Investment security in the Meditteranean - June 2013 newsletter

7/27/2019 Investment security in the Meditteranean - June 2013 newsletter

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INVESTMENT SECURITY IN THE MEDITERRANEAN (ISMED) SUPPORT PROGRAMME

Mediterranean Guarantees

A newsletter on risk mitigation instruments forinfrastructure investment in the Mediterranean

Issue 1, June 2013

With the financial assistance of the European Union

CROSS-CURRENCY SWAP

CASH FLOWS AT FINANCIAL CLOSE

The Investment Secur i ty in the Mediterranean (ISMED) Support Programmeseeks to increase private infrastructureinvestment in the Mediterranean by providing advisory services to governments on reducing the legal risk of specificprojects, conducting public-private policy dialogue on broader legal framework improvements, and informing investors ofavailable risk mitigation instruments. It is implemented by the OECD with funding by the European Commission.

Hedges can minimise currency risk on infrastructure investments

Infrastructure investment in the SouthernMediterranean carries a number of risks, political,commercial and currency-related. Politicalinstability in some countries real or perceived has led to increased exchange rate uncertainty,and this is a concern for potential investors,according to consultations by the ISMED SupportProgramme. So how does currency risk play outand how can it be mitigated?

Most international transactions involve somecurrency risk. Whenever there is a mismatchbetween the currency of revenue earned and thecurrency of costs incurred, including debt servicecosts, and whenever return on equity is to berepatriated to an investors homecountry, there iscurrency risk. These risks are either:

1) Risk related to controls over conversion of localcurrency into another currency and/or capitalcontrols that restrict the ability to transfermoney out of a jurisdiction, or

2) Risk related to exchange rate volatility.

Numerous products and techniques have evolvedto mitigate these risks.

Currency Conversion and Transfer Controls

Risks relating to currency conversion and transferarise from policies of governments or centralbanks, and are properly characterised as politicalrisk. Political risk insurance, offered by multilateralfinancial institutions, national export creditagencies and private-sector insurers, usuallycovers this risk but may limit reimbursement to partof the insured amount. However, coverage limitsare typically 90% or more, if the conditions of thecontract are met. For the investor, this transformsan element of political risk into the counterparty

risk of a highly-rated entity. Most political riskpolicies explicitly state that losses due to exchangerate volatility are not covered.

RISK MITIGATION INSTRUMENTS DATABASE

Risk mitigation tools for investment in theMediterranean region are not sufficiently well-known.The ISMED Support Programme is developing a riskmitigation instruments database that will providedetailed information on available tools, focusing initiallyon instruments applicable to Jordan, Egypt, Tunisiaand Morocco, and products offered by multilateralagencies, export credit agencies and private insurers.

On-line access to the database will help raiseawareness of the many instruments already availableand facilitate investment. The database should beavailable later in 2013.

Foreign Investor

Hedge Provider

Lenders

Hard Currency

Principal

Hard

Currency

Princi al

Local

Currency

Principal


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With the financial assistance of the Euro ean Union

Volatility risk

Volatility is what is more typically thought of whenconsidering currency risk. Exchange ratefluctuations can wreak havoc with financial

projections and turn profitable ventures into moneylosers when revenue is converted into aninvestors home currency. A number of strategiescan hedge this risk and they can be characterisedas natural hedges or financial hedges.

Natural hedges

Natural hedges are the easiest and usually theleast expensive form of currency hedgerevenueand expenditure are denominated in the samecurrency. For example, the output and thus the

revenue of an oil development will be priced inUSD, so issuing debt to finance the developmentin USD creates a natural currency hedge. It is notpossible to adopt this strategy in many emergingmarkets, as a scarcity of hard currency may meanthat revenue is available only in local currency. Intransactions with public sector entities, it may alsobe a matter of policy that revenue be denominatedin local currency. Lack of depth, sophistication orliquidity of local capital markets may also mean itis impossible to raise financing in local currency.

Financial hedges

Financial hedges are contractual arrangementswhereby a counterparty, usually a financialinstitution, agrees to take the currency risk inreturn for a fee or premium. Typical instrumentsinclude forward contracts, currency options andcurrency swaps.

