The credit crunch being felt by the governments of nearly every Latin American country and the alarming fluctuations in some local currencies has created severe problems for the investment community in the region. With many international banks and investors still hesitant after having their fingers burned in Argentina, economic growth driven by key investment projects has stalled in many economies.

It has fallen on development institutions such as the Inter-American Development Bank (IDB) to try and unlock both international interest and local savings by encouraging Latin American pension funds away from government debt and into the private capital markets. "Our aim at the IDB is to develop local capital markets through local currency based debt and new products based on asset backed securities. This will help the channelling of resources from newly created institutional investors into the private productive private companies," says Ellis Juan, head of the IDB's capital markets unit.

As well as encouraging private pension funds into private sector projects, the bank is also seeking to play an additional development role in selecting key projects that will contribute to economic recovery in the region. "As a development bank we have to have some additionality in the deals. They must help develop the domestic capital markets through the creation of new securities.

"In addition, we look at creating jobs, at what infrastructure or investment project the deal promotes, but because we are the capital markets group we also look at whether that deal helps develop features such as local currency instruments that eliminate fx risk, liquidity in the domestic market, a domestic yield curve to price assets or to see whether we can educate pension funds on new products," says Juan. Under this auspice, the bank has developed innovative structures that have started to provide results.

A host of credit risk and political risk products ranging from partial credit guarantees, political guarantees and A/B loans have all helped the bank encourage further investment in the region. "If Latin American countries want to grow they have to find ways of channelling savings into the private sector, because all the governments have reached the top of their spending limits," says Juan.

Assorted guarantees

One of the methods being adopted by the bank is highlighted in a recent bond issue placed in Peru for the construction conglomerate, Graña & Montero. Under the terms of the issue, the country's largest construction group was able to raise fresh medium-term finance that enabled it to release cash-flow to fund domestic investment plans for the next five years. At the same time, the development bank was able to encourage local pension funds to participate in the $50 million, AA+ rated placement.

To improve on the company's BBB+ credit rating, first, IDB and its advisors wrapped four of the group's six companies and placed them in a trust before adding a partial credit guarantee in conjunction with Dutch development bank FMO. The enhancement of the internal structure helped diversify the income stream and reduce the risk of bankruptcy, providing an A grade credit rating, according to Juan, but it was the bank's partial credit guarantee that pushed that rating up to the AA+ and encouraged local pension funds to participate.

?The guarantee can be used is in two main ways. We can provide a liquidity facility, which would eventually reduce the risk of a default or we can provide a guarantee that would reduce the exposure in the case of a default.? For the Peruvian placement, the latter was adopted, providing institutional investors with the security that they would recover 40% of their investments, and also at the same time pushed the responsibility for the recovery of assets onto the development bank. "Eventually the company, which was BBB+, was able to tap the domestic market with an 8-year bond issue which was placed at between 80 basis points and 100 basis points above the Peruvian sovereign curve," says Juan Mario Laserna, IDB's project leader for this transaction.

"For a construction conglomerate whose revenues have a very high correlation with economic growth, to have it priced just above sovereign risk is very good. It's a very significant improvement from what they could have done otherwise," he says. "Most of the company had a short-term debt, 2-3 years maximum and the average was around 15%-16% but with this way it was ale to issue 8-year paper. They would never have been able to issue with this sort of term if it had not been for the guarantee." For a cyclical business such as construction, the advantage of having medium-term debt priced at 7.5% makes G&M much less vulnerable to a downturn in the business. "With this they will be able to restructure their balance sheet and turn short-term liabilities into medium term ones. That allowed cash flow to finance domestic investments for the next 5 years," says Laserna.

Partial guarantee development

The partial credit guarantee builds on technology developed in the bank's support, for Rutas del Pacifico in 2002. On Pacifico, the IDB's credit guarantee differed from the method used for G&M by providing investors with liquidity security as part of the project to fund a new road linking Santiago and the port of Valparaiso and resort town of Viña del Mar.

