Viewpoint The World Bank May 1996 Note No.79 Mitigating Project Risks World Bank Support for Government Guarantees PhilrppeBenoit Project risks and risk mitigation as an offshore bank, issue the guarantee (for example, a letter of credit). Under this struc- Private investors try to mitigate the risks facing ture, often used to provide coverage to for- a proposed project before they invest Foreign eign investors concerned about timely payment investors in developing countries are often con- from a host government guarantor, the inves- cerned about two kinds of risk in particular. tors look to the third-party guarantor for pay- The first is political risk-risk relating to politi- ment, and the third party relies on the host cal acts of government and to the general coun- government for reimbursement. try context, including war, expropriation, and restrictions on repatriation of earnings The sec- World Bank support for guarantees ond kind of risk, referred to here as 'parastatal risk," relates to the performance of parastatal The World Bank has employed two distinct companies and includes such risks as failure financial vehicles to support developing coun- of the government-owned power company to try governments that decide to provide guar- supply electricity to a project antees to attract private investment issuing guarantees to investors and making loans to To mitigate project risks, investors generally host governments to fund guarantees require guarantees from the project sponsors For protection specifically against political risks, World Bank guarantees investors often procure insurance or guaran- tees from specialized institutions, such as ex- The International Bank for Reconstruction and port credit agencies or private political risk Development (IBRD), one of the World Bank's insurers. Another source of political risk insur- two constituent organizations, has established ance for foreign investment in developing coun- a guarantee program to issue guarantees to tries is the Multilateral Investment Guarantee lenders covering either all or a part of their Agency (MIGA), a specialized organization in loan against certain specified risks (partial risk the World Bank Group guarantees), or certain specified payments un- der their loan against all risks (partial credit In addition, foreign investors in developing guarantees) The Bank's other constituent or- countries often approach host governments for ganization, the International Development As- guarantees, particularly for political and sociation (IDA). which lends at concessional parastatal risks. Host governments structure rates, has never issued guarantees and has no these guarantees in a variety of ways They guarantee program in place. may issue guarantees directly to investors. Or they may establish a special facility to do so, When the IBRD issues its guarantee, it receives such as a facility to issue guarantees for export a counterguarantee from the host country, un- financing. In both these approaches, investors der which the country remains financially re- rely on the host government to finance pay- sponsible for any payments that the IBRD ments under the guarantee. But in some makes to lenders (figure 1). The IBRD has is- projects, governments have a third party, such sued guarantees for several large infrastructure ku Private Sector Development Department . Vice Presidency for Finance and Private Sector Development L&W Mitigating Pmject Risks-World Bank Support for Government Guarantees FIGURE 1 - IBRD GUARANTEE Ceirnie,- ~~~~~projects For example, in the 1994 Pakistan Hub - , = -e River Power Project, the IBRD issued a partial iGuaratntee risk guarantee protecting lenders against debt service defaults resulting from a breach by the Pakistan government of its undertakings to the project company These undertakings relate to -~ - - ---- ~ ~ -~ l Loan1- - - ~ parastatal performance and certain political risks (such as currency transfer). Projects in- votving the partial credit guarantee include the 1994 China Yangzhou Thermal Power Project and the 1994 Philippines Leyte-Luzon Geother- mal Project; in both cases, the IBRD guarantee -IURE Z WORLD BANK-FINANCED T'HIRiJIPRY GUARANTEE ~~ covered long-term maturities.' World Bank financing of government guarantees ReinE bnrementwgreenieni E - r -- The World Bank can also support host govern- ment guarantees by providing loans to finance them The host country provides investors with Guarantee ~~~~a guarantee, the World Bank provides a loan - - ~~~~~~~Guarantee ---==- ---- to the country, and the country draws down the loan if and as required to finance payments due to the investors under the guarantee. Such World Bank loans could be provided to finance - - - -- - Yesi0nt-- - - -a wide range of government guarantee struc- tures, ncluding the third-party guarantee struc- ture (figure 2). The World Bank has provided loans to fund guar- antees and other forms of coverage in