How the Pandemic Heightens Macroeconomic Risks for Private Infrastructure Financing?
Infrastructure gap remains, and is clustered in the emerging markets where the economic effects of the global pandemic are severely felt. COVID19 may remind infrastructure investors the importance of various debt service reserve accounts, cash sweep mechanisms, inflation-linked off-take agreements, PPAs, supply and O&M agreements… Projects may also increasingly favor the idea to match the currency of availability payments and guarantees to the funding currency at least to an extent which covers the desired debt service coverage ratios; as well as currencies of maintenance and reserve accounts to respective currencies that the accounts would serve in times of difficulty, such as a global pandemic.
Introduction
The global pandemic’s impact on project financing and provision of infrastructure through PPPs may be categorized in two buckets: 1) its impact on operational projects; those that have already secured financing; that are past construction and in the revenue-generating phase; and 2) its impact on construction and development stage projects; those that are still in the phase of constructing facilities; or waiting on permits etc. and searching for financing; that are most of the time not generating any sort of revenue.
The pandemic has stalled demand around the globe, for energy, transportation; and even a temporary disruption of demand of this sort is expected to, and have already for most projects[1], cause in revenue-losses for most operating projects. The pandemic has also disrupted supply chains around the globe; which is to affect construction and development phase projects more deeply, resulting in construction delays and cost overruns, maybe rearrangements in construction and financing schedules due to shortages of labor, equipment & raw material[2].
This article defines three risks by which buckets of COVID’s potential effects identified above are examined; commercial risks, macroeconomic risks and regulatory/political risks; and then focuses on macroeconomic risks. All of these risks have been heightened especially in emerging markets due to the pandemic, where most of the infrastructure gap is clustered. For commercial risks, and a broader background on project finance and various stakeholders in an infrastructure project and/or public private partnership, please see the previous commentary on COVID19 and infrastructure projects.
Infrastructure Gap is Clustered in Emerging Markets with Most Macroeconomic Risks
Macroeconomic risks deem greenfield infrastructure investments riskier, macro-focused risk mitigation and financing tools more necessary
Macroeconomic risks faced in project finance are risks that aren’t innate to the project itself, but to the economic environment the project is located in. Most prevalent of them would be inflation risk, interest rate risk and currency exchange rate risks. Macroeconomic outlook in emerging markets is deteriorating due to the COVID19 slowdown: With the exception of Asia; emerging countries around the world are expected to post dire contractions. According to IMF, 5.2% contractions is expected in emerging and developing countries in both Europe and Latin America[3].
Even though advanced economies may pose the danger of worsening macroeconomics in the near future, the fact that most of the infrastructure financing gap, as well as existing large projects and maintenance needs are clustered in emerging economies that are much more fragile and susceptible to shocks is concerning regarding infrastructure investments. According to the Global Infrastructure Hub the world will be facing a $15 trillion gap between projected investment and the amount needed to provide adequate global infrastructure by 2040[4].
Source: International Monetary Fund
As the global shutdown is unfolding in the form of demand disruption and supply chain distortions; already limited financing capacity of governments to fund new projects & to continue making the payments on already extended demand guarantees, traffic guarantees as well as off-take agreements with availability payments, sometimes indexed to hard currencies and covering even a certain level of return on equity for private investors, hints more problems ahead regarding private financing and/or PPPs in infrastructure investments. Project structures that have hard currency financing, inflation linked off-take agreements, a legal framework that allows for refinancing of long-term projects may even prove more problematic depending on the duration of the pandemic and the pace of the economic recovery awaited.
It would be wise to note here that macroeconomic risks, as most other risks faced in infrastructure, may have different impacts and raise different concerns from the perspectives of lenders and sponsors, as well as private companies and governments, depending on the phase of the project. For example, during construction, higher inflation results in higher costs and therefore reduce net cash flow even if there is no debt payment scheduled. However, if the project is in the operating phase, then higher revenues and higher expenditures may increase net cash flow if debt payments are fixed for the duration of the project[5].
COVID19 resulted in massive supply chain disruption around the globe and therefore may exacerbate risks related to the development and construction phases of infrastructure projects: Inflationary risks on inputs such as labor, equipment, raw materials that are heavily sourced during the construction phase[6] may prove unmanageable for some project that may not have adequate revolving lines to rely on for short-term lending. These may result in construction delays and/or cost overruns, requiring rescheduling of construction and therefore financing schedules, rearrangement of milestones or redefinition of key performance metrics designed for this stage of project financing.
