Proposal for Tenor Extension Guaranties

October 17, 2004

Executive Summary of

Proposal for Tenor Extension Guaranties

1.Proposal.

The proposal is for multilateral development banks and others to begin to offer guaranties of local-currency lending by commercial banks to infrastructure projects, as a way of mobilizing local-currency financing for those projects in countries that do not have local-currency bond markets.

2.Tenor Extension Guaranties.

In the last few years, multilateral institutions and bond insurers have completed a series of financings in which they guaranteed local-currency bonds issued in the domestic market of a developing country such as Chile, Mexico or Colombia. Many of these financings have been for toll roads and other infrastructure projects with revenues denominated in local currency. If these projects had borrowed in dollars or other hard currency, project investors and creditors would have been exposed to losses in the event of a local currency devaluation. But by financing the projects with local-currency debt, investors and creditors have a natural hedge, with revenues and debt service both denominated in the same currency. The local-currency guaranty approach appears to be a particularly successful way to protect infrastructure projects against currency risk, and project participants believe the bonds could not have been issued in the local markets without the guaranties.

Can this approach be used in countries that do not have local-currency bond markets? Infrastructure projects typically require financing with a longer maturity than commercial banks can typically provide. Banks that fund their loans with deposits or other short-term liabilities simply may not be able to provide longer-term financing, even in cases where the borrower’s credit is supported by a multilateral guaranty.

The most promising way to overcome this asset-liability mismatch may be a variant of the local-currency guaranty approach, in which a multilateral institution (or other financial institution) would offer the bank a put option, under which the bank would be able to sell its local-currency loan to the multilateral institution at a specific time in the future, before the ultimate maturity of the loan. If the bank has an option to sell the loan at par before the ultimate maturity date, it may be able to offer longer-term financing than would otherwise be the case.

An example of this put option (or tenor extension guaranty) is the Societé Camerounaise de Mobiles (SCM) wireless telecom financing in Cameroon that closed in 2002. A group of local banks led by Societé Generale lent SCM the CFA Franc equivalent of $45 million, of which a total of 25% was guarantied by IFC and Proparco, the French development finance institution. The banks also were granted an option to require IFC and Proparco to refinance 100% of the outstanding debt in the sixth and seventh years after disbursement. This feature (the functional equivalent of a guaranty) allowed the banks to treat the seven-year loans as having a five year maturity for regulatory purposes, which reduced the amount of capital they were required to set aside for the loans and enabled them to extend the maturity of the financing they could provide.

This approach envisions that the local banks will take project credit risk as long as they hold the loan. One implication of this is that the banks cannot exercise the put option if the loan is in default on the put exercise date. If banks did not have an appetite for project credit risk, this structure could in principle be modified to combine the put option with a credit guaranty from the multilateral lender, similar to the guaranties that the multilateral lenders already provide for bond offerings. In the modified structure, the guarantor would take credit risk at all times, and in addition would give the local banks an option to sell the loan on specified dates, whether or not the loan was in default. The effect of combining these features would be to transform the role of the local banks in the transaction into that of a local-currency funding vehicle for the multilateral guarantor.

3.Benefits.

*The tenor-extension guaranty may allow an infrastructure project to attractlocal-currency financing that would not otherwise be available, even in countries that do not have local-currency bond markets.

*The tenor-extension guaranty could help mobilize local savings to fund local investment in infrastructure in countries that do not have well-developed local bond markets.

*By using local-currency debt, an infrastructure project is protected against devaluations of the local currency.

*From the guarantor’s perspective, since the guarantor’s exposure is denominated in local currency, a devaluation has the effect of reducing the guarantor’s exposure to the project – a benefit that is not present with hard currency loans.

4.Obstacles.

*Banks tend to offer floating rate debt, which will not be attractive to borrowers (or guarantors) unless there is some assurance that the borrower’s revenue will increase to cover the increase in debt service expense associated with increases in interest rates. The borrower may be able to hedge this risk if it has an offtake contract or host government concession agreement that authorizes it to pass along the variable element of its capital cost to the project’s customers. In addition, if the borrower is permitted to increase its prices in line with local inflation, it will have some protection against interest rate increases if the interest rate increases result from higher local inflation rates.

*To achieve significant extensions of the tenor of bank loans, it might be necessary to offer the banks the right to put the debt to the guarantor on a series of dates, and not just on one date.

*The credit risk profile of infrastructure projects may not be attractive to local banks. As a result, it may be necessary to combine the put option with a credit risk guaranty to induce banks to lend.

*The infrastructure project loans – with or without a credit guaranty – must be priced to be competitive with other assets available to the local banks.

*In particular, the pricing on the local bank debt has to be attractive enough so that the local bank has an incentive to continue to hold it, instead of exercising the put option. The purpose of the structure is defeated if the local-currency lender does not stay in the deal, because the multilateral lender (for its own hedging purposes) will typically require the loan to convert to hard currency once the loan is acquired by the multilateral, which has the effect of destroying the project’s currency hedge from the moment the loan is acquired.

*Some multilateral institutions have policies against refinancing that might make them reluctant to participate in this kind of structure (even if the put option is a key feature of a structure that attracts new investment for a greenfield project).

5.Recommended Next Steps for Implementation.

*Disseminate information about this proposed approach.

*Try to use it in an infrastructure project where project revenues are expected to adjust in line with changes in financing costs (or at least in line with local inflation) and where local bond markets are not available.

DOCSDC1:197414.2
1-3146 JWH