The Role of the Financial Sector: Channeling Private Savings to Infrastructure Investments

1. The Role of the Financial Sector: Channeling Private Savings to Infrastructure Investments Sept 20, 2004, Washington, DC Mahesh Kotecha, President, CFA Structured Credit International Corp. (SCIC)

2. Key Recommendations • Encourage development of viable projects • Via reduction of real risks through better policies • Via reduction of perceived risks with investor education and better use of ratings • Encourage the rising role of local and regional players • Regional sponsors with growing capacity have an important role as niche players • Local banks can develop a role in project lending but must have early warning signs to watch against excessive maturity mismatches and large concentrations • Extend the use, effectiveness. efficiency and simplicity of risk mitigation techniques • To make viable projects stronger • To distribute risks to a wider investor base • Most of all, encourage local capital market development to reduce and /or better distribute FX risks

3. Welcome Feedback On • Making projects more viable • Encouraging sound cost recovery • Greater flexibility versus predictability in indexation • Encouraging flexibility in working things out in good faith (as Chile did for toll road sector when traffic demand was slow to ramp up) • Need to work more closely with regional and local institutions • Early warning signals for domestic banks doing project lending • Innovations in risk mitigation • Higher leverage for multilateral lenders’ guarantees • Broader coverage and eligibility – contract abrogation, regulatory risk • Developing public private partnerships in risk mitigation • Developing local capital markets • Municipal finance market development • Extending maturities • Fixing terms

4. Financial Engineering Cannot FixPoor Project Economics or Poor Policies for Infrastructure

5. Key Post – 1997 Lessons • Projects should be economically viable -- provide essential services on an affordable and a profitable basis • Only possible within a framework of sound sector strategies, good policy planning and a long-term commitment to improving country ratings • Requires willingness to uphold legal contracts, even in adversity • E.g., Philippines and Thailand did so in power; Indonesia generally did not • But poor project economics enhance pressures to renege on policy protections , e.g., take or pay contracts and commitments to raise rates • Poor project design / poor public policy can hurt (Maylinad) • Even good documentation cannot offset weak demand (Meizhou Wan) • Poor projects may exacerbate direct / indirect public contingent liabilities • Financial engineering / risk mitigation (PCG, PRG, full wrap) can help • Attract foreign investors, extend maturities, reduce costs, etc. • But no substitute for project fundamentals

6. What Makes a Project Viable? • Predictable country risks, with transparent legal / business environment • Sound infrastructure sector strategies and policies • Acceptable country risk (could be measured with credit ratings) • Willingness to abide by contracts and enforce arbitral awards • Sound deal economics • Experienced and reliable sponsors • Secure supplies with agreed or acceptable price expectations • Adequate demand at affordable prices generating attractive ROI • Sensible, transparent, affordable PPAs or other support payments • Exit options via IPOs or sale to strategic investors or a handover to the government after expiration of the concession period • Adequate local / international financing and risk mitigation • No substitute for sound policies and sound project economics

7. Risk Mitigation Can Help Viable Projects • Can widen investor base & reduce costs • But broader eligibility and scope of cover are needed • Mitigate policy and non-policy risks • With PRI, PRG • With PCG, monoline or multiline guarantees, etc. • Extend maturities for domestic and offshore debt with maturity and partial credit guarantees • e.g., for EGAT, Telecom Asia • Reduce currency and interest rate mismatches • Via better FX indexation (BLCP – too inflexible) and liquidity facilities (Tiete – too complex) • Development of currency and interest rate swaps • Distribute lenders’ post-construction risks via pooling • e.g., Road King and Hong Kong tunnels and bridge financing

8. What Could EAP Countries Do to Make Projects Viable?

9. Adopt Good Policies to Reduce Real Risks • Establish predictable policies for key sectors: • E.g., telecoms, power, water, piped gas, etc. • Deficient in such countries as Vietnam, Indonesia, etc. • Abide by the rule of law • Accept enforcement of external judicial and arbitral awards • Accept New York Convention • Reduce corruption • Improve credit culture, especially at state-owned financial institutions • Use ratings for asset quality assessments to enhance risk management and bank supervision • Be willing to work things out in good faith if reality changes dramatically • E.g., Chilean Government agreed to extend concessions for toll roads and investors capped returns when traffic was significantly below projections • Use World Bank / other multilaterals as “honest broker” as needed

10. Use Ratings to Reduce Perceived Risks • Reduce perceived risk through better sovereign ratings • Improve existing sovereign ratings • Obtain and use new sovereign ratings • Ratings: an independent opinion of the creditworthiness • Well accepted by investors • Impose a market discipline on country leadership • Can help separate stronger countries from weaker countries • Rating changes can measure progress over time • Ratings can also be used for loans • Not currently being used in Asia • Their use is developing in international markets • Ratings can also be used for local capital market development

11. Develop Local Capital Markets • Local capital market financings can reduce FX and other risks • Develop a sequenced strategy for all sectors – corporate, municipal bond, structured finance and equity markets • Improve currency swap markets to better hedge FX risks • Extend maturities with “take out” financings and maturity guarantees • Develop issuer and investor with better regulatory frameworks • Covering pension funds, insurance companies, mutual funds and non-bank finance companies • Using national scale ratings to improve domestic credit culture • Improve disclosure standards for issuers • Securitization frameworks where appropriate – perfection of security interests, SPVs, enabling framework for efficient transfers of assets and enforcement of claims • Promote municipal financings by increase transparency and legal basis for inter-governmental fiscal and service arrangements

12. How Can the Official Sector Help?

13. Help Develop Local Capital Markets • Help fix rates • 10 year swaps are possible in the Philippines • 15 years in Thailand may be possible • There may also be some capacity for Indonesian swaps • Help extend term in domestic markets • ADB is developing a local currency swap facility (e.g., in the Philippines) • IFC can provide PCG in local bond markets, e.g., for Telecom Asia and can also provide swaps • Help develop institutional infrastructure (investor regulations, rating agencies, etc.) • Offer lessons from Chile, Malaysia, etc.

14. Help Mitigate and Manage Risks • Improve efficiency and effectiveness of existing risk mitigation tools • E.g., combine MIGA PRI with IFC / ADB B loans • More timely responses • Higher leverage for guarantees (would reduce pricing) • Consider innovations in credit enhancement • New tools? • Devaluation risk cover (e.g., AES Tiete) • Better arbitration award default (AAD) cover. • Pursue public – private partnerships • With bilateral institutions • With private sector (e.g., multilines and monolines)

15. Financial Engineering Cannot FixPoor Project Economics or Poor Policies for Infrastructure

16. Appendix 1: How Can Public – Private Partnerships Work?

17. Must Develop Public - Private Partnerships Second loss Protection Private Financial Guarantee Bank LOCs, puts, etc. Recourse to originator Public Sector Guarantee Senior/Subordination Cash Collateral First Loss Protection

18. Appendix 2: What Could the Private Sector Do to Make Projects Viable?

19. What Could the Private Sector Do? • Take a longer term view on EAP investments • There is a continuing need for international sponsors • Regional sponsors with growing capabilities have a rising role • Sponsors and banks must be skeptical when governments make unrealistic promises to bear high costs to attract investment • Domestic banks need to be prudent in long term project lending • Such loans reduce FX risks • But they are risky as they pose significant maturity mismatches and large concentrations • Greater use of pooling strategies might be beneficial • E.g., Road King experience and Hong Kong tunnel financings • E.g., Project finance CDOs (a few have been done) • Engage in public – private partnerships to mitigate risks