The Retreat From Emerging Markets
The speakers are Carol Mates, principal counsel for the International Finance Corporation, Bruce P. Robertson, vice president for petroleum markets at El Paso Corporation, Tony Muoser, managing director for global project finance at Citigroup, Robert J. Munczinski, managing director of BNP Paribas, Julie Martin, a former vice president for insurance at the Overseas Private Investment Corporation and currently vice president and a member of the political risk group at Marsh, Inc., and Eric McCartney, head of project lending in North and South America for KBC Bank. The moderator is Kenneth Hansen.
MR. HANSEN: This morning we are going to be talking about the retreat of project developers from international opportunities, in particular opportunities that were perceived some time ago in emerging markets. Before launching immediately into retreat, the thought was to spend a few minutes exploring why the initial outreach. Carol Mates, why did the US developer community go into the emerging markets in the first place?
MS. MATES: There were enormous opportunities abroad in the late 1980’s and early 1990’s when there were fewer opportunities at home for US companies to build more projects. You had a deregulated industry that was all dressed up with nowhere to go at home. At the same time, you had the breakup of the Soviet Union and the collapse of communism in Eastern Europe. Socialism, or state control of the economy, was suddenly out of vogue. You had the entire world on sale. You had privatizations, and nature forced a vacuum. So the US power industry went abroad.
MR. HANSEN: Bruce Robertson, is Carol’s sketch a fair basis for what brought Coastal and El Paso overseas?
MR. ROBERTSON: Yes, but there was more to it. The domestic energy market is a mature market. It was difficult to find the rates of return that companies required for their investments. They had cash, and they saw the international market as a place where they could earn high returns and gain first-strike footholds in other countries.
Some investments that some companies made have proven a mistake, but most companies picked areas of the world where they had prior dealings and an understanding of the social and political climate. For example, our companies looked at sub-Asia — India, Pakistan and Bangladesh — as well as China and southeast Asia. Those were areas where the two companies had prior dealings. They understood how the markets would react not just to their investments in power projects, but also in complementary areas like pipelines and E&P.
Single investments are the wrong investment strategy. Companies that went into a country in just one sector are now having to shed those investments because the one industry is doing poorly.
MR. HANSEN: I was going to ask why they were leaving; was it a misperception of the opportunity or was it that the times have changed?
MR. ROBERTSON: It depends on why you went into those countries in the first place. If you were just investing in one power plant or in the power industry in a country, what we see is most of those companies fleeing the market. Most of Latin America is a good example. We have investments in China and in sub-Asia and in southeast Asia. Some of them are doing well and some of them are not doing so well, but our strategy is to maintain those assets.
There is one other point, which is that capital is a scarce resource. Many US companies are asking, “What’s the highest and best use for our capital?” If they can put it to more productive use back home to shore up the balance sheet or if the capital can be redeployed elsewhere to earn a higher return, then companies will not hesitate to sell their foreign assets.
MR. HANSEN: Fair enough. Speaking of capital, Tony Muoser, what is the perspective of the bankers? Are you part of the retreat?
MR. MUOSER: I think we have to go back to how this whole thing started. It was in a way a very opportunistic strategy from most of the players. There was pressure for additional growth. That wasn’t possible at that time in the US markets so you had to deploy capital abroad. That goes not only for the sponsors and developers, but also the lenders and equity investors who follow their clients. That’s what happened.
Things obviously have changed. A lot of the sponsors have domestic issues, domestic problems, balance sheet issues that are forcing them to cut back and retreat. If the company had only an opportunistic approach, then it makes sense to get out and focus on its core market again.
The banks are approaching things in a similar manner. It is not necessarily that capital is scarce. It is more an issue of how to allocate cross-border limits. At Citigroup, there is a single cross-border amount that is available for a country across the entire institution. Even if a project is being financed on a non-recourse basis, it still falls under this cross-border limit. Even if there is political risk insurance available, there must still be capacity to lend under the cross-border limit. These limits are another factor that is contributing to the current retreat. The banks are dealing with their own cross-border issues, which are not necessarily just related to the power industry.
I have a struggle inside the company to get an allocation of cross-border limit. I must fight it out with a lot of other people who want to do business in the same country.
