NOTE NUMBER 266 P U B L I C P O L I C Y F O R T H E privatesector 54118 DECEMBER 2003 Exchange Rate Risk Philip Gray and Timothy Allocating Exchange Rate Risk in Private Infrastructure Projects Irwin E a c h ye a r d eve l o p i n g c o u n t r i e s s e e k b i l l i o n s o f d o l l a r s o f i nve s t m e n t Philip Gray (pgray@ i n t h e i r i n f r a s t r u c t u re , a n d p r i vat e i nve s t o r s , m o s t l y i n r i c h worldbank.org) is a senior private sector development c o u n t r i e s , s e e k p l a c e s t o i nve s t t r i l l i o n s o f d o l l a r s o f n ew s av i n g s . T H E W O R L D B A N K G R O U P PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY specialist, and Timothy P r i vat e f o re i g n i nve s t m e n t i n t h e i n f r a s t r u c t u re o f d eve l o p i n g Irwin (tirwin@worldbank. org) a senior economist, at c o u n t r i e s wo u l d s e e m t o h o l d g re at p ro m i s e . B u t f o re i g n i nve s t o r s the World Bank. This m u s t c o p e w i t h vo l at i l e d eve l o p i n g c o u n t r y c u r re n c i e s . M a ny at t e m p t s Note is a companion to Philip Gray and Timothy t o d o s o h ave c re at e d a s m a ny p ro bl e m s a s t h ey h ave s o l ve d . T h i s Irwin, "Exchange Rate N o t e p ro p o s e s t h at i nve s t o r s t a ke o n a l l f i n a n c i n g - re l at e d ex c h a n g e Risk: Reviewing the Record for Private r at e r i s k , eve n t h o u g h t h i s m ay m e a n h i g h e r t a r i f f s f o r c o n s u m e r s a s Infrastructure Contracts," a p re m i u m f o r b e a r i n g t h at r i s k . Viewpoint 262 (World Bank, Private Sector and The standard advice on allocating risk--to cost of the service and the risk can be shared Infrastructure Network, assign it to the party best able to manage it--has widely to lessen the impact. Washington, D.C., 2003). controversial implications for the allocation of The allocation of exchange rate risk is often exchange rate risk in a private infrastructure done through tariff adjustment formulas that project. Three parties can bear the risk of implicitly share risk through the way they adjust exchange rate movements in the first instance: the tariff over time. If indexation is allowed, tar- the private investors (whether foreign or local iffs can reflect the exchange rate in several ways: equity-holders or creditors), the host country Allowed prices or revenue can be fully or par- government (ultimately, its taxpayers), and cus- tially indexed to the exchange rate. tomers of the service. Some argue that investors Input costs that depend on the exchange rate --or at least their ultimate shareholders-- can be treated as a pass-through, so that cus- should bear the risk because they can diversify tomers pay the actual costs of the inputs. away country-specific exchange rate risk. Others The contract can provide for a renegotiation argue that the government should bear the risk of allowed prices or revenue if the exchange because it is responsible for macroeconomic rate moves outside a specified band. policies that strongly influence the exchange At one extreme of the risk sharing spectrum, rate. Still others argue that customers should Argentina effectively indexed 100 percent of bear it because they must ultimately pay for the costs to the dollar. The implications of this are E X C H A N G E R A T E R I S K ALLOCATING EXCHANGE RATE RISK IN PRIVATE INFRASTRUCTURE PROJECTS now being fought out by the investors and the They can influence the underlying source of Argentine government, which has prevented the risk. Governments, for example, can significant tariff increases since the devaluation reduce the rate of depreciation and the of the Argentine peso. Most countries use a volatility of the exchange rate by keeping hybrid approach to tariff adjustment. Part of the budget deficits small and inflation low. tariff is indexed to local inflation, part is They can influence the sensitivity of the value indexed to dollar inflation, and some costs are of a project or of their interest in it to the risk. straight pass-throughs. But there is still much Project sponsors, for example, can reduce debate about what share of the cost base should the sensitivity of the value of their share- 2 be indexed to local inflation and what share to holding to the exchange rate by reducing the international costs. And tariff adjustment mech- project's reliance on foreign currency debt. anisms are not the only approach: governments They can hedge or diversify away the risk. sometimes provide exchange rate guarantees to Hedging exchange rate risks is possible in only cover repayment of foreign currency debt. a few developing countries. But most of the ultimate foreign shareholders of the project Nature and sources of exchange rate risk company--individuals with savings in mutual To shed more light on the debate requires first funds, pension plans, and life insurance--can looking more closely at the nature and sources diversify their savings, limiting their exposure of the risk. Exchange rate risk, as defined here, to any one country's exchange rate risk (as is variability in the value of a project, or of an defined). interest in the project, that results from unpre- The principle of optimal allocation can there- dictable variation in the exchange rate. fore be restated as follows: Exchange rate risk There are two types of exchange rate risk: should be allocated according to the