Scope & limits of financial guarantees for development James Winpenny Wychwood Economic Consulting Ltd

Scope of the study guarantees with a developmental motive for equity investors & project lenders & borrowers for long term investment. products offered by IFIs & some schemes of bilateral development agencies. Criterion: the operation, if it had been financed directly by donors through concessional credits, would be considered as oda. Export credit insurance is excluded: this normally covers only payment risks for the export of goods and services by firms resident in the country of the agency concerned

Purpose of guarantees encourage lending and investment in developing countries and emerging markets by mitigating key risks. apply both to physical infrastructure projects & to promotion of local capital markets as suppliers of finance. works through credit enhancement of local borrowers and bond issuers, and development of new types of local financial institutions.

How guarantees work Mitigating specific risks which are the critical sticking points on a project Enhancing securities (e.g. bonds, share issues) to take them over a critical threshold of creditworthiness (e.g. investment grade) Improving terms on which borrowers and project sponsors can get access to loans & equity Giving lenders & investors exposure to unfamiliar markets & products

Four principal risks Political: war, civil disturbance, terrorism, kidnappings, nationalisation, expropriation, restrictions on conversion & transfer of foreign exchange. Regulatory & contractual: Breach of contract by public partner, adverse decisions by regulators etc. due to political pressure. Credit: late payment or default on loans made, or for goods and services provided Foreign exchange: devaluation, increasing local currency cost of debt servicing, dividend remittances & other forex commitments.

Main sources of guarantees IFIs; bilateral donor agencies; bilateral official insurers; & private insurance cos. Political: MIGA, other IFIs (through B loans), bilateral official agencies, private companies. A large, well established and active market, with supply well matched to demand. Regulatory & contractual: MIGA Breach of Contract policy, World Bank Partial Risk Guarantee. Few policies issued so far. The product is case-specific, complicated to draw up & recovery difficult. Credit: Partial Credit Guarantees by IFC & other IFIs; bilateral donor Partial Loan Guarantees; insurance policies of private Monoline companies. Foreign exchange: in practice, this is not widely available from either private or official agencies (n.b. OPIC, & Camdessus proposal).

Extent of usage Size of bilateral agency guarantees difficult to estimate: data not collected systematically by DAC. annual amounts c. $ mn ?? (below 1% of total oda). IFI guarantees $2 bn. p.a., below 10% of their total operations. (above based on data)

Constraints to wider use supply-side attitudes & self-imposed constraints. capital provisioning rules and practices; low internal profitability and appeal of guarantees compared to direct loans and other services; attitudes of ratings agencies; agencies’ desire to preserve AAA rating. attitude of host/borrowing country. prefer direct loans where these count equally with guarantees against national borrowing limit; hostility by host governments and local banks to other agencies “crowding in” on local savings markets. Limited understanding of guarantees. weak pipeline of projects (e.g. power and water). Flux of international capital flows & volume of PSP cases, which generate demand for guarantees. Absence of necessary conditions for the success of guarantees, e.g. sound local banking system, potential supply of local savings, good local project promoters, good system of commercial law and legal redress, clear central-local fiscal relationships, established policy framework (e.g. over tariffs), etc.

Potential downsides Costs to supplier: opportunity cost of a contingent liability; high transaction costs in creating the products; “diversion” & “dilution” of aid; not reckoned as oda by DAC. Costs to recipients: charges & premiums; competes with sovereign debt; capital market “distortions”; risk of unsustainable debt Theoretical objections: moral hazard; adverse selection; rent-seeking

Developmental impact Correlation with level of development? Can’t compensate for lack of fundamentals distorting capital markets – or compensating for market and policy failures? Comfort, prop or stimulus? GUARANTEES GO WITH THE FLOW & CAN’T SWIM AGAINST THE TIDE!!

Says it all! Impact of Partial Credit Guarantee on loan terms Without guaranteeWith guarantee Philippines 3% 7 years 2.5% 15 years Uganda 8% n.a. 3.1% 16 years Bangladesh3% 1 year 2% 13 years Ivory Coast 3% 1 year 2.75% 12 years China: maturity7 yr15 yr Pakistan: maturity3 yr15 yr Jordan: maturity2 yr7 yr

Promoting use of guarantees Change rules on IFI capital provisioning Change DAC recording conventions Cooperation public-private insurers More local currency guarantees (Guarantco?) Identifying first-time market entrants Extending range of products Streamlining & more realistic pricing Create specialised Guarantee Agency?