Note No. 180 April 1999 Karen Mitigating Currency Convertibility Risks Rasmussen in High-Risk Countries A new IDA lending approach This Note examines A proposed Currency Convertibility Fund, backstopped by a contingent credit from the how the International Development International Development Association (IDA)—the World Bank’s concessionary window for the Association’s lending instruments can be world’s poorest countries—has been designed for the Songo Songo Gas Development and tailored to support foreign equity Power Generation Project in Tanzania. The fund is a transitional mechanism aimed at investment in projects that generate only local supporting the Tanzanian government’s efforts to attract foreign equity in circumstances where currency and for which currency convertibility the private sector perceives a high level of risk and is otherwise unwilling to invest. The Songo insurance is not commercially available. Songo power project has suffered delays since 1997 arising from a dispute between the government and the Malaysian sponsors of another private power project. Now that this dispute is being resolved, preparation of the proposed Songo Songo project has resumed. The World Bank’s support for the Currency Convertibility Fund is not due to go before the Bank’s board for approval until 2000. Still, the fund may be a replicable mechanism that, by mitigating sovereign risks that investors are unwilling to bear and unable to hedge against, could help catalyze foreign equity investment in other IDA countries and in projects that generate local currency. The government of Tanzania solicited private The project would establish Songas, a majority sector interest in a project involving the con- privately owned and managed gas and electricity struction of a gas processing plant on Songo utility. The project would be structured as a build- Songo Island and of a 220-kilometer gas pipeline. own-operate arrangement, underpinned by a The project also includes the privatization and power purchase agreement between Tanesco conversion to gas firing of a 110-megawatt gen- and Songas. Project costs are estimated at about erating plant owned by Tanesco, the public elec- US$280 million (table 1). Equity investors would tricity utility. The government saw significant provide about US$72 million, and the govern- advantages in a public-private partnership—with ment would contribute about US$8 million. The a direct stake in the project, equity investors remaining US$200 million would be provided to should have a strong incentive to operate the the government through a credit from IDA and a facility efficiently, and Tanzania has no expertise loan from the European Investment Bank, both in gas-fired electricity generation and so could of which would be on-lent to Songas on com- benefit from private sector technical and man- mercial terms. In addition, IDA would provide a agerial expertise. contingent credit of US$35 million that would T h e Wo r l d B a n k G r o u p ▪ F i n an c e, P r i v at e Sec t o r, an d In fr as t r u c t u r e N e t wor k Mitigating Currency Convertibility Risks in High-Risk Countries TABLE 1 PROJECT FINANCING PLAN US$ millions Source Equity Debt Total against which they could not hedge. Specifically, OTC (Ocelot Energy and TransCanada foreign investors wanted assurances that, on pro- Pipelines, the two private sponsors) 50 50 ject sustainability grounds, they could reasonably International Finance Corporation 6 6 expect to cover the project’s operations and maintenance expenditures payable in foreign Commonwealth Development Corporation 6 6 exchange, and repatriate their earnings in a con- Deutsche Investitions und vertible currency.1 Entwicklungsgesellschaft mbH 6 6 European Investment Bank/Tanzania The conclusions of a World Bank study and dis- Development Finance Corporation 4 4 cussions with international oil and gas companies IDA project loan (on-lent to Songas) 155 155 and political insurance agencies confirmed that foreign equity investment for the project would European Investment Bank loan not materialize unless IDA or other donors were (on-lent to Songas) 45 45 willing to address the project’s currency convert- Government 8 8 ibility risk. The project’s foreign exchange needs Total 72 208 280 would be high relative to the size of the foreign exchange market. The project would require the IDA contingent credit 35 35 equivalent of 8 percent of the annual volume of foreign exchange transacted in the market. Source: International Development Association. The World Bank Group examined the instru- ments it had available to encourage equity invest- ment. At the time the Bank’s pilot program for provide limited protection to the project sponsors partial risk guarantees to private lenders in IDA against the risk of currency inconvertibility. countries was not available to help raise com- mercial debt. Moreover, the Multilateral Invest- The currency pro blem ment Guarantee Agency (MIGA) was unwilling to offer currency convertibility coverage on its own Private involvement in the project ran into two account because of the high perceived risk of the main impediments: the unavailablity of currency project. So, to maximize mobilization of private convertibility insurance from public and private equity in the proposed project, the Bank de- sources, and Tanzania’s weak balance of pay- signed a new financial mechanism, the Currency ments performance and heavy debt burden. Convertibility Fund (CCF), to mitigate the risk of There were no prospects for commercial debt currency inconvertibility. financing for the project because foreign com- mercial banks have been willing to lend only for What is the Currency Convertibility short-term trade transactions (all export credit Fund, and how does it work? agencies are off cover in Tanzania). And in any event, foreign-denominated commercial debt The CCF is a financial instrument, to be backed would have exacerbated the project’s foreign by a contingent IDA credit of US$35 million, that exchange requirements. would provide the project sponsors with limited protection (up to US$35 million) against currency For these reasons, the government preferred to inconvertibility for operations and maintenance seek private equity in the project rather than com- expenditures, dividends, and capital redemptions mercial debt. But while foreign equity investors payable in foreign exchange. were willing to assume the construction and com- mercial risks associated with the project, they The CCF will mitigate but not eliminate the risk to were not willing to take on sovereign risks Songas of currency inconvertibility. Songas’s annual foreign exchange requirements for opera- mercial operations under the twenty-year power tions and maintenance, dividends, and capital purchase agreement). This period