ENERGY AND MINING SECTOR BOARD DISCUSSION PAPER PAPER NO.9 DECEMBER 2003 Foreign Exchange Risk Mitigation for Power and Water Projects in Developing Countries Tomoko Matsukawa, Robert Sheppard and Joseph Wright THE WORLD BANK GROUP The Energy and Mining Sector Board AUTHORS DISCLAIMERS Tomoko Matsukawa ([email protected]) is Senior Financial Officer of the Project Finance and Guarantees unit The findings, interpretations, and conclusions expressed in of the World Bank. She has worked on various power and this paper are entirely those of the authors and should not be water projects, structuring public-private risk-sharing schemes attributed in any manner to the World Bank, to its affiliated and implementing World Bank guarantee transactions. Prior organizations, or to members of its Board of Executive Directors to joining the World Bank she worked at Morgan Stanley, or the countries they represent. Citicorp and the Chase Manhattan Bank; she holds MBA from Stanford Graduate School of Business. The material in this work is copyrighted. No part of this work may be reproduced or transmitted in any form or by any means, Robert Shepard ([email protected]) is a an independent electronic or mechanical, including photocopying, recording, or consultant working on ways to improve access to capital inclusion in any information storage and retrieval system, without markets for developing country infrastructure projects. the prior written permission of the World Bank. The World Bank He was previously responsible for project finance capital encourages dissemination of its work and will normally grant markets at Banc of America Securities and is a member of permission promptly. For permission to photocopy or reprint, the North Carolina Bar and of the American Bar Association. please send a request with complete information to the Copyright He is a graduate of the University of North Carolina Clearance Center, Inc, 222 Rosewood Drive, Danvers, MA (Juris Doctor and MBA). 01923, USA, fax 978-750-4470. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Joseph Wright ([email protected]) works on energy regu- Office of the Publisher, World Bank, 1818 H Street N.W., lation, energy reform and rural energy issues in the World Bank Washington DC, 20433, fax 202-522-2422, e-mail: where he is presently assigned to the South Asia Energy and [email protected]. Infrastructure Unit. He is co-author of Mitigating Regulatory Risk for Distribution Privatization – The World Bank Partial Risk Guarantee, a discussion paper in this series. Prior to joining the CONTACT INFORMATION World Bank he was adviser to the Government of Uganda. To order additional copies please call the Energy and Water Help Desk 202-473-0652 [email protected] This paper is available online www.worldbank.org/energy/ The material in this work is copyrighted. No part of this work may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or inclusion in any information storage and retrieval system, without the prior written permission of the World Bank. The World Bank encourages dissemination of its work and will normally grant permission promptly. For permis- sion to photocopy or reprint, please send a request with complete information to the Copyright Clearance Center, Inc, 222 Rosewood Drive, Danvers, MA 01923, USA, fax 978-750-4470. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, World Bank, 1818 H Street N.W., Washington DC, 20433, fax 202-522-2422, e-mail: [email protected]. THE WORLD BANK GROUP The Energy and Mining Sector Board The World Bank 1818 H Street N.W. Washington, D.C. 20433 USA ENERGY AND MINING SECTOR BOARD DISCUSSION PAPER PAPER NO.9 DECEMBER 2003 Foreign Exchange Risk Mitigation for Power and Water Projects in Developing Countries Tomoko Matsukawa, Robert Sheppard and Joseph Wright The World Bank, Washington, DC THE WORLD BANK GROUP The Energy and Mining Sector Board Copyright © 2003 The International Bank for Reconstruction and Development/The World Bank. All rights reserved CONTENTS INTRODUCTION..............................................................................................................2 1. WHAT IS FOREIGN EXCHANGE RISK?.....................................................................2 Interest Rate Parity Theory .........................................................................................3 Purchasing Power Parity Theory.................................................................................3 Forecasting Exchange Rates .......................................................................................3 2. FOREIGN EXCHANGE RISK ALLOCATION ...............................................................4 Investors ......................................................................................................................4 Consumers ...................................................................................................................5 Government.................................................................................................................5 Risk Allocation among Investors in Infrastructure Projects.......................................5 3. ALL INDUSTRIES FACE FOREIGN EXCHANGE RISK: WHAT’S SPECIAL ABOUT INFRASTRUCTURE? .........................................................6 4. MECHANISMS FOR THE ALLOCATION AND MITIGATION OF EXCHANGE RATE RISK ........................................................................................7 Local Currency Financing............................................................................................7 Local Capital and Bank Market Development ............................................................8 Local Currency Fund Schemes...................................................................................9 Local Currency Credit Enhancement..........................................................................9 iii MLA Local Currency Instruments .............................................................................11 Currency Hedges .......................................................................................................11 Mechanisms That Allocate Exchange Rate Risk to Government .............................12 Fixed Exchange Rates..............................................................................................12 Public Sector Lending in Local Currency ..................................................................13 Exchange Rate Guarantees .....................................................................................13 Tariff Indexes.............................................................................................................15 Foreign Exchange Index ..........................................................................................16 Inflation Index ........................................................................................................17 Regulatory Risk Mitigation .......................................................................................18 Liquidity Facilities......................................................................................................20 Escrow Accounts .....................................................................................................20 Liquidity Facilities Dedicated for Exchange Rate Risk Mitigation ................................20 Suspension of Investment Programs ........................................................................22 5. SUMMARY OF FINDINGS ........................................................................................23 APPENDIX 1: CURRENCY CONVERTIBILITY GUARANTEES.......................................25 APPENDIX 2: DESCRIPTION OF OPIC’S REAL EXCHANGE RATE LIQUIDITY FACILITY..............................................................................26 APPENDIX 3: AN INTRODUCTION TO HOW RATINGS AGENCIES EVALUATE FOREIGN EXCHANGE RISK...............................................27 iv FOREWORD The importance of the infrastructure sectors in achieving growth, poverty reduction and the Millennium Development Goals is well established. Meanwhile, private financing of infrastructure projects in developing countries has decreased and private participation in the power sector has not reached the levels originally anticipated. Foreign exchange risk has been identified by private financiers as a major factor in their reluctance to invest in developing country infrastructure projects, especially in the wake of the East Asia financial crisis and the Argentine and Brazilian currency crisis. Foreign exchange risk is as much a concern for the financial sustainability of public infrastructure projects as for private projects. This paper explains how foreign exchange risk affects v power and water infrastructure projects. It analyzes the effectiveness of various mechanisms that have been used to mitigate the risk of local currency depreciation and examines how these may be improved, with a view to suggesting a variety of potential roles for donor agencies in facilitating foreign exchange risk mitigation. There is a range of approaches to mitigating and allocating foreign exchange risk and the best approach for each project will be determined by the specific project structure and the sector and country circumstances. We expect that paper will provide