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The World Bank Group Infrastructure Economics and Finance Department Capital Markets Instruments : Financing Infrastructure Development IDB Business Seminar Series 2004, Capital Markets for Development,The Role of the Private Sector, Washington DC, June 4th, 2004 Infrastructure Economics and Finance Department (IEF) Contents Overview of Bond Markets Capital Markets and Infrastructure Development Infrastructure Needs Local capital markets Local currency debt instruments Guarantees Definition Options under Consideration Guarantee Liquidity Facility Capital Markets in the Region 2 Infrastructure Economics and Finance Department (IEF) Size & Structure of the Bond Markets (LATAM) Institutional Investor Assets for Larger LAC markets, 2001 Local Currency (equivalent US$ billions) Country Argentina Brazil Chile Mexico Peru Otherse TOTAL Pension Funds Insurance Co. Mutual Funds Total 1999 Total 2001(e) 14.0 53.0 33.0 8.5 2.5 16.7 2.0 11.0 10.0 2.4 .4 3.9 7.5 44.0 4.0 13.0 .5 10.4 23.5 108.0 47.0 23.9 3.4 31.0 29.5 135.0 58.7 29.9 4.2 38.7 127.7 29.7 79.4 236.8 297.0 Source: Internal PRI (IDB) market research Capital Markets still represent a very small % of GDP (except Chile) : average 11% (est. 2001). Average holdings of sovereign risk by investors is relatively high (70 % to 85%) 3 Infrastructure Economics and Finance Department (IEF) Relative Size of local Capital Markets Table 2: Capital Markets Capitalization as a % of GDP for selected countries, Year 2001[1] (equity and bond markets) Country Stock Market as % GDP Bond Markets as % GDP Public Bond Market % GDP Private Bond Market % GDP Bond Markets as % GDP (1991) Argentina 12.42 15.86 10.83 05.03 05.00 Brazil 27.58 61.26 51.25 10.01 13.20 Chile 74.56 52.72 30. 40 22.32 30.10 Colombia 07.30 N.A. N.A. N.A. N.A. Mexico 9.25 15.89 10.83 05.04 05.60 Peru 16.32 07.16 02.96 04.20 00.70 USA 123.0 149.31 41.51 107.80 122.0 U.K. 144.0 64.42 29.70 34.72 48.15 France 85.65 81.16 46.12 35.04 73.25 Japan 55.93 145.11 95.52 49.59 87.53 [1] 4 Infrastructure Economics and Finance Department (IEF) Infrastructure Needs : LATAM (2005-2010) New Investments Maintenance Total (000 US$) (000 US$) (000 US$) Electricity (power) 15,034.00 10,593.00 25,627.00 Basic Telephone Mobile Sub-Total 3,276.00 4,175.00 7,451.00 15,049.00 10,015.00 25,064.00 18,325.00 14,190.00 32,515.00 2,791.00 4,198.00 6,989.00 0.00 733.00 733.00 1,792.00 3,234.00 5,026.00 37,942.00 32,948.00 70,890.00 Roads Railway Water & Sanitation Total Source : World Bank, Working Paper 3102, Fay-Yepes, 2003 Note : /1 Does not include rehabilitation, deferred past maintenance and upgrades 5 /1 Infrastructure Economics and Finance Department (IEF) Infrastructure Needs : LATAM (2005-2010) LATAM infrastructure needs are estimated at US$ 71 billion per year (it was close to US$ 60 back in 1995). Of this close to 45% is represented by maintenance. The most demanding sector in the Region will appear to be the Telecom Sector (US$ 32.5 billion per year or 46% of the total), with the mobile sub-sector alone demanding US$ 25 billion annually. Following Telecom will be Electricity (mainly generation) with US$ 25 billion per year, and toll roads with US$ 7 billion per year. In the golden years of infrastructure finance in the Region (1996), total amount of financing raised was closed to US$ 30 billion. This figure is probably now in the US$ 8 to US$ 10 billion at best. These demand figures do not include a stock of deferred investments and maintenance. If we add the weak foreign capital flows into LATAM infrastructure during the last years (and immediate future), the outcome is a pressing need for new financing options: Redesign of the government role (from regulator to partner, PPPs) Development of risk mitigation products that can addressed the FX risk Development of local currency debt instruments 6 Infrastructure Economics and Finance Department (IEF) Real Investment in Infrastructure Projects with Private Participation in Developing Countries(1990-2002) US$Bn 140.0 120.0 100.0 80.0 60.0 40.0 20.0 0.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 All low and middle income countries Source: PPI Data Base (IEF, WBG) 7 Low income countries Infrastructure Economics and Finance Department (IEF) New Agenda : Connect Infrastructure with private financial markets Transparent and efficient rules to determine future returns and risks with clear enforcement and dispute resolution mechanisms (economic regulation, judicial reform,investment climate) Development of local capital market development (local currency financing) and hedging instruments against currency risk. Development of risk-mitigation products to support financing instruments capable of dealing with credit, fx, contractual and regulatory risks. Enable and support access of municipal governments, sub-sovereign entities and public utilities to private financial markets via improvement of corporate governance, credit worthiness, and initial financial backing. 