The World Bank Group Infrastructure Economics and Finance ...

The World Bank GroupThe World Bank GroupInfrastructure Economics and Finance DepartmentInfrastructure Economics and Finance Department

Capital Markets Instruments : Capital Markets Instruments : Financing Infrastructure Financing Infrastructure

DevelopmentDevelopment

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)

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ContentsContents 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


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Size & Structure of the Bond Markets Size & Structure of the Bond Markets (LATAM)(LATAM)

I nstitutional I nvestor Assets for Larger LAC markets, 2001

Local Currency (equivalent US$ billions) Country Pension

Funds Insurance

Co. Mutual Funds

Total 1999

Total 2001(e)

Argentina 14.0 2.0 7.5 23.5 29.5 Brazil 53.0 11.0 44.0 108.0 135.0 Chile 33.0 10.0 4.0 47.0 58.7 Mexico 8.5 2.4 13.0 23.9 29.9 Peru 2.5 .4 .5 3.4 4.2 Otherse 16.7 3.9 10.4 31.0 38.7 TOTAL 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%)


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Relative Size of local Capital MarketsRelative Size of local Capital 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

Table 2: Capital Markets Capitalization as a % of GDP for selected countries, Year 2001[1]

(equity and bond markets)

[1]


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Infrastructure Needs : LATAM (2005-2010) Infrastructure Needs : LATAM (2005-2010) /1

New Investments Maintenance Total

(000 US$) (000 US$) (000 US$)

Electricity (power) 15,034.00 10,593.00 25,627.00

Basic Telephone 3,276.00 4,175.00 7,451.00

Mobile 15,049.00 10,015.00 25,064.00

Sub-Total 18,325.00 14,190.00 32,515.00

Roads 2,791.00 4,198.00 6,989.00

Railway 0.00 733.00 733.00

Water & Sanitation 1,792.00 3,234.00 5,026.00

Total 37,942.00 32,948.00 70,890.00

Source : World Bank, Working Paper 3102, Fay-Yepes, 2003

Note : /1 Does not include rehabilitation, deferred past maintenance and upgrades


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Infrastructure Needs : LATAM (2005-2010) 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)Redesign of the government role (from regulator to partner, PPPs) Development of risk mitigation products that can addressed the FX riskDevelopment of risk mitigation products that can addressed the FX risk Development of local currency debt instruments Development of local currency debt instruments


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Real Investment in Infrastructure Projects withReal Investment in Infrastructure Projects with Private Participation in Developing Private Participation in Developing

Countries(1990-2002)Countries(1990-2002)

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

All low and middle income countries Low income countries

US$Bn

Source: PPI Data Base (IEF, WBG)


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New Agenda : Connect Infrastructure New Agenda : Connect Infrastructure with private financial marketswith 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 developmentlocal capital market development (local currency financing) and hedging instruments against currency risk.

Development of risk-mitigation productsrisk-mitigation products to support financing instruments capable of dealing with credit, fx, contractual and regulatory risks.

Enable and support access of municipal governmentsmunicipal governments, sub-sovereign entities and public utilities to private financial markets via improvement of corporate governance, credit worthiness, and initial financial backing.


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Local Capital Market DevelopmentLocal Capital Market Development Financial des-intermediationdes-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 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 mitigate cross-border riskcross-border 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 build-in contracting clauses for US$ tariff based there is a tolerance to FX adjustments in a particular economy)


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Development of local currency debt Development of local currency debt instruments 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)


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Guarantees: OverviewGuarantees: Overview Political Risk Guarantees (US$ debt instruments)

sovereign (transfer & convertibility) and selected non-commercial 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).


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Financial Guarantees, partial credit guarantees (local currency Financial Guarantees, partial credit guarantees (local currency debt instruments) 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.

Guarantees: OverviewGuarantees: Overview


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A Partial Credit Guarantee (PCG) can guarantee debt service for specific periods

$150 million

Average financing term forChina without

World Bank Guarantee

Additional uncoveredrisk taken by

commercial banks

World BankGuaranteed

Total risk assumed by commercial banks

$50 million

0 3 6 9 12 15

Example: China Example: China Ertan Power Ertan Power

ProjectProject

Guarantees: Extending tenors for required Guarantees: Extending tenors for required longer maturities.longer maturities.