Construction delays postpone projected revenues and therefore diminish the project’s ability to meet its planned debt service requirements. Any deterioration in projected debt service coverage ratios may require additional grace periods for debt service for either interest payments during construction phase if any, or even principal payments if the repayment schedule contains any construction stage revenues as part of the planned cash waterfall.
Image: https://retailtouchpoints.com/
Supply distortions may also lead EPC contractors to seek force majeure claims specified under concession agreements, which would cause borrowers to continue onto making force majeure claims as well to avoid breaching key performance indicators, milestone completion dates and any liabilities for liquidated damages[7]. Similar problems may be faced by supply and O&M contractors in operational projects, and maybe even for those with PPAs, especially PPAs indexed to inflation, another currency etc. as most governments and private sector companies may also be in foreign currency and overall liquidity crunches.
In short, despite potential negative impacts on both construction phase and operational phase projects, — at least from one stakeholder’s perspective, either sponsors or lenders or the government/society — ; the most observable and immediate of all these effects may deem greenfield projects temporarily riskier from the perspective of lenders. According to industry professionals, there have already been examples of projects that had to declare force majeure as the supply of photovoltaic panels from China was interrupted[8].
Despite huge stimulus packages & 0% rates; most emerging markets need liquidity
Major central banks around the globe have been responding to COVID with unprecedented packages. With policy rates already around 0% or below 0% levels and limited room for interest rate maneuvers, additional support packages have been announced to provide liquidity. FED announced a $2 trillion support package, along with cutting the funds rate by 1.5% since the beginning of March. ECB kept all key rates at 0% or below 0% levels and announced massive asset purchase programs, similar to BOJ immediately after the spread of the pandemic.
The FED has provided Swap lines to provide dollar funding to the central banks around the globe, but risk of liquidity crunches continue as a considerable portion of local currency debt is also foreign owned in emerging markets, they are highly vulnerable to capital flight[9]. IMF is putting up large amounts of lending on the table and multilaterals are asking bilateral lenders, such as China, to halt debt payments from 76 low-income countries[10]. The liquidity crunch will surely affect existing and future infrastructure projects that are mostly clustered in emerging markets.
Interest rate risk arises from the fact that large infrastructure projects are much longer term compared to most bank lending, and banks usually would like to make sure the interest they would be getting paid on a given loan is adjusted according to the macroeconomic developments during the life of the project. If a project was to be financed with fixed rate loans or bonds, then interest rate risk would be minimal. However, interest rate risks arise if floating rate funding is fully or partially present in the financing scheme of a project, e.g. rates are adjusted according to some metric, such as LIBOR, US Ts etc. In that case, investors may undertake the risk accepting that there will be fluctuations in their expected return in times of higher interest payments than planned for; or sometimes demand that governments embed some sort of guarantee scheme is embedded in concession agreements to provide for the losses at such times in PPPs.
COVID19 may make it more difficult for sponsors to secure financing due to the difficulties in predicting the future of interest rates. Despite rate cuts by all major central banks, emerging markets are still in crunches of liquidity and lending in long term tenors may be problematic by nature. Banks do not prefer lending long-term due to uncertainties even in normal times. Additional burden on banks due to the uncertainties regarding sustainable interest rates may decrease the number of projects that are deemed bankable in the near future, and therefore further limit greenfield investments.
On the other hand, it may also be possible for sponsors to execute their refinancing option, which may create problems especially in PPPs where governments may limit the extent to sponsor can take advantage of low interest rates and increase their rate of return, when the off-take agreements, demand guarantees and traffic forecasts usually remain as they are. Revisioning of concession agreements, as well as other project documents such as the PPAs may be an additional topic on the table for some operational projects.
Emerging currencies at risk, FED Swaps insufficient
Emerging market currencies are tumbling as risks and uncertainties around the globe skyrocket with no foreseeable end to the pandemic and how the economic crisis will unfold afterwards. As investors fly into safe assets such as the US dollar, the FED has immediately provided Swap lines to provide dollar funding to several central banks such as the Reserve Bank of Australia, the Banco Central do Brasil, the Danmarks Nationalbank, the Bank of Korea, the Banco de Mexico, the Norges Bank, the Reserve Bank of New Zealand, the Monetary Authority of Singapore, and the Sveriges Riksbank[11]. Yet, some emerging markets still experience currency depreciation with central bank reserves dwindling; and vulnerabilities to further capital flight.
