Foreign Exchange Rate Indexation Liquidity Facilities
Outline of Proposed Concept:
Although a liquidity facility could protect infrastructure projects financed with longterm local-currency loans from default induced by local-currency interest rate
volatility, such a facility would not be likely to encourage an extension of tenors in
countries that are currently characterized by the availability of only short-term
local-currency financing.
Opinions vary as to the factors that keep lenders in many countries from offering
long-term financing, but the correlation between high exchange rate volatility and
short-term markets suggests that lenders prefer to keep their commitments short
to enable them to exploit opportunities to shift assets from one currency to
another. Although many local borrowers cannot repay the full amount of their
short-term loans at maturity, even partial repayment coupled with appropriately
timed currency conversion can produce significantly higher returns than a
strategy based on exclusively investing within the host-country.
The opportunities to increase returns by means of a foreign-exchange based
strategy vary from country to country. For example, an analysis of quarterly
interest rate and foreign exchange data from 1995 through 2004 for Brazil and
the Philippines indicates that a Brazilian investor with perfect foresight (and no
transactions costs) would have switched currencies twelve times, while a
Philippine investor would have preferred to remain in pesos throughout the
period. For the Brazilian investor, such a strategy would have increased returns
from 33% to 40% during 1995-2004 and by much larger amounts for the periods
1997-2004 (from 23% to 37%) and 1999-2004 (from 21% to 50%).
It is possible that lenders in countries with short-term financing markets can be
induced to lend on a long-term basis if they are guaranteed a sufficient
percentage of foreign exchange gains. For example, a long-term local-currency
loan could specify that principal payments (and the outstanding balance of the
loan) will be indexed to a percentage of the change in nominal foreign exchange
rates between closing and the payment date. For example, if the lender were
offered 50% of gains and the FX rate moved from 2.0 : 1 at closing to 3.0: 1 at
the payment date, the payment would by increased by 25%, an amount reflecting
one-half of the change in the FX rate since closing [(3.0+2.0) / 2 = 2.5; the
payment is, therefore, multiplied by 2.5 / 2.0 = 1.25].
Although the proposed structure might appear to be overly favorable to local
lenders, from the standpoint of an infrastructure project that requires long-term
financing to offer economically-feasible tariffs, it could be preferable to US dollar
financing (which may be its only realistic alternative). If the project were financed
with US dollars, the local currency value of its debt service payment in the above
Bob Sheppard
Co-chair, Experts Group on Public / Private Risk Sharing
Projfin@bellsouth.net
1
example would increase by 50% – not 25% – and the increase would apply to
both interest and principal, not to principal alone, as in the proposed structure.
(On the other hand, a portion of these advantages is offset by the fact that local
currency interest rates tend to be higher – often much higher – than US dollar
interest rates.)
A sharing of 50% of foreign exchange gains with local lenders can increase
lenders’ expected returns from the “domestic only” rate to a rate closer to the
“best” rate that would be produced by skillfully-timed currency conversions. In
fact, to achieve an appropriate rate, it is likely that lenders will need to accept an
interest rate slightly lower than the prevailing local market rate. For example, in
the Brazilian example for 1997-2004, an interest rate 2% below market and a
50% sharing of FX gains would produce returns to lenders of 30%, rather than
the 23% returns produced by a “domestic only” strategy. In the case of the
Philippines, a 1% discount from the market rate and a 50% sharing of FX gains
would raise returns for the 1995-2004 period from 11% to 15%.
To protect an infrastructure project financed with a long-term, floating-rate localcurrency loan embodying this FX indexation structure, a liquidity facility should be
used to mitigate against both interest rate and FX volatility. As in the case of a
foreign exchange liquidity facility, the liquidity facility would function as a
revolving loan, with outstanding amounts repaid from the project’s cash available
for distribution when interest rates have fallen. Amounts owed to the liquidity
facility would be subordinated to the senior debt that was used to finance the
project.
