When the Mong Duong 2 independent power project (IPP) financing closed in August 2011, many in the project finance industry were optimistic that the transaction signaled an evolution in the Vietnamese build-operate-transfer (BOT) framework and would open the door for a second wave of internationally financed power projects in the country.

But 6 months on from Mong Duong 2 there has been only limited progress on the next large-scale power project, Nghi Son 2. The three remaining bidders on coal-fired Nghi Son 2 are still awaiting the announcement of a preferred bidder, which was initially scheduled for December 2011.

If the BOT framework in Vietnam really has evolved to a point where it works for international sponsors and lenders, and the government has a long list of priority electricity infrastructure projects, then what is holding the process back?

Growing pains

Following economic reforms in the late 1980s, which opened up the country to foreign investment and improved the local business climate, Vietnam became one of the fastest-growing economies in the world, averaging around 8% annual GDP growth for much of the 1990s. More recently, the Vietnamese economy has continued to grow by more than 8% annually from 2004 to 2007, although this has slowed somewhat in the last few years to a more modest level of between 5% and 7%.

One consequence of the rapid growth over the last 20 years has been that Vietnam’s power infrastructure is now struggling to cope with increasing demand, driven by industrial load growth, increased residential usage as incomes increase, and dramatically increased electricity access – from 51% of households in 1995 to around 90% in 2005.

Serious electricity shortages occurred in 2005 to 2007, when drought conditions coincided with capacity constraints, and the government has admitted that such shortages are likely to continue unless it moves to increase generation capacity.

In 2006 the Vietnamese government released its sixth power master plan, which outlined an ambitious capacity expansion programme for the period 2006-2015. According to this plan, the government estimated the power sector would need investments of $3 billion per year, 70% of which would be for the expansion of generation capacity, with the remainder used to upgrade transmission and distribution capacity.

The government outlined a programme to restructure the power sector and attract private investment through independent power producer projects, as well as the privatisation (or equitisation) of various generation and distribution assets currently in the hands of state-owned power utility EVN, the establishment of a regulator, and tariff reform.

If it ain’t broken...

While Mong Duong 2 has attracted plentiful market attention, there were already precedents for financing power projects in Vietnam that were well understood and acceptable to international lenders and sponsors. Indeed the last internationally financed power projects Phu My 2-2 (which was tendered) and Phu My 3 (a negotiated project) were closed back in 2003.

“The previous projects in the power sector were well structured with robust project documents and a risk allocation that everyone got comfortable with, including the development banks” says William McCormack, a partner at Shearman & Sterling in Singapore, who represented Mong Duong 2's lead sponsor, AES.

Mong Duong 2 was also a negotiated project, and AES drafted its documentation on the basis of the Phu My 3 transaction in 2005. During the negotiations that followed, the government’s position was that AES should not receive more favourable terms than the tendered Phu My 2-2. Although the risk allocation between the two Phu My projects was not dissimilar, the documentation was quite different and handled various issues differently. This might explain why the negotiations on Mong Duong 2 lasted from 2005 through until the end of 2009, with an investment certificate issued in April 2010, and financial close taking place in August 2011.

The documents that finally emerged for Mong Duong 2 were similar enough to the established precedents that the transaction was able to attract significant interest from international lenders when they started working on the deal in 2010, although there were still some differences. “The essential risk allocation on Mong Duong was very similar to Phu My but any deviation required a certain amount of analysis with the banks,” says McCormack.

Devaluation and defaults

Although AES was prepared to play the long game on Mong Duong 2, such a drawn-out development process is less than ideal, particularly given the recent upheavals in global financial markets and the challenges facing the Vietnamese economy. In recent years, Vietnam has wrestled with repeated devaluations to its currency, inflation in excess of 20%, high nominal interest rates, a high trade deficit and a generally negative economic outlook.

The discovery of fraud and the subsequent default of the Vietnamese shipbuilding company Vinashin at the end of 2010 was a blow to lender confidence in Vietnam. Vinashin had raised about $600 million in amortising debt from foreign lenders, on top of local currency bonds, so the default was something that project lenders looking at Vietnam could have done without.

The government issued a letter of comfort to support the Vinashin facility when the loan was made in 2007, but did not provide an explicit guarantee – providing a stark reminder to international banks and insurers never to regard state-owned enterprises as being representative of, or backed by, the sovereign. Vinsahin was essentially a corporate transaction and the default is unlikely to prevent lenders from lending to Vietnamese projects. But it has raised concerns among lenders and rating agencies that the various Vietnamese state-owned companies will not receive government support in the event of financial difficulties.

As a result, there is now an even greater focus on the structure of government guarantees, with international lenders now even less willing to take uncovered risk on an entity such as EVN, although some lenders would question whether anyone would have done so in the first place.

Another deal, another template

Mong Duong 2 attracted 12 international lenders to $1.5 billion in 18-year debt, and lenders now ask whether it serves as a precedent that can be followed for future transactions. The answer appears to be: Maybe.

Tphe Mong Duong 2 IPP documentation was ultimately bankable, and involved finding solutions for a number of complex Vietnam- specific issues – such as the difficulties in taking security, working with foreign currency controls, and mitigating payment risk associated with EVN.

The transaction also heralded the arrival of the Korean ECAs Kexim and K-sure into the Vietnamese market, and which took a leading role in the transaction. The Korean ECAs serve as another source of funding in the Vietnamese market, and an alternative to the potentially politically sensitive involvement of Chinese contractors and lenders.