parties' abil- project and financing related. Project exchange ity and incentives to influence the exchange rate, rate risk arises when the value of a project's change the sensitivity of the value of the project inputs or outputs depends on the exchange (or of their interest in it) to the exchange rate, rate. Typical infrastructure projects sell their and hedge or diversify away the risk. Because the outputs domestically, so, valued in local cur- principle involves three types of management, its rency, revenues usually are not subject to implications are not clear cut (table 1). exchange rate risk. But any input that is trad- The government's influence over the able, even if it is not imported, will have a world exchange rate is one factor that, other things price, so its cost, measured in local currency, will equal, argues in favor of allocating project and vary inversely with the exchange rate. The cost financing-related exchange rate risk to the gov- of fuel, for example, creates exchange rate risk ernment. But this argument should not carry for a thermal electricity generator. too much weight. Allocating the risk to the gov- Financing choices affect the amount of ernment is unlikely to improve the quality of its exchange rate risk borne by different partici- decisions affecting the exchange rate--both pants in the project (shareholders, creditors, because the relationship between the exchange customers, taxpayers). In particular, loans rate and the government's financial position is requiring repayment in foreign currency expose affected in complex ways by many factors unre- shareholders to exchange rate risk. As a result, lated to the project and because governments shareholders may seek to shape the contractual do not respond to financial incentives in the arrangements to pass on some or all of the risk same way as firms and individuals do. to the government or customers (through If the government does not assume the exchange rate guarantees or indexation of the exchange rate risk, the risk must be shared tariff to the exchange rate). between customers and investors (sharehold- ers). Neither can influence the exchange rate, Optimal allocation of exchange rate risk so the choice turns on the other two factors. Parties can manage exchange rate risk in three Consider first project exchange rate risk. ways: Customers can sometimes influence the sensi- Table Ability of customers, shareholders, and government to manage exchange rate risk 1 Project risk Influence over exchange rate Customers None Shareholders None Government Great Influence over sensitivity of project Limited, but can change Limited, but can Little to exchange rate consumption in response sometimes change inputs to changes in the cost in response to changes in of tradable inputs the cost of tradable inputs 3 Ability to cope with risk by Little Great Little hedging or diversification (through diversification) Financing-related risk Influence over exchange rate None None Great Influence over sensitivity of value of None Great (through choice None investors' interest in company to exchange rate of financial structure) Ability to cope with risk by hedging Little Great Little or diversification (through diversification) tivity of a project's value to the exchange rate by the project to the exchange rate (they have no changing their consumption levels in response control over whether the investors decide to use to changes in the cost of tradable inputs. When financing that creates exchange rate risk). the cost of fuel rises as the exchange rate depre- Moreover, most customers have no good natural ciates, customers may be able to mitigate the hedges against the risk of currency fluctuations-- adverse effect on a power project's value by cut- and in most developing countries no realistic ting their electricity consumption. In other opportunities to acquire hedges or diversify away cases investors may be better placed to mitigate the risk. Indeed, because exchange rates tend to project exchange rate risk. For example, they fall during macroeconomic crises, their ability to may be able to change the mix of inputs (using pay higher tariffs is likely to be lowest just when more hydro and less thermal power) to soften the exchange rate has fallen. the effect of depreciation. Shareholders are also Investors, however, choose financing and better placed than customers to diversify away or thus control the extent of financing-related hedge exchange rate risk--because of their abil- exchange rate risk. And their ultimate share- ity to diversify risk in equity markets and, in a few holders are well placed to diversify away much developing countries, to hedge risk using of the risk they choose to take on. exchange rate derivatives. This suggests that project exchange rate risk Implications for prices and financing should be shared between investors and cus- Although investors should generally face some tomers according to their ability to respond in project and all financing-related exchange rate value-enhancing ways to changes in the exchange risk, they still need to be able to recoup their rate--erring toward investors, given their greater costs and make a return that is reasonable given ability to hedge or diversify away the risk. For the risks they take. Not protecting investors many infrastructure projects, however, project from exchange rate risk may well imply higher exchange rate risk is small. Financing-related