The World Bank Group Infrastructure Economics and Finance Department

1. The World Bank GroupInfrastructure Economics and Finance Department Capital Markets Instruments : Financing Infrastructure Development IDB Business Seminar Series 2004, Capital Markets for Development,The Role of the Private Sector, Washington DC, June 4th, 2004

2. Contents • Overview of Bond Markets • Capital Markets and Infrastructure Development • Infrastructure Needs • Local capital markets • Local currency debt instruments • Guarantees • Definition • Options under Consideration • Guarantee Liquidity Facility • Capital Markets in the Region

3. Size & Structure of the Bond Markets (LATAM) • Capital Markets still represent a very small % of GDP (except Chile) : average 11% (est. 2001). • Average holdings of sovereign risk by investors is relatively high (70 % to 85%)

4. Country Stock Market as % GDP Bond Markets as % GDP Public Bond Market % GDP Private Bond Market % GDP Bond Markets as % GDP (1991) Argentina 12.42 15.86 10.83 05.03 05.00 Brazil 27.58 61.26 51.25 10.01 13.20 Chile 74.56 52.72 30. 40 22.32 30.10 Colombia 07.30 N.A. N.A. N.A. N.A. Mexico 9.25 15.89 10.83 05.04 05.60 Peru 16.32 07.16 02.96 04.20 00.70 USA 123.0 149.31 41.51 107.80 122.0 U.K. 144.0 64.42 29.70 34.72 48.15 France 85.65 81.16 46.12 35.04 73.25 Japan 55.93 145.11 95.52 49.59 87.53 Relative Size of local Capital Markets Table 2: Capital Markets Capitalization as a % of GDP for selected countries, Year 2001[1] (equity and bond markets) [1] Source: World Bank Financial Structure Data Base (using FIS)

5. Infrastructure Needs : LATAM (2005-2010) /1 Source : World Bank, Working Paper 3102, Fay-Yepes, 2003 Note : /1 Does not include rehabilitation, deferred past maintenance and upgrades

6. Infrastructure Needs : LATAM (2005-2010) • LATAM infrastructure needs are estimated at US$ 71 billion per year (it was close to US$ 60 back in 1995). Of this close to 45% is represented by maintenance. • The most demanding sector in the Region will appear to be the Telecom Sector (US$ 32.5 billion per year or 46% of the total), with the mobile sub-sector alone demanding US$ 25 billion annually. Following Telecom will be Electricity (mainly generation) with US$ 25 billion per year, and toll roads with US$ 7 billion per year. • In the golden years of infrastructure finance in the Region (1996), total amount of financing raised was closed to US$ 30 billion. This figure is probably now in the US$ 8 to US$ 10 billion at best. These demand figures do not include a stock of deferred investments and maintenance. If we add the weak foreign capital flows into LATAM infrastructure during the last years (and immediate future), the outcome is a pressing need for new financing options: • Redesign of the government role (from regulator to partner, PPPs) • Development of risk mitigation products that can addressed the FX risk • Development of local currency debt instruments

7. Real Investment in Infrastructure Projects with Private Participation in Developing Countries(1990-2002) Source: PPI Data Base (IEF, WBG)

8. New Agenda : Connect Infrastructure with private financial markets Transparent and efficient rules to determine future returns and risks with clear enforcement and dispute resolution mechanisms (economic regulation, judicial reform,investment climate) Development of local capital market development (local currency financing) and hedging instruments against currency risk. Development of risk-mitigation products to support financing instruments capable of dealing with credit, fx, contractual and regulatory risks. Enable and support access of municipal governments, sub-sovereign entities and public utilities to private financial markets via improvement of corporate governance, credit worthiness, and initial financial backing.

9. Local Capital Market Development • Financial des-intermediation is a key component of a sustainable economic development strategy. • Support of good quality credit rating private sector instruments as a way to diversify investors portfolio (e.g., pension fund development in LATAM – increased sovereign risk cases of Argentina, Uruguay, Brazil, Colombia) • Develop local currency funding instruments that could mitigate cross-border risk (FX risk). Projects that are typically local currency generators Water & sanitation, toll roads, irrigation, etc. will have a tough time getting finance in the US$ markets (even with the best build-in contracting clauses for US$ tariff based there is a tolerance to FX adjustments in a particular economy)

10. Development of local currency debt instruments • Matching of revenue generation (productive assets) and liabilities for private corporations. • Mitigation of economic regulation framework under volatility scenarios (I.e., US$ based tariffs in utilities – public services) • Development of local savings capacities (I.e., diversification from investments in government related securities). • Incorporation of local debt holders as stake holders in infrastructure projects (mitigate regulatory risk) • Introduce market performance benchmarks to improve risk & return remuneration for local savings (domestic investment)

11. Guarantees: Overview • Political Risk Guarantees (US$ debt instruments) • sovereign (transfer & convertibility) and selected non-commercial risks (contract frustration) for infrastructure development in the Region. Streamlined approval process (3 months). • Could include selected non-commercial risk [regulatory risks] such as breach of contract by the grantor of the concession (e.g., San Pedro de Macoris, IPP, Republica Dominicana).