The problem for future transactions, however, is that Mong Duong 2 may turn out to be the exception rather than the rule. Several sources familiar with the Vietnamese market have pointed out that Mong Duong 2 was the result of a drawn-out bilateral negotiation between AES and the Vietnamese government, and therefore should not be regarded as representative of the government’s official position on the use of the BOT template in future deals.

The next generation of deals already in the market is bearing this observation out. The Nghi Son 2 project is based on yet another template, which came out in 2008 while Mong Duong was still underway, and continued to change after Mong Duong was finalised. Some sources refer to Nghi Son 2 as a third generation power deal, though this implies that Nghi Son 2 has been able to benefit from the lessons of Mong Duong 2, even though the two deals moved forward in parallel for the majority of their history. More importantly, Mong Duong 2 was a negotiated transaction while Nghi Son 2 was tendered, and Mong Duong 2 benefits from domestic coal supply, whereas Nghi Son 2 uses imported coal.

All three bidders on Nghi Son 2 are said to have included markups to the documents in their submissions, so it seems likely that there will continue to be several different templates in use. “With several different templates out there now, banks and sponsors are a bit unsure as to what is a bankable structure,” says McCormack. “But the appetite for Vietnam is there, provided that the structure is appropriate”

Liquidity and looking elsewhere

The current upheaval in the Eurozone could have a significant impact on the project finance market in Vietnam, if only because of the impact it has had on the health of the French banks. Traditionally, French lenders have been particularly strong in Vietnam, and favourable withholding tax arrangements arguably gave them an advantage over other international lenders.

The recent reforms to the banking industry in France, and the introduction of significantly more onerous capital requirements under Basel III, have forced many of the French banks to refocus their international operations, reducing their international footprint – including their activities in Vietnam.

Although French institutions in Vietnam may scale back in the short to medium term, few in the market are expecting them to close shop altogether. “Despite the current market volatility and the impact it has on banks’ (mostly European) strategy in Asia, we still expect that the lending community – including French and more generally European banks – will continue to seek opportunities in Vietnam on a selective basis,” says Simon Gaudin, an associate director in the project and export finance group at HSBC in Hong Kong.

Mong Duong 2 benefitted from the absence of any other deals in the regional market at the time, and several lenders felt they had to do the deal to make their budgets in 2011. In contrast, Vietnam may face some tough regional competition in 2012 from countries such as Malaysia, where activity is tipped to pick up on the back of an ambitious 5-year government development plan.

Many of Vietnam’s neighbours such as Malaysia and Thailand have more established infrastructure finance markets, and an established track record of performance on the part of government and project offtakers.

In the case of Malaysia, there is also the added benefit of a developed Islamic finance market, which allows projects to raise long-dated sukuk bonds at attractive pricing by exploiting a scarcity of suitable assets for bond buyers. The Malaysian market is expected to be very active in 2012, though the presence of this additional source of liquidity may actually benefit Vietnam, because Malaysia may not divert too much liquidity from the rest of the region.

uCurrency concerns One of the key issues for projects in Vietnam is the currency risk associated with projects earning revenues denominated in Vietnamese dong. The Dong has depreciated considerably over the last 4 years, something that unnerves dollar lenders and sponsors. The situation is not helped by the government’s reluctance to guarantee the free convertibility of these dong revenues into dollars.

The Dong still faces downside risks, with factors such as double- digit inflation, negative real interest rates, and a sizeable trade deficit all contributing to expectations that the Dong will continue to depreciate by 2-3% this year. But the currency is then expected to stabilise by the end of 2012, according to a recent research report from HSBC.

And despite concerns that inflation may become a problem again in other parts of Asia this year, Vietnam could be different, with inflation expected to continue to decelerate to single digits by the end of 2012 as a result of sluggish domestic demand, slow credit growth, and a favourable base effect from last year’s rapid rise in inflation.

It’s all about the structure

Despite the various economic and political challenges, there remains strong appetite amongst international sponsors, lenders and insurers for Vietnamese projects, though both government and sponsors are still searching for the right balance.

There is currently little appetite for anything that involves a domestic currency payment obligation of the government, and any deals closed in recent years with an element of uncovered exposure have tended to be on projects where there is access to foreign currency revenues – such as offshore oil and gas, or port projects.

So if government wishes to attract international lenders to finance the next wave of IPP projects it will probably have little choice but to offer a robust guarantee package, which explicitly supports the obligations of Vietnamese state-linked counterparties, and addresses lender and sponsor concerns surrounding the stability of the Dong. A banker familiar with the power sector in Vietnam commented that “for anything based on a domestic government tariff you will still be looking for substantial political and commercial risk mitigation along the lines of the Mong Duong 2 model.” Given that Mong Duong 2 was a bilateral negotiation and is likely to be superseded by the template for Nghi Son 2, at least as far as the government is concerned, the new model may not provide sufficient mitigation of political and commercial risks.

Private insurers suggest that they may be able to provide some mitigation of these risks, though their offerings are less well publicised than those of ECAs, probably thanks to policies’ confidentiality provisions. “There is definitely appetite in the private insurance market for Vietnam, although not among every underwriter, and not for every risk,” says David Anderson, head of Asia-Pacific for Zurich Credit & Political Risk.

But even if the Vietnamese authorities agreed to return to the more sponsor- and lender-friendly framework from 2003, there is a limit to what the government and the relevant export credit agencies can afford to provide in terms of guarantees. “We believe that the Vietnam project finance market could support a deal flow in excess of $1 billion of IPP or infrastructure projects every 12 to 18 months, provided it is well structured, and there is no further deterioration in the credit outlook for Vietnam.” says HSBC’s Gaudin.