project finance international

project finance international

The Role of Project Finance in International Development

1. Introduction to Project Finance

Recent research provides a mostly positive assessment of the ability of country authorities to commit, particularly in cases that impinge directly on the distribution of income in the recipient developing country. A multitude of domestic assets and liabilities would insulate these countries against external default. Effective tax rates and the average effective tax rate of the G-7 Bank Supervisors’ capital adequacy ratios clearly influence the amount of cross-border (partly syndicated) project finance committed to projects located in developing countries, but do not appear to influence the volume of U.S. commercial banks’ foreign direct loans. These results are robust along several dimensions, including measures of default risk, usage of proxies, and changes in the specification. Contrary to what theoretical models would suggest, interest rates in the range of 8-12% do not seem to provide the necessary discipline. Besides these, our results may provide the equilibrium conditions for looking at the flows of equity, short-term currency-financed debt, and long-term project finance.

Why should countries be interested in promoting project finance? Project finance is the mechanism to replace broken promises with reliable commitments. Promises provide limited restraints to country authorities that find themselves facing a choice of paying the price of (selective) default or causing the private banks to pick up an unanticipated portion of the national development bill. Project finance provides real equity and deep pockets, as domestic entrepreneurs and multilateral development banks are realigning their roles and participating directly in project equity. Political risk insurance programs such as MIGA fill the chinks in the best and surety bonds, and construction performance bonds cushion project lenders. This time, development diplomats solve rather than cause headaches for country authorities.

2. Key Concepts and Principles of Project Finance

With the selection and implementation of new concepts of project finance for development projects, including infrastructure projects, the same reasons for reducing the use of equity in corporate firms and increasing the use of debt of imperfect capital markets are also applicable to project financing: benefit from potential gains of specialization, separation of different types of risks. In project finance, therefore, the legal form and the capital structure of the vehicle assume importance not merely as an element of the tax shield, but essentially as the natural consequences of the evolutions of the debates in corporate finance and the markedly different nature of project risks. It is simply a historical fact that, in the modern economy, these risks have a tendency to be concentrated in large complex projects, performed by entities different from the industrial firms that own the equity.

In project finance, the unique nature of the project risks, the time profile of the debt service, legal covenants in the debt contract, and the establishment of a closely monitored flow of funds and a dedicated management make the liabilities rather independent from the corporate risk. In non-project, corporate lending, the same pool of assets of the company secures most, if not all, the financing of the company (this is why the costs of debt of a company tend to increase with the debt/equity ratio). On the other hand, by limiting the recourse of the lenders to the physical assets of the project and by creating off-balance-sheet financing, the possibility of funding projects otherwise than with equity becomes feasible.

3. Benefits and Challenges of Project Finance in International Development

At the same time, for international development projects, the project finance scheme also presents a particular set of challenges. Since private placements and merchant loans tend to be small and more standard, project sponsors should aim to capture the funds of the marketed placements; otherwise, an important additional incentive would be eliminated. Virtuous conditions (or favorable political acts) are usually politically conditioned and complex and risky worldwide throughout the payout requirements. Entities adopt a familiar and limited dollar finance regime, but at heightened risk compared to corporations: the political and regulatory context of countries can change, the ad hoc public assessment of public sector projects may be weak or decrease during the life of a long investment project. Commercial banks compete closely with the bond market, especially for short-term portfolio of credit projects and are valueless performing best “in river” projects or projects for which request guarantees are needed. Banks may therefore incur additional transaction and monitoring costs. Securities are usually issued, buyers are good buyers of both money and high due diligence. Surfacing is concentrated and less diverse with financial products offered by the banking and insurance markets, which can cause a specific “market opportunity”.

The design of project finance permits practical benefits for all international development projects: it encourages loan syndication and risk diversification, ensures that the composition of participants also matches their expertise and risk appetite, enhances discipline and dedication of project sponsors and members of the facility by imposing the principle of “success equals money”, adds a strong knowledge of project management and budget estimations, and just correspondence of human and financial resources. In certain situations, when the budget of the project sponsor is limited or there are more efficient uses of it, project finance tends to attract additional private funds compared to projects set up in commercial law, thereby moderating the moral hazard problem associated with the distribution of benefits and risks.

Benefits and challenges of project finance for international development

4. Case Studies: Successful Applications of Project Finance in Global Projects

The Asian Crisis has provided some project finance opportunities for those well-prepared investors or contractors. In Malaysia, a new power station is under construction. The project company includes some reputable utility companies, a finance company, and a key contractor. In China, Power Utility has become very focused on project finance as the limited resources in the PRC government-owned power assets cannot satisfy the extensive demand of the rapidly growing economy. In each of the enclaves (Guangdong, Shenzhen, Fujian, and another southern coast region), Power Utility is negotiating with Spanish contractors to form a construction subsidiary. French EDF is the model for Power Utility. It concentrates on constructing and operating power facilities for 15-20 years with a guaranteed purchase by the Chinese power plant and with the financial assistance from every member of the EDF consortium.

In Asia, a successful example in the privatization and modernization of an airport is the Bangkok International Airport through the Bangkok International Airport Public Company, whose shareholders are Bangkok Land, Conseco Infrastructure Fund, a government-operated fund, and US Insurance Fund. This company acquired a concession to manage the airport and finance its modernization and expansion.

5. Future Trends and Innovations in Project Finance

The development of limited recourse project financing in the 1970s and 1980s, in response to evolving legal and regulatory risks and needs, is well-documented. Through the 1960s and early 1970s, limited recourse project financing was viewed as a special category of financing for the independent power project industry, and this historical niche has led to certain common characteristics of project financings which remain in place to this day. Since that time, however, a number of significant changes have occurred in both the project industry and the project finance market. Among the more significant developments that have contributed to the expansion of project finance as a mainstream financing alternative for a much broader range of businesses in all parts of the world have been the following: Technology, Counter-Migrations, Cash-flow Forecasting, and Development Risk.

The evolution of independent power project finance in the 1970s and 1980s, and the subsequent development of products and practices to apply the principles of limited recourse project finance to a wide range of industrial projects, has been well documented. As history suggests, innovation in project finance goes through two distinct stages: development of innovative structures and standardization of such structures to make them readily applicable to a wide range of industry sectors and corporate participants. This article provides a broad survey of a number of recent developments and future trends in the world of project financings. Although the emphasis is on private market transactions, we also refer to some related developments in the OECD export credit and multilateral agency lending programs, which can be of particular significance for large, complex projects and project finance participants.