Question

To what extent will the capital markets substitute commercial bank lending to projects?

Answer 1

Solution =

Capital markets have several beneficial features for different participants in the economy. For a company or entity in need of funding, domestic capital markets provide an alternative source of funding that can complement bank financing. Capital markets can offer better pricing and longer maturities, as well as access to a wider investor base. They can also offer funding for riskier activities that would traditionally not be served by the banking sector, and by doing so contribute significantly to innovation in an economy. While some governments can access international capital markets, the development of local capital markets can increase access to local currency financing and thereby help manage foreign exchange risk and inflation better. For governments, this is a valuable benefit since it can allow them to finance fiscal deficits by borrowing from local markets without exchange rate risk. Government borrowing has been done in international markets in local currency and/or indexed to the exchange rate, but local markets have the benefit of more easily tapping local investors, and often local banks.

The end of bank financing for infrastructure projects has been predicted in the past, and banks are still making loans. But it is clear that many banks which have provided the bulk of private project finance through long-term loans before the Global Financial Crisis (“GFC”) have steadily reduced their exposure to the long-term infrastructure market. Some governments have got deals closed by reducing the bank debt required, often by committing to significant milestone payments (i.e. 40% to 50% of the capital value of the project) either during construction or when the project is built out. This structure effectively prepays some of the availability charge that would otherwise be paid to the concessionaire, reducing the senior debt required whilst attempting to retain a suitable risk transfer. In other cases, governments have more formally co-lent into deals, or taken on project risk by offering guarantees to the lenders. In still others, reliance on multilaterals.

For many markets (including Brazil, India, Turkey and several countries in Central and Eastern Europe) project level credit enhancement is not currently relevant. In these markets, a significant amount of infrastructure is either built by government directly or funded by state owned banks. Following an abrupt decline since 2007/8 and much discussion thereafter, viability of capital markets financing for infrastructure has reached a tipping point – in particular over the past 6 to 12 months. Although volumes never really declined in some markets, i.e. Canada and the US, there have been notable developments in markets such as Brazil, Spain, Holland, the UK, France and the Middle East. Banks are continuing to lend, but will likely be unable to meet the financing demands of a growing project pipeline. New banking regulations make long tenor project finance loans even less attractive, and sovereigns are only like to face continued fiscal pressure.

Due to the high cost of loan financing, particularly in developing countries where country risk premiums add to the cost of capital, some projects simply are not economically feasible, based on a traditional debt-equity financing structure. However, the tide could be turning. As sovereign and sub-sovereign public entities in emerging market countries develop their own capital markets infrastructure, they will make increased use of these markets to fund major public-private works projects. Also, as institutional investors look for new ways to balance their portfolios, capital markets issues are becoming an increasingly interesting option. Banks might not see a rising competitive threat for their project lending from capital markets. After all, bank project lending hit US$140bn in 2005, compared to bond issues of US$12.5bn. However, the potential for more attractive terms and lower cost of project capital provided by capital markets issues for developing countries, when covered by risk mitigating instruments, could impact this emerging rivalry in the future. “Today’s marketplace is clearly moving away from a focus on equity and looking more towards lenders as a key source of finance,” says Yukiko Omura, Executive Vice President of the Multilateral Investment Guarantee Agency (MIGA). “At the same time, we’re seeing more and more lenders eyeing bond issues and securitisations as a way of generating funds in less traditional markets, versus the syndication of loans.