tariffs. Moreover, if tariffs are not linked to the exchange rate risk tends to loom much larger. exchange rate, they need to be linked to an Should investors or customers bear this risk? index of local inflation, possibly adjusted to Customers are in a poor position to manage more closely reflect the cost of inputs (for exam- the risk because they have no influence over the ple, an electricity utility's tariffs might be linked sensitivity of the value of shareholders' interest in to an index in which the price of fuel has greater E X C H A N G E R A T E R I S K ALLOCATING EXCHANGE RATE RISK IN PRIVATE INFRASTRUCTURE PROJECTS weight than in the consumer price index). Over caught up with the exchange rate reduction, AES the long term the effect on prices will be similar Tietê will repay the advances from cash that would whether tariffs are linked to local inflation or to otherwise have gone to shareholders. the exchange rate (see the companion Note). But with a link to local inflation, currency crises Conclusion will tend not to cause such immediate, politi- Despite the drawbacks of high levels of foreign viewpoint cally perilous price increases. currency debt, the argument for foreign capital What are the implications for financing if nei- remains. Developing countries need investment is an open forum to ther the host country government nor customers in infrastructure, and local debt and equity encourage dissemination of protect foreign investors from financing-related investors may well be unable to meet all the costs public policy innovations for exchange rate risk? Unless the government pro- of the investment efficiently. The problem with private sector­led and vides explicit subsidies in place of the implicit many deals is the mix of foreign capital: many market-based solutions for subsidies in having taxpayers or customers bear projects have too much dollar-denominated debt, development. The views the exchange rate risk: which drives the demand for allocating exchange published are those of the Projects may be able to raise less financing, rate risk to governments and consumers. While authors and should not be with shorter terms and higher initial rates. allocating the risk this way keeps the initial financ- attributed to the World Traditional project finance deals, with dollar- ing costs low, it risks a blowup in the longer term. Bank or any other affiliated denominated debt financing a large share of Reducing reliance on foreign debt may mean that organizations. Nor do any of the project cost, may be less feasible, leading the volumes of private finance mobilized in the the conclusions represent to greater use of local currency debt and local 1990s for greenfield projects and privatizations in official policy of the World and foreign equity and therefore higher ini- developing countries will not be forthcoming-- Bank or of its Executive tial rates of return and higher project prices. and that the initial costs of finance will be higher. Directors or the countries In East Asian and other countries with high sav- But the benefits may be longer-lived and more they represent. ings rates, the prospects for raising more local robust investments that can weather the vagaries equity and debt for infrastructure seem prom- of emerging markets. To order additional copies ising. Elsewhere, progress will take longer. But contact Suzanne Smith, governments can help by facilitating the devel- managing editor, Room I9-009, opment of local capital markets and contrac- The World Bank, tual savings institutions such as pension funds Note 1818 H Street, NW, and insurance companies--including by For different perspectives on the issue, see Ignacio Mas, Washington, DC 20433. ensuring that tariff formulas do not implicitly "Managing Exchange Rate­ and Interest Rate­Related discourage local currency financing. Project Exposure: Are Guarantees Worth the Risk?" in Telephone: While foreign debt financing will be scarcer, Timothy Irwin, Michael Klein, Guillermo E. Perry, and 001 202 458 7281 innovative financing structures offer solutions. Mateen Thobani, eds., Dealing with Public Risk in Private Fax: The Tietê project in Brazil illustrates one Infrastructure, Latin American and Caribbean Studies 001 202 522 3480 approach to mitigating investors' exposure to Viewpoint (Washington, D.C.: World Bank, 1997); and Joe Email: financing-related exchange rate risk. To finance Wright, Tomoko Matsukawa, and Robert Sheppard, ssmith7@worldbank.org the generating facilities, AES (the U.S. parent "Foreign Exchange Risk Mitigation for Power and Water company of the operator, AES Tietê) issued Projects in Developing Countries," Energy and Mining and Produced by Communications US$300 million in U.S. dollar bonds with an aver- Water and Sanitation Sector Boards Discussion Paper Development Inc. age maturity of 10 years, at rates less than those (World Bank, Washington, D.C., 2003). paid by the Brazilian government for debt of an Printed on recycled paper equivalent maturity. The project sells power at prices indexed to local inflation with no provision for changes in the exchange rate. If the exchange rate declines substantially and AES Tietê has insuf- ficient cash to pay its debt service, however, it may draw on a US$30 million liquidity facility (revolv- ing loan) provided by the U.S. Overseas Private Investment Corporation. Once local inflation has This Note is available online: http://rru.worldbank.org/Viewpoint/index.asp