21107 Infrastructure Notes Atatioo, 4eEveV°i Marchi 1997 no The World BaIink Urbaii No. FM-9 Financing Mechanisms at the Subnational Level in Emerging Markets Borrowings and Privatizations/Concessions Benjamin Darche INTRODUCTION deregulation of financial markets to allow for foreign ownership and investment, liberalized tax and trade laws, This note reviews the current borrowing trends for shifts in global production, and liberalized monetary subnational entities (e.g., provinces, states and policies that will continue to draw foreign investors. municipalities) in developing countries where-in addition to the traditional municipal credit institutions Despite these favorable developments, subnational sponsored by central governments-a number of new governments so far have limited access to the financing instruments have been developed based on the international markets. Over a trillion dollars of debt has security provided by intergovernmental transfers and been issued for emerging markets in the past five years, taxing authority. It also reviews the trends in but only a few hundred million dollars have been raised privatization and concession of urban infrastructure for general use by municipalities. An example is the (primarily transportation toll facilities and water/sewer US$125 million Eurobond issued by the municipality of systems) which have led to an increased demand for Rio de Janeiro in 1996. domestic and international financing. It finally discusses possible future directions for subnational financing In domestic capital markets, the changes in the "human through borrowings and privatizations/concessions in and institutional culture" required to develop local domestic and foreign private financial markets. private capital markets have significantly lagged changes in technology. Improvements in management, changes in There have been dramatic shifts in international capital regulations, and the further privatization and reform of transfers from industrialized countries to emerging the banking sector have created more sophisticated markets. Net capital flows (debt and equity) to the private banking institutions in developing countries. emerging markets reached over US$160 billion in 1996. Still, local governments have not kept pace with these Capital transfers have accompanied the liberalization of changes, especially with regard to financial management. many economies, especially in Latin America and to a More significantly, the perceived lack of smaller degree in Asia (primarily China). This has creditworthiness and limited confidence in the capacity attracted a significant amount of direct foreign of local governments to repay debt obligations have investment by industrial country companies looking to limited local government ability to borrow in local expand their markets and by portfolio investment private markets, leaving much of the funding burden to managers (equities and to a lesser extent, fixed income government-owned municipal development funds. securities) seeking higher returns in emerging markets. Central government lending intermediaries will continue to play a significant role in financing local governments The structural changes occurring in many emerging until the foundations for improved credit quality and economies are key to attracting foreign financing. These management are well established. include privatization of state-owned enterprises, BACKGROUND AND CURRENT TRENDS FOR In Mexico, a variety of the intercept method was recently SUBNATIONAL GOVERNMENT BORROWINGS used to secure payments to concessionaires for wastewater treated at their sewer treatment plants. Many The significant change in the roles and responsibilities municipalities and state governments have concessioned between local and central governments is the primary sewer treatment plants. Part of the security for the force driving changes in subnational borrowing. In Latin financing of the plants derives from a line of credit from America, Central and Eastern Europe, and other areas, the state development bank, BANOBRAS. In the event central governments have shifted tax revenues and that a municipality is unable to pay the concessionaire service provision to local authorities. In many cases the for the plant's treated water, the concessionaire can draw transfer of these revenues has been unbalanced, leaving down on a line of credit provided by BANOBRAS. local governments with increasing service burdens but BANOBRAS, in turn, could intercept the state's transfer with insufficient resources to cope with the growing revenues to repay the credit line in the event that the needs of the target populations. Local resources are municipality did not repay it in a timely fashion. After primarily absorbed by personnel and other operating the financial crisis in late 1994, BANOBRAS has not expenditures and little funding is available for entered into new credit lines using this mechanism. investment in urban infrastructure. Access to International Capitalfor Subnational The strain on operating budgets, combined with macro Governments structural economic adjustments in many countries, have left local authorities in a precarious credit situation. Unless subnational governments develop stable fiscal Local governments often have significant operating conditions, it will be difficult to access capital markets. deficits which are funded through delayed payments to However the financial condition of subnational suppliers and short-term borrowing from the public and governments is closely intertwined with the private markets, if available. macroeconomic, monetary and fiscal policies of the sovereign entity, in addition to the local economic tax "Tax Revenue Intercept" base and intergovernmental transfers, the efficiency of service delivery, and the ability of the subnational One of the private borrowing techniques that has government to manage its financial operations with emerged in Latin America is a "tax revenue intercept" adequate accounting and budgeting systems. mechanism for securing bank loans. Municipalities in