New Product for Devaluation Risk
By Kenneth W. Hansen
The first project financing to be guaranteed against devaluation risk closed successfully in mid-May.
AES borrowed $300 million for a 15-year term to refinance its costs of acquiring the recently privatized Tiete hydroelectric generating stations in Brazil.
The transaction is noteworthy not only because of the way it handled devaluation risk, but also because it is the first project-risk bond in Brazil to pierce the sovereign ceiling and achieve an investment grade rating. The debt was rated Baa3 by Moody’s Investors Service and BBB- by Fitch. The rating reflects — in addition to strong project economics — support by the Overseas Private Investment Corporation both with conventional currency inconvertibility insurance and a new guaranty by OPIC of the US dollar value of local currency net revenues. This is a form of devaluation coverage.
For the past year, OPIC — the US government agency that since 1971 has provided political risk insurance and financing in support of US investment in emerging markets — has worked with Banc of America Securities on a structure to provide lenders to a project with protection against fluctuations in currency values. The structure can be used to protect any project that generates local currency and is otherwise commercially sound against defaulting on its dollar-based debt because of serious devaluation or depreciation of the local currency.
The AES Corporation proposed Tiete as a test case for this new product.
The coverage is not insurance in the traditional sense but rather is structured as a standby foreign exchange liquidity facility upon which the project company can draw if, as a consequence of devaluation, it would otherwise be unable to make its dollar debt service payments. OPIC disbursements then become a junior loan to the project company whose repayment is subordinated to current payments on the bonds.
The OPIC disbursement must be both necessary and sufficient to avoid a payment default.
It must be necessary in the sense that, if the project company can make the payments due notwithstanding the devaluation or depreciation, then no OPIC disbursement will be available.
The OPIC disbursement must be sufficient to avoid a default. That is, if the maximum amount of the OPIC disbursement available as a consequence of the devaluation, when added to the current dollar value of project revenues or other sources of funds available for debt service, is inadequate to make the payment then due, then an OPIC disbursement will again not be available. In other words, OPIC will not disburse “into a default.”
Through use of such triggers, the OPIC coverage distinguishes exchange rate risks from operational risks, with OPIC supporting the former while leaving the project, and its lenders, to other devices to deal with the latter.
Substantial economic and policy analysis supported the development of the devaluation product. The basic economic theory underlying the product is “purchasing power parity” – the proposition in international economics that exchange rates will adjust to reflect the relative buying power of each currency; that is, exchange rates will adjust to inflation.
OPIC retained Wharton Economic Forecasting Associates to study the adequacy of relative inflation rates as an explanation of exchange-rate changes in a number of countries, including Brazil. The study confirmed that “depreciation” — or market deterioration in a currency’s value — and “devaluation” — or change in currency value declared by monetary authorities — that are not explained by current inflation do occur naturally. In some countries — including in recent years Indonesia, Thailand, Russia, Mexico, Brazil and Argentina — such exchange rate volatility has been substantial. The Wharton analysis was comforting to OPIC because it suggested that significant deviations of currency values from the rates predicted by inflation tend to be of limited duration. While headlines capture dramatic devaluations, they tend not to report the return of rates to more predictable levels.
The Wharton analysis suggested that even dramatic devaluations are likely to pose only a temporary problem for an otherwise healthy project, unless the dollar debt is disbursed at a time when the local currency is significantly overvalued. The consequence for the OPIC product is that draws from a standby facility may occasionally be needed, but a project that is otherwise financially sound in local currency terms should be able to repay those draws in relatively short order.
One motivation for the product has been the observation that, contrary to the expectations of many lenders and developers, dollar-tied offtake agreements may not effectively protect a project and its investors from devaluation risk. When severe devaluations occur, the risk of offtaker default becomes a high likelihood. Consider Indonesia. Offtakers face strong customer resistance at passing on price increases triggered by international currency market events that seem far removed from local life. In contrast, if prices under an offtake agreement are tied to local inflation, then price increases will also be tied and be proportionate to the economic changes surrounding both the offtaker and its down-stream customers. For reasons of both economics and politics, such contracts are likely to be less subject to breach or repudiation in times of economic turmoil than are dollar-based contracts.
Where the project revenues escalate in proportion to local inflation, the OPIC facility assures that the local net revenue, together with the OPIC disbursements, will be adequate to meet hard currency debt service payments as long as the project is operating successfully in local currency terms.
This was a pilot project for OPIC and has not yet been adopted as a regular product. That next step will depend, in part, on whether demand exists in the marketplace from appropriate projects. Appropriate projects would be those with strong local currency project economics –- so that repayment of draws on the foreign exchange liquidity facility can be expected as exchange rates return to more “normal” levels. Appropriate projects would necessarily have project revenues that adjust to local inflation. The more often tariffs under an offtake agreement adjust to inflation, the more appropriate would be OPIC’s product to protect the project from foreign exchange volatility.
Additionally, appropriate countries would exclude those with currencies generally perceived to be artificially supported at overvalued levels, creating the risk of a one-time devaluation unrelated to current local inflation.