Currency risk is one of the greatest obstacles to infrastructure project development in emerging markets. Projects in industries such as power, toll roads, and telecommunications typically produce revenues in local currency, but many such projects have been financed with hard-currency debt. The resulting mismatch between local-currency revenues and hard-currency debt exposes the projects to currency risk, because a large devaluation of the local currency can make it impossible for a project to cover its debt service or pay the expected return to sponsors.

A number of the lending institutions traditionally most active in emerging markets have begun to use a new tool to address this risk. By offering to guarantee project debt denominated in local currency, institutions like the Inter-American Development Bank (IDB), the African Development Bank (ADB), and the International Finance Corporation (IFC) have been able to mobilize long-term local-currency funding for infrastructure projects in a way that largely insulates the projects from currency risk.

While this approach has its limitations, it is a valuable addition to the arsenal of currency risk mitigation tools, and it will be the preferred approach to management of currency risk for some projects.Traditional tools for managing devaluation risk in infrastructure projects have not been fully satisfactory. Ideally, projects would be able to match their local-currency revenues with local-currency liabilities, but in many countries long-term debt financing for infrastructure projects is not available in local currency at reasonable cost, and hedging products such as currency swaps are not an option.Dollar-indexed tariffs.

In the 1990s, many projects with offtake contracts sought to hedge devaluation risk by using a dollar-indexed tariff, often supported by a host government guarantee. In these projects, the tariff payable by the offtaker was denominated in local currency and was designed to increase in proportion to any devaluation of the local currency. (Sometimes, tariffs were even denominated in dollars.) The intention was to shift the currency risk to the offtaker and to any host government guarantor.

While this approach is sometimes still used today, it is not realistic in many cases to expect a financially weak offtaker to pay the massive tariff increases associated with a large devaluation, or to pass them along to customers. And since large devaluations are associated with increased risks of host government default, a host government guarantee may be of least value precisely when it is most needed.

Some of the limitations of dollar-indexed tariff structures can be overcome with political risk insurance products, but these have limitations. Inconvertibility insurance, for example, can cover the risk of host country foreign exchange shortages, but not the risk that the host government will default on its local-currency obligations.

In some projects, the risk of a host government default has been mitigated by the use of government breach of contract insurance,¹ but this has limitations, too. For example, the investor may be required to obtain an arbitral award against the host government before the insurer will pay, which can make the investor's ultimate recovery hostage to success in the arbitration. Furthermore, some of the products are designed to cover only project debt, and not sponsor equity.² Even where equity coverage is available, project lenders may insist on retaining the government contract as collateral (instead of allowing it to be assigned to the insurer as required for payment of a claim), which can limit the practical value of the equity coverage.

Liquidity facility products

A different approach was taken in the $300 million AES Tiete bond offering that closed in 2001. The issuer derived its revenues from electricity sales under power purchase agreements that provided for payment in Brazilian Reais at a rate indexed to Brazilian inflation (but not to the exchange rate). To mitigate devaluation risk, the Overseas Private Investment Corporation (Opic) provided a $30 million subordinated liquidity facility that the issuer could draw to pay debt service on the bonds in situations where a payment default would otherwise occur as the result of a devaluation. The liquidity facility enabled the bonds to receive an international investment grade rating.

Tiete represented a new approach to mitigating currency risk, but no other transactions of its kind have closed. Still, the Tiete structure continues to be actively discussed. In early 2003, for example, the report of the World Panel on Financing Water Infrastructure proposed a variation in which the liquidity facility provider would have recourse to the host government, instead of the issuer, for repayment of advances, and in which the liquidity facility could be used to protect equity cash flow streams, as well as debt. It remains to be seen whether Tiete will ultimately be a model for any future transactions.

What is the new approach?

In the face of the obstacles described above, institutions like the IDB, the ADB, and the IFC are increasingly using a new approach. Instead of providing loans denominated in hard currency, these institutions have begun to provide guarantees of project debt denominated in local currency. The guarantee typically covers a local-currency lender against defaults occurring for any reason (although in some cases the guarantees are limited in amount or cover only specified scheduled payments). Following a default in a scheduled payment that is covered by the guarantee, the guarantor pays the lender in local currency (or in some cases the equivalent amount in hard currency).

In a number of transactions, this structure has been successful in attracting local-currency financing that would not otherwise have been available. This is attractive to the borrower, because it provides a natural hedge of currency risk while avoiding the limitations of other currency risk mitigation approaches discussed above.

The guarantor has a similar perspective: a project with debt denominated in local currency avoids much of the currency risk of one that is financed with hard currency debt,³ and a devaluation is less likely to place the project in default. In addition, since the guarantor's exposure is denominated in local currency, a devaluation has the effect of reducing the guarantor's exposure to the project - a benefit that is not present with traditional hard currency loans.⁴

The Costanera example

An example is the Costanera Norte Chilean toll road financing that closed in December 2003. The project borrowed the local-currency equivalent of $260 million on the strength of a guarantee from IDB, which passed along 85% of its guarantee exposure to Ambac, the monoline bond insurer. The principal was denominated in Chilean Unidades de Fomento, an inflation-indexed unit of account that is denominated in Chilean pesos and adjusted daily according to the Chilean consumer price index, and the interest rate was 5.5%. Project lenders were primarily local institutional investors who had only limited experience in evaluating project credits and only limited capacity to purchase lower-rated debt. The IDB guarantee covered 100% of principal and interest, a level of credit support that project participants believed was necessary to place the debt in the Chilean domestic market.