Argentina, Colombia and Mexico use some variation of Bond offerings for emerging market countries have this approach. grown dramatically. In the period 1993 through 1995, Mexican public and private entities issued 103 offerings In Argentina, provinces use tax revenues collected by the valued at some US$20 billion. Other major emerging central government and distributed to the provinces as market issuers during this period include: security for borrowing from private or state-owned banks. The tax revenues, generated primarily by federal * Brazil US$ 13.8 billion, 155 issues income and value added taxes, are allocated to each * Argentina US$15.2 billion, 106 issues province based on a formula agreed upon between * Thailand US$7.1 billion, 78 issues provincial and central government legislatures. The * Indonesia US$4.5 billion, 39 issues central government collects the tax and distributes it to * China US$4 billion, 23 issues the provinces' accounts at the state-owned national bank. * The Philippines US$3.2 billion, 28 issues This allows for an "intercept" mechanism wherein a creditor can have the national bank remit the debt service Most of these issues were related to sovereign borrowers, owed by the province to its own account at the national state enterprises, or private companies. Only a handful of bank. Debt service on the private bank loan gets paid and subnational governments issued bonds, such as the the remaining taxes are then remitted to the province's provincial banks and governments from well-known account at the national bank. This mechanism has also Argentine and Chinese provinces, some Brazilian states, been used by a province in Argentina to borrow from an and other familiar subnational units in other countries. international creditor. Lenders have a first lien on the tax The large exposure of market participants to Brazil and revenues of the province. Another version of the Argentina (almost US$30 billion of bonds in 3 years intercept method as security for private bank loans has with over 260 issues) provided investors with additional been developed in Colombia through the FINDETER comfort regarding sovereign risk, the first level of credit program (Financiera de Desarrollo Territorial, S.A.). analysis required for purchasing subnational bonds. Table I shows some of the subnational entities that have I'age 3 U rban No. I'PBIJ offered bonds in the Euromarkets. This list is comprised addition to expanding their local market share. They are of government agencies or names that are known by also looking for strategic alliances with foreign foreign investors-perhaps the most important factor in companies for cross border investments. Other players in marketing their bonds. These entities have a relatively privatization/concession transactions include well diversified and mature economic base comprised "developers/project sponsors" seeking high returns from primarily of manufacturing and service sectors, The privatization and concession projects, foreign financial statements provided by the bond prospectus commercial and investment banks seeking to arrange indicate a relatively healthy operating account for most financing, and a host of other service providers from of these entities, although events last year in Cordoba engineering and consulting companies to lawyers and Minas Gerais demonstrate the speed at which the negotiating project finance documents. fiscal condition of subnational governments can change.' The volume of debt and equity financing has grown Another interesting lesson about the Minas Gerais bond significantly for concessions and some interesting offering is the link with the state owned electric financing mechanisms have evolved, mostly syndicated company, CEMIG. The Mineros structured a bond bank loans arranged by foreign banks and, to a much offering whose primary appeal was tied to the fate of the smaller degree, bond financing. These projects have also electric company. Investors following Brazil knew that spurred development of new domestic financing the government was reforming the electric sector and instruments, such as in the newly emerging regional Asia considering privatization and concession of the bond market, and in Mexico where, for instance, production, transmission, and distribution of power. domestic capital markets provided bond funding for toll Although the situation of CEMIG was not clear roads and other infrastructure concessions. A limited regarding its privatization or concessioning of number of these bonds were underwritten by commercial independent generation units, investors were willing to and investment banks and targeted to high net worth bet that the share price of CEMIG would rise (its stock local individuals. Demand for these bonds dried up as a was undervalued) providing an incentive to exercise the result of the 1994 financial crisis demonstrating the warrants, sell the shares at a profit and boost the return fragile and illiquid nature of this market. on their bond investment. This example shows the direct linkage between privatization and international fixed The most well-known projects include the concessioning income flows to subnational governments. of the Mexico City and Buenos Aires water systems. These projects were financed with concessionaire equity TRENDS RELATED TO PRIVATIZATIONS AND and syndicated bank loans, the latter involving the CONCESSIONS OF LOCAL INFRASTRUCTURE participation of the IFC, and foreign and domestic banks. A large number of individual water and sewer treatment International and domestic capital has also been raised plants for cities and states have been concessioned in for urban infrastructure projects related to privatizations Mexico including Toluca, Tampico, Ciudad Juarez, and concessions. These projects are interesting in that Cancun, Puebla Puerto Vallarta, and others. The primary they combine several different players with diverse concessionaires are the Mexican construction companies interests. Local and federal governments are looking for often accompanied by participation by foreign