noTE NO. 2 – july. 2012 SNTABriefs 73641 Sharing knowledge, experiences, and innovations in sub-sovereign financing for infrastructure The Importance of Sub-National Authorities Avoiding Foreign Exchange Risk When Borrowing Long-Term David Painter and Joshua Gallo I t has become an internationally recognized Foreign currency risk exists because the exchange best practice to match the repayment term of rate between a local currency and foreign currencies long term debt financing to the expected useful is constantly changing in the international currency life of the infrastructure financed; sometimes 15 markets. When a borrower’s local currency decreases years or more. This makes infrastructure afford- in value compared to the foreign currency in which able. However, it is equally important to match the they have to repay their debt, the amount that has to currency of the debt repayment to the currency in be repaid immediately increases. which the sub-national authority obtains its reve- nues. Unlike national governments, sub-national authori- ties are not in a position to affect the value of their When national governments are the ones building local currency in the international currency markets. and financing infrastructure, they can repay some of Although options may be limited even for national the cost out of the foreign currency they controlled. governments, they can at least officially intervene in Sub-national authorities do not have that option the currency markets to support the value of their since their revenues are (with only rare exceptions) currency and negotiate additional support from IFIs. collected only in local currency. This is one of the There is little incentive for a national government to principal reasons that the IBRD and most other Inter- intervene in the currency markets simply to protect a national Financial Institutions (IFIs) only lend in foreign sub-national authority from rising debt service costs. currency to national governments. Unlike national governments, sub-national authorities typically do Nor are there any available mechanisms that sub- not have the capacity to manage foreign currency national authorities can use to protect themselves risks, and therefore require local currency financing. from currency market fluctuations. Purchasing currency futures as a hedge against exchange rate Successful sub-national authorities avoid foreign fluctuations is not an option because they are not currency risk, and do not fall prey to the myth that available for transactions many years in the future. foreign debt is somehow superior to local currency Currency traders recognize that the inherent unpre- PPIAF debt. Approved Instead they Logo Usage are smart operators and hard- dictability of exchange rates increases the further one nosed negotiators who are unaffected by those who looks into the future and they are not willing to offer imply there isLogo greater - Black prestige or a stronger transac- long term futures contracts. Sub-national authorities tion associated with a foreign currency financing. that borrow in foreign currency are entirely at the Nor are they impressed by what appear to be low mercy of market fluctuations. PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY repayment costs that are based on current foreign exchange rates. David Painter is a Development Finance Consultant, and Joshua Gallo is Program Leader for PPIAF’s Sub-National Technical Assistance Program. Logo - 1-color usage (PMS 2955) PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FAC ILITY The Importance of Sub-National Authorities Avoiding Foreign Exchange Risk 2 The foregoing example illustrates the problems that Illustrative Example face sub-national authorities that have borrowed in a Let’s imagine that a sub-national authority borrows foreign currency. Currency markets are unpredictable US$100 million for an infrastructure project at a and at times can be extremely volatile. Although our fixed rate of 5% interest for 15 years with semi- example only covered two years, the risks are seri- annual payments in June and December. The ously compounded by repayment periods stretching authority’s semi-annual debt service payments over 15 years or more. Over such a long term, it is would be US$4,778,000. Let’s also assume that entirely possible for debt service payments in local when the borrowing take place the local currency (called LC) has an exchange rate of LC 2.093 per 1 currency to increase dramatically as demonstrated in US$. This means that the authority’s debt service the multi-country Asian financial crisis of 1998 and Sub-national payments should be LC 10 million every six months. the collapse of the Argentine currency in 2002. Even For this example, let’s say the authority’s total if the increases are gradual, they can wipe out non- authorities budget is LC 200 million per fiscal year (January 1 essential items in a sub-national authority’s budget that borrow through December 31) divided into: LC 100 million for Personnel costs; LC 70 million for purchase of and even cut drastically into essential spending or in foreign Essential Goods and Services; LC 10 million for fund- force reductions in personnel costs. Sudden large currency are ing Programs & Activities with citizens and external increases can be financially devastating as Argentine organizations; and LC 20 million for debt service (a sub-nationals with foreign debt learned in 2002. entirely at the relatively conservative 10% of the total budget). mercy of market The example also illustrates that even an attractively Now imagine the following scenario… fluctuations low interest rate on a foreign currency loan can be misleading. Let’s assume that the interest rate of 5% • After the first debt service payment of LC 10 million in June the LC devalues against the US dollar in our example is half the rate that would be required by 10% to LC 2.302 per 1 US$. Now the author- to secure local currency financing from lenders in the ity needs LC 11 million before the end of the fiscal authority’s own country. The foreign currency loan year to make payment #2. If there is LC 10 million sounds like a good deal for the authority. The local still available in the Programs & Activities budget, currency financing at 10% for 15 years would require the authority would have to take 10% of those debt service payments of LC 13.6 million every six funds to cover the increased debt service (of course a higher percentage of the remaining budget would months compared to only LC 10 million per payment be needed if part of that budget has already been on the foreign currency loan. That appears to be a spent). 