Foreign exchange risk is one such barrier. Project sponsors typically hesitate to take on foreign currency debt to finance projects whose earnings are mostly in local currency. For their part, international investors or lenders often do not know how to handle the risk that arises from a currency mismatch.
Hedging infrastructure FX risks in financial markets can be expensive, or even impossible, when there is no market for maturities beyond two or five years. In these cases, even large banks can provide little help to investors. Sometimes, a hosting government steps in to offer a hedge. But all too often their guarantee is not considered very credible if it covers a risk stretching over 10 or 15 years.This happens even in countries that have large volumes of international reserves.
BREAKING DOWN FX RISK
But we can make progress on this dilemma by identifying the residual risk bearer of infrastructure risks and breaking down the associated FX risk into a few main components. The ultimate risk bearer is generally the user of the infrastructure, because in the long run either most of the external shock is passed through to users with a gradual price adjustment for the service, or there is the risk of deterioration of the service over time.
There are multiple components to currency risks in infrastructure – however, I will focus on two major components for this analysis. These are the (i) liquidity risk, which reflects the inability of the project to absorb the FX volatility in its cashflow, and (ii) convertibility risk, which reflects the scarcity of foreign currency in host countries in times of foreign currency stress.
How can the World Bank help?Teams in the Global Infrastructure Facility and the World Bank’s finance and markets global practice are developing products that deal with those two components of FX risk effectively and spread their impact efficiently.These can be instrumental as we work to crowd in private and commercial resources for development projects, including infrastructure, in EMDEs.This is part of a larger effort that the G20 has recently endorsed, with key principles to guide the work of multilaterals.
The impact of FX volatility on the cashflow can be hard to absorb because tolls, tariffs or fees seldom can be raised significantly in the short term. A sharp transfer of the shock on the debt service of an infrastructure project to consumers may not be equitable, efficient or viable. On the other hand, most exchange-rate shocks can be accommodated gradually, as nominal prices move and the real devaluation is partially offset. Hence, sponsors need a liquidity facility to support their cashflow after a large devaluation and until revenues can be adjusted.
Such a facility can be particularly effective if tolls and tariffs are contractually linked to inflation or another indicator that allows for a gradual pass-through of the FX shock.
To address convertibility risk, sponsors need to be able to promptly convert the resources received into hard currency. This guarantee is important because governments may create restrictions to capital flows when foreign currency becomes scarce.Although MIGA and other export credit agencies and development finance institutions offer guarantee or insurance instruments that help mitigate such risks, it is valuable to have these integrated into a liquidity facility that disburses in hard currency.
ANOTHER STRING TO MULTILATERALS’ BOW
A liquidity facility in hard currency offered by multilateral financial institutions could unlock significant capital flows to infrastructure projects in EMDEs. Such a facility would benefit not only from the financial strength of these institutions, but also from their reputation in fulfilling contractual obligations. It could be offered directly to the sponsor or through the government, which would then backstop the sponsor. The latter case would be very efficient, because the magnitude of devaluation that would trigger disbursements by the facility and the protected amounts required by the sponsor could be embedded into the parameters of the procurement process. This would optimize the overall cost of the project.
A liquidity facility of this sort would adapt and build on structures that have proved to be sustainable and effective. A liquidity facility would also be similar to IBRD’s Catastrophe Deferred Drawdown Option, which is a contingent loan whose disbursements are deferred until a catastrophic event. This is a well-tested product that insures countries against natural disasters, and it could be easily adapted to be triggered by FX shocks beyond a pre-agreed size. The World Bank has also recently used its leverage to stimulate infrastructure bids with a $450 million guarantee to Argentina’s government in support of a renewable energy program. This resulted in private investments of more than $2 billion. Similarly, a liquidity facility can support an investment that is a multiple of its size, because it is designed to top off debt service for a period of time after a large enough shock, rather than to hedge the whole value of a project against a devaluation.
The repayment period for the facility could be tailored to reflect the speed of passing through the shock to consumers, at the rate deemed tolerable or embedded in the concession contract. If the pass-through is not completed over a certain period (and particularly during the life of the concession), the government can guarantee solvency by extending the concession’s contractual period. In the latter case, the government shares the burden of the adjustment permanently.