MR. MUNCZINSKI: The problem we face within our own institution — and I am sure other banks are wrestling with the same issue — is the fact that it is very difficult to finance on hard currency basis transactions that generate a local currency cash flow. We learned our lesson in Indonesia where, in concept, power purchase agreements were indexed to US dollars, but after the massive devaluation of the local currency, the utility was unable to continue to pay very high US dollar-indexed power purchase prices. One of the conceptual problems we have with emerging market countries is how can we lend hard currency dollars into strictly indigenous transactions? It is much easier to finance export-oriented projects in emerging market countries than a power plant that is selling power to a local community and generating local currency.
MR. HANSEN: I am tempted to throw it over to Carol Mates. Carol, how are the multilateral lending agencies thinking about addressing this clear issue?
MS. MATES: It is very hard to address the issue of inconvertibility —
MR. MUNCZINSKI: It is not inconvertibility. It is devaluation.
MS. MATES: Devaluation is another issue, and I believe where we all come out is you just can’t escape that risk. You can mitigate it to a degree. There are some insurance products on the market that attempt to go to that risk.
Only in the last 10 years have we as a community been financing private infrastructure in emerging markets. One thing we are all appreciating now is that when you have a private provision of a public service, you can never get out of that country. The end users are paying you in local currency, and you have the macroeconomic risk of the whole country and the whole system. To a certain extent, you are really stuck. Can this country support its currency? That’s a different issue than one faces in a domestic deal.
MR. HANSEN: Let’s hold the specific devaluation concern a little bit because we are going to come back to that, and we happen to have a couple of folks here who have looked at that with a lot of attention and some success. Carol, more broadly, given what appears to be at least on a net basis an evacuation of support by private sector money, private sector expertise, that has been marketed for quite a while as the brightest alternative way to develop infrastructure in emerging markets, what are you going to tell your developing member countries that they ought to do in order to produce power going forward? The folks who have marketed to them in recent years are losing interest.
MS. MATES: One thing is that both sides have to start shifting some of their expectations. Governments in developing countries are going to have to realize that the private sector has to be accommodated — that they are going to have to be more flexible. In a sense, even if you have a contract for 100% private provision of a service, the government is still there as the partner.
Now in terms of getting an allocation of hard currency toward servicing some of the payments that have to be made, that is a macroeconomic issue. In some cases, I don’t think the developing countries understood really how the private sector works because their economies were state controlled.
MR. HANSEN: There is a chapter in everybody’s develop-ment and economics textbook on the “obsolescing bargain.” There is a tendency for investors to be coaxed into a developing market, sink their capital, commit themselves and once they are there, the terms change. At the end of the day, the folks who have the longer-term commitment, which is to say the indigenous population and government, get the last laugh. They get the plant. The investor goes home wishing he had never come.
Couldn’t one argue that is simply what has happened again and, at this point, the emerging markets have the plants, they got the expertise through training of indigenous experts, and now the developers can simply go home and wait for the next time?
MS. MATES: Well —
MR. HANSEN: The suggestion was the emerging markets have screwed up and may need to fix things. Another perspective would be they got exactly what they were trying to get.
MS. MATES: I think this is all going to sort itself out, but perhaps over a longer timeframe than the average US developer wants. If you are looking at your next quarterly earnings statement, it is not going to sort out in that time period. There is a need for power in these countries. The governments are going to realize they need the expertise that foreigners can provide, and I think US companies will want to be there.
What is the realignment that is going to happen? Probably there will be more local participation in projects. There will probably be more local sourcing of capital. There will probably be a better legal structure so that every time you do a plant in a country, you don’t have to do one-off deals with the government and spend an enormous amount of time just getting the contracts right. A better legal system also leads to greater transparency. These things will take time. The parties are beginning to each realize what their own interests are. Institutions such as mine — the World Bank Group, the IFC in particular — have the capital. We are very eager to support this process going forward.
MR. HANSEN: Before the spasm, if you can call a decade of private investment in power projects in developing countries a spasm, the lead financier of such infrastructure was, of course, your institution, the broader institution, in particular the World Bank. The World Bank can only lend to governments. As the private model, at least as supported by US developers, steps back a bit, subsides in its interest in such development, would you expect the World Bank to come back? I guess the question is: was the World Bank one model that we have moved beyond, and now the private development of public infrastructure is another model, but we are going to move beyond it into some new place? Or are we going to go back more to the traditional model of “Let the ministry of power do it. Let the World Bank pay for it”?