Partial guarantees

In many cases, a guarantee need not cover all of the local-currency debt to attract financing. Some projects only need a partial guarantee, which covers only certain payments or is subject to a cap. This can be cheaper for the borrower than a guarantee of 100% of the debt, and it can allow the guarantor to reduce its exposure to any one project and conserve scarce capital for other transactions.

Take the MTN Cameroon telecom project financing in Cameroon that closed in 2001. The borrower raised the equivalent of Eu90 million ($110 million), of which the equivalent of Eu35 million was denominated in the CFA Franc, with the remainder denominated in Euros. Interest on the CFA Franc tranche was payable at a floating rate based on the bidding rate of the Cameroon central bank. ADB and FMO, the Dutch development finance institution, provided partial guarantees covering an aggregate of 75% of the principal of the CFA Franc tranche. Any payments under the guarantee would be payable in Euros in an amount equal to the Euro-equivalent of the defaulted payment, calculated at the relevant exchange rate in effect on the date the guarantee payment was due.

IFC has also been notably active in partial guarantee transactions. An example is the Sociedad Acueducto, Alcantarillado y Asieo Barranquilla SA ESP water and solid waste treatment project for the city of Barranquilla, Colombia, that closed in 2003. The project raised the local-currency equivalent of $63 million on the strength of an IFC guarantee that covered the greater of five debt service installments and 25% of the outstanding principal. The debt had a variable interest rate equal to 850bp over a Colombian inflation index.

Extension of Tenors

Often, local financial institutions can provide shorter-term loans but not the longer-term debt that is typically required for infrastructure. A guarantee of later maturities may permit the local institutions to extend the tenor of their loans. An example is the Societé Camerounaise de Mobiles (SCM) wireless telecom financing in Cameroon that closed in 2002. A group of local banks led by SG lent SCM the CFA Franc equivalent of $45 million, of which a total of 25% was guarantied by IFC and Proparco, the French development finance institution. The banks also were granted an option to require IFC and Proparco to refinance 100% of the outstanding debt in the sixth and seventh years after disbursement. This feature (the functional equivalent of a guarantee) allowed the banks to treat the seven-year loans as having a five-year maturity for regulatory purposes, which reduced the amount of capital they were required to set aside for the loans and enabled them to provide a greater amount of financing.

Limitations of the New Approach

While the local-currency guarantee is a useful innovation, it has a number of limitations that must be addressed when a project is being structured.

(a) Inflation risk: The guarantee provides protection against credit risk but not against inflation risk. In countries without long-term fixed-rate debt markets, local lenders will require features to mitigate the inflation risk. Frequently, floating rate debt is used for this purpose, as in the MTN Cameroon project. An alternative approach is available in countries like Mexico, Colombia and Chile, where inflation-indexed debt is commonly issued, as in Costanera Norte and the Barranquilla water project. Either approach can protect the local lender against inflation risk, but only by shifting that risk to the borrower and the guarantor.

In order for the borrower and the guarantor to accept this risk, there must be some assurance that the borrower's revenue will increase to cover the increase in debt service expense that will result from an increase in local inflation. Perhaps the most common way to obtain this assurance is by means of an offtake contract or host government concession agreement that authorizes the borrower to increase its prices in line with local inflation or to pass along the variable portion of its capital cost to its customers.In Costanera Norte, for example, the project had a concession agreement in which the Chilean government provided a minimum revenue guarantee and authorized the project company to increase tolls by up to 3.5 percentage points per year above the local inflation rate.

(b) Government performance risk: Where the project's ability to pass through increased costs depends on the host government, there is an element of host government performance risk. As a result, project participants have to assess sovereign risk and determine whether any mitigants are necessary. In Costanera Norte, for example, Ambac elected not to purchase any formal political risk guarantee to cover the risk of default under the concession agreement with the Chilean government, but the IDB 'umbrella' could be expected to partially mitigate the host government risk. To strengthen that umbrella, the project was structured with IDB as 'guarantor of record' for 100% of the debt, with Ambac in effect taking a 'participation' in 85% of IDB's exposure.

If local-currency guarantee structures do not eliminate host government performance risk, do they suffer from the same weaknesses as the dollar-indexed tariff structures discussed above? In most cases, the answer should be no. Under a dollar-indexed tariff, a large devaluation can lead to a very large increase in the payments required from project customers - significantly in excess of short-term increases in the local inflation rate - and it can be unrealistic to expect local customers and governments to make those payments, especially in the context of the extreme financial stress that typically accompanies a major devaluation. By contrast, it may be much easier for customers and governments to pay tariff increases that merely adjust prices in line with local inflation, or that merely pass through a high short-term interest rate that substantially tracks the local inflation rate.