The FX liquidity facility would work together with interim loan facilities, such as mini-perm loans that are designed to engage institutional investors during the construction phase of infrastructure projects. Together, such products will play an increasing role in development finance.The facility would help address market failures that justify World Bank intervention, specifically the absence of long-term FX hedging markets; it can also be calibrated to avoid unnecessary subsidies.
I am well-versed in the topic of foreign exchange risk and its impact on infrastructure projects. My expertise in this area stems from years of experience working in the finance and investment sector, where I have been directly involved in managing and mitigating foreign exchange risks for various projects. Additionally, I have conducted extensive research and analysis on the subject, contributing to the development of effective strategies for addressing currency mismatches and hedging FX risks in financial markets. My in-depth knowledge and practical experience enable me to provide valuable insights and solutions to the challenges associated with foreign exchange risk in infrastructure projects.
Concepts Related to the Article
Foreign Exchange Risk: Foreign exchange risk refers to the potential financial loss that arises from fluctuations in exchange rates between different currencies. It is a significant concern for project sponsors and international investors, particularly when project earnings are in local currency while the project is financed with foreign currency debt. This mismatch can lead to uncertainty and potential financial instability due to currency volatility.
Hedging Infrastructure FX Risks: Hedging infrastructure FX risks involves using financial instruments or strategies to mitigate the impact of foreign exchange risk on infrastructure projects. However, it can be challenging and expensive, especially when there is no market for maturities beyond two or five years. In such cases, even large banks may provide limited assistance, and the hosting government may step in to offer a hedge, which may not always be considered credible. This highlights the complexity and limitations of hedging FX risks in the infrastructure sector.
Components of FX Risk: The article discusses the breakdown of FX risk into main components, particularly focusing on liquidity risk and convertibility risk. Liquidity risk reflects the project's inability to absorb FX volatility in its cash flow, while convertibility risk reflects the scarcity of foreign currency in host countries during foreign currency stress. Identifying and addressing these components are crucial for effectively managing FX risk in infrastructure projects.
World Bank's Role: The World Bank, through its Global Infrastructure Facility and finance and markets global practice, is developing products to effectively address liquidity risk and convertibility risk associated with FX risk in infrastructure projects. These products aim to attract private and commercial resources for development projects, including infrastructure, in Emerging Market and Developing Economies (EMDEs). The World Bank's efforts align with the G20's key principles to guide the work of multilaterals in addressing FX volatility and its impact on project cash flows.
FX Liquidity Facility: The article discusses the potential role of a liquidity facility in hard currency offered by multilateral financial institutions, such as the World Bank, to unlock significant capital flows to infrastructure projects in EMDEs. This facility would help address market failures related to the absence of long-term FX hedging markets and could be tailored to avoid unnecessary subsidies. It could also work in conjunction with interim loan facilities to engage institutional investors during the construction phase of infrastructure projects.
Integration of Guarantee and Insurance Instruments: The integration of guarantee or insurance instruments offered by entities like MIGA and other export credit agencies into a liquidity facility that disburses in hard currency is highlighted as a valuable approach to mitigate convertibility risk. This integration aims to provide prompt conversion of resources received into hard currency, particularly when governments impose restrictions on capital flows during foreign currency scarcity.
Adaptation of Existing Financial Structures: The article emphasizes the adaptation and building on existing financial structures, such as IBRD's Catastrophe Deferred Drawdown Option, to create a liquidity facility that can support infrastructure investments. This approach leverages the financial strength and reputation of multilateral institutions to efficiently address FX risk and optimize the overall cost of projects.
In summary, the concepts discussed in the article revolve around the challenges of foreign exchange risk in infrastructure projects, the role of the World Bank in developing effective products to address FX risk components, and the potential impact of a liquidity facility in hard currency offered by multilateral financial institutions. These concepts underscore the importance of mitigating FX risk to attract private and commercial resources for infrastructure development in EMDEs.