Usually, project financing is provided in strong currencies. The resultant mismatch is rather like trying to drive a sledge pulled by a zebra and a thoroughbred horse: your journey is bound for catastrophe and perdition...

When projects collect all or most of their revenue in local currency, while the majority of their outlay (including operating expenses such as the price of hydrocarbons, debt servicing costs, or the dividends payable to foreign shareholders) is deducted and expressed in foreign currency, they face serious problems as a result.

This obstacle is one of the main factors stunting the resumption of strong economic growth in developing economies: until electricity production capacity is increased, water processing and distribution systems developed and effective transport solutions put in place, economic development will continue to be hampered by bottlenecks.

The difficulty is made more acute by the duration of the financing that is required: it is often 15 years or more. Over such a long period, changes in the local currency with respect to goods and services (its degree of inflation) and its changes with respect to strong currencies (its degree of appreciation, or, more frequently, depreciation) will be so different over prolonged periods of times that this ill-matched team has every chance of overturning the sledge.

Dollarisation is not the solution

The solution (with a capital S) was thought to lie at macro-economic level: either by forcing the local currency to willingly or unwillingly keep step with a foreign reference currency, or by signing its death warrant and transferring its functions to a foreign currency (in theory the currency with which the highest volume of exchange activity is expected in the future).

This is a political choice called ?dollarisation?, whether the foreign currency is the US dollar or some other foreign currency such as the euro or the rouble.

Incomplete dollarisation, which involves creating a compulsory link between the two currencies of a statutory or even constitutional nature, as was the case in Argentina, is not a satisfactory solution. Facts have demonstrated that what the law enacts, it can be led to repeal under the pressure of events.

Perfect dollarisation, involving the local currency's disappearance, can substantially reduce risk in the medium term. This is because it takes more than a few months to properly revive an independent currency.

However, any sovereign state can bring back its national currency, even if the cost has become very high. This means that the risk of a return to the old discordant situation cannot be totally banished.

Moreover, the dollarisation of an economy has such a high price in terms of the abandonment of sovereignty and the vassalisation of economic policies that it may be doubted whether it represents a panacaea for the majority of emerging economies.

The idea that in the present decade, it offers a ready-made solution to this problem in most emerging countries should probably be abandoned.

Domestic currency financing: the way forward?

Capital markets are developing in emerging countries, in the currencies of these countries.

It is easier to conceive of the prices of services and goods produced by the infrastructure projects concerned keeping pace with local inflation than to imagine them adapting to fluctuations in the value of the local currency compared with the financing currency.

However, this response is highly unsatisfactory.

The local capital markets offer a volume of financing that is very much lower than these countries' capital requirements. That means that this method can only cover a very low fraction of financing requirements.

Moreover, financing offered in local currencies is only provided over periods of time that are much shorter than those needed for infrastructure projects (two or three years compared with at least twelve years).

Again, the interest rate of financing in local currency does not just reflect the determination of investors to see their investment maintain its purchasing power in the local currency (which would presuppose that the interest rate compensated for the loss of purchasing power resulting from local inflation).

For the investor in local currency, such an investment frequently represents an alternative to investing in foreign currency. The interest rate therefore reflects the desire to hedge against the depreciation of the investment currency compared with the strong currency.

Given the high volatility in conversion rates between the two currencies, this margin often turns out in retrospect to have exceeded the level that would have been necessary to compensate for the actual depreciation.

The cost of financing in local currency for the project could therefore turn out to be significantly higher than an equivalent amount of financing in foreign currency.

The limits of depreciation cover

The cover against the risk of depreciation offered by Opic (Overseas Private Investment Corp) to a hydro-electric power station project in Brazil presents a new and very attractive possibility.

The system is based on the principle of purchasing power parity: the idea that, in the long term, the conversion values between the currencies offset the differential in inflation rates between them, so that the price of the same goods and services in the two economies regains equality.

If the price of the service produced by the project (in this case, electricity), duly inflated to preserve the same value in local currency, does not enable the project to service its debt in foreign currency because inflation has not compensated for the local currency's depreciation, a subordinated loan may be used by the project to service its ?senior? debt. Theoretically, this loan will be paid off at a later stage when the rate of inflation has offset the differential between the exchange rates.

This is definitely a risk cover product that can make a good many projects bankable, and even enable them to attain a coveted investment grade. This means that it extends the range of potential financing available to the project, and thus reduces the cost of its financing.

Today this is still clearly an instrument of official support, available only for the American investors and with which private capital markets cannot compete.

It can only be hoped that European countries will follow the same example ? or why not the European Union itself? ? so that this type of public funding is also placed at the disposal of European investors.

One can draw a parallel between this hedging product and the various interest rate stabilisation systems that have for a long time been offered to the market mainly by the public sector, and have today broadly been replaced by the practice of private operators fixing rates.

However, this new hedging product and its apparent justification should rapidly come up against their limitations.

Government organisations that use this kind of solution will need to have plenty of stamina, and will sometimes find their patience being tested to the limit. How do you withdraw support for a project when the credit line that protects it from depreciation is nearly exhausted ?

The investors themselves will have to bet on purchasing power parity, because protection is provided to the senior creditors at the expense of the shareholders, who will have to completely pay off the subordinated loan before they see any sign of their first dividends...

Based as it is on the principle of purchasing power parity, this system of cover should only be applied to a given project if parity is fairly accurately assessed between the two economies, at a time of relative equilibrium between the values of goods and services taking account of the current exchange rate. This constitutes a further restriction on the possibility of using this kind of hedge.

Finally, the principle of purchasing power parity between currencies appears to be increasingly poorly validated, even over long periods of time. It certainly used to provide a good explanation and an accurate prediction of fluctuations between currencies in an economic world that was dominated by commercial exchanges. In a world where financial exchanges have clearly assumed preeminence, its predictive power has become more doubtful.

What are the multilateral financial institutions doing?

It is surprising that this innovative product has only been put on the market by Opic for the benefit of American investors, and that its initiators were not the IFC (International Finance Corporation) and the other multilateral bodies whose primary purpose is to encourage the flow of private investment to the emerging countries.

After all, the IFC and its fellow multilateral organisations would be much better placed to develop the full potential of such a system of cover.

The effectiveness of this kind of product does not really depend on the validity of the idea of purchasing power parity, and can even dispense with it. One can play on the idea that inflation is relatively higher over the long term in the emerging economies, without needing to actually regain parity over the very long economic life of most infrastructure facilities.

The economic life of a power station or water-treatment plant, or even of a railway, is obviously considerably longer than the duration of the financing introduced to create it.

The role of the multilateral financial institutions is to make up for deficiencies in the private sector, not to compete with private lenders for a service that they can offer, thereby creating competitive distortions.

The volumes of credit that these institutions turn over nowadays represent only a very small fraction of the total volume of private investments and loans that are invested long term in emerging countries (a few percent only).

By using a large proportion of their resources to reduce the major risk of this financing ? from the depreciation of the local currency much more than from the moratoria that are such a common phenomenon nowadays ? they would be much more effective at fulfilling their purpose of multiplying the private finance that generates development.

Finally, in a globalised economy, it is important for financial instruments to be neutral with regard to investors' nationality. It is neither fair, efficient or desirable for American investors ? and perhaps European ones eventually ? to be the only ones to benefit from this type of support. Investors in emerging markets must benefit from equality of treatment.

Let us hope that the organisations that have been created for this purpose soon regain the initiative and show evidence of their creativity in this area.