The World Bank Group is playing a leading role in thinking through better approaches to infrastructure financing in emerging markets and developing economies (EMDEs). Part of this work entails understanding the key barriers that might impede private capital from participating more actively in EMDE projects. This is why we focus so much on developing local capital markets and other means to unlock the power of local institutional investors. It is also why we’ve been working to facilitate cross-border investment, in a time when returns in advanced economies remain low.
Foreign exchange risk is one such barrier. Project sponsors typically hesitate to take on foreign currency debt to finance projects whose earnings are mostly in local currency. For their part, international investors or lenders often do not know how to handle the risk that arises from a currency mismatch.
Hedging infrastructure FX risks in financial markets can be expensive, or even impossible, when there is no market for maturities beyond two or five years. In these cases, even large banks can provide little help to investors. Sometimes, a hosting government steps in to offer a hedge. But all too often their guarantee is not considered very credible if it covers a risk stretching over 10 or 15 years. This happens even in countries that have large volumes of international reserves.
BREAKING DOWN FX RISK
But we can make progress on this dilemma by identifying the residual risk bearer of infrastructure risks and breaking down the associated FX risk into a few main components. The ultimate risk bearer is generally the user of the infrastructure, because in the long run either most of the external shock is passed through to users with a gradual price adjustment for the service, or there is the risk of deterioration of the service over time.
There are multiple components to currency risks in infrastructure – however, I will focus on two major components for this analysis. These are the (i) liquidity risk, which reflects the inability of the project to absorb the FX volatility in its cashflow, and (ii) convertibility risk, which reflects the scarcity of foreign currency in host countries in times of foreign currency stress.
How can the World Bank help? Teams in the Global Infrastructure Facility and the World Bank’s finance and markets global practice are developing products that deal with those two components of FX risk effectively and spread their impact efficiently. These can be instrumental as we implement Cascade, our approach to crowd in private and commercial resources into infrastructure projects in EMDEs.
The impact of FX volatility on the cashflow can be hard to absorb because tolls, tariffs or fees seldom can be raised significantly in the short term. A sharp transfer of the shock on the debt service of an infrastructure project to consumers may not be equitable, efficient or viable. On the other hand, most exchange-rate shocks can be accommodated gradually, as nominal prices move and the real devaluation is partially offset. Hence, sponsors need a liquidity facility to support their cashflow after a large devaluation and until revenues can be adjusted. Such a facility can be particularly effective if tolls and tariffs are contractually linked to inflation or another indicator that allows for a gradual pass-through of the FX shock.
To address convertibility risk, sponsors need to be able to promptly convert the resources received into hard currency. This guarantee is important because governments may create restrictions to capital flows when foreign currency becomes scarce. Although MIGA and other export credit agencies and development finance institutions offer guarantee or insurance instruments that help mitigate such risks, it is valuable to have these integrated into a liquidity facility that disburses in hard currency.
ANOTHER STRING TO MULTILATERALS’ BOW
A liquidity facility in hard currency offered by multilateral financial institutions could unlock significant capital flows to infrastructure projects in EMDEs. Such a facility would benefit not only from the financial strength of these institutions, but also from their reputation in fulfilling contractual obligations. It could be offered directly to the sponsor or through the government, which would then backstop the sponsor. The latter case would be very efficient, because the magnitude of devaluation that would trigger disbursements by the facility and the amounts protected required by the sponsor could be embedded into the parameters of the procurement process. This would optimise the overall cost of the project.
A liquidity facility of this sort would adapt and build on structures that have proved to be sustainable and effective. A liquidity facility would also be similar to IBRD’s Catastrophe Deferred Drawdown Option, which is a contingent loan whose disbursements are deferred until a catastrophic event. This is a well-tested product that insures countries against natural disasters, and it could be easily adapted to be triggered by FX shocks beyond a pre-agreed size. The World Bank has also recently used its leverage to stimulate infrastructure bids with a $450 million guarantee to Argentina’s government to support of a renewable energy programme. This resulted in private investments of more than $2 billion. Similarly, a liquidity facility can support an investment that is a multiple of its size, because it is designed to top off debt service for a period of time after a large enough shock, rather than to hedge the whole value of a project against a devaluation.
The repayment period for the facility could be tailored to reflect the speed of passing through the shock to consumers, at the rate deemed tolerable or embedded in the concession contract. If the pass-through is not completed over a certain period (and particularly during the life of the concession), the government can guarantee solvency by extending the concession’s contractual period. In the latter case, the government shares the burden of the adjustment permanently.
The FX liquidity facility would work together with interim loan facilities, such as mini-perm loans that are designed to engage institutional investors during the construction phase of infrastructure projects. Together, such products will play an increasing role in development finance. The facility would help address market failures that justify World Bank intervention, specifically the absence of long-term FX hedging markets; it can also be calibrated to avoid unnecessary subsidies. As is the practice already for standard guarantees in some countries, the government can charge sponsors a relevant shadow price for this protection, ensuring the efficient use of scarce public resources.