Creating a Level Playing Field for Local Investors in the Developing World
May 2005
The economic crisis in Argentina served as
a wake-up call for lenders and foreign investors alike. Now that foreign creditors
have been forced to accept 30 cents on the dollar in debt forgiveness—following
the rescheduling of Argentina's $107 billion debt default—minds are focused
on the lessons that have been learned. One of these is the realization that
the existence of foreign currency mismatches (created when project revenue streams
are generated in local currency while debt obligations are owed in foreign currency)
compound economic crises. This was vividly illustrated in the late 1990s, when
the Asia Crisis first arose.
by Daniel
Wagner and Christophe S. Bellinger*
Asian Development Bank
In both cases, contracts to provide infrastructure services between private
companies and governments were not honored. This occurred not because of malfeasance
on the part of government contracting parties, but because of a massive devaluation
of national currencies—they simply no longer had the financial means to honor
their payment obligations. Many infrastructure projects involved foreign investors,
who, together with local companies, established joint ventures financed by foreign
commercial banks. Indeed, billions of dollars of foreign direct investment (FDI)
were made in the 1990s through private investment in infrastructure. What happened
when some of these deals went sour? Mediation occurred initially, followed more
often than not by arbitration between the project company and the respective
government.
The Political Risk Insurance Response
Even though the economic crisis in Argentina is now 4 years old, a number
of these investment disputes remain outstanding. Many, but not all, of the investors
and lenders have had to write off their investments for the period. A number
of foreign investors and lenders purchased political risk insurance (PRI) to
protect against these events. Those that purchased PRI filed claims with their
insurers and in some instances recouped some or all of their investments. The
same cannot be said for the local investors in these projects. Why?
The availability of PRI has historically been the domain of developed country
investors. That is because the flow of investment tended to be greater from
developed countries to developing countries, but also, the perception of risk
was higher among developed country investors going into the developing world
than vice versa. Indeed, the growth of the PRI industry—which doubled in size
during the 1990s—was the result of the enormous flow of foreign direct investment
(FDI) in private infrastructure into developing countries.1
Not only was it the case that more investment flowed from "north" to "south,"
but fewer developing country governments that had the capability, offered this
coverage to their national investors. Also, fewer developing country investors
perceived the need to purchase PRI, believing that the political risks associated
with investing in the developed world did not warrant purchasing it. Most developing
country governments still do not have an official public insurance company.2 Those that do, will generally not insure local investors investing in their
home country against political risks. Likewise, government PRI providers in
the developed world generally do not provide insurance to local investors in
their own countries.3
If local investors were able to purchase PRI for local investments, this
would provide a similar degree of comfort and would place local investors on
a level playing field with foreign investors. So why do local investors in developing
countries not purchase PRI to protect their investments against actions of their
own governments? There are two primary reasons for this. The first is cost.
Premium rates for PRI coverage are generally seen as expensive, and the concept
of insurance—PRI in particular—is not always fully appreciated. And, as noted
above, even if a local investor wanted to buy the insurance, most PRI providers
are unwilling to sell it to them.
Additional explanations include a lack of knowledge about local investors
and a hesitance to rely on locally generated information about them (which raises
the larger issue of how insurers can obtain reliable information about their
clients in developing countries). Another reason is the perception that a host
government is more likely to treat a foreign investor more favorably than a
local investor. This view is widely held because developing host government
laws often do not afford local investors the basic rights foreign investors
take for granted. Finally, local investors usually do not have the same level
of international legal protection afforded to foreign investors through, for
example, international investment protection agreements.
The Role of FDI
By 1997 the flow of FDI in private infrastructure reached its peak.4 FDI has declined steadily since then not only because of a heightened perception
of risk in developing countries by foreign investors, but also because bank
credit lines for developing countries were drastically cut in the wake of the
crisis and many have still not been replenished. Perception of risk among developed
country investors/lenders associated with trade of investment transactions in
many developing countries remains high.