Forward Currency Contract: A contract to buy orsell foreign currency at a predetermined price on afuture delivery date. This is one of the simplestfinancial hedges and allows the purchaser to lock-in an exchange rate at a future date. This is mostuseful where there is no doubt that a foreigncurrency cash flow will be received on a futuredate and where certainty of the exchange rate isparamount. The downside is that the obligation tobuy the currency remains, whether exchange ratemovements have been positive or negative.

Currency Option:A contract that allows the holderto buy or sell a predetermined quantity of foreigncurrency on a future date at a predetermined price.Unlike a forward contract, the purchaser of the

option is not required to exercise it on the strikedate and will only do so if it is advantageous, i.e.would result in more hard currency than convertingat the prevailing spot rate. Otherwise, the option

will be allowed to expire with the only cost beingthe option premium paid to the counterparty.

Currency Swaps: These derivative contracts cantake a number of forms. The simplest, usually

referred to as a foreign-exchange swap or cross-

currency swap, will see a predetermined amount ofcurrency exchanged at a future date at apredetermined price. These swaps are very similarto forward contracts but may be much longer term.

A cross-currency swap essentially sees theexchange of loans denominated in differentcurrencies. The participants exchange principalamounts at an agreed exchange rate uponentering the transaction and subsequentlyexchange interest payments denominated in theother currency. This allows funding to be raised in

one currency while debt servicing costs are paid inthe other, perhaps using foreign currency revenue.

Less stable currencies

Properly structured, these instruments caneliminate currency risk in many circumstances.However, they are generally only available onstable, liquid and freely convertible currencies.When available on less stable currencies, costsmay be prohibitive, as counterparties will demanda premium for taking heightened volatility risk. Toaddress volatility risk on less stable currencies,

non-deliverable forward contracts and non-deliverable cross-currency swaps have evolved.With these instruments, no foreign currency is

CROSS-CURRENCY SWAP:

ONGOING CASH FLOWS

Hedge Provider

Lenders

Local

Currency

Debt

Service

Hard

Currency

Debt

Service

LocalCurrency

Revenue

Hard

Currency

Debt

Service

Foreign Investor

Local

Currency

Opera-

tions/

Contract


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GLOBALASSETS OF ISLAMIC FINANCE

End-year, $bn

*UKIFS estimate. Source: The Banker, Ernst & Young. Reproduced courtesy of the

UK Islamic Finance Secretariat.

Islamic financial instruments gain ground in the Mediterranean

exchanged but the difference between apredetermined exchange rate and the spot rate issettled in a hard currency. These products areavailable on a wider range of currencies, butagain may be costly and/or of a limited duration.

There are instruments that can help reduce thecosts of financial hedges. For example, manyfinancial hedge products, such as swaps, will

include mark-to-market collateral postingrequirements, but these may be waived where anational export credit agency or other credit-worthy entity provides a guarantee to the financialinstitution providing the hedge. By replacing

collateral with the guarantee of a highly-ratedentity, capital that otherwise would have beenposted as collateral is made available for otherpurposes.

Islamic finance has become an increasinglyintegrated part of the global financial system, asSouthern Mediterranean governments, among

others, have sought alternatives to traditionalfinancial products to raise funds, including for bigticket items like infrastructure.

Islamic finance has evolved from a limited industryto a global sector encompassing numerous majormarkets. By the end of 2011, the Islamic financemarket was already approaching USD 1.3 trillionin value, and it is a recurring theme in ISMEDSupport Programme consultations.

Sukuk, the centrepiece of Islamic financialinstruments, are often referred to as the

equivalent of bonds. However, unlike conventionalfixed-income bonds, which are merely debtinstruments with no ownership stake in the issueror its assets, sukuk confers a stake in anunderlying asset, along with the correspondingcash flows and risks. Sukuk replaces a bondsperiodic fixed interest payments with pro-rataprofit sharing agreements based on an assetsfuture cash flows. Cash flows can also bestructured as rent paid by the issuer to theinvestors in return for the use of the asset. Assuch, sukuk adheres to Islamic law (Shariahprinciples) that prohibits interest payments.