British, foreign capital to help them expand urban infrastructure French, and some US water companies. Most of these services. Foreign companies, both manufacturing and projects have used domestic bank financing, although a service providers, are looking to expand their markets. few have been negotiating with foreign institutional Local companies are seeking foreign partners to improve investors, such as G.E. Capital, to provide convertible their management skills and for technology transfers, in debt financing (non-payment provisions which convert the debt to equity-a "pre-workout" or exit strategy). The Cordoba bond was issued in September, 1994 and was based on financial information from 1993. By the summer of The financial crisis in Mexico has significantly delayed 1995 the province's fiscal condition deteriorated to such an the financing of many of these projects as banks re- extent that it had difficulty paying its workers. The Minas assess their role in project financing. Banks are more Gerais issue was offered in January, 1994. These bonds were cautious about lending to projects and will require sold in spite of the state government's considerable debt greater security and risk coverage. For those projects that burden, the majority of which was not being serviced. Minas have payment defaults, the banks negotiate a debt also had difficulty in paying its workers towards the end of restructuring with the government playing a crucial role 1995 and had to use additional CEMIG shares as collateral in re-negotiating the concession agreement, especially for loans. These subnational entities have passed through the clauses related to the tariff structure In one case the their respective financial crises, but they still face unstable . n financial conditions. government allowed the concessionaire to reduce the initial tariff but to have a large step-up when users were develop clear, commercially oriented regulatory more able to pay. Flexible tariff structures and the active structures to manage the concessions. participation of the government regulatory body will become increasingly important for water and sewer FUTURE TRENDS FOR SUBNATIONAL GOVERNMENT concession financing. BoRRowINGS AND PRIVATIZATIONS/CONCESSIONS An innovative financing in the transportation sector Subnational Borrowings recently emerged in the Zhuhai Special Economic Zone, Guangdong Province, China. The Zhuhai Highway Service provision in subnational governments is moving Corporation, Ltd. (the Company) sold US$85 million of in two directions. There is a separation between those 10-year, 9.125% Senior Notes and US$115 million of services that can be supported by user fees, such as water 11.5%, 12-year Subordinated Notes in the Euromarket. and sewer distribution, collection and treatment, and The structure of the financing is similar to a US urban transport, and those activities that will require municipal toll road revenue bond with features unique to budget support from general revenue sources, such as circumstances in China. The notes are primarily secured basic education and safety and security. Subnational by annual usage fees paid by vehicle owners traveling on governments are converting their user fee activities, for Company roads, bridges and tunnels, and non-locally example, utilities and enterprises, into privately run registered vehicles that pay a toll upon entering the City companies or concessioning these services to the private (Vehicle Charges). The Company is also required to sector. This trend is gaining momentum throughout the maintain a 1.25 net debt service coverage ratio. There are developing world and should continue for the annual usage fees and entry toll mandatory increases; foreseeable future. quarterly debt service coverage ratio tests and increases in Vehicle Charges in the event the coverage ratio falls Domestic borrowing by local govemments for services below 1.25%; a Debt Service Support Agreement to and programs unrelated to privatization will continue to insure the convertibility of Renmimbi into US dollars; a use a mix of domestic public and private creditor pledge of all outstanding shares of the Company as sources. A strong domestic capital market can work only collateral; and a US$ Debt Service Reserve. These where the creditworthiness of local governments features enabled the notes to secure an investment grade improves. Creditworthy local governments should rating from both Moodys and Standard and Poors. always be able to borrow from private banks and in some Another Eurobond financing for a toll road in the Beijing cases issue domestic bonds, but the majority of small metropolitan area was almost completed last year but local governments might still need to rely on municipal was delayed because of a lack of central government development funds and other central government approval. sponsored financial intermediaries to finance infrastructure needs. Argentina has concessioned access roads to Buenos Aires attracting consortiums of foreign and domestic There are alternative ways of diversifying the risks of companies, The roads have been financed with equity smaller government units through the use of bond banks, raised by merchant banks for the concessionaire loan pools, and guarantees. These concepts, prevalent in supplemented by syndicated bank loans with foreign and industrialized countries, may be adopted to local domestic banks participating. The IFC has also provided situations on a country-by-country basis. However, the debt and equity for some of these projects. One of the hard work of developing the foundations for financing structures includes a bank syndicated loan with creditworthy local governments cannot be avoided. This the banks having the option to convert a portion of the entails credible accounting and management systems; loan interest into equity, This demonstrates, as it did in independent auditing of financial results; multi-year the Mexico water case, the increasing willingness and, in capital and operating budgeting systems; sound financial some cases, the requirement