MS. MATES: There isn’t the political support to return to the old model. The multilateral institutions are composed of governments. The governments are shareholders. The US government is the largest shareholder, and US and western Europe — particularly the US — are not going to go back to the state-supported enterprises. My guess is we will move to more of a mixed joint venture in countries where the purely private model hasn’t worked and the private sector is unwilling to take all the development risk. The risks will have to be apportioned differently.
Political Risk Claims
MR. HANSEN: Besides the project developers and the project lenders, a group of institutions that has shared in the disappointments that some projects have experienced is the political risk insurers. Julie Martin, I would be interested in your reaction as a political risk insurer to some of the comments that have been made this morning.
MS. MARTIN: September 11th knocked the insurance industry for a loop. Everyone has experienced dramatic increases in the cost of standard programs — property and casualty, directors and officers. However, the political risk insurers have not had as dramatic a downturn. Many power projects that political risk insurers supported are just now coming on line. Many such projects are having to renegotiate their terrorism or cancellation or non-payment coverage.
Political risk insurers are still in the process of sifting through recent experience with claims to figure out what lessons there are to be learned. OPIC paid its largest claim ever a couple of years ago for a project in Indonesia. Many political risk insurers are involved with the Dabhol project in India. That one is just now being sorted out. A number of projects in Argentina were supported by political risk insurance.
My guess is the political risk insurance industry will continue to support power projects as the power industry has been a significant source of revenue in the last few years, but the insurers will adjust how they do it. They will analyze risks a little more carefully than they did in the past. Just because you have a government PPA does not mean it is a good project. You will look at how the pricing and dispatch work within the overall system.
MR. HANSEN: It is intriguing. You mentioned Argentina, Indonesia and India. At least insofar as Dabhol and Argentina are concerned, I am not aware of any political risk insurance claims actually having been paid. To some extent, the occurrence of an actual insurance payment — dramatic though it was a couple of years ago in Indonesia — is an anomaly. One of the concerns about the political risk insurance market is that, notwithstanding all the billions of dollars of coverage out there and a series of bank crises and political crises in this country and that country, it turns out to be really hard to qualify to get a claim paid. There is a concern that maybe the insurance market isn’t providing the insurance that is needed. Just generally, how do you think the political risk insurance market is doing in serving infrastructure development?
MS. MARTIN: There are some risks that are clearly political, some are commercial, and there is a big grey area in between. Some of those are still being sorted out as to which bailiwick they fall into.
There was a big push starting in 1996 by political risk insurers to develop products that respond to developer needs. With the downturn in the insurance markets, some insurers are pulling back.
Some of the policies issued in Argentina have a new form of clause that responds to a fear by generators and distribution companies that they could be squeezed by regulatory-type actions that are not necessarily a violation of international law. These new policies have not been fully tested. It will be interesting to see how they fare.
On the other side of it, as Ken well knows because he was our lawyer on this transaction, after the Asian crisis when I was still at OPIC, many companies came to us and said, “We are not interested as much as in convertibility. What we are really concerned about is devaluation”. OPIC didn’t think it had any better way of predicting devaluation than all those smart Wall Street houses, but we did want to try to find a way to help.
What we did was we structured a liquidity facility that is available to be drawn by the AES Tiete project in Brazil when there are shortfalls in cash available for debt service as a consequence of devaluation. It worked in Brazil because Brazil has a relatively free-floating exchange rate. We would never have done it in Argentina where the peso was pegged to the dollar because we knew once you went off the peg, you were dead. It worked because we did a lot of analysis. We hired Wharton Econometrics to look at how purchasing power parity held up in a number of countries. It worked because the underlying project had a very strong and predictable cash flow. So with utilization of about $30 million of this type of capacity on a $300 million bond issue, we were able to cover the devaluation risk for the rating agency purposes. It is the only one that has been done that I know of.
