The republic has at least 35 transport-related construction projects on the go, ranging from toll roads to bridges, harbours, subway systems, light railways and cargo terminal complexes. All told, the projects could amount to a staggering A$100 billion worth of infrastructure opportunities, and not surprisingly, international banks are eager for a piece of the action.

What makes Korea Asia's most active market for transport-related project finance is more than simply the volume of developments being planned. Most of the transport projects under consideration are to be built under the government's Private Participation in Infrastructure (PPI) initiative which replaced the former Social Overhead Capital scheme. The PPI framework has successfully encouraged substantial private sector involvement in infrastructure and, as a consequence has generated substantial private sector funding needs.

Among the incentives for private participation in infrastructure under the existing PPI legislation are: a 50% exemption on capital gains tax, a tax rate of 15% on infrastructure bonds issued by the concessionaire, and exemptions from acquisition tax and registration tax for all projects. Private sector involvement has also been stimulated by the use of Build Transfer and Operate (BTO) or Build Operate Transfer (BOT) methods. Design Build Finance and Operate Schemes (DBFO) which are increasingly popular in Europe, have not yet been seen in the Korean market. "BTO is particularly popular," says one Korean banking source, "because if the concessionaire transfers the property rights to government its own concession rights tend to be better secured."

Macquarie Bank, which has extensive experience of toll road financing in Australia, is one of the most active foreign banks in the Korean market, particularly in the role of financial advisor. The bank secured its role in Korean infrastructure financing in May when it signed an agreement with Korea's third largest bank, Shinhan Bank, precisely aimed at pursuing infrastructure advisory mandates. To that end the two institutions have formed a new company called Shinhan Macquarie Financial Advisory Co.

The partnership has already proved its worth: according to Nick Hann, director at Macquarie's Asset and Infrastructure Group in Sydney, the institution has been mandated as advisor for 10 separate toll roads projects in the country.

Equity funds

One noteworthy aspect about the spurt of infrastructure activity in Korea is that banks are discussing capital markets and public equity funds to provide part of the finance for roads developments and other transport-related projects. Bankers say that public equity funds have already been used to finance roads in the region but the majority of this equity has gone into transport projects in Australia.

Leveraging off its experience of tapping equity funds for toll roads in Australia, Europe and North America, Macquarie Bank is looking at opportunities to place equity fund capital in transportation projects in other parts of the region, particularly Korea.

In February, Macquarie announced a new Global Infrastructure Trust fund (GIF), Australia's first unlisted global infrastructure fund for retail investors. According to Hann no more than 25% of GIF is expected to be invested in Australia with 75% allocated to buy into assets in OECD countries. As with most infrastructure funds there is still a bias towards developments in western Europe and North American, and it is not yet clear how significant the equity volumes will be that are pumped into the Korean market by the Macquarie fund or other foreign funds.

The risk profile of a toll road project prior to construction is clearly considerably higher than for an already completed and operational road scheme. Despite this, Andrew Ancone, director Macquarie's Investment Banking Group in Kuala Lumpur, says that equity investors will look at investing both in new toll road projects as well as the acquisition of existing toll roads.

It is the scale of opportunities available in Korea that has drawn the interest of equity funds, rather than any evidence that toll road project have performed better in Korea than elsewhere. "Investors are going to have to pick and chose as carefully here as elsewhere," says the Korean banker. So it is no surprise to learn that the investment banks are also looking at equity fund options for toll road schemes in other Asian countries, including Malaysia. Although several toll road projects have been financed in Malaysia in the last three years, equity funds have not yet been deployed in the country because of regulatory environment restrictions. Financial institutions are currently examining ways to work around those restrictions.

Macquarie sources say that GIF investments will be made predominantly via equity and quasi-equity instruments. According to the guidelines of the fund, individual investments will not exceed more than $30 million or 20% of the committed capital of the Fund which has a total size of about $200 million. The Fund, which has a 10 year investment term plus two 1 year extensions if approved by unit holders, is managed by Macquarie Specialised Asset Management Limited.

Although other infrastructure funds do exist, some private (like the Nomura Asian Infrastructure Fund) and some related to quasi-governmental agencies like the Asian Development Bank (e.g. the ADB's Asian Infrastructure Fund), the volume of foreign equity funds used in Asian projects is still small. "There's no evidence to suggest that the use of these funds by Asian infrastructure projects is increasing," notes one Hong Kong-based banker.

But more novel than third party equity would be the use of Japanese Samurai bonds in the financing of Korea transport projects. According to one Japanese banking executive, Daiwa SBCM and others been looking at opportunities for structuring Samurai bonds in Korea. Whether they are successful will depend on the concession agreement.

A government guarantee would be needed in order to be able to tap into the Japanese bond market. "Generally speaking, the South Korean government is reluctant to provide guarantees to private sector companies. But a distinction can be made between the local government and the central government – local government authorities are less hesitant about providing guarantees," adds the Japanese banker.