Sukuk departs from the concept of risk-sharingthat is familiar to traditional debt and equityinvestors. In many ways, sukukis much more likeequity than debt, with investors potentiallyparticipating in the fortunes of the issuer more aswould a shareholder than a bond holder.However, various structures can be coveredunder the heading sukuk, with a given instrumentfalling somewhere on a continuum of debt andequity-like features. Risk mitigation tools aretherefore just as relevant for Sukuk investors asthey would be for other bond and equity investors.

Sovereign and state-related entities are the mostfrequent issuers of sukuk. Malaysia on its own

accounts for 75% of global issuance. Recentlythough, after the global financial crisis and the

Arab awakening, various other MENA economieshave developed sukukmarkets. Saudi Arabia andTurkey are leading the way in the Middle East,and Jordan recently passed a new sukuk law.Tunisia, Morocco, Libya and Egypt are alsoexploring the sukukmarket.

Egypt has recently promulgated legislation toallow the issuance of sukukfor the first time. The

law allows joint stock and limited liabilitycompanies, governmental and quasi-governmental entities, and banks to issue sukuk.

Sukuk can be issued in a number of forms,including investment sukuk, murabaha (cost plus)finance and ijara (which is similar to leasing)sukuk. Other types include, inter alia, selm,modraba, mosharaka.

Additional funds raised through sukuk couldfacilitate budgetary management, help financeinfrastructure, and encourage investment by Gulf

states across the region.


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RELEVANT OECD INSTRUMENTS

The Policy Framework for Investment (PFI)The PFI is a tool providing a checklist of issues for consideration by any government interested in creating an attractive

investment environment and in enhancing the development benefits of investment to society. The policy areas covered are

widely recognised, including in the Monterrey Consensus, as underpinning a healthy environment for all investors, from

small-and medium-sized firms to multinational enterprises.

OECD Principles for Private Sector Participation in Infrastructure

These OECD Principles aim to help governments work with private sector partners to finance and bring to fruition

infrastructure projects in areas of vital economic importance such as transport, water and power supply and

telecommunications. They offer governments a checklist of policy issues to consider in ensuring that citizens get the services

they need at a fair cost and with viable returns to private sector partners.

OECD Principles for Public Governance of Public-Private Partnerships

These OECD Principles provide concrete guidance to policy makers on how to make sure that Public-Private Partnerships

(PPP) represent value for money for the public sector. In concrete terms, the Principles will help ensure that new projects

add value and will stop bad projects going forward. They provide guidance on when a PPP is relevant e.g. not for projects

with rapidly changing technology such as IT, but possibly for well known generic technology such as roads. They focus on

how to get public sector areas aligned for this to work: institutional design, regulation, competition, budgetary transparency,

fiscal policy and integrity at all levels of government.

Arrangement on Officially Supported Export Credits

The Arrangement is a Gentlemens Agreement amongst its Participants who represent most OECD Member Governments.

The Arrangement sets forth the most generous export credit terms and conditions that may be supported by its Participants.

The main purpose of the Arrangement is to provide a framework for the orderly use of officially supported export credits. Inpractice, this means providing for a level playing field (whereby competition is based on the price and quality of the exported

goods and not the financial terms provided) and working to eliminate subsidies and trade distortions related to officially

supported export credits.

CONTACTS

Mr. Alexander BhmerHead, MENA-OECD Investment Programme

[email protected]

Mr. Carl DawsonISMED Support Programme Coordinator

MENA-OECD Investment [email protected]

www.oecd.org/mena/investment
mailto:[email protected]:[email protected]:[email protected]:[email protected]://c/Users/DRAIA_S/AppData/Local/Microsoft/Windows/Temporary%20Internet%20Files/Content.Outlook/4G7IRDFD/www.oecd.org/mena/investmenthttp://c/Users/DRAIA_S/AppData/Local/Microsoft/Windows/Temporary%20Internet%20Files/Content.Outlook/4G7IRDFD/www.oecd.org/mena/investmenthttp://c/Users/DRAIA_S/AppData/Local/Microsoft/Windows/Temporary%20Internet%20Files/Content.Outlook/4G7IRDFD/www.oecd.org/mena/investmentmailto:[email protected]:[email protected]

Investment security in the Meditteranean - June 2013 newsletter

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