262 privatesector P U B L I C P O L I C Y F O R T H E NUMBER NOTE 2003 Exchange Rate Risk JUNE Philip Gray and Timothy Reviewing the Record for Private Infrastructure Contracts Irwin Over the life of a typical contract for an infrastructure project--say, Philip Gray (pgray@ 25 years--the value of developing country currencies is likely to fall worldbank.org) is a senior private sector development substantially. Sometimes the decline is gradual, but sometimes it is specialist, and Timothy precipitous. Many contracts have been structured so that taxpayers Irwin (tirwin@worldbank. org) a senior economist, at or customers bear the exchange rate risk. During crises the result has NETWORK the World Bank. often been traumatic: governments breach contracts, adversely affecting their access to capital markets, or customers must bear large price hikes, undermining support for privatization. This Note tracks the record. A companion Note proposes better ways to manage INFRASTRUCTURE exchange rate risk. AND Among the key risks facing foreign private enti- The difficulty arises because the contracts raise SECTOR ties investing in the infrastructure of develop- prices precisely when the economy is suffering ing countries is depreciation or devaluation of the most. If the government bears the risk the local currency. Indeed, over the past 25 because a state-owned utility is purchasing power PRIVATE years developing country currencies lost 72 per- from an independent power producer at prices cent of their value relative to the U.S. dollar on denominated in U.S. dollars, for example, a con- average--and about a fifth lost more than 99 tract will require steep increases in local currency percent of their value. Sustainable private prices just when the utility's revenues--and those GROUP investment in infrastructure depends on of its owner, the government--are likely to be addressing this risk well. declining. In the 1990s such problems led state- BANK Private infrastructure contracts in developing owned utilities to default on payments to inde- countries have usually passed much of this risk on pendent power producers in Indonesia and to customers or the government. But because Pakistan. If the project is a concession selling to devaluations and large depreciations in develop- end users, linking the tariff to the exchange rate WORLD ing countries often occur in the context of will similarly increase tariffs when customers' real macroeconomic and financial upheaval, such incomes--and their ability to pay--are declin- THE risk allocations cannot always be made to work. ing. Raising prices at such times is politically dif- E X C H A N G E R A T E R I S K R E V I E W I N G T H E R E C O R D F O R P R I V A T E I N F R A S T R U C T U R E C O N T R A C T S Currency depreciation and volatility relative to the U.S. dollar in 174 Table countries, 1976­2001 1 Average annual rate of depreciation (percent) Volatility (percent)a All developing countries 16 22 Countries by region or groupb East Asia and Pacific 10 20 2 Europe and Central Asia 23 31 Latin America and the Caribbean 23 33 Middle East and North Africa 6 14 South Asia 8 13 Sub-Saharan Africa 16 27 OECD 2 11 Countries by per capita incomec Poorest quartile 11 19 Second quartile 19 33 Third quartile 17 25 Richest quartile 4 12 Top 10 developing countries by investment in private infrastructure projectsd 26 31 Note: All averages are arithmetic. a. Measured as the standard deviation of annual depreciation. b. Classified according to the World Bank's analytical grouping as of 2002 (World Bank 2002). c. Based on gross national income per capita in 1976. d. The 10 countries receiving the most investment in private infrastructure projects in 1990­2001 (World Bank 2003). Source: Authors' estimates based on data from the International Monetary Fund's International Financial Statistics data series. ficult, and governments often choose to breach gories. Among developing regions, South Asia contracts rather than enforce them--as in and the Middle East and North Africa had the Argentina today. lowest average rates of depreciation, while Attempts to mitigate exchange rate risk can Europe and Central Asia and Latin America therefore simply transform it into political or and the Caribbean had the highest (table 1). regulatory risk. Moreover, even when allocating Interestingly, the countries that received the exchange rate risk to customers or the host most investment in private infrastructure in the country government is feasible (because con- past decade experienced some of the highest tractual price increases will be effected and rates of depreciation--in part because this guarantee payouts made even during a macro- group includes Argentina and Brazil, whose economic crisis), the question arises whether currencies lost virtually all their value in just five such an allocation is desirable. That is, are cus- years after 1985 (figure 1). tomers or host country taxpayers well placed to Developing country currencies also tend to bear exchange rate risks? be about twice as volatile as OECD country cur- rencies. Thus investors not only can expect a The record secular decline in the dollar value of the local Over the past 25 years developing country cur- currency; they also face much uncertainty as to rencies have tended to move in one direction. the rate of decline. So even if they are protected On average in 1976­2001 they fell by about 16 against the expected (average) decline in a cur- percent a year against the U.S. dollar. The trend rency, they still face major risks. Higher volatil- was downward in all regions and income cate- ity also means that the cost to developing Currency depreciation in the top five developing countries by investment in private Figure infrastructure projects, 1985­2002 1 120 100 India 80 3 60 Indonesia Brazil 40 China 20 Argentina 0 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Note: The selection of countries is based on data for 1990­2001 from the World Bank's Private Participation in Infrastructure (PPI) Project Database. Source: Authors' estimates based on data from the International Monetary Fund's International Financial Statistics data series. country governments or