How can we mitigate foreign exchange risk for infrastructure investments?
Infrastructure projects are capital-intensive and emerging countries often rely on private investment to implement them. As projects generate revenues in local currency (usually escalated by local inflation), the mismatch between the revenues and the debt service in foreign currency represents a major risk. Without a reliable mechanism to properly mitigate the foreign exchange (FX) risk, relevant sources of potentially long-term and less expensive funding are not accessible. A deep assessment of the FX risk and the development of innovative mitigatory solutions is critical to amplify the offer of long-term credit facilities for infrastructure financing.
After carrying out benchmarking studies in 10 selected jurisdictions, we have identified several strategies to mitigate FX risk - outside of financing alternatives in local currency. These strategies include:
- FX hedging/derivatives: Private FX hedging instruments, such as currency swaps at over-the-counter onshore or offshore markets, are available for all jurisdictions, although in many countries the market liquidity is limited, or not available for longer terms.
- Rebalancing of the contractual equilibrium: In countries with civil law tradition, the concessionaire is, explicitly or not, entitled to the rebalancing of the agreement. However, unless FX risk is objectively allocated between the parties in each relevant contract, such broad rebalancing right does not seem to offer much predictability for the concessionaire. This is because it is difficult to determine to which extent the depreciation of local currency could be qualified as an extraordinary and unforeseeable event.
- Long-term private offtake agreements indexed to hard currency: All the analysed countries require contracts between domestic parties to be denominated in local currency. Nonetheless, except for Brazil, all such countries seem to permit corporate parties to freely index their contractual obligations to foreign currency. In general, foreign currency indexed agreements would only be entered into by offtakers capable of absorbing these risks, such as exporters.
- Long-term offtake agreements with state-owned companies indexed to hard currency: State-owned companies acting as long term offtakers of power generation, water supplies, subway services, etc., and indexing payments (in total or in part) to foreign currency (e.g. Colombia, India, and Mexico).
- Government foreign currency indexed payments under public private partnership (PPP)-type structures: In certain countries, we identified PPP structures adopting government payments (either based on availability, service levels, or completion of works) that were indexed, in total or in part, to hard currency, thus mitigating FX risk for the private concessionaire and project lenders. Colombia, Peru, and Turkey are examples of this practice.
- Governmental funds: Certain countries have created funds to guarantee and/or make government payments, whether co-guaranteed by the government itself or not (or yet by a third-party guarantor, typically a multilateral or a development bank). Argentina and Indonesia are examples of this.
- Local currency financing made available by state-owned companies: Another alternative for governments is to ensure that the projects have access to local currency financing, even if offered by a state-owned financing or non-financing institution which, in turn, is the one raising foreign debt and handling FX risk. India, Indonesia, and Mexico are examples of such practices.
- Early termination of concession: Some of the countries, such as Turkey, Indonesia, India, Colombia, and Argentina specifically guarantee that termination shall cover either 100% or a relevant portion of outstanding indebtedness, whether in local or foreign currency
Other innovative solutions
Additionally, we have also identified other notable FX mitigation mechanisms not fitting the categories above.
In the late 1990s, the Government of Chile created public insurance to cover FX in cross-border financing for infrastructure projects, in response to a lack of available long-term foreign exchange hedging instruments. For one to two years as of the execution of an agreement, PPP counterparties could choose to have the coverage under the foreign exchange guarantee.
If local currency depreciated against the US dollar by more than 10% relative to a rate locked in at the time of the debt placement, the Government of Chile would compensate the concessionaire for the adverse impact of such depreciation on its foreign indebtedness. Conversely, the concessionaire should pass on and pay the Government the economy resulting from local currency appreciating by more than 10% in any specified contractual period.?
Another innovative solution was conceived by the International Finance Corporation in conjunction with the State of São Paulo. It comprised a contractual provision granting the concessionaire the right to deduct from the variable component of signing bonus annual installments the adverse impact of FX variation to the principal amount of foreign currency indebtedness assumed by the project company up to the limit outlined in the tender documents and duly evidenced to the granting authority.
A common theme in the strategies above is that all the jurisdictions have resorted to different instruments which may encompass the involvement of the Government. Since Government benefits from a broader variety of revenues and acts in the condition of promoter and final beneficiary of infrastructure projects, it is only natural that Governments may offer alternative mechanisms (with or without potential impact on their budget) for the mitigation of FX risk. Governmental actions as such play an important role in attracting foreign investment into infrastructure, on the top of alternatives relying solely on market instruments.
As part of GI Hub's Country Engagement Program with Brazil, Machado Meyer was engaged to conduct a benchmarking exercise and developed case studies on global leading experiences and instruments that address the foreign currency exchange risks in infrastructure transactions.