MR. HANSEN: One of the surprises for the people working on the Tiete project was when OPIC brought in the economic consultants and we analyzed what had happened after the Mexican and other crises, although everyone remembered the headlines from the other devaluations, no one remembered how long it took for rates to be restored to normal levels. Suppose you were to establish a reserve twice what would have been required to weather the worst devaluation Brazil had ever had to date for a $300 million bond offering. The size of credit facility necessary to protect the $300 million in bonds against double the devaluation that had ever occurred was only $6 million. It sounded so small. It just wasn’t dramatic enough, so ultimately the facility was $30 million, or five times the size that historically could be defended.
As a business matter, it seems this wasn’t such a tough nut to crack. At the end of the day, the actual product was just a credit line, with very special terms but, nonetheless, just a credit line.
Tony Muoser, why have institutions like Citibank not run into this business? Is it for lack of having examined it or is it that you have examined it and decided that it is not such a smart product after all?
MR. MUOSER: I suspect we have not explored it. The devaluation issue is the number one issue for lenders and bond investors. I don’t think that expropriations are a big concern at this point. Maybe we have to go at it from different angles. Devaluation risk coverage from multilaterals or private insurers is one way to do it. I do think that we need to develop the local capital markets as Carol pointed out. Maybe the multilaterals can play a role there as well by providing local currency guarantees.
When you look at the US domestic market, at least for bank financing, it is a “mini perm” market. Maybe we should try to move in that direction for the emerging markets. That might be another way to mitigate the devaluation risk.
On the other hand, I am not sure the commercial bank market will be willing to take the refinancing risk in an emerging market. Maybe there is another role for the multi-laterals to play. They can follow the Brazilian model where the BNDS, which is the Brazilian development bank, is serving as a backstop to some capital markets transactions by taking that refinancing risk. Investors have a “put” to sell the project to the BNDS after four or five years.
I doubt people will simply sit back and see what time can heal. But you are probably going to need another generation of bankers because this generation still has wounds to lick from the lending that was done in the last decade in emerging markets. Many bankers have lost their jobs over bad loans. People who are still there are going to be extra careful.
MR. HANSEN: It’s intriguing. I hadn’t really thought about this before, but taking the long view, it was the Bretton Woods conference that gave rise both to the establishment of the World Bank Group and a system of fixed exchange rates. The US government responded within a number of months with the first plank of its political risk insurance program in the Marshall Plan, which was currency inconvertibility insurance. It made sense in a world of fixed exchange rates. It responded to a likelihood that it would have been impossible to maintain those rates and, thus, things would go inconvertible.
Since 1972 — it’s quite a while ago — we haven’t been living in a fixed exchange rate world except for special countries here and there, the Dominican Republic, Argentina at different times, pegging their rates.
It would somehow seem appropriate if the offspring of the Bretton Woods conference — the World Bank Group — would come up with a way of supporting what appears to be well established as the dominant currency-related risk in emerging market investment, which is devaluation.
Carol Mates, any thoughts about following OPIC’s lead or striking off in your own direction in doing something — whether it is through MIGA or the IFC or otherwise — that would help developers and lenders manage devaluation risk?
MS. MATES: I am more optimistic than Tony is. In my time at the World Bank Group, I have seen several debt crises. Going back to the early 1980’s, there was a Latin debt crisis. At the end of the 1980’s, there was the Mexican crisis. Everybody moans “It is terrible” and, within three years, the lenders are back in because the returns have returned to normal levels and there is money to be made in restructurings and reschedulings. In my view, people have very short memories once it seems there is a way to make some money off of something. [Laughter]
At the IFC, we work only with the private sector. We have recently been doing a fair number of what we call “partial credit guarantees,” which are guarantees of local bond offerings, to help with capital markets in our member countries. This is to ensure there will be local currency financing in projects. It does not solve the problem of devaluation risk for hard currency loans, but it mitigates against it because a project requires less hard currency to be built.
We are willing to look at other approaches. We offer political risk insurance through MIGA. Things will evolve. The market will respond to need. Exactly how it should do so, I’m not sure, but the market tends to respond more quickly to demand than people think.
MR. HANSEN: With the time remaining, let’s turn to the future of the industry in emerging markets. Bruce Robertson, what do you think is ahead? Just how are projects going to be developed in these regions that are less popular than they were some months ago? There is still a need for electricity.
