During the second half of 1999, there was an increase in project finance activity out of Mexico, and bankers are beginning the new year with a more positive view of Mexican risk, especially where either state-owned entities or blue-chip corporates are involved via offtake agreements.

But the capital markets remain a tough sell. Investors are continuing to demand wide spreads that few Mexican project sponsors are willing to pay. And with an election due in Mexico on July 2, few investment bankers envisage that capital markets access will improve much in the short term. As one banker says, "The bank market can price these deals much more effectively than the bond market. So, at least for the time being, Mexican transactions are going to be bank deals."

At time of going to press, syndication was underway for a power plant serving Cemex, sponsored by French independent power producer group Sythe Energies, and arrangers ABN Amro believe that similar financing structures will be repeated for other industrial electricity users big enough to have their own dedicated power stations.

State-owned oil company, Pemex, with its vast dollar revenue streams, also remains a solid bet for project financiers. In a deal closed last November, US Eximbank broke new ground by providing cover for $180 million worth of commercial risk during the construction phase of a project. The US Exim move to include construction risk was prompted by the fact that since the Asian economic crisis commercial banks have pulled back from project construction financing.

The deal involved the expansion and modernisation of the Madero Refinery, sponsored by Pemopro, a joint venture between SK Engineering & Construction of South Korea, Siemens of Germany, and Grupo Tribasa. Upon project completion, Pemex will assume the Eximbank supported debt.

And in another unusual transaction, which closed in late August, Citibank was able to arrange and syndicate uncovered bank debt for a nitrogen manufacturing facility serving the Cantarell oil field - the biggest oilfield owned by Pemex. This $1.06 billion project had $437 million in equity, provided by a group of sponsors which include BOC Holdings of the UK, Marubeni Corporation of Japan, and Westcoast Energy of Canada.

An additional $623 million of debt financing was required, and Jexim let it be known at the outset that it would provide 60% of this amount, while looking for commercial banks to provide the remainder. Few people would have predicted that the commercial portion could be achieved on an uncovered basis, particularly with a term as long as 10 years, but that is what transpired.

"There were some strategic reasons that the banks felt comfortable," explains Sanjay Khettry, managing director and head of Americas region in Global Project Finance at Citibank in New York. "The recourse here was to the project assets, and cashflows that arise out of a nitrogen supply contract direct with Pemex. The project has strategic importance because Cantarell is the largest oilfield in Mexico, and this project supplies the nitrogen necessary to keep the field pressure on."

This strategic importance, says Khettry, combined with Jexim funding, and the fact that Pemex is the largest single generator of foreign currency in Mexico, were enough to convince banks to come in on the deal although some structural matters such as the project generating dollar revenues which were paid into offshore account structures also helped.

But in spite of the success with Cantarell, Khettry sees political risk insurance as continually necessary for most projects in Mexico, with the nitrogen injection project likely to remain something of an exception.

This view is supported by a Frankfurt-based banker who participated in the Madero syndicate, but steered clear of the Cantarell loan. "Our appetite in Mexico is moderate," he says. "We are concerned about currency transfer risk, and we like to do deals which are mitigated against certain types of risk, such as those with ECA support or multilateral co-financing. Uncovered US dollar lending into Mexico is something we are very reluctant to do."

Bruno Mejean, senior vice-president of structured finance at NordLB in New York, also expects to see multilateral and ECA involvement required by most lenders during 2000. "There is quite a flurry of activity, since some project arrangers have finished their due diligence and are ready to bring projects to the market. And the bank market is quite receptive," says Mejean. "But most projects involve the IFC or IDB, or the export credit agencies, and we are seeing structures which involve both export credit agencies and multilateral agencies in the same transaction." Overseas Private Investment Corporation (OPIC) does not cover Mexico, but bankers envisage a bigger role for Miga, which has improved its programmes, and now has bigger limits for both individual projects and country limits. In addition, private sector insurers such as Zurich and AIG are looking closer at Mexico and other Latin American countries.

Private power deals will undoubtedly be a major sector where insurance will be required. In December, ABN Amro was heading towards the closing of a $275 million loan financing for the Termoelectrica del Golfo power plant, sponsored by Sythe Energies and Alstom, and with Cemex as the power offtaker. The debt on the 230MW plant is being 60% provided via an IDB loan, with the remaining 40% guaranteed by Coface. "I think the Sythe-Cemex deal is a precursor of things to come in the Mexico market," says Joe Lane, managing director and co-head of the power and infrastructure group at ABN Amro in Chicago, which is acting as co-lead on the Sythe transaction along with Deutsche Bank.

