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Constraints & Impediments Affecting Financial Markets and Private

Sector Investment in Developing Countries

Barbara Samuels, Senior Advisor, WEF & Project Director, Business Steering Committee, UN FfD

Robert Sheppard, Co-ChairInfrastructure Experts Group

26-27 October 2004WEF FfD WorkshopSão Paulo, Brazil

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Agenda

• Measures of Decline: 1997 - 2004

• Reported Constraints & Impediments

• Specific Financial Market Impediments

• Impediments to Successful Financial Strategies

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Measures of Decline: 1997 - 2004

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Measures of Total Debt Financing for Developing Countries

• Although private financing for developing countries rebounded in 2003, total debt financing has followed a downward trend since 1997

• Both bank lending and capital markets issues for developing countries increased modestly in 2003 compared to 2002, but the trend of both has been down since 1997

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Debt Flows to Developing Countries

Source: Global Development Finance 2004, The World Bank, 2004

-40

-20

0

20

40

60

80

100

1997 1998 1999 2000 2001 2002 2003

Net Annual Flow (in billions of US$)

Official Creditors Private Creditors

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Bank Lending and Capital Markets Financing for Developing Countries

Source: Global Development Finance 2004, The World Bank, 2004

0

20

40

60

80

100

120

140

160

180

1997 1998 1999 2000 2001 2002 2003

Gross Annual Volumes (in billions of US$)

Bank Lending Capital Markets

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Measures of Infrastructure Finance for Developing Countries

• IFC’s A Loan / B Loan program has seen a consistent decline in B Loan participation since 1998

• IDB’s A Loan / B Loan program has experienced an even more dramatic drop in both A Loans (since 1999) and B Loans (since 2000)

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International Finance CorporationA Loan / B Loan Lending Program

0

2000

4000

6000

8000

10000

12000

FY 1998 FY 1999 FY 2000 FY 2001 FY 2002 FY 2003

Annual Loan Volume (in millions of US$)

A Loans B Loans

Source: International Finance Corporation

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Inter-American Development BankA Loan / B Loan Lending Program

0

100

200

300

400

500

600

700

800

900

1999 2000 2001 2002 2003

Annual Loan Volume (in millions of US$)

A Loans B Loans

Source: Inter-American Development Bank

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Reported Constraints & Impediments

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Constraints & Impediments at Multiple Levels

• Country-Level

• Multilaterals

• Bilaterals

• The Gap: Market Requirements for Greater Mobilization

• Demand vs. Supply: Estimates & the Current Role of Guarantees

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Country-Level: Reported Constraints and Impediments

• Unprofitable projects (e.g., too risky, insufficient profitability & scale, high upfront expense)

• Inadequate legal and regulatory frameworks (especially at regional and subsovereign levels; issue with local banking provisions for guarantees)

• Unacceptable cross-border risk & insufficient access to local funding (government crowding out, pension funds restrictions, government fiscal constraints)

• Weak local partners (e.g., operators, government)

• Unrealistic public expectations

• Difficulty/expense coordinating with multiple official donors

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Multilateral Level: Reported Issues & Constraints (1)

• Limited resources & suboptimal utilization (e.g., existing private sector portfolio limits)

• Bias toward lending to public sector (e.g., skill base, operations, policies, culture, backlash with unsuccessful privatizations & lack of success)

• Charter interpretations (e.g., restrictions on private sector, subsovereign, involving nonmember countries, etc)

• Concern with losing AAA ratings, tendency to emulate private sector risk management processes (competing with private sector rather than absorbing unacceptable risks)

• Unwillingness to openly engage private sector, concerns with avoiding perceptions of collusion (e.g., how to score guarantees, devise regional & country infrastructure plans)

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Multilateral Level: Reported Issues & Constraints (2)

