a) The Challenge of the Availability of Long-Term Finance
Private finance PPPs require long-term finance, the majority of which should be in the form of debt so as to maximize financial efficiency through gearing (see section 7).
A sound financial structure requires that the debt is denominated in the same currency as the revenues of the debtor (that is, the private partner or SPV). Therefore, when the PPP revenues are denominated in local currency, debt should be provided by local lenders (unless the currency of a country is a supranational currency, as in the case of the Euro). Otherwise the project will be affected by one of the more severe and difficult to manage risks, that is foreign exchange risk (if the project is financed using a foreign currency and there is a devaluation of the local currency, this results in an increase in the amount of debt in local currency terms, which has to be repaid from the devalued revenues).
A country without a relatively developed financial system — that is one able to lend significant amounts for long terms (e.g. above 10 years) — will have to rely on cross-border financing in hard currency, such as US dollars or Euros. However, it will only be able to do this if one of the following options is available and credible:
- Foreign exchange risk hedging mechanisms (such as Cross Currency Swaps [CCS], currency forwards, and so on) which are not usually available in undeveloped financial markets, but could be an option in some countries. This is an area where the multilateral development banks (MDBs) may play a relevant role by providing or participating in CCS structures; and
- Government insurance or guarantees against devaluation risks. This may be done to different degrees. At the highest degree, in government-pays PPPs, this is done by denominating the payment in a hard currency (for example, in some projects in Peru) or, more commonly, by providing protection to the debt (rather than including the equity) in the form of direct guarantees to the lenders. At a lower degree, it is done by contractual guarantees (that is, providing compensation to the private partner through the contract when devaluation reaches certain thresholds). For this solution to be effective, the guarantees provided by the procuring authority should be clearly enforceable (for example, irrevocable and unconditional), and the risk of breach of such an obligation must be acceptable for the lenders.
When that is not the case, the lenders may require access to political risk guarantees (for example, insurance from an ECA) or the presence of a MDB as co-lender in an A/B loan structure (section 7.2 provides more information about the role of MDBs and ECAs including an explanation of A/B loan structures).
A less effective technique to mitigate currency risk, only accessible in user-pays projects, is to transfer the risk to the user by allowing the private partner to increase tariffs according to the consumer price index (CPI) and the currency exchange rate.
- Decrease the size of the private finance package significantly, accepting that the government will have to directly finance a significant portion of the project capital expenditure (or do so indirectly through a public loan). This is in addition to other support-like guarantees or direct letters (section 7.3 further explains the co-financing approach, and chapter 5.4 provides further details of different forms of public financial support to increase commercial feasibility). For example, for the $150 million new national referral hospital in Lesotho, developed under an integrated PPP with an 18-year contract term, the government contributed 37 percent of the capital expenditure, and the debt was provided by the Development Bank of South Africa with a direct lender agreement signed by the government to improve the creditworthiness of the project.
Some projects based on user charges (denominated in local currency) provide the ability for transferring the foreign exchange risk to the users by increasing the tariffs. However, this protection is inefficient for material devaluations as they will heavily affect demand/use of the infrastructure or the increased charges will lead to significant public protests.
Governments should be aware that assuming foreign exchange risk may significantly increase their liabilities and should incorporate this risk in the VfM analysis.
When none of these strategies is workable or available, or the government does not find it efficient to assume such risks, some subsidiary strategies may be assumed.
- Concentrate or restrict private finance PPPs to projects that generate hard currency revenues (for example, ports, airports, and so on), so as to match the revenues with cross-border financing. For example, in Sub-Saharan Africa, from 1996 to 2007, the majority of the infrastructure projects with private participation were seaports (World Bank - Farquharson, Torres de Mästle, and Yescombe, with Encinas 2011).
- Concentrate or restrict PPPs in general to those without private finance, so as to gain knowledge and maturity in managing the PPP model. This is done by extracting Value for Money through the PPP option in those projects and under those PPP schemes that are not dependent on long-term finance (for example, using DBOM instead of DBFOM, and applying the PPP concept only to service and management contracts).
b) Budgetary Restrictions/Financial Capacity of the Government
Regardless of whether projects in a country have access to long-term finance in local currency, PPP contracts have to be paid for (by the general public as taxpayers or by the direct users) and governments must acknowledge that infrastructure is a capital intensive business.
Countries (and within the country, different levels of governments – see box 1.19) with significant budgetary constraints and generally low levels of personal income known as Low Income Countries (LICs) should carefully assess the financial impact of a PPP on the budget and, in the case of user-pays projects, on the individuals’ affordability. Financing charges due to the private finance nature of PPPs may be overwhelming for some countries, in which case it may be better to rely on conventional infrastructure delivery and public debt, including debt provided by development banks.
If there are budgetary restrictions but reasonable access to long-term finance in local currency, user-pays and private finance PPPs with strong revenue generation capacity (revenue makers) should still be possible, provided that willingness to pay is tested and the tolls are affordable for the population (that is, the government should be extremely cautious with socio-economic appraisal in projects funded by tolls or tariffs).
A concentration on non-capital intensive PPPs and/or service PPPs is also an appropriate strategy.