MR. ROBERTSON: Very slowly and very carefully if at all. Going back to the 1980’s when the emerging market boom started, everyone was trying to do a big power project. It was never a 100 megawatt facility. People wanted to do 1,000 megawatts. They wanted to do the big showcase projects. Many of these projects are just now coming on line. The local countries frequently lack the ability to distribute the power efficiently. The World Bank should be helping these countries improve their transmission and distribution facilities. In the interim, I think the best future opportunities for private developers are for smaller off-mainline-type power projects in the outlying areas. Most of these countries have baseload power plants and transmission lines to take power from these big baseload plants to the big industrial cities. The outlying areas have nothing, and they have been left behind.
The US Export-Import Bank and I believe the IFC as well are starting to support development projects in rural areas. I think that is where some of the investments are going to happen in power. It is not going to be large showcase projects.
We are a lot smarter now. These things work in cycles. The cycle is this. If you look at your power bill now that you are paying in the United States and you look at what they are paying internationally, rates are lower overseas. That’s why the industry moved back to the US market. We are back home for three to five years — I don’t think it will be a whole generation, Tony — but already you have the same people sitting in this room talking about where we are all going to go next.
MR. HANSEN: Tony Muoser, if we were to put together one of these smaller projects sponsored by a fully-integrated energy company and we came knocking on your door recognizing that the welcome mat actually wasn’t put out that morning, what would it take to get the banks interested? Might it be multilateral support? I mean, besides the passage of time and replacement of personnel. [Laughter]
MR. MUOSER: It is even more difficult for us to get involved when you are talking about developing rural areas. The first reaction will be, “I would rather be in the city where there is a larger consumer base and higher per capita income.” If you are really talking about a small project in a rural area, I would have to put it back to the multilaterals. Such projects are very difficult for the commercial banks to evaluate. The banks and capital markets have been moving away from the smaller transactions.
MR. HANSEN: What about lending shoulder to shoulder under the umbrella of a multilateral like IFC or one of the regional development banks? Would that get you there?
MR. MUOSER: That approach has been tarnished by recent experience. We do not believe that the mere fact it is a “B” loan means the lender is in a stronger position. I guess I am not very optimistic.
MR. HANSEN: The goal of this panel was to wake everybody up, not to make you wish you hadn’t gotten out of bed. [Laughter]
MR. McCARTNEY: The biggest risk today for a banker is devaluation risk, and you don’t get rid of that with a “B” loan. Having the IFC or the InterAmerican Development Bank involved helps, but it does not eliminate the risk.
MR. MUNCZINSKI: I wonder if we could get a reaction from the audience about the valuations that the equity markets place on companies that are sponsors of international projects. It seems to me that if you are operating in a small country that may have 3,000 megawatts of total capacity and you develop 300, you supply 10% of a very small market; even a healthy equity market is going to take a big yawn at something like that. That is not a driver of value.
I am confused by the business strategy that some of our clients have in terms of going after very small playgrounds. They may be big players but in very small playgrounds. I don’t think the equity markets ascribe very much value.
Look at AES. In early 2000, AES probably had a P/E ratio of 60. It was trading at $70 a share. The company’s profile probably isn’t that different today than it was in early 2000. AES has been involved throughout in places like Kazakhstan and Argentina and Brazil, and the equity markets in early 2000 ascribed a great deal of value to international diversification. In the short period of a year and a half, the equity market did a complete turnaround on that issue and has driven that valuation down. Obviously, AES has also been harmed by the taint in the energy sector as a whole.
Lenders are subjected to the same type of questioning from equity analysts. When Russia hit the wall in 1997 or 1998, equity analysts asked leading international banks how much emerging markets exposure they have. From quarter to quarter, the analysts tracked whether lenders were increasing or reducing their exposure in such markets. More recently, the questions have been about telecom and energy sector exposure.
The international banks that look at trying to maximize their equity valuations are very sensitive to issues like this.
MR. HANSEN: Our master of ceremonies has been tugging me to the side.
MS. MATES: Can I just make one tiny comment?
MR. HANSEN: Please do.
MS. MATES: Emerging markets are not called emerging for nothing. They are unstable. They go up and down as anyone who has had the misfortune as I have to invest in emerging markets stock funds knows. But there are cycles, and this latest period of handwringing too shall pass. We will have a different model in a few years and people will find ways to do projects in these countries and earn a respectable return.
MR. HANSEN: By your model, this topic too shall come back again. [Laughter]