Construction Costs, Inflation, and Developing Countries

As our construction cost project moves forward, we are expanding our database to be as complete as possible. My original dataset is mostly in developed countries, but does have decent coverage in developing ones other than China. However, decent and good are two very different things, and expanding coverage showcases some problems. These are all resolvable, but they require some delicate care.

When I wrote about Yinan Yao’s work on construction costs in China, I mentioned we would expand to more parts of the world. We have a mostly complete table for the Arab world, thanks to the work of Anan Maalouf, and a growing table with exceptional detail thanks to the work of Elif Ensari. I’m going to give each a complete post fairly soon, later this month or in July, since they both have insights that have seriously challenged the way we have to think about costs. But for now, I want to focus on one cross-national issue: inflation, and generally currency conversion rates.

The best example of this is actually not in either the Arab world or Turkey, but in Iran. I have three Iranian projects in my dataset: the extension of Line 3, and Lines 6 and 7. They are fully underground and cluster around PPP$200 million per kilometer, which is slightly lower than the global median and roughly in line with the global median excluding the English-speaking world. The problem is figuring out what conversion rate to use. Line 3 cost 20 trillion rial and was built between 2012 and 2014. But what year should we deflate costs to? Iran had 30% annual inflation in that period, and after a brief lull of 10% inflation went up to 40% last year. A one-year error in the PPP conversion rate can lead to sizable errors in the final costs.

Moreover, high inflation leads to nominal cost overruns if it is higher than expected or if the project takes longer than expected. These nominal overruns can lead to real problems if there are contract disputes or a budget crisis, and usually if your inflation rate is 30% then your budget is in perpetual crisis mode. Check the source above for the costs of Lines 6 and 7: it mentions nominal overruns, disputes, and schedule slips.

The OECD has PPP conversion rates for different countries by year, going back to 2000. If the numbers increase over time, it indicates the country in question has more inflation than the United States; if they decrease, it indicates the opposite. For example, in Japan, the real value of the yen has strengthened from 154.718 to the dollar in 2000 to 101.474 in 2019, in line with Japan’s lack of inflation – in fact, it’s had slight net deflation. The eurozone has had positive inflation but less so than the United States, so the real value of the euro has increased from $1.159 to $1.416. These relative changes are significant in looking at the long-term evolution of costs, but they’re gradual, so over a 5-year construction period, they’re not too important.

In contrast, on the same table, we can look at Turkey. Between 2000 and 2019, the lira’s real value weakened from 0.282 to the dollar to 1.841. This is about 10% annual inflation above the US rate, so maybe 12% a year; moreover, this is an average of relatively moderate inflation in 2005-2015 and high inflation before and after. Getting the exact conversion correct is important, and evidently the data table I uploaded in November got one Turkish project wrong, making the spread in costs between different lines look larger than it really was.

But this is about more than just picking the correct year. The standard way to compare projects’ real costs is to deflate to the midpoint of construction. It’s an approximation that works when inflation rates are low – and for the purpose of this discussion, 5% over the course of a 6-year subway timeline is low; I am not making a macroeconomic claim about long-term price stability, but an econometric claim about measurement errors. However, when inflation is high, especially at the Iranian rates rather than the Turkish ones, we have to be more precise.

More precise here means having some idea when most of the money was spent. Was it spent evenly over the construction timeline? If so, then the midpoint is not a bad approximation at 10-15% inflation, and even at 20-30% inflation it is not terrible if the construction timeline is short, which it was for the Line 3 extension in Tehran. However, the money is not always spent at a uniform rate. Maybe there is a long preliminary engineering process followed by a quick construction period toward the end, or maybe most of the construction is done early and then thee timeline drags for the final elements like systems or testing or one particularly hard segment.

This introduces a new element – keeping track of how much money was spent in each year – that I didn’t do much before when I was only looking at first-world countries. About the only first-world projects for which I care much about the timeline are ones that have become legendary for how long they took, like Rome Metro Line C and Barcelona Metro Lines 9 and 10.

The broader point here is that it is often difficult to adapt knowledge from one context to another. The context in which I began looking at construction costs was that of New York during the construction of Second Avenue Subway, so I was focusing on fully underground lines in the centers of large first-world cities. I’ve since adapted it to a more global context, and in some cases it’s worked fine (e.g. smaller cities), but it’s critical to keep track of when new complications arise.

I wrote this thread a few days ago about third-world construction costs, and there I pointed out that it’s critical to analyze third-world issues in terms of what is relevant to the third world. Global consultancies (and here I’m including Japanese and European governmental organizations focusing on international development, and not just private consultancies) don’t often do this right – their money comes from the first world, so they think about how to be efficient in the first world. This is also relevant to us – our money comes from the US. But it’s critical to take developing-country factors into account nonetheless.

11 comments

  1. Alon Levy

    Incidentally, even the concept of “third world” and “developing country” is weird here. Turkey is an upper middle-income country, and Iran is poorer but still solidly middle-income. Living standards there are a lot more similar to those of Germany than to those of Kenya. And yet, middle-income economy issues like high inflation rates force the analysis to be a lot more careful to avoid making casual 50% errors in either direction.

    • Herbert

      Isn’t there also an issue in Iran that they have difficulty sourcing certain parts?

      I know it majorly affects their airlines but I don’t know whether it does rail as the U.S. plays a much smaller role in that and the European Union routinely flouts the embargo…

  2. Jacob R Hensel

    The US Army Corps of Engineers uses construction midpoint to deflate constructions costs, which in some cases span a decade or longer. That works well enough for a low inflationary environment. If costs are significantly uneven during the construction period or inflation rates fluctuate over time or they are high then deflate (or inflate) costs annually to whatever year you are using for comparison.

  3. Mikel

    Venezuela was opening metros as late as 2015, when inflation was already out of control. It would be great to have the yearly breakdown of construction costs for those latest extensions in Caracas and Maracaibo.

    I don’t know about Rome Line C, but Barcelona L9/10 is perhaps a special case, in that the delays are not due to technical reasons, but purely financial/political. When the recession hit, the Generalitat decided they couldn’t afford finishing the central section right then (fair enough). But even though they do have the money now, post-2011 Catalan politics has become such a shitshow that they haven’t managed to get a new regional budget passed through the Parlament. So no new investments until the deadlock ends…

    Oh, and just in case it helps, in my corner of the rapid transit world the spending schedule for the under-construction San Sebastián subway was reasonably easy to find. Out of a total of € 180M: 20M in 2018 (tunneling, started September), 28 in 2019 (tunneling), 41 in 2020 (tunneling and systems), 53 in 2021 (mostly systems), 34 in 2022 (systems and testing), 4 in 2023 (wrapping up). This timetable is consistent with the data I sent you a while back, showing the tunneling accounted for roughly 1/4 of the total cost. I don’t think this distribution necessarily applies to developing countries or to projects in different urban geography, but it might be useful as a sanity check. The regional budget for past years is accesible online as a huge spreadsheet, so if you’re interested I can look for the costs of L3 in Bilbao, which did suffer from delays and cost overruns.

  4. Pingback: We Ran a Conference About Rail Modernization | Pedestrian Observations
  5. Tony

    The terms “first world” & “third world” are pretty antiquated & no longer describe anything useful so I’m surprised to see you toss them around.

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