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Guarantees: PCG applications under Guarantees: PCG applications under developmentdevelopment

Mezzanine Guarantee (local currency instruments)

Pool Guarantee (local currency instruments) Guarantee Liquidity Facility

Application of Partial Credit Risk Enhancements to Application of Partial Credit Risk Enhancements to potential PPP projects in infrastructurepotential PPP projects in infrastructure

Design the “optimal” partial credit enhancement for a given project in order to Design the “optimal” partial credit enhancement for a given project in order to improve its credit risk profile enough to capture private capital on adequateimprove its credit risk profile enough to capture private capital on adequate

terms & conditionsterms & conditions

Design the “optimal” partial credit enhancement for a given project in order to Design the “optimal” partial credit enhancement for a given project in order to improve its credit risk profile enough to capture private capital on adequateimprove its credit risk profile enough to capture private capital on adequate

terms & conditionsterms & conditions


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PCG applications under developmentPCG 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.

IllustrationIllustration: 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.


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Mezzanine Guarantee (energy distribution Mezzanine Guarantee (energy distribution co.)co.)

Project Revenues(High Credit Risk Quality Layers)

Project Revenues(High Credit Risk Quality Layers)

Layer of Lower Credit Risk QualityLayer of Lower

Credit Risk Quality

Transaction Reserves

Over-collateralization

Project Debt Service Reserve Account

Liquidity Reserve (sponsors recourse)

Partial Partial Guarantee Guarantee

(a portion of the credit loss on the transaction, -- debt service)

Transaction (Receivables Securitization ) Mitigation of the lower credit

risk quality and improving the transaction rating attracts participation of Monoline Monoline Insurers to provide a Insurers to provide a “wrap”“wrap” on the whole transaction, improving further the transaction credit rating.


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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.

IllustrationIllustration: 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.



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Pool Guarantee:Pool Guarantee: CBOCBO, for, for Illustrative Illustrative purposespurposes

Source: Rating Agencies Methodology (Case Example)

1. Stressed Default Rates (%)

CollateralRating BBB A AA

AAA 0.50 1.00 1.50AA 1.00 1.50 2.00A 2.00 3.00 4.50BBB 6.00 11.00 13.00BB+ 22.00 30.00 40.00 Approximation to Required Credit EnhancementBB 24.00 32.00 42.00

BB- 30.00 36.00 48.00Desired Rating (CBO) A

Underlying C redit Quality of Pool (AVERAGE) BB+

Stressed Default Rate for a A rating 30.00%Recovery Rate (AVERAGE) 25.00%

Loss severity (1-recovery rate) 75.00%

2. Assets Recovery Assumptions Expected Loss 22.50%(Default Rate * Loss Severity)

EM Sovereign without guarantee 25%EM Sovereign with guarantee 40%(principal + 12 month interest)EM Corporate 20%

Minimum Amount of C redit Enhancement = 22.50%(for bond holders guaranteed payment of interest + principal)

Desired CBO Rating

(illustration purposes)

CBO (Collateralized Bond Obligations) for Emerging Markets (EM) Debt


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Liquidity Facility 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


/1 Foreign Exchange Risk Mitigation for Power and Water projects in Developing Countries, World Bank, Energy Discussion Papers, Matsukawa, Sheppard and Wright, December 2003


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Guarantee Liquidity Facility (GLF)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.



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GLF : (transmission and distribution GLF : (transmission and distribution PPPs)PPPs)

Debt / Service

Coverage Ratio

1.51.5

1.01.0

Outstanding Principal

Years

N N + I

DSCRDSCR

Guarantee Liquidity Facility


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Liquidity Facility Guarantee : FX mitigationLiquidity Facility Guarantee : FX mitigation

Years

Local currency Project Cash-flows expressed in real US$ (going exchange rate)

Projected Cash-Flows

Real Cash-Flows

(after FX adjustment)

N N+1

US$ cash shortfall

US$ cash shortfall

N+2

Product currently under development


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Years



Real Cash-Flows(after FX adjustment)

N N+1

DSCR

US$ cash shortfall to cover DSRA

N+2

US$ cash shortfall to cover DSRA




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Years



Real Cash-Flows(after FX adjustment)

N N+1

DSCR

N+2

Liquidity Facility covers short fall

up to debt service payment

Liquidity Facility covers short fall

up to debt service payment




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Capital Markets in the RegionCapital 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. I f 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.

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