8 Infrastructure Economics and Finance Department (IEF) Local Capital Market Development Financial des-intermediation is a key component of a sustainable economic development strategy. Support of good quality credit rating private sector instruments as a way to diversify investors portfolio (e.g., pension fund development in LATAM – increased sovereign risk cases of Argentina, Uruguay, Brazil, Colombia) Develop local currency funding instruments that could mitigate crossborder risk (FX risk). Projects that are typically local currency generators Water & sanitation, toll roads, irrigation, etc. will have a tough time getting finance in the US$ markets (even with the best buildin contracting clauses for US$ tariff based there is a tolerance to FX adjustments in a particular economy) 9 Infrastructure Economics and Finance Department (IEF) Development of local currency debt instruments Matching of revenue generation (productive assets) and liabilities for private corporations. Mitigation of economic regulation framework under volatility scenarios (I.e., US$ based tariffs in utilities – public services) Development of local savings capacities (I.e., diversification from investments in government related securities). Incorporation of local debt holders as stake holders in infrastructure projects (mitigate regulatory risk) Introduce market performance benchmarks to improve risk & return remuneration for local savings (domestic investment) 10 Infrastructure Economics and Finance Department (IEF) Guarantees: Overview Political Risk Guarantees (US$ debt instruments) sovereign (transfer & convertibility) and selected noncommercial risks (contract frustration) for infrastructure development in the Region. Streamlined approval process (3 months). Could include selected non-commercial risk [regulatory risks] such as breach of contract by the grantor of the concession (e.g., San Pedro de Macoris, IPP, Republica Dominicana). 11 Infrastructure Economics and Finance Department (IEF) Guarantees: Overview Financial Guarantees, partial credit guarantees (local currency debt instruments) : credit enhancements to improve credit risk profiles of local issuers to enable them to access market financing under better conditions (tenor and pricing). Instruments [mechanism] that cover or protect debt service payments to institutional investors (bondholders). Products can be structured to guarantee an specific layer of credit risk,in order to elevate the risk profile of the overall transaction and thereby attract investors. By guaranteeing an intermediate part of the debt (I.e., guaranteeing to pay a portion of the obligation after the internal cash reserves or sponsor support has been exhausted) the local investor maybe more willing to put its capital at risk for the remaining exposure. 12 Infrastructure Economics and Finance Department (IEF) Guarantees: Extending tenors for required longer maturities. A Partial Credit Guarantee (PCG) can guarantee debt service for specific periods $150 million Example: China Ertan Power Project $50 million 0 3 6 Average financing term for China without World Bank Guarantee 9 Additional uncovered risk taken by commercial banks 13 Total risk assumed by commercial banks 12 15 World Bank Guaranteed Infrastructure Economics and Finance Department (IEF) Guarantees: PCG applications under development Application of Partial Credit Risk Enhancements to potential PPP projects in infrastructure Design the “optimal” partial credit enhancement for a given project in order to improve its credit risk profile enough to capture private capital on adequate terms & conditions Mezzanine Guarantee (local currency instruments) Pool Guarantee (local currency instruments) Guarantee Liquidity Facility 14 Infrastructure Economics and Finance Department (IEF) PCG applications under development Mezzanine Guarantee A “credit” loss protection enhancement with the WB providing a guarantee for a specified mezzanine layer of credit risk, thereby elevating the overall transaction to investment grade on the local currency scale. Illustration: For a project bond supporting PPP investments in electricity distribution, the WB could provide a partial credit guarantee to support electricity payments by government related clients to project. 15 Infrastructure Economics and Finance Department (IEF) Mezzanine Guarantee (energy distribution co.) Transaction (Receivables Securitization ) Project Revenues (High Credit Risk Quality Layers) Transaction Reserves Over-collateralization Project Debt Service Reserve Account Layer of Lower Credit Risk Quality Liquidity Reserve (sponsors recourse) 16 Mitigation of the lower credit risk quality and improving the transaction rating attracts participation of Monoline Insurers to provide a “wrap” on the whole transaction, improving further the transaction credit rating. Partial Guarantee (a portion of the credit loss on the transaction, -debt service) Infrastructure Economics and Finance Department (IEF) PCG applications under development Pool Guarantee for Asset-Backed Securities A partial credit enhancement product with WB providing a PCG for a portion of principal and interest sufficient to offset potential losses resulting from non-performing assets within the underlying collateral pool. The Pool Guarantee’s amount will be calibrated for each transaction to improve the project’s credit rating in a manner sufficient to attract targeted local investors. Illustration: A utility company may pledge credit receivables as collateral to repay a bond issue. Although the collateral enhances the bond’s credit quality, the information on the collateral in emerging markets may not be adequate (e.g. incomplete records of past performance) and as such, the collateral may not be sufficient to attract local investors to purchase the bond. The WB could further enhance the bond with a partial credit guarantee in order for the bond to achieve a credit quality sufficient to interest targeted local investors. 