The Next Frontier: Subsovereign Projects
Municipal project finance is presenting itself as a new frontier in emerging market project development.
Until the past decade or so, debt investment in emerging markets went largely to national governments. The 1990s saw a reallocation of debt investment toward private project financings and public-private partnerships of various forms as the challenge of developing and operating public infrastructure — power, roads, water, ports, airports and telecommunications — was moved in country after country from the relevant government ministry to the private sector.
With the Asian economic crisis, Argentine collapse and Enron bankruptcy, the decline in private capital available for emerging market infrastructure development was dramatic. For instance, with respect to the power sector, Jamil Sagkin, the director of the World Bank’s energy department, notes:
Private participation and investment has not paid off recently, and can no longer be relied on to fulfill expectations . . . . In the tax year between June 30, 2001 and July 1, 2002, private investment in energy projects throughout the developing world fell almost 50%, compared to a high of US$46 billion that was spent 1996-1997. And private investment in energy sector projects is showing further signs of decreasing.
The collapse in energy investment was paralleled to a greater or lesser extent in other sectors.
The retrenchment of private capital had reinforcing motivations from both the supply and demand sides. On the demand side, host governments had found the panacea of private capital to be less than advertised. The off-balance sheet image was clouded by comfort letters and government support undertakings that gave rise to claims, arbitrations and attempted recoveries from political risk insurers.
On the supply side, a number of developers, particularly in the power and telecom sectors, responded to weak economic environments, especially in the US and Europe, by “hunkering down,” focusing on core activities and withdrawing from the business of developing public infrastructure in emerging markets.
This is a particular disappointment for those countries that continue to see private development of public infrastructure as the right way forward. But it is clear that public-private partnerships as they evolved in the 1990s are widely being rethought — by foreign investors as much as by their hosts.
However, it is also clear that infrastructure development and operation by national ministries is not likely to return as the dominant model in many countries. The convenience of private capital and the value of private sector development and operating expertise are too great, and the related efficiencies are too well demonstrated, for things to go full circle. But pure privatization has not worked out well in all contexts. The search is on for new models that help address both public needs and the risk management concerns of project sponsors and lenders. What that search is likely to find is a variety of public-private partnerships in which the relative advantages of each sector are tapped to enhance the prospects for success of particular projects.
Part of that next phase of project structuring is beginning to percolate at the municipal level. In the United States, where municipal financings are supported by local taxes and user fees as well as by, in qualifying cases, a federal tax exemption on interest income, municipal bond finance has become a huge industry.
Similar financings in emerging markets have been relatively unusual. The principal clients of the dominant public lenders to emerging markets have been sovereigns — i.e., national governments. The World Bank by its charter is only permitted to lend to national governments or under a sovereign guaranty. The regional multilateral development banks — with the possible exception of the newest member of the tribe, the European Bank for Reconstruction and Development — have also historically been primarily sovereign lenders, although they all now have important and growing private sector programs. Likewise, the export credit agencies were, until recently, dominantly sovereign lenders and, in the past 10 to 15 years, have expanded their focus to privately-developed infrastructure projects. Missing from all these, however, was a public sector window dedicated to municipal or other subsovereign lending.
A theme to emerge from the past decade of experiments in the private development of public infrastructure has been that full privatization is not necessarily the efficient answer. Some projects may belong in the public sector for some purposes — such as ownership — but provide an efficient private sector role — such as operator. Municipal water projects are a good example. So are toll roads.
The challenge for emerging market subsovereigns is how to persuade financiers to rely on their projects, their balance sheets and their tax bases as an adequate source of repayment. Subsovereigns are not just “little sovereigns.” Depending on the nature of the entity, they may pose (unlike their national counterparts) the risk of bankruptcy or otherwise ceasing to exist. Their revenue flows may be subject to interruption by higher legislative authorities. Sovereign undertakings may, at least to some extent, be reinforced by international legal principles or treaties that may not apply to subsovereign entities.