36% savings on each payment. However, this also means that the LC only has to decrease in value by • In anticipation of the increased debt service 36% to eliminate the per payment savings. If the payments, the authority prepares the next year’s semi-annual payments increase by an average of LC budget to reflect LC 22 million for debt service and only LC 8 million for Programs & Activities (a 20% 500,000 per payment over 8 years (an average LC cut from the prior year). But then the LC devalues devaluation of 3.8% every six months), then the total by an additional 5% before the third debt service cost of the foreign currency loan is actually more than payment in June, and the authority has to come that of the local currency loan. For many countries the up with LC 11.55 million, and plan for a similar decline in their currency value over a 15 year period payment at the end of the year. This takes another can easily exceed these kinds of changes when the LC 1.1 million out of the remaining Programs & Activities budget for payments #3 and #4; which economy suffers inflation. amounts to an additional cut of almost 14%. The financial risks for a sub-national authority are even • Toward the end of the year the value of the LC greater if their foreign currency loan carries a variable improves by 2% so payment #4 is only LC 11.32 interest rate based on a foreign benchmark rate. In million, but there is hardly any time left to reprogram such cases the authority’s debt service payments will the savings of LC 230,000. By now the authority is fluctuate in response to changes in two variables: the finding it difficult to prepare a realistic budget for the following year and wishes that it did not have to benchmark interest rate and the foreign exchange face constantly shifting debt service requirements. rate. While there is no fixed relationship between these variables, it is not uncommon for currencies 3 such as the US Dollar, the Euro, and the Japanese Yen tries have established regulations that require some to appreciate in value against other currencies when form of national government approval for sub- their benchmark interest rates increase. In such cases, national borrowing. However, this latter approach sub-national authorities with Dollar, Euro or Yen debt is not as strong as an outright prohibition of foreign can experience a double increase in their debt service currency borrowing by law. Where national legisla- payments: one with the increase in interest rate and tion is inadequate, prudent sub-national authorities another with the decline in the value of their local have adopted their own by-laws or written policies currency. to prohibit foreign currency borrowing. In either way, the avoidance of foreign exchange risk is insti- Some sub-national authorities borrow in foreign tutionalized. This does not mean that international currency with a guaranty from their national govern- investors are not welcomed to invest in sub-national ment, but with so many national governments facing authorities, but simply that they have to invest using difficult financial choices and pressure from IFIs, guar- local currency. A positive side effect of avoiding the anties for sub-national authorities’ borrowings are currency risk is that sub-national authorities become becoming more and more difficult to arrange. In any more creditworthy (all other factors being equal) and case, a national government guaranty does not protect they may be able to access local currency financing on the authority from currency fluctuations. It simply better terms as a result. protects the lender from a default by the authority and makes the national government responsible for payment as a last resort. National governments can still require that the sub-national authority exhaust all The Sub-National Technical Assistance (SNTA) Program other options to make the payments (including pain- ful budgetary cutbacks and steep increases in fees or As more and more countries decentralize, the taxes) before the guaranty is exercised. provision of infrastructure is increasingly becom- ing the responsibility of sub-national authorities A rapidly declining local currency value can quickly (local governments and public utilities). These bankrupt a sub-national authority with foreign authorities are finding it necessary to seek long currency debt. This has serious consequences for the term private financing for their infrastructure people who depend on the authority for essential projects. Using annual budget allocations to services such as electricity, water supply, transporta- build infrastructure is difficult to manage because tion, and solid waste disposal. The local economy the funds required vary greatly from year to year. can be affected and people can loose their jobs. Long term debt financing allows sub-national Public health conditions can deteriorate and people authorities to smooth out the annual funding can become ill or die. The risk of facing such serious requirement by borrowing a large amount of consequences should not be underestimated, and the capital at one time and then repaying the debt in risk should be avoided. predictable annual increments small enough to make the project affordable to the people served. Avoiding foreign exchange risk can be done SNTAbRIEFS PPIAF Approved Logo Usage either at the national or the sub-national The Public Private Infrastructure Advisory Facil- ity (PPIAF) works with sub-national authorities SNTAbriefs share emerging knowledge on level. In some countries, such as to enable access to private financing on the best sub-sovereign financing and give an overview Mexico, nationalLogo governments - Black have of a wide selection of projects from various possible terms, and shares the lessons learned adopted laws that bar sub-national regions of the world. Related notes can be found from its global experience. at www. ppiaf.org. SNTAbriefs are a publication of authorities from borrowing in PUBLIC-PRIVATE IN F R A S T R U C T U R E A D V IS O RY FA C IL IT Y PPIAF (Public-Private Infrastructure Advisory Facility), a foreign currencies. Other coun- multidonor technical assistance facility. The views are those of the authors and do not necessarily reflect the views or the policy of PPIAF, the World Bank, or any other affiliated organization. Logo - 1-color usage (PMS 2955) c/o The World Bank, 1818 H St., N.W., Washington, DC 20433, USA For more information visit the PPIAF website at Phone (+1) 202 458 5588 FAX (+1) 202 522 7466 www.ppiaf.org. general EMAIL ppiaf@ppiaf.org web www.ppiaf.org PUBLIC-PRIVAT E INFRASTRUCTURE ADVISORY FACILITY