"The Comision Federal de Electricidad [CFE] deals that have been steadily coming to market will probably not be able to satisfy the need for new electric power facilities in Mexico over the next few years, and I think that inside-the-fence deals such as Sythe-Cemex will be able to fulfil some of Mexico's needs," says Lane. "So we will see a real trend in that direction, to complement what is going on in the CFE market."

CFE is the state-owned entity to which power plants have traditionally been obliged to sell all their electricity, but President Ernesto Zedillo has been trying to push through legislation that will greatly expand the role of private sector power companies.

This is crucial if Mexico is to meet its fast-growing power requirements. In a speech in Washington DC in March, Jorge Chavez Presa, deputy secretary for policy and development at the Ministry of Energy, outlined the size of the task, forecasting that over the next six years Mexico will need to build 13,000MW in new power plants, costing $25 billion.

"With demand growth outpacing capacity additions, Mexico has been more willing to approve IPP-type projects versus the build-lease-transfer (BLT) arrangements of the recent past, which restricted the ownership of energy assets," says Daniel Kastholm, head of the Latin America corporate group at Duff & Phelps Credit Rating in Chicago. "The result should be renewed interest in Mexico, and a trend towards increasing investment opportunities in plant construction and ownership."

Another reason for looking at deals that do not rely upon the CFE is that the market may soon run into problems with commercial bank exposure limits on CFE risk. "It may be okay for the first slew of projects, but if the CFE has an insatiable appetite then at some point banks are going to be much more careful," says one banker.

"Every CFE deal will have to be, from a pricing point of view, just a little bit better than the previous one, to entice the people who finance these deals," comments another banker. "So pricing is going to be higher, and availability is going to be strained. People are getting filled up on CFEs, so deals that get done soon will have an advantage, because the ones coming later will struggle to get the financing in place, especially in the absence of a clear capital market alternative. Since people are getting filled up on their CFE limits, lenders are looking for a little diversity, especially if you can have one of the Mexican blue chips as an offtaker.

"There are quite a few CFE deals coming to market, but in addition to that you will see inside the fence sector of the market develop quite well, for top quality names."

It will help if a strong project bond market develops, but after a promising start in 1997 investor appetite for Mexican project bonds dropped off, and they started demanding very high spreads. Bankers say that project bonds for the Madero refinery - with notes to be issued in the euromarkets - were considered. But difficult conditions for emerging markets paper during 1999 meant that it did not happen.

"The coupons would have been so high that the issuer did not feel it wanted to be locking in those rates at that time," says one source. "The bond markets are focussed upon relative values, and the relative values they are looking at in the context of emerging market paper mean that yields are very high compared to what good quality issuers are prepared to pay, so between borrowers and investors there is not much of a meeting ground."

During the year 2000, demand for emerging markets bonds may improve, but in Mexico there is the challenge of a presidential election. Few expect a repeat of the chaos seen in 1994, when both the presidential candidate of the ruling Institutional Revolutionary Party and the party's general secretary were assassinated. Nonetheless, the uncertainty generated up until the July polls, could still scare emerging markets investors away from Mexican paper.

Indeed, some bankers say they want to get syndicated loans in place during the first half, and if possible well ahead of the election. And those who are envisaging a subsequent capital markets takeout believe that they may have to wait a while. "With this year being an election year in Mexico, I would not expect the capital markets to come back. If anything it will be late 2000 or early 2001," says one source. Nonetheless, there is a consensus that, over the long term, the bond markets are going to be needed in order to help finance Mexico's very large project finance requirements. Some sponsors are building projects with the intention of going to the capital markets later, and for this reason are getting their projects rated.

"We are seeing some ratings on bank debt, to help syndicate loans, but it is also a pro-active approach by the banks that may have a securities division, and may eventually want to take out the bank debt with a capital market offering," says one credit analyst. "They want these entities to be rated, so if there is a window of opportunity they can go to market quickly."

William Chew, managing director at Standard & Poor's in New York, expects to see upcoming projects being financed by both banks loans and capital markets offerings. But even if only bank debt is involved, he points to a growing trend towards Mexican and other Latin American project loans being rated. "The surveillance of the project after the initial rating process, with the objective of maintaining the rating, is providing value added to bank participants," says Chew.

A role is also envisaged for domestic currencies in Mexican projects, and both the IDB and some commercial banks have been looking at ways to raise peso capital in the domestic capital markets. But it is not easy. Whereas in some markets in Asia the rates on the local market are fairly competitive with international rates, in most of Latin America interest rates are often in the high teens or even higher, and much more expensive than the US market, where even with a generous spread over treasuries borrowers can get dollars at 10% all in.

Bankers believe that local peso debt is eventually going to be a component of Mexican project finance, but this is likely to make up only a small proportion of financing requirements. In the meantime, with limited access to the global capital markets, Mexican project finance is going to rely upon the commercial banks to keep the deal flow moving.