• Slow, bureaucratic & politicized procedures (rigidity of Board approval process, fear of innovation, politically-based decisions)– One-off deals– Lack of new programs/services (unresponsive to market

requirements)– Politicization of work-outs & recovery processes

• Reduced faith in umbrella value (e.g., IFC default rate on B loans up from 1% pre-Asian crisis to 17% June 2003; Argentina deals)

• Lack of “coherence” with IMF fiscal policies (inadequate differentiation of expenditure vs. investment)

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Bilateral Level: Reported Issues & Constraints

• Sometimes more innovative & flexible than multilaterals, but lack scale

• Political focus, often bureaucratic (resistance to new programs)

• Often anti-business culture, fear of collusion

• Lack of sufficient coordination with other official sector entities (in some cases many chasing same deals)

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The Gap: Market Requirements forGreater Mobilization

• Credit requirements: 100% confidence that unacceptable risks covered with timely payouts, transparency of recovery and workout procedures (without politicization)

• More relevant & credible guarantee products (covering equity, regulatory risks, cross-border risk, demand risk, etc)

• Reduction of project development costs (e.g., official support to governments in project identification and structuring)

• Open business participation in development of country and regional development plans, regulatory & legal frameworks, etc (without being precluded from deals)

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Demand vs. Supply: Annual Estimates& the Current Role of Guarantees

Demand

• Total Annual:

– Water: $80 B

– Power: $80 B

• Brazil Long-Term PPP Program: $65 B PPP

• Mexico Long-Term: $100 B Energy, $ 6B water (public sector investment fallen from 12% GDP in 1981 to 2% in 1998)

Supply

• Total Annual:– ODA: $66 B– Major IFI Guarantees: $2B– Bilateral Guarantees: $0.3 B (.005% total aid)

• From 2001-3 only 14 infrastructure project covered for breach of contract ($976MM), 6 MDB credit guarantees ($800MM)

Source: Winpenny, 2004

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Financial Market Impediments

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Impediments to Infrastructure Financing for Developing Countries

• Sponsors are now reluctant to make new equity investments

• Commercial banks have retreated from project finance in both developed and developing countries

• International capital markets investors avoid developing country issues to finance infrastructure

• Local capital markets in developing countries are hesitant to bear both the commercial and financial risks of infrastructure

• Multilateral institutions have been unable to replace or attract new private funding

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Sponsor Reluctance to Make New Developing Country Investments

• Previous developing country investments have produced disappointing returns because:

– Regulatory risk has frequently reduced expected local currency cash flows

– Devaluation has often reduced the US dollar value of local currency cash flows

• Difficult conditions in sponsors’ home markets require that attention be given to sponsors’

– Credit ratings

– Balance sheet improvement

– Share prices

• Sponsors’ avoid new investments because:– They fear regulatory risk and devaluation will adversely affect new investments

– They do not want to make decisions which appear to increase the risk profile of their firm to rating agencies or shareholders

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Reasons for Retreat By Commercial Banks

• Commercial banks do not view provision of infrastructure financing to developing countries as an attractive standalone product:

– Project financing is provided only if commercial bank clients demand it

– Other, easier transactions are used by sponsors to reward banks which provide support for difficult project financings

– Sponsors’ avoidance of new investment ends pressure on commercial banks to continue to provide infrastructure financing

• Commercial banks wish to present a lower risk profile to shareholders

• Current banking strategies emphasize:

– Fee income transactions, not transactions requiring assets to be held for long periods

– Mergers & acquisitions and equity business, rather than traditional debt products

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Why International Capital Markets Investors Avoid Developing Country Infrastructure

• Capital markets investors are very conscious of the risk of downgrades:

– Many international infrastructure transactions which initially carried an investment-grade rating were downgraded to below investment-grade

– Linkage between sovereign rating of host country and transaction rating worries investors

• Capital markets investors were particularly disillusioned by Argentina’s default

– Investor’s have a heightened awareness of devaluation and regulatory risk, which they see as linked

– Investors now give less credence to co-participation by multilateral agencies in infrastructure financings