An FX rate indexation liquidity facility could be provided by a host-country
government (either directly or by guaranteeing amounts advanced by local
financial institutions) or by a multilateral agency (either directly or by
guaranteeing an undertaking by the host-country government). The fact that the
ultimate beneficiaries of the liquidity facility would be local financial institutions
would, in most circumstances, lessen the need for support from multilateral
agencies.
Benefits:
This structure will provide substantial benefits to host-country governments,
project sponsors, and lenders:
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Host-country governments would benefit because the structure will promote
needed investment with a contingent financial commitment tied to risks that
are partially within the control of the government itself.
The structure may provide sufficient incentives for local lenders to offer longterm local-currency financing in countries where it would otherwise be
unavailable. The fact that FX indexation will be based on movements of the
Bob Sheppard
Co-chair, Experts Group on Public / Private Risk Sharing
Projfin@bellsouth.net
2
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nominal FX rate provides a high degree of certainty that the structure will
work to lenders’ benefit.
The structure enables local lenders to provide longer-term financing without
the risk of interest-rate induced default and its consequence of lengthy
restructuring negations.
The structure may enable project sponsors to obtain and utilize long-term
local currency financing, thus avoiding much of the currency mismatch risk
entailed by US dollar financing.
Obstacles to Date:
The two major obstacles to offering this structure are:
1. Due diligence: A substantial amount of analysis would be needed to convince
project sponsors and liquidity facility providers that the structure will function
properly under a wide variety of economic circumstances. The proposal
offered here is a sketch; it does not represent the type of detailed analysis
that underlay the concept of a foreign exchange liquidity facility before its first
use.
2. Reputation risk: Many financial and governmental institutions are cautious
about advancing new ideas that might fail in a very public manner. Here the
risk is not that a transaction might encounter difficulties sometime after
closing; it is that investors would not accept the proposed structure or might
demand unacceptably high pricing after it was known in the market that the
structure was being marketed for a specific transaction. As in the case of a
foreign exchange liquidity, a new, very different structure is an experiment,
the results of which will not be known until an actual attempt is made to
implement it.
Recommended Next Steps for Implementation:
A host-country government should decide to provide such a liquidity facility and
select a demonstration project with a sponsor willing to accept a loan or offer
securities with the proposed structure. Implementation would entail the following
steps:
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Selection of an appropriate infrastructure project sponsored by a domestic or
international firm that is willing to devote effort to implementing a new
structure
Evaluate both the local bank market and the local capital market as possible
sources of financing using this structure (This will entail an evaluation of
market participants’ understanding of and comfort with infrastructure project
financing, as well as their ability and willingness to extend financing of the
tenor required to make the project feasible.)
Bob Sheppard
Co-chair, Experts Group on Public / Private Risk Sharing
Projfin@bellsouth.net
3
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Decide on a strategy to use in structuring the FX rate indexation loan and/or
securities and in approaching selected local financial institutions; either:
o Approach local financial institutions during a pre-marketing period
to explain the FX rate indexation structure and solicit comments (at
the risk of structuring a transaction that is more favorable to lenders
than is in fact necessary to obtain their participation), or
o Structure the transaction without feedback from lenders, obtain
ratings for the transaction (see below), and present lenders with a
fully-structured transaction (With this second approach, lenders will
tend to limit requests for changes in the transaction to items that
are in fact deal points from their perspective.)
Determination of the form in which the host-country will provide the liquidity
facility – through a direct commitment from the Ministry of Finance or other
governmental agency, through a government-owned development bank, etc.
Structure the liquidity facility – establish conditions under which it may be
drawn, repayment terms, interest rate on outstanding balances, etc.
Seek appropriate national scale ratings from local and/or international rating
agencies
Arrange financing and close the transaction
Bob Sheppard
Co-chair, Experts Group on Public / Private Risk Sharing
Projfin@bellsouth.net
4