The economic crisis in Argentina served as a wake-up call for lenders and foreign investors alike. Following the rescheduling of Argentina's $107 billion debt default, foreign creditors have been forced to accept 30 cents on the dollar in debt forgiveness. The major lesson for project lenders was that the existence of foreign currency mismatches – created when project revenue streams are generated in local currency while debt obligations are owed in foreign currency – compound economic crises.

The problem was also vividly illustrated in the late 1990s, when the Asia Crisis first arose. In both cases, contracts to provide infrastructure services between private companies and governments were not honored. This occurred not because of malfeasance on the part of government contracting parties, but because of a massive devaluation of national currencies – they simply no longer had the financial means to honor their payment obligations.

A number of foreign investors and lenders purchased Political Risk Insurance (PRI) to protect against these events and in some instances recouped some or all of their investments. But the same cannot be said for the local investors that are often partners with international investors in joint project ventures.

Local PRI availability

The availability of PRI has historically been the domain of developed country investors. That is because the flow of investment tended to be greater from developed countries to developing countries, but also, the perception of risk was higher among developed country investors going into the developing world than vice versa. Indeed, the growth of the PRI industry – which doubled in size during the 1990s – was the result of the enormous flow of FDI in private infrastructure into developing countries.

Not only was it the case that more investment flowed from 'north' to 'south', but few developing country governments that had the capability, offered this coverage to their national investors. Also, fewer developing country investors perceived the need to purchase PRI, believing that the political risks associated with investing in the developed world did not warrant purchasing it.

Most developing country governments still do not have an official public insurance company. Those that do, will generally not insure local investors investing in their home country against political risks. Likewise, government PRI providers in the developed world generally do not provide insurance to local investors in their own countries.

If local investors were able to purchase PRI for local investments, this would provide a similar degree of comfort and would place local investors on a level playing field with foreign investors. So why do local investors in developing countries not purchase PRI to protect their investments against actions of their own governments? There are two primary reasons for this. The first is cost. Premium rates for PRI coverage are generally seen as expensive, and the concept of insurance – PRI in particular – is not always fully appreciated. And, as noted above, even if a local investor wanted to buy the insurance, most PRI providers are unwilling to sell it to them.

Additional explanations include a lack of knowledge about local investors and a hesitance to rely on locally generated information about them (which raises the larger issue of how insurers can obtain reliable information about their clients in developing countries). Another reason is the perception that a host government is more likely to treat a foreign investor more favorably than a local investor. This view is widely held because developing host government laws often do not afford local investors the basic rights foreign investors take for granted. Finally, local investors usually do not have the same level of international legal protection afforded to foreign investors through, for example, international investment protection agreements.

The need for local PRI

By 1997, the flow of foreign direct investment (FDI) in private infrastructure reached its peak. FDI has declined steadily since then not only because of a heightened perception of risk in developing countries by foreign investors, but also because bank credit lines for developing countries were drastically cut in the wake of the Crisis and many have still not been replenished. Perception of risk among developed country investors/lenders associated with trade of investment transactions in many developing countries remains high.

The financing requirements for infrastructure development around in the world – whether in energy, water, or transportation – are in the trillions of US dollars. Governments do not have the means to finance their vast infrastructure requirements. Most look to the private sector – both foreign and domestic investors – to finance the gap. Following the economic crisis in Argentina and elsewhere, foreign investors and commercial banks are loath to invest or finance private investment in infrastructure in developing countries unless there is some form of PRI available. However, even private PRI providers, who are typically known for their flexibility and willingness to take risk, are, as result of their own bad experience in insuring infrastructure projects, increasingly reluctant to offer the same terms and conditions they did pre-Crisis to foreign investors and lenders. There is also considerably less business for them to contemplate than before as a result of the drop in FDI flows to private infrastructure projects.

Turning to Asia, the region's needs for infrastructure are enormous. A recent study released by the ADB, the Japan Bank for International Cooperation, and the World Bank estimates that the 21 countries in East Asia will need more than $200 billion per year to finance new investment in roads, water, communications and power. The region will require $3-4 trillion in investment in energy alone during the next 20 years. Between 1990 and 2001, there were 611 privately financed infrastructure projects in Asia valued at $192.9 billion, peaking at $40 billion in 1997.9 In 2003, after the recovery, Asia only attracted $11.5 billion of investment in this sector in only 23 projects. Most of these were in a handful of countries in the region, with the People's Republic of China accounting for almost half.

Today, foreign investors from outside of Asia (including Japan) are noticeably absent from the infrastructure sector, and lenders are cautious about lending to projects financed by local investors. The word on the street today is that there is some $6-7 trillion of monies available to invest in Asia.

So why is this money not flowing into Asia? Local investors, like their foreign counterparts, have also lost substantial sums of money due to the occurrence of political events in their countries – largely the result of the contract breaches and cancellations by their government. It is therefore understandable that they do not want to invest any further in their home countries. For them, it is preferable to invest their funds in Japan, the United States or Europe, which are seen to be safer havens.

Is local PRI realistic?

What if local investors could be afforded the same level of protection given to foreign investors and lenders against government actions? Would local investors be prepared to invest more of their monies into their own countries and repatriate their offshore funds home if they knew their investments were protected? We believe they would.

Also, the existence of local investment financing would reduce the level of perceived political risk in countries that have experienced an economic crisis. Local investors would naturally prefer to invest in local currency, thereby eliminating currency conversion and transfer risk.

Whether funds flow in local currency or hard currency, local investors deserve to have their investments protected against the same political risks as foreign investors, and the ability to do so would likely make a substantial difference to local economies.

While some developing countries have established official agencies to provide PRI to their local investors, most do not. Therefore, it is up to the private PRI industry and multilateral PRI providers to step up and meet the challenge to offer protection to local investors. A critical key to doing this will be to establish the benefit of rule of law that affords local investors the same basic protections foreign investors receive. Where this can be established, there should be little reason why private and multilateral PRI providers would not issue such coverage. However, establishing such rule of law will be a considerable undertaking.

The Asian Development Bank (ADB) will work with other public or private PRI providers to develop this important element of the market to provide a level of comfort to the insurers through its direct guarantees, as well as its Guarantor-of-Record product. The potential for growth in this market is enormous. As private insurers gain more experience with local investors, they will ultimately be prepared to offer coverage on a stand-alone basis.

While providing PRI to local investors and commercial banks will not by themselves solve the tremendous financial requirements for infrastructure construction in developing countries, let alone Asia, providing a level playing field will go along way toward helping to ensure that at least a substantial portion of these needs will be met.

Christophe S. Bellinger and Daniel Wagner are both Senior Cofinancing Specialists in the Office of Cofinancing Operations at the Asian Development Bank in Manila.

Importance of factors determining whether to invest outside a home country

Source: East Asia & Pacific Private Investors in Infrastructure: Perception Survey, June 2004, World Bank, Sharon Felzer