When it closed in April 2002, the $300 million financing was the largest local capital markets infrastructure deal in Chile, achieving the lowest fixed coupon rate for a local currency infrastructure bond in Chile (5.8%) while pushing tenor to a record 23 years. This deal used a special purpose vehicle owned by ACS and Sacyr, each with a 50% stake, but IDB's credit guarantee worked differently, providing a certain amount of liquidity in case toll fees dropped below forecast levels for a period of time.

In the case of Rutas del Pacifico, says Juan, "The deal had a full wrap provided jointly by both the IDB and FSA - the IDB acting as guarantor of record - but the guarantees would be triggered once the money trapped by the trust is not able to pay the bondholders. The best bit is that if you are unable to pay then the guarantee has liquidity so the bondholders have a reserve account that would kick in before a default." Whereas in the case of G&M, if the company goes into default then there is an accelerative clause and the whole bond defaults. In this case, the trustee can seize the assets and start a liquidation process. At that point the IDB and FMO pay 40% of the amount of the debt. "Once that is paid then creditors not only have a smaller expectation of the loss that could occur but in addition would not have to go after assets to recover the rest of the debt because that is what IDB and FMO would do," says Juan.

In Rutas del Pacifico, IDB's clout was needed to entice investors to back a complicated structure arising from an open-ended concession lasting for as long as it would take for the sponsors to earn back a fixed return. This approach, dubbed the NPV model, is known as the Ingresos Total de la Concession (ITC). A consequence of the ITC system is that the bonds were structured with a mechanism for mandatory prepayment. This aspect was not allowed to affect the saleability of the bonds by using the creation of an anticipated prepayment account, which accrues cash if the concession revenues exceed certain projected levels. That cash is then used to prepay the bonds as necessary harmonising the termination of the concession upon accrual of the ITC with the repayment of the bonds.

The $300 million debt issuance comprised three sets of notes. Series A at 12 years with a 5.5% coupon; Series B and C both at 23 years and with a 5.8% coupon. The bonds denominated in local currency with daily adjustment to inflation are popular with long-term Chilean investors because they are not overly exposed to currency fluctuations.

However, it was the guarantee that provided the investment with wings, handing the local pension funds the security they required.?One of the important things is that since the late 1980s-1990s when the Washington Consensus was promulgated, multilaterals have promoted the change in the pension systems from a pay as you go to funded systems. But many of these pension funds have been unable to invest with regulations that did not allow them to put money into most local certain credits. These credit guarantees help bridge or help enhance the guarantee of the security so that they [Latin America companies] are able to issue long-dated paper and tap money from institutional investors in which pension funds are of course the biggest players.?

Repeating the Rutas template

The IDB will look to replicate the structure on the forthcoming Costanera Norte transaction, which was set to launch as Project Finance went to press. This concession, for a part of urban Santiago, is cofinanced with Ambac, while Pacifico's co-insurer was FSA (for more details see Project Finance, October 2003, pp19-21).

IDB is now looking at employing a similar structure in Colombia, where a 40-year civil war and the defeat of a recent government referendum which would have restructured the country's finances, has left the government in need of the IDB's private sector group and the capital markets group's financial assistance to unlock key growth driving projects. "We're seeing some progress in Colombia. The department is currently looking at several infrastructure deals. Some are purely private and the others are sponsored by the governments such a concession toll-road that has been in the making for a while," says Laserna.

Increasing turmoil in the country as a result of the ongoing fight between drug gangs, narco-guerillas and the government is not something that concerns the bank. "Obviously the more turbulent times become then the more interesting becomes this product," he says. As well as the $135 million road project, the IDB earlier this year placed a $50 million issue for Colombian bank, Colpatria. The mortgage-backed security was underpinned by IDB's liquidity partial guarantee facility. The first tranche was placed in December and the final tranche in January.

The partial credit guarantees have been widely adopted in Mexico, which due to its size and the maturity of the pension fund system has been quick to capitalize on IADB guarantees. "Mexico is the largest user of partial credit guarantees," says Juan. This year, the bank is involved with a $200 million mortgage portfolio securitization for a private bank.

?In Mexico, the pension funds are very mature and the system is partially developed but most of the investment is in government paper. A lot of funds are trying to change that and reduce their reliability on the government sector. ?Currently, in Mexico the market is seeing a lot of activity in the banking sector and also in the securitisation of receivables, where this type of guarantees have a huge potential.?