Source: https://www.cnbc.com/2020/04/14/emerging-market-currencies-have-been-hammered-by-covid-19.html
Emerging markets that have high amounts of dollar-denominated foreign debt and already wide current account deficits face inflationary pressure due to the harsh decision between providing liquidity to the economy by issuing currency and further lowering already low lending rates, and facing high inflation in the near term; or maintaining the strength of their currency and not being able to pay for stimulus packages, credit support to the economy whose end result may be IMF debts, austerity to follow etc. or increasing number of defaults, unemployment and people’s inevitable reliance on more state support to get through the crisis.
The situation is not very favorable for funding large infrastructure projects as creating project structures in which currency risks are mitigated may be difficult in the near term. Currency exchange rate risks arise both during the construction and operational phases of an infrastructure project. If funding for the construction is provided in a currency and the costs are in another, any movement in the exchange rate between the two currencies may result in cost overruns and delays accordingly. During the operational phase of the project, if costs and debt funding are in different currencies, movements in exchange rates result in either inability to serve the debt obligations or in higher rate of return for the sponsors which may be problematic from the public authority’s perspective and may cause in needs to adjust to the concession agreement. Fluctuations in exchange rates, especially where a part of debt service is indexed to hard currencies such as the US dollar, and allocation of revenue currency either does not meet this structure, or revenue is simply disrupted, may increase the probability of default[12], covenant breaches and increasing scrutiny from lenders.
Tumbling currencies in some of the emerging markets may cause in deteriorating debt service coverage ratios, covenant breaches and even defaults for operational projects with local currency revenues and foreign currency funding. Unless demand guarantees, availability payments or still recurring revenues are denominated in currencies that match the debt service obligations, sponsors may have difficulties keeping their debt service coverage at bankable levels to even look for short-term financing, credit lines etc. Developers drawing cash from revolving lines ahead of schedule due to concerns regarding the macroeconomic outlook may add to the liquidity crunch[13].
On the other hand, projects with local currency funding and revenues in hard currencies may collect skyrocketing returns, which may also be problematic from a PPP perspective. Tax-payers, as a party to a large infrastructure investment, are concerned about both the availability and amount/quantity of the products/services provided, as well as how costly the provision of these services are, and whether their tax money is being spent wisely. In a project where sponsors make more profits than once promised due to tumbling local currencies, tax-payers may be disturbed about buying an infrastructure service that shouldn’t cost that much. This may cause projects to lose their political value for money[14].
High inflation expected in many emerging economies as currencies tumble
As mentioned above, emerging markets face the decision between providing liquidity and facing inflationary pressures once the economy is up and running full force again; or a worsening economic downturn and increasing number of bankruptcies and unemployment rates due to the liquidity crunch. Some food prices already show inflationary pressures around the globe, but due to record low oil prices the overall inflation levels remain low. Unless there is a fundamental shift in people’s spending behavior after the lockdowns[15], inflationary pressures are expected in emerging economies given their need to utilize monetary policy to revive economies out of the recession and maintain healthy exchange rates and export activity.
The inflation level affects both construction/development phase projects and operational projects; and sometimes the effects may even be contrary to each other. Inflation is related to the price of inputs and the price of outputs in a project structure. High inflation may lead to higher costs for the project both during the construction and operational phases, and may result in cost overruns, delays etc. For a construction phase project, higher inflation results in higher costs and therefore reduce net cash flow even if there is no debt payment scheduled. However, if the project is in the operating phase, then higher revenues and higher expenditures may increase net cash flow in case debt payments are fixed for the duration of the project[16]. Yet, by lowering the net return expected from the investment, high inflation may still lower private interest in a project.
The level of inflation, and inflationary outlook, also determines the difficulty level for financing a large infrastructure project in an emerging country: For a development phase project where sponsors are looking for financing, high inflation increases difficulties in securing debt financing due to uncertainties regarding the future of interest rates since interest rates are closely associated with inflation management policies of most emerging economies. In other words, countries may use monetary policies to either curb inflationary pressures or to increase liquidity during similar times, and uncertain outlook on interest rates keep lenders away from long-term lending, concentrating loans in large projects etc., and therefore deem large infrastructure projects riskier.