Korean domestic bonds (called PPI bonds) are already much in use in the local project finance market. However, Japanese institutions hope that they can lure Korean sponsors to the Japanese capital markets because of the historically low interest rates that Japan currently enjoys. The fact that Daiwa SBCM and others are pitching capital market solutions in Korea suggests that they have been able to tack on reasonably priced foreign exchange and interest rate swap mechanisms, allowing the total cost of financing to come in lower than on-shore alternatives.

Interestingly, there are few Japanese financial institutions that have the expertise to be able to offer project bond solutions. To date, the Japanese debt capital markets have never been used in the financing of a domestic Japanese infrastructure project.

The samurai market as a whole picked up considerably last year driven by several factors. With yields on Japanese corporates at yen Libor plus 5bp to 10bp, the yield pick-up for sovereigns issuing at 65bp to 95bp is attractive to Japanese investors. Investors are flush with cash and the bond market is seen by many as one of the few places worth investing in. However, there have been no cases this year of Asian projects financed by samurai bonds. Korea is a better bet because of the relatively favourable view Japanese investors have of Korean investments. "The Japanese capital markets are reasonably comfortable with Korean risk which is another reason why Japanese institutions are targeting transport projects there," says the Japanese banker.

Toll road liability?

The Korean transport sector may prove to be a testing ground for new financing precedents, but it is not without its detractors. One Singapore based financier says, "a good proportion of the toll roads being developed are not really viable and have to be backed by 90% government guarantees. The banker, who has had extensive experience of financing projects in Korea thinks that lenders will ultimately have to revert to the government guarantees to get their money back.

Or at least they will try. "The documentation is all worded in a very Korean way and the government is likely to turn to the lenders in the event of a default and say that the guarantee was never meant to operate in the way that lenders thought it was meant to," the source says. As with a large number of infrastructure developments in Japan over the last decade, market observers believe that the Korean government is pushing transport schemes as a way of keeping struggling domestic construction companies afloat and a means to buoy up the economy.

The Singapore banker believes that the Daegu-Pusan Expressway project, on the verge of financial close as Project Finance goes to press, is a prime example of an uneconomic Korean road scheme.

The financing, arranged by Dai-Ichi Kangyo (DKB) Bank and Korea Development Bank (KDB) includes a Won 490 billion Won-denominated on-shore tranche, a Won 500 billion project bond (to be launched in two to three years time depending on market conditions) a Won 921 billion government subsidy and a $100 million off-shore loan.

The offshore loan makes the Daegu-Pusan Expressway deal South Korea's first PPI project with foreign bank participation and a real oddity. "Why on earth does the project require a US dollar tranche," questions Ashley Wilkins, managing director and head of project finance at Societe Generale, Hong Kong. The skeptic's answer is this: having overseas lenders in the deal will encourage the government to honour its guarantees, rather than face the embarrassment of letting a state supported project default on loans from the foreign banking community.

Yet, foreign banks are still being attracted to the Daegu-Pusan transaction. According to a source at Dai Ichi Kangyo, which is arranging the foreign loan tranche, three foreign banks, one European and two Japanese will join the syndication. The source declined to name further details of the participants until after the deal has formally closed.

Korean bonds

Asian transport projects generally rely on bank debt for the bulk of their financing, not funds from the capital markets. The recent financing for Manila North Tollways Corp (MNTC)'s North Luzon Expressway rehabilitation project is a case in point. Most of the funds will come from a $350 million export credit agency-backed debt facility. Lenders include: Asian Development Bank, the International Finance Corp, COFACE, Export Finance and Insurance Corp, Export Finance and Insurance Corp, ABB Structured Finance, Credit Agricole Indosuez, the Dai Ichi Kangyo, Bank Limited, DG Bank Gonossenschaftsbank, Industrial bank of Japan, Sumitomo Bank and Westdeutsche Landesbank Girozentrale.

But the relatively large size and maturity of Korea's bond market provides more options for domestic infrastructure projects. After a period of stagnation during the financial sector restructuring post Asian crisis, the bond market is growing again at a fast rate. According to the government run financial watchdog, the Financial Supervisory Service, between January and May this year the total issuance of general bonds in the Korean market surged by 128% to Won 12.16 trillion compared with the same period last year.

While the current buoyancy of the domestic bond market is good news for project sponsors in Korea, it is clearly less good news for foreign financial institutions hoping to bring foreign capital into the market. And just as the bond market is awash with liquidity, so too is the bank market. Foreign financiers therefore believe that only a few select Korean transport deals will feature foreign debt tranches.

Only the very largest schemes are likely to see foreign debt participation, thinks one Japanese banker. Such schemes include the upcoming Seoul Beltway project (with an estimated cost of Won 1.6 trillion, the Seoul-Hanam and Seoul-Uijeongbu light rail transit projects and the Seoul Subway Number 9 development – all of which are Private Participation in Infrastructure (PPI) projects. Where foreign firms are involved as project sponsors, foreign banks are naturally more likely to be involved. Project Finance understands that several Japanese trading houses are participating in light rail developments in Korea and have asked for financial support from Japanese banks. Due both to its large size and the involvement of Japanese construction companies, the Seoul subway extension project is a likely candidate for foreign debt participation, says the Tokyo-based source.