In Panama, the IDB is also looking at what will be a landmark water transaction. The project to clean and put in place sewage treatment plants for the bay off Panama City has been on the cards for almost 40 years, but with the IDB committed to the project alongside the Japanese government, the $350 million project is set to take centre stage in the bank's Panamanian portfolio next year.

According to Jeremy Gould, IDB representative in Panama, "we are moving very closely in on an action plan to get this thing done next year." The total commitment of the bank towards the project has not yet been decided, he says. So far it has been extremely difficult to structure a concession in such a way that the private sector makes sufficient returns to entice investment in the water sector.

In Panama, one of the projects, which had attracted the interest of the IDB's Private Sector Group, was the airport, multimodal transport hub and distribution centre in Colon. The $300 million Cemis project, however, this year became the centre of a corruption scandal involving allegations of politicians being paid to vote to approve the project. The bank is, as a result, reassessing its commitment. "We have to examine all of the things that have recently happened and analyse that very clearly," says Gould.

The bank's president Enrique Iglesias was in Panama to celebrate the country's 100 years of independence from Colombia at the start of the month. For a small country it is presenting some large proposals, with the bank also taking a close interest in plans to expand the Panama Canal. The project, which has a price tag of between $4 billion and $8 billion, will most probably require some form of private sector investment due to the budget restraints on the Panamanian government. "That's a lot of money so they are going to have to seek funding. I don't see how it could be done without commercial banks," says Gould. For an institution like the Canal, which has been generating positive cash flow for nearly 100 years, the project should be attractive to both international and domestic investors.

But the desire to create a credit rating for a government-owned body that is higher than that of Standard & Poor's sovereign credit rating of BB for the Republic will be a key challenge in any proposed funding. With the credit crunch becoming ever more apparent in nearly all the Latin American economies, Juan says: "This is a product with the potential of transforming the face of the private sector in the region that is just at the beginning of its development in Latin America."

Political Risk and Credit Guarantees (from www.iadb.org)

Political Risk Guarantees
The IDB offers several types of political risk guarantees for debt instruments. Coverage needs are tailored for each project to cover specified risk events related to non-commercial factors. Coverage extends up to 50% of project costs or US$150 million, whichever is less.

Breach of contract guarantees provide IDB coverage to debt financing for risks of selected contractual/fiscal undertakings by host country governments in project agreements with private sector investors. For example, a guarantee could cover default on debt service payments to a project company if a project was terminated early or a granting authority failed to make required payments. Guarantees can be provided for government contracts made at the sovereign or sub-sovereign level. Currency convertibility and transferability guarantees cover the specific risk of non-payment of debt service to the guaranteed lender exclusively due to the inability of the borrower to convert local currency into foreign exchange and/or effect its remittance outside the host country. This coverage does not include losses due to devaluation. Guarantees for other political risks. The IDB may consider providing guarantee coverage on debt instruments for other political risks such as expropriation of physical assets or other related arbitrary and confiscatory governmental action, on a case-by-case basis.

Credit Guarantees

All-risk credit guarantees. Several types of comprehensive all-risk credit guarantees are available. These consist of IDB coverage for all risks for selected terms of a loan made by a commercial lender. All-risk credit guarantees are tailored on a case-by-case basis to provide the most effective credit enhancement of the guaranteed amount according to the needs of each client.

Per project limits that apply to credit guarantees are the same as those that apply to direct loans. The IDB can support up to 25% of project costs, up to a maximum of US$75 million per project. For projects in smaller countries that typically have more limited access to financial markets, the IDB can support up to 40% of project costs, up to a maximum of US$75 million per project.Fees. Annual guarantee fees for credit guarantees are charged on a similar basis as the approximate spreads charged for long-term loans. Rates are based on several considerations, including the term of the underlying loan, corporate market benchmarks, and the overall risk characteristics of the project. Other fees are applied as appropriate to each project, including analysis fees to evaluate the project, commitment fees on the undisbursed balance, a one-time front-end fee payable on the IDB guarantee, a structuring fee payable for participation by other commercial lenders, and annual fees on the facility for administration services.