Projects may involve instruments such as inflation-indexed financing taking into account the possibility of both the dangers and advantages of higher or lower inflation while projecting the future cash flows of a project. Similar structures may also exist in off-take agreements, where a portion of availability payments may be linked to inflation, based on the thought that higher inflation also increases the price paid for inputs for production, unless a supply agreement also mitigates inflationary risks from supply perspective.
Conclusion
COVID19 may remind developers and sponsors the importance of various debt service reserve accounts. Operational projects may utilize these reserve accounts, maintenance accounts etc. if there are only couple payment periods affected by revenue disruption, but projects that are earlier in their operational phases may not be able to as they may not have filled up their reserve accounts entirely. For projects under construction, these are usually not an option since most projects do not start making revenue at least until the very last stages of construction and therefore most are still in grace periods for debt service payments until fully operational.
Sponsor may also increasingly favor cash sweep mechanisms; which enable projects to devote excess profits if any into making early payments on debt service, therefore lowering interest payments and in turn in fact increasing shareholders’ return; in the future for greenfield projects. A cash sweep mechanism refers to the use of a borrower’s excess cash to prepay its loans. Excess cash is taken or swept from the borrower’s bank accounts and applied to pay down debt. Excess cash is usually the amount remaining after the borrower’s operating costs and regular debt service have been paid; and may be the equity return in the context of a project financed PPP. A cash sweep provision reduces the outstanding balance of the borrower’s loans and, consequently, the lenders’ exposure to the borrower usually earlier than planned.
Post COVID19, project structures may also start increasingly favoring inflation-linked off-take agreements, PPAs, supply and O&M agreements, given that it may not always be possible to integrate inflationary outlooks into forecasting cash flows for the project during due diligence and development phases. Projects may also increasingly favor the idea to match the currency of portions of availability payments and guarantees to the funding currency at least to an extent which covers the desired debt service coverage ratios, as well as matching the currency of maintenance and reserve accounts to respective currencies that the accounts would serve in times of difficulty.
[1] Toni Baini. Coronavirus outbreak puts brakes on project finance — Lenders focus on reviewing their portfolios and providing short-term liquidity, rather than drumming up new deals. March 20, 2020.
[2] The World Bank. PPPs and COVID-19 Resource. April 9, 2020.
[3] International Monetary Fund. World Economic Outlook, April 2020: The Great Lockdown. April 2020.
[4] Anita George. Rashad-Rudolf Kaldany. Joseph Losavio. The world is facing a $15 trillion infrastructure gap by 2040. Here’s how to bridge it. 11 April 2019.
[5] E.R. Yescombe. Principles of Project Finance. Academic Press Elsevier. 2002.
[6] Toni Baini. Coronavirus outbreak puts brakes on project finance — Lenders focus on reviewing their portfolios and providing short-term liquidity, rather than drumming up new deals. March 20, 2020.
[7] King & Spalding. The Impact of COVID-19 on Project Financing. March 21, 2020.
[8] Toni Baini. Coronavirus outbreak puts brakes on project finance — Lenders focus on reviewing their portfolios and providing short-term liquidity, rather than drumming up new deals. March 20, 2020.
[9] Marcus Ashworth. Emerging markets peering over precipice as financial fallout from Covid-19 spreads. April 11, 2020.
[10] Paulina Restrepo-Echavarria. COVID-19’s Economic Effects on Poor and Emerging Markets. April 6, 2020.
[11] RTTNews. Major Central Banks Take Further Steps to Boost Liquidity Amid Covid-19 Shock. March 20, 2020.
[12] King & Spalding. The Impact of COVID-19 on Project Financing. March 21, 2020.
[13] Toni Baini. Coronavirus outbreak puts brakes on project finance — Lenders focus on reviewing their portfolios and providing short-term liquidity, rather than drumming up new deals. March 20, 2020.
[14] Political value for money here refers to the thought that governments may be more willing to finance infrastructure projects that would secure higher electoral support.
[15] Neil Shearing. Capital Economics. How to think about the inflationary consequences of COVID-19. 6 April 2020.
[16] E.R. Yescombe. Principles of Project Finance. Academic Press Elsevier. 2002.