17 Infrastructure Economics and Finance Department (IEF) Pool Guarantee: CBO, for Illustrative purposes CBO (Collateralized Bond Obligations) for Emerging Markets (EM) Debt 1. Stressed Default Rates (%) Col l ater al Rati ng Desi r ed CBO Rati ng BBB A AA AAA AA A BBB BB+ BB 0.50 1.00 2.00 6.00 22.00 24.00 1.00 1.50 3.00 11.00 30.00 32.00 1.50 2.00 4.50 13.00 40.00 42.00 BB- 30.00 36.00 48.00 Appr oxi mati on to Requi r ed Cr edi t Enhancement (illustration purposes) Desired Rating (CBO) 2. Assets Recovery Assum ptions EM Sov ereign w ithout guarantee EM Sov ereign w ith guarantee (principal + 12 m onth interest) EM Corporate A Underlying Credit Quality of Pool (AVERAGE) Stressed Default Rate for a A rating Recov ery Rate (AVERAGE) BB+ 30.00% 25.00% Loss sev erity (1-recov ery rate) 75.00% Expected Loss (Default Rate * Loss Sev erity) 22.50% 25% 40% 20% Minim um Am ount of Credit Enhancem ent = 22.50% (for bond holders guaranteed paym ent of interest + principal) Source: Rating Agencies Methodology (Case Example) 18 Infrastructure Economics and Finance Department (IEF) PCG applications under development Liquidity Facility A form of project support that is funded in a separate escrow account, or available on a contingent basis from a third party and that maybe utilized under defined circumstances. Liquidity Facilities are intended to assist the project in coping with problems that are believe to be temporary. The liquidity facility will be repaid over a number of years through: (a) phased tariff adjustments to return tariff to a cost recovery level, or (b) a special levy on consumers. /1 Foreign Exchange Risk Mitigation for Power and Water projects in Developing Countries, World Bank, Energy Discussion Papers, Matsukawa, Sheppard and Wright, December 2003 /1 19 Infrastructure Economics and Finance Department (IEF) PCG applications under development Guarantee Liquidity Facility (GLF) A partial credit enhancement product with the WB providing a liquidity guarantee to cover a specified number of interest and/or principal payments, on a rolling forward basis – i.e. the guarantee is in place throughout the life of the bond or until depletion. The guarantee could be predetermined as an lump sum amount of the debt service covering a rising share of remaining debt service (on a mortgage style payment), or the guarantee could be designed as to cover only a predetermined % of principal throughout the life of the bond. 20 Infrastructure Economics and Finance Department (IEF) GLF : (transmission and distribution PPPs) Outstanding Principal Debt / Service Coverage Ratio DSCR 1.5 1.0 Guarantee Liquidity Facility Years N N+I 21 Infrastructure Economics and Finance Department (IEF) Liquidity Facility Guarantee : FX mitigation Product currently under development Local currency Project Cash-flows expressed in real US$ (going exchange rate) Projected Cash-Flows Real Cash-Flows (after FX adjustment) US$ cash shortfall US$ cash shortfall N N+1 22 N+2 Years Infrastructure Economics and Finance Department (IEF) Liquidity Facility Guarantee : FX mitigation Projected Cash-Flows Product currently under development Real Cash-Flows (after FX adjustment) Local currency Project Cash-flows expressed in real US$ (going exchange rate) DSCR US$ cash shortfall to cover DSRA US$ cash shortfall to cover DSRA N N+1 23 N+2 Years Infrastructure Economics and Finance Department (IEF) Liquidity Facility Guarantee : FX mitigation Projected Cash-Flows Product currently under development Real Cash-Flows (after FX adjustment) Local currency Project Cash-flows expressed in real US$ (going exchange rate) DSCR Liquidity Facility covers short fall up to debt service payment Liquidity Facility covers short fall up to debt service payment N N+1 24 N+2 Years Infrastructure Economics and Finance Department (IEF) Capital Markets in the Region Local capital markets are not the magic solution to what economists call the original sin (weak currency environment). They are still limited in size (as a % of GDP), there still far from perfection for a pricing point-of-view, they need better and speedier enforcement of regulations and so on… Pool of approximately US$ 350 to 400 billion (assets held by LATAM institutional investors – Brazil, Mexico, Chile and Argentina representing roughly 60%) and growing at anywhere between 5% to 10% per year. Of these assets around 75% are held in sovereign related paper. If by offering good credit quality private instruments this number could be reduced to 50%, it will free resources of up US$ 50 billion to be invested in new infrastructure let’s say. Or if new growth could be ear-marked for private sector development we will be talking of anywhere between US$ 20 to 40 billion in needed local funding for private projects. 25