BOX 1.19: The Local Government Challenge
Generally, sub-sovereign governments and authorities find it harder to access private finance with reasonable conditions or to access it at all, especially in developing countries. This may happen at the level of states or regions, but especially at the level of local governments. This situation is exacerbated by a trend toward increasing decentralization of powers from central governments to municipalities/local governments.
The exercise of prudence and realism is even more necessary at local government levels. These governments should only assume long-term commitments commensurate with their revenue capacity. Furthermore, they should consider the appropriateness of tariff levels for municipal services, and ensure that the necessary subsidization of certain public services is appropriately sized and structured.
Risk perception may overstate the real capacity of local governments. Central governments have mechanisms to subsidize the development of projects by regional and local governments, which is mandated in some sectors or specific projects.
For this reason, proper PPP policy management should include ways and routes of support at the central government level, and the development of PPPs by sub-national governments (by co-financing through grants, public loans or credit wraps). At the same time, the framework should introduce control mechanisms so as to avoid excessive exposure by sub-sovereign authorities and/or the promotion of unfeasible projects.
c) Country Risk Perception
Country risk represents the collection of risks associated with investing in a foreign country, including exchange risk, economic risks (GDP evolution, inflation risk), transfer risks (the risk of suffering a block in repatriation of distributions and cash flow to the investor), political risks, social risks (including risks of general riots), regulatory and legal risks (the risk of existing legal provisions affecting a foreign investor, or being more onerous than in the home country), corruption, and sovereign risk (the risk of default of financial obligations by the country).
The business climate in a country (the risk of being adverse), including common or general legislation affecting a normal business (labour legislation, taxation, judicial system, and so on), the state of the infrastructure necessary for the business, development or restrictions in the supply market (especially the availability of a qualified workforce and solvent local subcontractors) may be considered part of the country risk concept, or at any rate, distinctive factors for an investor when approaching an emerging market.
It should be noted that some of the risks accepted as part or components of the “country risk” may overlap or be used differently by different authors. For example, political risks are assumed by the insurance industry to include risk of war, general riots and transferability or convertibility of the currency. Confiscation, nationalization or expropriation are considered events included in political risks. Sovereign risk may be considered as a subset or potential concretion of political risk.
Usually, high country risk perceptions and low credit ratings are correlated with a lack of financial market development and poor budgetary health. High country risk perception (especially high levels of corruption, high political and social instability, social conflicts, and so on) together with specifically poor credit worthiness (that is, high sovereign risk perception by foreign creditors) are huge obstacles for developing private finance PPPs.
In such countries, PPPs may still be a useful and valuable approach for non-capital intensive projects and “service only” projects, and those should be the focus unless there is clear access to political risk insurance provided by MDBs or ECAs.
For countries with very low levels of income, high political and social instability, and limited local financial markets, using PPPs as an option to finance and manage new infrastructure has to be carefully considered. When setting the PPP strategy, an LDC needs to be realistic and prudent.
A modest and realistic approach, adapting the PPP strategy of the government to the market restrictions and budgetary capacity of the country, has been implemented by some countries (a notable example being Bangladesh).
 Gearing and leverage mean “the ratio of a company’s loan capital (debt) to the value of its ordinary shares (equity)” (Oxford English Dictionary). The term “gearing” is used interchangeably with “leverage” in this PPP Guide.
 See case study 3, Lekki Toll Road Concession (WEF 2010, page 94). In this toll road project in Nigeria, awarded in 2006, the AfDB provided a significant portion of the debt in hard currency (US dollars) and helped to provide, with the commercial MLA, a swap that mitigated the currency risk of the concessionaire. Also, the Asian Development Bank (ADB) is allowed to raise rupee bonds and carry out CCS to support long-term debt in projects in India (WEF 2010).
 See Health System Innovation in Lesotho prepared by UCSF Global Health Group and PwC, 2013.
 LIC countries is a subgroup of developing countries with the lowest gross national income (GNI) per capita. See http://data.worldbank.org/about/country-and-lending-groups
 For some specific projects in LDCs or targeting poor areas or poor communities, Output-Based Aid (OBA) has been used to increase the feasibility of a project, with the Global Partnership Output-Based Aid (see www.gpoba.org) providing subsidies to the project in the forms of grants. OBA financing and a case study (Improved Access to Water Service in the East Zone of Metro Manila, Philippines) is explained in World Bank - Farquharson, Torres de Mästle, and Yescombe, with Encinas (2011).
 According to a Multilateral Investment Guarantee Agency (MIGA)/ Economist Intelligence Unit (EIU) survey (World Investment and Political Risks, 2012 – www.miga.rg/documents/WIPR.pdf) as cited in the World Bank, January 2014 (Overcoming Constraints for the Financing of Infrastructure), regulatory failings represent the top concern of foreign direct investors. Also highlighted was “government behaviour” such as historical handling of contract disputes, expropriations, and ruling of repatriation of capital.
 For the sake of doubt, this PPP Guide considers political risks as those risks related to government action that affect the private partner or its operations. These may include non-payment of the retributions, unfair termination of the contract, omission in executing other obligations which affect the contract, and discriminatory changes in law, amongst others.