only a Fi&URE 3 -WORLD BANK(FINANCED AND few projects to date. One such project, the 1995 -- MIGA-ADMINISTEBEI GUARANTEE=- 8 Moldova Pre-Export Guarantee Facility Project, _ i~~~~~~~~nvolves both a government guarantee facility -ean ff -and a third-party guarantor. Moldova established a guarantee facility to cover foreign supplier - ~ ~ Admtnistrat,opagree,ment4g |-------- - ~- =- credit provided to its exporters against speci- fied political risks In parallel, an offshore bank (the agent bank), acting as a third-party guaran- tor on behalf of Moldova, issued standby letters - -- -~ Gnaaantea -; ~ ~~= ~ of credit to the foreign creditors, backstopping bank could draw down the IBRD loan to fund payments to be made under its letters of credit - - --lfvetuoe[ - 7- - - --=--------------- to the foreign creditors. In a second project, the 1994 Argentina Capital Market Development Project, the government created a backstop fa- cility to purchase eligible commercial bank bonds from banks otherwise unable to place them because of specified market disruptions. The IBRD provided a loan to Argentina to fund First, the World Bank has greater leverage than eventual payments from the facility. most commercial banks and other private in- vestors over developing country govern- Integrating Bank and MIGA support ments-in large part because of its financial, contractual, and cooperative relationships with The World Bank and MIGA are exploring an these countries, as well as its multilateral char- integrated approach to supporting host gov- acter. It can use this leverage to discourage ernments of developing countries in providing unreasonable government actions that would political risk coverage for foreign investments threaten the success of a project. Second, a where insurers are unwilling to issue insurance payment by the World Bank always entails a funded from their own resources (figure 3) corresponding obligation from the host gov- Under this approach ernment-under the counterguarantee for an * The World Bank would provide a loan to the IBRD guarantee, and under the loan itself for host country. a loan financing a guarantee This obligation X The country would use the loan to provide creates a financial disincentive for a govern- designated investors with coverage against ment to take actions that would trigger pay- specified political risks ments to the investors * The country would have MIGA administer * Guarantees and loans to finance guarantees the coverage. allow host governments to shed project rnsks * Both the investors and the country would that they would assume under a traditional rely on MIGA to evaluate and process any World Bank loan Under traditional debt fi- investor claims nancing, the country must repay the World * As administrator, MIGA would pay investors' Bank loan even if the project fails, regard- claims, using the proceeds from the country's less of the reason Under guarantees, the Bank loan Bank makes payments, which trnggers the * The country would be obligated to repay to government's financial liability, only for speci- the Bank all amounts withdrawn under the fied risks These instruments thus provide loan-but the loan would be drawn down governments with a straightforward mecha- only if and as required to pay valid claims. nism for shedding project risks, particularly commercial ones, by leaving the exposure This approach is being considered for a power for them with private investors. project whose foreign sponsors are concerned Guarantees also provide a mechanism for gov- about their ability to convert local currency ernments in transnational projects, such as the earnings into foreign exchange The host gov- construction of a pipeline between two coun- ernment has requested an IDA loan to finance tnes, to allocate political risks between the currency transfer coverage for these investors, host countries. In such a project, each host to be administered by MIGA. government could provide lenders with a guar- antee covering the political risks relating to The implications of Bank support its country The lenders would be covered against all political risks, while each gov- World Bank support for guarantees presents emient's liability to the lenders would be lim- several advantages' ited to the political risks its country poses * The IBRD, under its guarantee program, * The World Bank can provide developing serves as an independent offshore guarantor countrnes with the financial resources (typi- with strong financial standing-to which cally in foreign exchange) to fund payments lenders can turn to for payment regardless to investors or to a third-party guarantor. of the host government's actions or financial * Guarantees often allow a project to obtain weaknesses. lending on relatively favorable terms by pro- * The World Bank's involvement in a transac- tecting lenders and mitigating political and tion can mitigate political risks in two ways parastatal risks This