(c) Other limitations: There are some other practical issues that project participants must consider when structuring local-currency guarantee transactions.

For one thing, not every country has financial institutions able to lend on the scale required for infrastructure projects. Even in countries that do, not every financial institution will have the capacity to make long-term loans of the kind that infrastructure typically requires. Countries like Chile and Mexico now have pension funds and insurance companies with an appetite for long-term assets, and local currency guarantees can make project debt attractive to these investors. But, in some countries, projects seeking local funding must turn to commercial banks that may be unwilling or unable to use their short-term deposits to fund long-term assets, even with a local-currency guarantee.

Another practical issue is that a guarantor that undertakes to pay in local currency must believe it will able to acquire local currency to fund its payment obligations if the guarantee is called. This may be an issue in smaller and less liquid currencies, or where the size of the guaranteed loan is large.

Also, many guarantors require the borrower's reimbursement obligation to the guarantor to be denominated in hard currency. This is done to protect the guarantor's balance sheet from the currency losses that would result from devaluations occurring after the guarantor makes a payment under the guarantee. But the effect of denominating the reimbursement claim in hard currency is that each guarantee payment reduces the borrower's insulation from the adverse effects of further devaluations.

Another practical issue arises if a substantial part of project cost is payable in hard currency. Project participants then need to consider whether to use hard currency financing that will protect against devaluations during the construction period, or instead to use local-currency financing that will protect against devaluations during the (typically much longer) operating period. (The amount and currency of project equity and of any ECA financing will also play a role.)

Different projects will assess the trade-offs differently. In the Costanera Norte project, for example, all of the debt was in local currency, despite the fact that some project costs were in hard currency. By contrast, the MTN Cameroon project used a combination of debt denominated in local currency and ECA-supported debt denominated in Euros, because imported equipment comprised a substantial portion of project cost.

Other activity in the market

The use of local-currency guarantee structures is spreading rapidly. In addition to the institutions mentioned above, the following institutions have been active.Standard Bank arranged a $28 million equivalent financing for MTN Uganda, of which $18 million equivalent was denominated in local currency, supported by a 75% guarantee from the German and Swedish development finance institutions, DEG and Swedfund. In Kenya, Citibank in 2002 and 2003 arranged separate financings for Safaricom, denominated in Kenyan shillings and supported by a 75% comprehensive guarantee from the Belgian export credit agency, OND.

The Asian Development Bank has announced that it is prepared to provide partial guarantees denominated in local currency, and in January, 2004, it announced plans to guarantee a portion of a proposed Indian bond offering designed to raise 7 billion rupees ($149 million) for an LNG terminal in the Indian state of Gujarat.

The Export-Import Bank of the United States (US Ex-Im) has a history of providing guarantees of loans in hard currencies such as Euros and Japanese yen and is now looking at providing guarantees in emerging market currencies. US Ex-Im has announced that it is willing to consider guarantees denominated in the Mexican Peso, Brazilian Real, Russian Rouble and CFA Franc, but it has not yet closed a guarantee transaction in any of these currencies.

Opic may be the newest entrant into the local-currency guarantee market. In December, 2003, its authorizing legislation was amended to give Opic the express authority to issue 'guaranties', denominated in currencies other than United States dollars, and to provide those guarantees to 'local financial institutions', as well as to institutions based in the United States. This new statutory authority means that Opic can now provide guarantees of local-currency debt.

Conclusions - the ideal project for this approach

The use of local-currency guarantees is spreading rapidly as a means of controlling currency risk in emerging market infrastructure projects. While it is not the only alternative for managing this risk, it should be considered when structuring any infrastructure project with local-currency revenues if the following circumstances exist:

* Local financial institutions have substantial resources for local-currency lending, but long-term local-currency financing for infrastructure projects is not available, or is not available at reasonable cost.

* Project lenders can obtain protection against inflation by providing either inflation-indexed debt or debt that carries a floating interest rate.

* The project will be able to recover from its customers the increased debt service cost associated with increases in local inflation, for example through an inflation adjustment to its tariff or a pass-through of the variable element of its capital cost.

* Factors are present that allow project participants to get comfortable with the project's host government performance risk.

Footnotes
1 Insurance of this kind (sometimes in the form of a guarantee of debt) is offered by the Overseas Private Investment Corporation, the Multilateral Investment Guarantee Agency, the Asian Development Bank and the Inter-American Development Bank. The partial risk guarantees sometimes offered by the World Bank provide an equivalent type of coverage for lenders.

2 This is the case of political risk guaranties offered by the Inter-American Development Bank and the Asian Development Bank and the 'partial risk guarantees' sometimes offered by the World Bank.

3 Many of the institutions active in this market convert the borrower's reimbursement obligation to US dollars or other hard currency as of the date when the guarantor makes a payment under the guaranty. Under this approach, the guarantor does have exposure to devaluation, but it does not begin until the date of a payment under the guaranty.

4 Of course, the reverse is also true: an increase in the value of the local currency increases the guarantor's contingent liability in hard currency. Guarantors generally seem prepared to live with this risk as part of the price for eliminating currency risk at the project level, assuming the project is otherwise well-structured.