Catalog

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p. 15 of 32 BACK | NEXT I. Introduction II. Assessment of Past Performance III. Rationale and Role IV. Operational Strategy A. Focusing Primarily on Existing Strengths B. Extending the Country and Sector Reach C. Wider Use of Innovative Financial Instruments D. Building Strategic Alliances and Partnerships V. Operational Improvements VI. Resource Requirements VII. Conclusions and Recommendations

Private Sector Operations: Strategic Directions and Review : IV. Operational Strategy

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C. Wider Use of Innovative Financial Instruments

59. While loans in foreign currencies and equity investments will continue to be the two most widely used instruments in PSO in the short-to-medium term, more innovative financial instruments are needed to leverage ADB’s capital to address the needs of DMCs more effectively. One difficult challenge is dealing with exchange risk in project finance.

60. Until recently, foreign currency financing of infrastructure projects was the rule in Asia, mostly in US dollars. However, this practice exposed projects dependent on local currency revenues to a large currency exchange risk. The Asian financial crisis showed the danger of this currency mismatch. The major, sustained fall in domestic currencies impaired the financial health of highly leveraged projects with such mismatches. Contracts allowing such projects to “pass through” financing costs, including losses from exchange fluctuations, to offtakers and end users resulted in unsustainable, high tariffs. Some of the recent build-operate-transfer power projects in Indonesia are examples of this phenomenon. To the IFIs and commercial banks that provided financing in foreign currencies to such projects, the exchange risk became credit risk and as a result of loan defaults, these lenders ultimately took losses in their books.

61. The preferred solution to the currency mismatch problem is to increase the proportion of local currency debt financing for projects dependent on local revenues. However, in most DMCs, such financing is not readily available in adequate amounts and in sufficiently long tenors to meet the requirements of long-payback infrastructure projects. ADB is therefore continuing to help DMCs develop local capital markets. But this is a long process. To be proactive in the interim, ADB would consider assistance to individual private infrastructure projects in raising local currency debt in the domestic market. Credit enhancement through guarantees is one form of such assistance (para. 67). Local currency financing represents the future of infrastructure project finance. Without such capability, ADB will not long retain a credible role in project finance in the region.⁴⁴

1. Complementary Financing Scheme

62. The CFS will remain an important tool for sovereign risk mitigation, but it will not be useful for all types of projects and in all DMCs. The CFS is typically used for relatively large projects that have (i) substantial cross-border financing requirements, and (ii) a structure (e.g., security package and syndication potential) that is attractive to international commercial lenders. The CFS tends to be most attractive for lower-risk projects and lower-risk countries in which commercial banks feel sufficiently comfortable to participate without explicit guarantee or insurance cover against specific political risks. One aspect that has tended to diminish the attractiveness of the CFS, from the perspective of commercial lenders, is the extent to which such lenders are asked to delegate their loan supervision rights to ADB, which acts as "lender of record" in CFS transactions. ADB has sought to widen the use of the CFS by relaxing its claim with respect to certain of these rights, provided that this does not compromise the principle that the CFS loan is an ADB loan and as such is accorded preferred creditor status.

63. Since the CFS relies on ADB's preferred creditor status, and is designed to ensure preferred access to scarce foreign exchange reserves, it is not a suitable mechanism to provide cover for domestic lenders, nor is it useful for mobilizing local currency loans.

64. It is ADB’s policy not to blend or overlap the CFS with political risk covers offered by third parties, such as private insurers or official export credit agencies (ECAs). However, the CFS is often packaged, on a parallel basis, with other credit enhancements. While respecting the policy not to extend ADB’s preferred creditor status to official ECAs, as well as the policy not to blend the CFS with credit enhancements offered by private insurers, we need to explore ways by which project lenders can take advantage of the benefits of the CFS provided by ADB and the credit enhancements available from third parties, provided that these products complement each other to more effectively catalyze commercial financing that would not otherwise be forthcoming.

2. Guarantees

65. Wider use of guarantees under ADB’s existing guarantee policies will also facilitate commercial cofinancing. Guarantees allow ADB to selectively cover risks that are of concern to lenders, and to achieve better leverage than possible with direct loans. They can be extended on a wide range of underlying debt instruments, including bonds, and can be structured to offer significant access and/or cost improvements in funding projects. Guarantees can also provide flexibility to ADB in its choice of modalities used to finance private sector projects. The two basic types of ADB guarantee available for PSO are the partial credit guarantees (PCG) and the political risk guarantees (PRG). PCGs provide cover against all risks (commercial and political) for a portion of debt service on commercial borrowings. PCGs can be designed to extend the tenor of a financing instrument particularly where longer-term project funding is not available unless credit enchanced. On the other hand, PRGs cover defaults by borrowers due to specifically identified political risks. ADB intends to pursue the use of guarantees more actively as part of PSO. The wider use of guarantees, however, particularly PRGs, also depends on appropriate staff resources for PSO.

66. The PRG is deemed by international lenders to provide a much more effective protection against sovereign risks than the CFS. Last year marked the first time that ADB used the PRG to support the debt financing of two private sector power projects, one in Bangladesh and another in Sri Lanka. With the recent Board approval of improvements in the PRG features,⁴⁵ ADB is now in a better position to use the PRG for catalyzing commercial debt finance for private sector projects, particularly in countries with no ratings or with ratings below investment grade. A more active promotion of the product by ADB would also help attract clients.

67. The PCG has so far been used for public sector projects in which there is a financing gap that requires funding from international commercial sources. The PCG would be a useful instrument for PSO if used to enhance credit of private sector borrowers from the domestic market. Under the existing policy,⁴⁶ ADB can issue PCGs denominated in US dollars or another foreign currency to cover local currency loans or bond issues.⁴⁷ Judiciously applied to cover later maturities of loans and bonds, PCGs could encourage domestic lenders and investors to agree to longer tenors on debt needed, particularly for infrastructure projects. By providing credit enhancement through PCGs, ADB would likewise be able to help augment the local supply of attractive, long-term debt instruments needed to stimulate the development of domestic capital markets.

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