can lead to a lower Mitigating Pmject Risks-World Bank Support for Government Guarantees interest rate or extend the maturity of the tory reforms-which reduce the cost to gov- loans, as has been the case with the IBRD ernments of attracting private investment and partial credit guarantees. But guarantees can eventually obviate the need for host govern- also add to the transaction costs. there typi- ment guarantees. cally are guarantee fees, and legal expenses may be higher if the guarantee makes the Use of guarantees transaction much more complex. Obtaining the services of a third-party guar- Whether the World Bank should provide an antor can be costly for governments of de- IBRD guarantee or a loan financing a govern- veloping countries that do not enjoy a strong ment guarantee for a proposed project depends credit rating Commercial institutions may on the assessment of the project and the costs require the government to provide escrow and benefits of such Bank support. The Bank accounts and other costly security arrange- assesses the project's development impact, the ments to back the government's reimburse- investor's need for the guarantee, the nature ment obligation. But the World Bank, because of the risks to be covered, the government's of its development character and leverage in actions to mitigate those risks, the cost of such securing reimbursement by member country coverage to the government, and the benefits governments, can fulfill the role of third- to the country from the investor's involvement party guarantor at a relatively low cost to in the project. Another factor considered by the government the Bank is the ability of the government and the investors to obtain alternatives to Bank sup- An integrated World Bank-MIGA approach port. These include MIGA insurance and risk would present several additional advantages mitigation provided by the International Fi- open forum intended to It would permit a developing country govern- nance Corporation (IFC), another member of encourage dissemina- ment to finance political risk coverage for in- the World Bank Group.3 tion of and debate on vestors in order to secure their participation in ideas, innovations, and beas practices for priority development projects It would give To date, the World Bank has issued few IBRD expanding the private these governments access to MIGA's expertise guarantees and loans to finance government sector The views in designing and administering political risk guarantees. Their use has been hampered in part published are those of the authors and should insurance And it would provide investors with by their newness As government officials, the not be attributed to the an offshore, independent third party to admin- private sector, and Bank staff become more com- World Bank or any of its ister the coverage The result of this integra- fortable with these instruments, and as the em- affiliated organizations Nor do any of the con- tion of the Bank and MIGA would be a structure phasis on prnvate sector investment in projects clusions represent that makes the most of the comparative ad- increases, the number of projects in which these official policy of the vantages of each institution instruments play a part wtll likely grow World Bank or of its Executive Directors or the countries they But World Bank support for government guar- l For a fuller discussion, see Philippe Benoit, Project Finance at the represent antees can raise concerns in certain circum- World Bank, World Bank Techmcal Paper 312 (Washington, Dc, Comments are welcome stances Guarantees are generally inefficient 1996) Pleas cal theFPD istruentswhere there is a strong likelihood 2For a fuller descnption of IBRDf guarantees, see the Wodld Bank's Please call the FPDJ instruments where there 1S a strong llkellhod Guarantees and the Project Finance and Guarantees sernes, pub- Note line to leave a that the risks guaranteed against will occur In lished by the World Bank's Cofinancing and Project Finance messonage S202458-111 these cases, efforts should focus on reducing Department or contact Suzanne the risks toreasould Fu rermore, For example, the IFC offeis a loan svndication program that pro- Smith, editor, Room the risks to a reasonable level Furthermore, vides commercial lenders with the protection of its lender-of-record G8105, The World Bank, the availability of guarantees might encourage umbrella For a fuller descnption of MIGA and the IFC, see their 1 818 H Street, NW, Washington, D C 20433, investors to seek broader protection from host 1995 annual reports or Internet address governments than they would otherwise re- ssmith7@worldbank org quire And while guarantees provide protec- Philippe Benoit, Senior Prvate Sector Develop- @Printed on recycled hon to specific investors in specific transactions, ment Specialist, Private Sector Development paper they are no substitute for substantive regula- Department (email pbenoit@worldbank org)