12. Guarantees: Overview • Financial Guarantees, partial credit guarantees (local currency debt instruments) : • credit enhancements to improve credit risk profiles of local issuers to enable them to access market financing under better conditions (tenor and pricing). • Instruments [mechanism] that cover or protect debt service payments to institutional investors (bondholders). • Products can be structured to guarantee an specific layer of credit risk,in order to elevate the risk profile of the overall transaction and thereby attract investors. By guaranteeing an intermediate part of the debt (I.e., guaranteeing to pay a portion of the obligation after the internal cash reserves or sponsor support has been exhausted) the local investor maybe more willing to put its capital at risk for the remaining exposure.

13. Guarantees: Extending tenors for required longer maturities. • A Partial Credit Guarantee (PCG) can guarantee debt service for specific periods $150 million Example: China Ertan Power Project $50 million 0 3 6 9 12 15 WorldBank Average financing term for Additional uncovered China without Guaranteed risk taken by World Bank Guarantee commercial banks Total risk assumed by commercial banks

14. Guarantees: PCG applications under development • Mezzanine Guarantee (local currency instruments) • Pool Guarantee (local currency instruments) • Guarantee Liquidity Facility Application of Partial Credit Risk Enhancements to potential PPP projects in infrastructure Design the “optimal” partial credit enhancement for a given project in order to improve its credit risk profile enough to capture private capital on adequate terms & conditions

15. PCG applications under development • Mezzanine Guarantee • A “credit” loss protection enhancement with the WB providing a guarantee for a specified mezzanine layer of credit risk, thereby elevating the overall transaction to investment grade on the local currency scale. • Illustration: For a project bond supporting PPP investments in electricity distribution, the WB could provide a partial credit guarantee to support electricity payments by government related clients to project.

16. Mezzanine Guarantee (energy distribution co.) Transaction (Receivables Securitization ) Mitigation of the lower credit risk quality and improving the transaction rating attracts participation of Monoline Insurers to provide a “wrap” on the whole transaction, improving further the transaction credit rating. Project Revenues (High Credit Risk Quality Layers) • Transaction Reserves • Over-collateralization • Project Debt Service Reserve Account • Liquidity Reserve (sponsors recourse) Partial Guarantee (a portion of the credit loss on the transaction, -- debt service) Layer of Lower Credit Risk Quality

17. PCG applications under development • Pool Guarantee for Asset-Backed Securities • A partial credit enhancement product with WB providing a PCG for a portion of principal and interest sufficient to offset potential losses resulting from non-performing assets within the underlying collateral pool. The Pool Guarantee’s amount will be calibrated for each transaction to improve the project’s credit rating in a manner sufficient to attract targeted local investors. • Illustration: A utility company may pledge credit receivables as collateral to repay a bond issue. Although the collateral enhances the bond’s credit quality, the information on the collateral in emerging markets may not be adequate (e.g. incomplete records of past performance) and as such, the collateral may not be sufficient to attract local investors to purchase the bond. The WB could further enhance the bond with a partial credit guarantee in order for the bond to achieve a credit quality sufficient to interest targeted local investors.

18. Pool Guarantee:CBO, forIllustrative purposes Source: Rating Agencies Methodology (Case Example)

19. PCG applications under development • Liquidity Facility • A form of project support that is funded in a separate escrow account, or available on a contingent basis from a third party and that maybe utilized under defined circumstances. Liquidity Facilities are intended to assist the project in coping with problems that are believe to be temporary. • The liquidity facility will be repaid over a number of years through: (a) phased tariff adjustments to return tariff to a cost recovery level, or (b) a special levy on consumers. /1 /1 Foreign Exchange Risk Mitigation for Power and Water projects in Developing Countries, World Bank, Energy Discussion Papers, Matsukawa, Sheppard and Wright, December 2003

20. PCG applications under development • Guarantee Liquidity Facility (GLF) • A partial credit enhancement product with the WB providing a liquidity guarantee to cover a specified number of interest and/or principal payments, on a rolling forward basis – i.e. the guarantee is in place throughout the life of the bond or until depletion. • The guarantee could be predetermined as an lump sum amount of the debt service covering a rising share of remaining debt service (on a mortgage style payment), or the guarantee could be designed as to cover only a predetermined % of principal throughout the life of the bond.

21. GLF : (transmission and distribution PPPs) Outstanding Principal Debt / Service Coverage Ratio DSCR 1.5 1.0 Guarantee Liquidity Facility Years N N + I

22. Liquidity Facility Guarantee : FX mitigation Product currently under development Projected Cash-Flows Real Cash-Flows (after FX adjustment) Local currency Project Cash-flows expressed in real US$ (going exchange rate) US$ cash shortfall US$ cash shortfall Years N N+1 N+2

23. Liquidity Facility Guarantee : FX mitigation Projected Cash-Flows Product currently under development Real Cash-Flows (after FX adjustment) Local currency Project Cash-flows expressed in real US$ (going exchange rate) DSCR US$ cash shortfall to cover DSRA US$ cash shortfall to cover DSRA Years N N+1 N+2

24. Liquidity Facility Guarantee : FX mitigation Projected Cash-Flows Product currently under development Real Cash-Flows (after FX adjustment) Local currency Project Cash-flows expressed in real US$ (going exchange rate) DSCR Liquidity Facility covers short fall up to debt service payment Liquidity Facility covers short fall up to debt service payment Years N N+1 N+2

25. Capital Markets in the Region