is considered redemptions are estimated at about US$25 mil- reasonable because it reflects the time required lion, or US$500 million over the twenty-year term for investors to generate adequate cash flows at of the power purchase agreement. The coverage the agreed tariff level, and because it will help provided by the CCF would help ensure the finan- ensure that Songas remains a going private sec- cial viability of the project in the event of a tem- tor concern over the long term. porary lack of foreign exchange in the market. The CCF is equivalent to about sixteen months of The CCF is structured to discourage both the the project’s foreign exchange requirements. government and the project sponsors from causing a claim to be filed. For the sponsors The CCF would disburse only as needed to pay these disincentives include an extended transfer valid claims submitted by the project sponsors delay period before which a claim can be filed, and substantiated by MIGA, which will adminis- a less than 100 percent claim coverage ratio, and ter the fund on behalf of the government (figure an annual stop loss. Government deterrents 1). The government would issue to MIGA an include mandatory use of any foreign exchange irrevocable right to make withdrawals from the recovered by MIGA in connection with a claim fund to pay eligible claims. The IDA credit (and to prepay the CCF credit to IDA, and IDA’s contract of guarantee) for the CCF would have a option of accelerating the credit if a call is made term of fifteen years (or thirteen years of com- on the CCF. FIGURE 1 THE CURRENCY CONVERTIBILITY FUND SCHEME Repayment through any MIGA recovery Project loans from IDA CCF contingent of claims in foreign exchange and credit European Investment Bank from IDA US$200 US$35 million Premiums less Repayment million standby credit administrative fee Currency Convertibility Fund Disbursements of IDA Government of Tanzania credit for valid claims MIGA US$200 million on-lent Repayment US$72 million Annual premium Songas Foreign equity payments (project company) Investors’ dividend investorsa Currency Convertibility payments Fund coverage Note: Arrows indicate money flows. a. Ocelot Energy Inc. and TransCanada PipeLines (the project sponsors) are providing US$50 million in contributions. CCF coverage is being provided only for the private equity sponsors. The International Finance Corporation, Commonwealth Development Corporation, Deutsche Investitions und Entwicklungsgesellschaft mbH, and European Investment Bank are providing US$22 million in equity. Mitigating Currency Convertibility Risks in High-Risk Countries In addition to the proposed development credit ibility risk coverage to the sponsors up to the agreement between the government and IDA for same amount. Thus this document would spell investment in the Songo Songo Gas Develop- out the specific terms and conditions of the ment and Power Generation Project, the CCF CCF contract of guarantee, including the items would involve three legal agreements: covered, the terms of coverage, and the pre- ▪ The development credit agreement between miums to be charged annually to the sponsors the government and IDA for the credit to fund and the procedures to be followed by the the CCF. The proposed IDA credit of US$35 sponsors before filing a claim. million to the government of Tanzania to fund the CCF would be provided under a separate Catalytic role development credit agreement because the CCF would involve terms and conditions that IDA’s involvement in the project is seen as cru- differ significantly from those that would gov- cial to catalyze foreign private investment by ern the proposed IDA credit to the govern- alleviating equity investors’ concern about non- ment for the investment project. For example, commercial risks. This involvement is consistent this agreement would contain conditions of with the Bank’s policies to assist sector reform disbursement related to the submission of by involving the private sector and to assist gov- documentation from MIGA substantiating that ernment borrowers in attracting this private cap- a valid claim had been filed for which pay- ital by alleviating investors’ and lenders’ concern ment was to be made. It would also confirm about sovereign risk. The contingent IDA credit Viewpoint is an open the government’s assignment to MIGA of an of US$35 million has a leveraging effect, mobi- forum intended to irrevocable right to withdraw funds from the lizing US$50 million of private equity and US$22 encourage dissemination of and debate on ideas, CCF credit on the occurrence of the defined million in other foreign equity that would other- innovations, and best events. Thus the CCF would disburse only if wise not have materialized. practices for expanding MIGA were to determine that the project the private sector. The views published are sponsors had filed a valid claim substantiat- 1 Investors were also concerned about the risk of nonpayment by those of the authors and ing their inability to convert or transfer Tanesco. This risk has been mitigated through a government- should not be attributed operations and maintenance expenditures funded revolving liquidity facility designed to ensure complete and to the World Bank or any timely capacity and energy payments by Tanesco to Songas, and of its affiliated organiza- payable in foreign exchange, dividends, or by an escrow account that would protect the project sponsors tions. Nor do any of the capital redemptions in accordance with the against the loss of their equity investment in the event of an incur- conclusions represent provisions of the contract of guarantee (see able government default. official policy of the World Bank or of its below). Executive Directors or ▪ The administration agreement between the Karen Rasmussen (krasmussen@worldbank. the countries they government and MIGA relating to the CCF. org), Africa Region represent. This agreement would spell out the relation- To order additional ship between the government and MIGA with copies please call respect to the management and administration 202 458 1111 or contact Suzanne Smith, editor, of the CCF and the responsibilities of each Room F11K-208, party, including the procedures for paying eli- The World Bank, gible claims, recovering claims, and distribut- 1818 H Street, NW, Washington, D.C. 20433, ing premiums. or Internet address ▪ The contract of guarantee between the project ssmith7@worldbank.org. sponsors and MIGA spelling out the insurance The series is also available on-line coverage to be provided by the government (www.worldbank.org/ and issued by MIGA. The contingent IDA credit html/fpd/notes/). of US$35 million to be made to the govern- Printed on recycled ment of Tanzania would provide the financial paper. backing for MIGA to issue currency convert-