While challenges in subsovereign or municipal lending are substantial, the opportunities posed are clear. Both host governments and agency lenders are recognizing that projects, like politics, are local. The benefits of a power project or a water project may well flow nationwide, but the immediate need is most likely to be felt most intensely locally. Increasingly, local governments have sought the necessary legal authority to develop such projects on their own. Once the legal authority is provided, the challenge is to convince the main players in the emerging market project finance market to take such projects — and the creditworthiness of their municipal partners — seriously.
In some cases, law has been a bigger issue than credit. While the US Export-Import Bank approved a project loan in favor of the city of Moscow, Russian municipal entities (other than Moscow and St. Petersburg) appear prohibited by Russian law from fresh borrowings of foreign currency. In many countries, municipal budgets are allocated by the central government, with local authorities lacking the power to tax or even to retain project-based revenues.
Still, great strides are being taken. For instance, the International Finance Corporation and the World Bank have jointly established a “Municipal Fund,” a window of IFC lending specifically targeted to private investor partnerships with municipal entities. While the IFC has invested in a variety of municipal projects over the years, its traditional focus has been projects with majority private sector sponsorship. The World Bank, in contrast, has lent billions of dollars to municipalities, but always, per its charter, under sovereign guarantees. The World Bank and IFC thus identified that “a gap exists for investment in well run subsovereign operations without sovereign guarantees.”
The Municipal Fund is designed to fill this gap by supporting emerging market subsovereign projects with debt and equity investment. According to the joint World Bank and IFC announcement, “The objective is to finance critical investments, promote commercialization and corporatization of services and help subsovereign development partners gain access to financial markets.” The World Bank and IFC describe typical projects to include a partial credit guarantee for a bond issue by a municipal water company to finance the construction of a water treatment plant, a loan against local rates on an electricity distribution company to finance a portion of its medium-term capital expenditure program, and investments in municipal sanitation facilities to be managed by a private concessionaire. To date, the Municipal Fund has completed 25 transactions in 12 countries.
Also, the United States Trade and Development Agency has recognized the challenges — and opportunities — in municipal project finance by providing technical assistance grants to explore municipal debt as a mechanism for financing water projects in China and India.
The Inter-American Development Bank has also supported municipal projects, including private concessions of water projects supported under its private sector lending program. However, it remains a cutting edge for the IDB, Dennis Flannery, the bank’s executive vice president (and a past head of project finance at First Boston Corporation) asserted in a speech at the recent annual conference of the US Export-Import Bank. While the IDB does not yet have any particular program for municipal or other subsovereign lending, Flannery said that figuring out structures for supporting municipal projects — especially municipal public-private partnerships — is an important mission at the bank.
Flannery also noted when interviewed that project finance has more than just physical infrastructure to offer Latin American municipalities. Such entities too often lack responsible fiscal policy and discipline. A well-structured project financing, with rigorously designed terms and careful implementation, offers municipalities a valuable model of responsible project management whose positive demonstration effects could extend beyond the particular infrastructure project.
Likewise at the US Export-Import Bank, municipal finance is considered to be the cutting edge. The preferred approach of the US Export-Import Bank to subsovereign landing has been, if a sovereign guarantee is not available, then to make a loan to a creditworthy local bank to be onlent to the subsovereign borrower. However, in the case of its loan to Moscow, the bank made the loan directly to the city, though with its credit supported by a guarantee from a Russian bank. Ironically, if this transaction had been structured according to the traditional onlending approach, then the loan would have gone into default during the 1998 Russian financial crisis when local banks were prohibited from making payments on such loans. As it was, the direct loan to Moscow remained current notwithstanding the difficulties that befell its bank guarantor.
Notwithstanding the credit, legal and structuring challenges, the importance of municipal infrastructure, and the apparent increasing likelihood that in many countries, municipal authorities will step up to the responsibility of pursuing such projects, suggest that the opportunities for the export credit agencies and the development lenders will fill some of the void left by the retrenchment in national build-own-operate and related concessions.
If the public lenders step up to the plate, and if successful municipal project financings follow, presumably the commercial lenders will also be quick to see, and seize, the opportunity.