1|
|Rubber|41.0|1.1|
|Tea ad coffe|22.4|_0.6_|
|Bsm and ince|317.1|8.4|
|Banks|72.9|1.9|
|Fi_ancial, lad amd investmt|244.2|_6.5_|
|Mlilnenam|8.1|0.3|
|Total|3,763.3|100.0|

Sowm Thom 1967, p.<sup>1 4</sup> .

40
The behavior of bond yields was differeaL Returns on Bntish and foreign railway bord yields fluctuated inversely in tie manner predictd by tihe Kuznets Cycle long-swing model. In one decade, British yields exceeded U.S., Canadian, and Ladn American ailway bond yields, while in the next decade the opposite paUtn prevailed. Over the entire 18701914 period, average retuns on domestic and foreign bonds appear to have been quite similar, suggesting a roughly comparable degree of risk despite variation in timing of events affecting yields. Only Indian bond yields failed to fit the pattern. The guarantee against default was virtually complete in India, as was the ability to arbitrage agast other assets on the London capital market. British and Indian railway bond yields consequently fluctated in tandem.

Thus, Edelstein's calculations yield evidence of a reasonably efficient intnadonal capital marks, in which investors arbitaged between altnative assets and demanded compensation for exeptional risks. None of his findings are inconsistent with the view that investors did this in the face of information costs that gave rise to adverse secton and moral hazard. These problems limited the ability of potential borrowers to raise fimds on the London market despite the prevalence of government intervention.

Conclusions and fiplications for Present-Day Developing Countries Recent suggestions for innovative solutions to the problem of financng infiatruct investments in deveoping countes have a back-to-the-futue quality. Relyg on pnvate finance, encouraging the growth of domestic financial markets that could play a larger role in 41
infrastucu investment, and choosing financial instuments so as to minimize the risks of dependence on foreign funds-these ideas were at the heart of th debate over fnancing infastructur investments, most notably the railways, in the 19th centuy. Thus, the historal record is replete with information on both the ircumstances under which such innovations are workable and their limitatons.

In middle-income developig countries, these methods have much to recommend them. Formal financial markets and prudential regulation are relatively well advanced. The i on requirent for efficient use of private and commercial finance are approximated if not fully met. Private iniiative, commercial bond and equity finance by public agencies, and limihts on government guarante could deliver at least some of fte beefit tumpeted by their advocates.

In less deveoped and less-liberli economies, in contrast, not all the informational and contrtua pecodions for efficient private or commercial finance of in projects prvail. As in regions of recent Euopean settlement and elsewhere in atin America, Afiica and Asia a century and more ago, it will be difficult to mobilize resources by tappi investors at home and abroad. Private insitutions (universal banks, for exmple) and public ones (such as regulatoxy agencies) are needed to ure an adequate flow of infomation to investors, to falitate montring, and to discipline management; these are not yet in phlac in many developing countres. With time, financial libetion and policies to encourage the gwwth of the formal financial sector can help to overcome these problems. But in the meantime, the hope that all problems of inftructure fimance can be dispatched through the adoption of policies friendly to prvate and commercidal inifiatives must be 42
# dismissed as naive.

So the history of infrastructure investment in fte 19th cenuy suggest. In places otherwise as different as the United States, Canada, Spain, and India, the informatonal asymmeties charactenstic of developing financial markets hindered efforts to rely on pnvate finance. Funds adequate to underwrte the construction of canals, railways and ports could not be mobilized through the operation of private financial markets alone, owing to the advers selection and moral hazard resulting from asymmetric information. This was tnie of attempts to access domestic and extemal financial markets alie. Obtaining adequate finance required government intervention in the form of the provision of coNllatal (and gants) and bond guarantees. This was necessarily-and, in prnciple, desirbly-tbe case in a situation where asymmetic information caused credit ationing.

Then as now, however, govenment intervention could simply replace one set of problems with another. Access to private markets was restored courtesy of the government, allowing promoters to seal sweethwart deals with cnstuio compie that left taxayers holding the bag. Govemment guarntees might render inlevant the informai probhlems that hindered investors' efforts to evaluat the commercial pospects of infatucture projects, but they ditnot provide effective mechanisms of public adminis to monitor the uses of external funds and protect the pubLic interest. Where govents made kst progress in solving these problems, undesrable outcomes ulimately drove them to public construction and opertio of railways and other infastuc rojects. The message for policymakers is dear. Exploiing tditional approaches to financing infs e investment requires action on two fronts: initiatives to libealize and 43
develop domestic financial markets, and reforms of administrative mechanis designed to ensure the accounitability of enterprises subsidized by or enjoying guarantees from the government Neither reform will work in isolation from the other.

44