The financing requirements for infrastructure development around in the world—whether
in energy, water, or transportation—are in the trillions of U.S. dollars. Governments
do not have the means to finance their vast infrastructure requirements. Most
look to the private sector—both foreign and domestic investors—to finance the
gap. Following the economic crisis in Argentina and elsewhere, foreign investors
and commercial banks are loath to invest or finance private investment in infrastructure
in developing countries unless there is some form of PRI available. However,
even private PRI providers, who are typically known for their flexibility and
willingness to take risk, are, as a result of their own bad experience in insuring
infrastructure projects, increasingly reluctant to offer the same terms and
conditions they did pre-crisis to foreign investors and lenders. There is also
considerably less business for them to contemplate than before as a result of
the drop in FDI flows to private infrastructure projects.
Turning to Asia, the region's needs for infrastructure are enormous. A recent
study released by the Asian Development Bank, the Japan Bank for International
Cooperation, and the World Bank estimates that the 21 countries in East Asia
will need more than $200 billion per year to finance new investment in roads,
water, communications, and power.5 The region will
require $3–$4 trillion in investment in energy alone during the next 20 years.6 Between 1990 and 2001, there were 611 privately financed infrastructure projects
in Asia7 valued at $192.9 billion8,
peaking at $40 billion in 1997.9 In 2003, after
the recovery, Asia only attracted $11.5 billion10 of investment in this sector in only 23 projects.11 Most of these were in a handful of countries in the region, with the People's
Republic of China accounting for almost half.
Today, foreign investors from outside of Asia (including Japan) are noticeably
absent from the infrastructure sector, and lenders are cautious about lending
to projects financed by local investors. The word on the street today is that
there is some $6–$7 trillion of monies available to invest in Asia. So why is
this money not flowing into Asia? Local investors, like their foreign counterparts,
have also lost substantial sums of money due to the occurrence of political
events in their countries—largely the result of the contract breaches and cancellations
by their government. It is therefore understandable that they do not want to
invest any further in their home countries. For them, it is preferable to invest
their funds in Japan, the United States, or Europe, which are seen to be safer
havens.
Another Option
What if local investors could be afforded the same level of protection given
to foreign investors and lenders against government actions? Would local investors
be prepared to invest more of their monies into their own countries and repatriate
their offshore funds home if they knew their investments were protected? We
believe they would. Also, the existence of local investment financing would
reduce the level of perceived political risk in countries that have experienced
an economic crisis. Local investors would naturally prefer to invest in local
currency, thereby eliminating currency conversion and transfer risk. Whether
funds flow in local currency or hard currency, local investors deserve to have
their investments protected against the same political risks as foreign investors,
and the ability to do so would likely make a substantial difference to local
economies.
While some developing countries have established official agencies to provide
PRI to their local investors, most do not. Therefore, it is up to the private
PRI industry and multilateral PRI providers to step up to the plate and meet
the challenge to offer protection to local investors. A critical key to doing
this will be to establish the benefit of rule of law that affords local investors
the same basic protections foreign investors receive. Where this can be established,
there should be little reason why private and multilateral PRI providers would
not issue such coverage. However, establishing such rule of law will be a considerable
undertaking.
The ADB is one source prepared to work with other public or private PRI providers
to develop this important element of the market to provide a level of comfort
to the insurers through its direct guarantees, as well as its Guarantor-of-Record
product. The potential for growth in this market is enormous. As private insurers
gain more experience with local investors, they will ultimately be prepared
to offer coverage on a stand-alone basis. While providing PRI to local investors
and commercial banks will not by themselves solve the tremendous financial requirements
for infrastructure construction in developing countries, let alone Asia, providing
a level playing field will go along way toward helping to ensure that at least
a substantial portion of these needs will be met.
*Christophe S. Bellinger and Daniel Wagner
are both Senior Cofinancing Specialists in the Office of Cofinancing Operations
at the Asian Development Bank in Manila.
Reprinted with permission from Project Finance Magazine (April 2005).
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