of lenders to participate in management and performance evaluation of government the project's upside while limiting their downside services; pension and administrative reforms to control exposure. This type of structure will most likely continue personnel expenditures; improved and transparent to develop as commercial banks become more infused procurement procedures; transparent political structure; with a merchant banking culture and seek higher returns and elected decision-makers accountable to voters. These on their capital, albeit with additional risk. In these cases changes will take place over time. In the meantime the banks and concessionaire would look to structuring domestic borrowing trends will change incrementally as transactions and the legal documentation to shift local governments have better access to capital, but with commercial and political risks to the government, creditors being more selective in choosing borrowers. making it increasingly important for governments to |>; 5 Urban No. I; Privatizations and Concessions projects advance into new sectors and deepen within the sectors will depend, to a large degree, on the availability Local governments look to the panacea of the private of financing, both domestic and foreign. Financing sector and concessions to provide their citizens with structures will continue to change and merge toward more efficient and hopefully cheaper services. However, higher equity participation by lenders (an oxymoron, but the government still has a critical role to play in true nevertheless) as the opportunity cost of capital raises regulating the private companies and, from a financing the return threshold. This will require that regulatory perspective, to develop concession agreements that bodies become more vigilant in the supervision and clearly allocate construction, commercial and political control of banks, especially in developing countries. risks, and are transparent and well developed. Banks over-extended in financing urban infrastructure Development of concession agreements goes hand in projects can be a significant problem, as was experienced hand with the development of the legal and institutional in Mexico. Hopefully the role of banks may be regulatory environment required to control private supplemented by pension funds and other institutional service providers. investors that allocate part of their resources into urban infrastructure investments that meet their return A trend that is emerging in concession and privatization requirements. financing is the increasing need for foreign creditors to participate in equity returns of projects. With companies and international investors seeking higher returns on TO LEARN MORE their limited capital resources, the response could be the use of financing structures with convertible debt Infrastructure Note, FM-7, October 1994, "Findeter: features. Concessions also act as a stimulus for the Financing Municipal Investment in Colombia" by 0. development of the local capital market as domestic Alvarado and V. Gouarne. financial institutions participate with foreign lenders and developers in projects. Transfer of "financial Infrastructure Note, FM-8a, February 1997, "Municipal engineering" technology and the interchange of credit Bond Markets-Experience of the USA" by Samir El risk concepts among foreign and local creditors will lead Daher. to further sophistication of domestic financing instruments. Several innovative debt and equity Infrastructure Note, FM-8b, February 1997, "Municipal financings have recently emerged in Asia, targeted to the Bond Markets-Prospects for Developing Countries" by domestic Asian capital markets.2 This "diffusion of Samir El Daher. innovation", to borrow a term from communications theory, will most likely accelerate in the near future, supported by the rapid change in global communications technology. However, significant gaps will continue to exist between subnational entities and foreign and domestic concessionaires and creditors. Filling in these institutional gaps by supporting appropriate forms of technical assistance and loan programs is an effective role for the World Bank. Concessions are broadening to solid waste and other traditional urban services. The pace at which these 2 These include: (I) a 5-year US$138 million transferable loan facility issued by Road King Infrastructure Finance Limited (RK), a private company listed on the Hong Kong Stock Exchange. RK has interests in 10 Chinese toll roads; (2) US$128 million secured Asia bonds due in 1999 for the Tanayoung Public Company Limited. Tanayoung will on- lend the funds to support its mass transit subsidiary building a metro in Bangkok; and (3) 3-year US$175 million Guaranteed Floating Rate Notes issued by PT Citra Marga, a joint venture tollroad operator with PT Jasa Marga (National Tool Road authority) and PT Krakatau Steel as major sharedoldersa TABLE 1 RECENT SUBSOVEREIGN EUROBOND OFFERINGS Agency Amount Maturity Security (Millions US$) City of Prague 250 5 years General Revenues Provincial Bank 60 2 years General Revenues Cordoba State of Minas 200 5 years General Revenues Gerais/CEMIG* CEMIG Warrants Banco de la Ciudad 100 commercial 180-365 days General Revenues Buenos Aires paper Municipality of Rio de Janeiro 125 3 years General Revenues Zhuhai Highway 85 Senior 10 years Usage Fee and Company LTD. 115 Subordinated 12 years Entry Tolls El Dorado Airport 116 15 years Landing Fees Bogota, Colombia Aerocivil Revenue Guarantee Province of Mendoza 150 6 years General Revenues Collaterallized Oil Escrowed Oil Royalty Notes Revenues Bogota, Colombia 100 5 years General Revenues (Syndicated loan) *The bonds included the rights to buy preferred shares in the state-owned electric company, CEMIG, within three years of the issue date and at a specific price. These "covered warrants", or rights to purchase shares, provided an equity type of kicker to the bonds which made them more attractive given the perceived value of CEMIG, the stock market value at the time of the bond offering, and the price of the warrants.