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Why Local Capital Markets Have Not Filled The Gap Left By International Institutions

• Limited understanding of the risks of structured financings for infrastructure projects

• Limited market capacity (average transaction sizes for local currency financings are much smaller than for US dollar-denominated financings):

– Government regulatory restrictions on the financial sector frequently hamper investment in local infrastructure financings

– Many countries do not have adequately developed long-term savings institutions– Local commercial banks may not be able to obtain long-term funding, thus creating asset/liability

mismatches if they provide infrastructure funding

• Macroeconomic policies (both current and historical) often make local investors prefer:

– Short-tenor transactions– Floating, rather than fixed-rate debt

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Why Multilateral Agencies Have Not Replaced or Attracted New Private Financing

• Role is to supplement and facilitate private financing to substitute for it - especially in current climate of privatization

• Lack of new investment by private sponsors has created fewer potential transactions in which they can participate

• More comfortable with commercial bank financing structures than with capital markets structures - but commercial banks participation requires clients as sponsors

• In some cases, reluctant to develop new products: willing to continue to offer old products until market for these products returns

• Culture does not demand or provide incentives for measuring success in terms of volumes of new transactions

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Impediments to Successful Strategies

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Four Financial Strategies

• Structured transactions without explicit protection against currency and country risk

• “Targeted risk” approach, offering explicit mitigation of currency and/or country risk

• Currency swaps

• Local currency financings

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Structured Transactions Without Explicit Protection Against Currency and Country Risk

• Used successfully in the 1990s to finance electric power generation in developing countries

• US dollar-denominated debt• Mostly low-investment-grade ratings, but some below investment-grade

transactions• Ratings limited by the sovereign ceiling

Current problems with use of this approach:• Fixed-income investors avoid developing country infrastructure

financings because of currency / regulatory risk• Only applicable in a small number of developing countries• Implementation of this strategy is dependent upon successful progress

on a broad range of institutional factors in host country, leading to higher sovereign ratings

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“Targeted Risk” Approach

• Political risk insurance to cover inconvertibility and / or coverage to protect against devaluation

• Used in a small number of transactions, beginning in 2000• US dollar-denominated debt• Can achieve ratings above the sovereign ceiling

Current problems with use of this approach:• Transaction rating (assuming use of a structure to breach the sovereign ceiling)

is limited by local currency rating of the transaction• Local currency ratings for infrastructure projects are generally limited by the

sovereign’s local currency rating because of regulatory risk• In most developing countries, the sovereign’s local currency rating is below

investment grade• Therefore, in the absence of a means of mitigating regulatory risk, the

transaction’s rating remains below investment-grade

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Currency Swaps

• Rarely used, especially in individual project financings• Can be used as part of a structured program to provide a facility for

financing multiple transactions• Attempts to deal with the fact that few developing countries have long

term swap markets• Currently a topic of interest and continued work

Current problems with use of this approach:• Difficult to implement in individual capital markets transactions because

unknown level of swap exposure at time of default is fatal to transaction rating

• Ultimately, all approaches lead to swap exposure resting with the government of the host country - and there is a limit on governmental willingness and capacity to bear this risk

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Local Currency Financings

• Eliminates problem of currency mismatch between project revenues and financing costs

• Has been used in a number of recent transactions, especially in local capital markets financings

• Currently subject of great interest on the part of multilaterals

Current problems with use of this approach:• Few developing countries have long-term fixed-rate debt markets• The risk which appears as FX risk in US dollar financings reappears in

local currency financings as interest rate risk• No structures have yet been devised to protect against local currency

project financing defaults caused by interest rate risk• Extension of tenors in most markets has been based on “puts” and similar

structures which leave most risk with the provider of the put

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Discussion Questions

FOCUS: Enhancing leverage of official sector & financial governance:

– What other impediments need to be identified so we can determine realistic concrete solutions?

– What do we need to understand about these constraints and impediments to construct viable proposals for changing transaction structures and the supporting process and structures?