customers of providing implication is that the percentage decline in the exchange rate guarantees is higher than the exchange rate between two currencies should cost of similar guarantees given by OECD coun- roughly match the percentage point difference try governments or customers. in their inflation rates: if a developing country Depreciation is sometimes gradual, some- experiences inflation 10 percentage points times sudden. Indonesia's currency, for exam- higher than that in the United States, its cur- ple, depreciated gradually during most of the rency can be expected to depreciate by about 10 1980s and 1990s. But it plummeted twice--first percent a year against the dollar. While this rela- in the mid-1980s, then during the East Asian tionship does not hold in the short run--when financial crisis in 1997. Private infrastructure investment flows often dominate other factors-- contracts need to be able to deal with both types it holds fairly well in the long run, especially of depreciation. when inflation is very high (figure 2). Interest rates tend to be higher in developing Depreciation, inflation, and interest rates countries, at least in part because inflation is Over periods as long as the term of a private higher. The theory of interest rate parity holds infrastructure contract, depreciation tends to that if interest rates are higher in one currency correlate with inflation. If it did not, traders than another, the difference reflects the could make easy money buying tradable goods expected depreciation of the higher-yielding in countries where inflation has been low and currency. Why is this? If it were not true, those reselling them in countries where inflation has holding the higher-yielding currency would been high. The Big Mac index published by the tend to earn higher rates of return than those Economist is a popular outgrowth of this "pur- holding the lower-yielding currency. Because chasing power parity" theory: currencies in markets tend to equalize risk-adjusted expected which McDonald's Big Macs are expensive can rates of return, funds would move from the be expected to depreciate. lower-yielding to the higher-yielding currency-- The theory has some complications--relating unless the exchange rate were expected to com- to nontradable goods, for example. But the main pensate for the difference in interest rates. Thus E X C H A N G E R A T E R I S K R E V I E W I N G T H E R E C O R D F O R P R I V A T E I N F R A S T R U C T U R E C O N T R A C T S for currency depreciations such as those expe- Average annual inflation and depreciation against the U.S. dollar in a sample of 89 rienced by Argentina, Indonesia, and the Figure countries, 1976­2001 Philippines. Governments have often acceded 2 to investors' requests, perhaps in part because Depreciation (percent) they have preferred to keep prices as low as pos- 60 viewpoint sible initially, even at the risk of higher prices in 50 the future. Swept up by a wave of enthusiasm for infrastructure investment in the mid-1990s, is an open forum to 40 both parties may also have underestimated the encourage dissemination of risks. Whatever the reasons, the long-term public policy innovations for 30 results have often been unsatisfactory for for- private sector­led and eign investors and local governments and cus- market-based solutions for 20 tomers alike. A companion Note considers development. The views whether there are better, more sustainable ways published are those of the 10 to allocate exchange rate risk. authors and should not be attributed to the World 0 10 20 30 40 50 60 Bank or any other affiliated ­10 organizations. Nor do any of Note the conclusions represent Inflation (percent) 1. When forward exchange rate contracts are avail- official policy of the World Note: The countries shown are those for which data on the exchange rate and the able, investors can make riskless (arbitrage) profits if the Bank or of its Executive consumer price index were available for both 1976 and 2001. Both inflation and Directors or the countries depreciation are measured as geometric means. forward exchange rate does not reflect the difference in Source: International Monetary Fund, International Financial Statistics database. interest rates. they represent. differences in interest rates tend to reflect References To order additional copies expected depreciation.1 Gray, Philip, and Timothy Irwin. Forthcoming. contact Suzanne Smith, The difference in interest rates between the "Exchange Rate Risk: Allocating the Risk in Private managing editor, U.S. dollar and developing country currencies Room I9-009, Infrastructure Contracts." Viewpoint. World Bank, Private is often large. The implication is that investors The World Bank, Sector and Infrastructure Network, Washington, D.C. 1818 H Street, NW, expect large depreciation against the U.S. dol- World Bank. 2002. World Development Indicators 2002. Washington, DC 20433. lar. Unfortunately, this implication appears to Washington, D.C. be overlooked in project finance deals in which ------. 2003. Private Participation in Infrastructure: Telephone: the sponsor loads up with "cheap" dollar debt. Trends in Developing Countries in 1990­2001. Washington, 001 202 458 7281 D.C. Fax: Conclusion 001 202 522 3480 Financing private infrastructure projects in Email: developing countries with loans denominated ssmith7@worldbank.org in dollars, euro, sterling, yen, and other hard currencies is attractive because the markets for Copyedited and produced by such loans are deep and the interest rates low. Communications But part of the attraction is superficial: expected Development Inc. repayments over the life of these loans can be high when calculated in local currency. Costs at Printed on recycled paper the beginning of the project may be low, but there is a risk that they will soar during a crisis. Investors have responded by asking customers--and sometimes host country governments--to protect them from this risk, perhaps overestimating the political feasibility of tariff increases large enough to compensate T h i s N o t e i s a v a i l a b l e o n l i n e : h t t p : / / r r u . w o r l d b a n k . o r g / V i e w p o i n t / i n d e x . a s p