The Nature of Credit Risk in Project Finance

7/24/2019 The Nature of Credit Risk in Project Finance

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Project Appraisal and Finance

Article Review

Nature of Credit Risk in Project Finance

By Marco Sorge

(World Bank Group International Finance Corporation)

Subitted !o

Anirban "#atak

Associate Professor

Institute of Management

Christ Uniersit!

"ame# $a!on %as

&oll' "o'# *+*,


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Project Financing and Credit Risk

Introduction

Project finance has been the one of the most important means for financing of project all

around the globe in various forms such as public infrastructure, defence, industrial

construction, machinery etc. In developing economies project finance has played a crucial

role in fastening the development process and building infrastructure and boosting GDP. This

has enabled developing economies to increase productivity, provide public infrastructure such

as bridges, drainage systems.

Analysis

Due to financial volatility and global market fluctuations, industrial problems in the energy

sector and telecommunication sector there has been many unsuccessful project financing

scenarios which has led to delayed project, monetary losses and increase in credit risk. The

long time period of maturities is one of the reason which results in high credit risk. ig

investment projects re!uire high capital, financial investments and investment at starting of

the project. It takes a long period of time to give back return on investment it raises the risk of

debt service coverage and cash flow as it has to be calculated as per present value. Thus,

project financing have higher maturities and risk associated than syndicated loans. The

project financing involves high leverages and long maturity debts which directly affects the

credit risk on assets and project. "inancial econometric analysis of the syndicated loans infers

that financing with long maturities have higher credit risk. #part from credit risk, long term

maturity e$poses the investor to various other types of risks such as structural risks, political

risks and country risks. %nsuring guarantees with the government, banks and e$port credit

agencies in developing countries will help mitigate the risk.

In recent times project finance has been relying on PPP &public private partnership' by

creating a (P) with independent financing from its parent entity and relying on cash inflows

generated from the (P) for repayment of loan. In the financial crisis of *++ investor

reinvested their portfolios in industrialised countries from emerging economies. This led to

increase of financing of project to new high. Industry risks of energy sector and

telecommunication sector and slowdown of the economy has led to decrease og financing of

project in the globe. In telecommunication sector high investment based projects such as


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optical fibre, ne$t generation bandwidth technology is yet to yield desired rate of return

around the globe.

Projects such as power sector, roads and airports have similar traits which create significant

number of challenges in term of project financing. -ising demand for energy has resulted

need for project financing in in this sector. In industries such as crude oil and petrochemicals

more than half of investments are over * billion which signifies that the investment is very

high and debt is of long term maturity in which risk is high. Two kinds of phases are

associated with these projects namely pre construction phase and operational phase. In pre

constructional phase risk associated are environmental and technological risk whereas in the

operational phase risks political risk, price volatility risk of cost of inputs and market risks.

#n also high investment project involves number of constituent and members and it involves

a collaborative effort of all the parties to cooperate and function with a same goal. Parties

involves government, company involved in construction, banks, financers, suppliers of goods

and raw materials etc. Thus, cohesiveness in terms of functioning and distribution of cash

inflow from the project is crucial for completion and operation of the (P).

In financing of projects various types of contractual agreements e$ists such as supply,

concessions, construction etc., thus, it re!uires to allocate various risks to different parties in

order to mitigate the risk. #s large projects are very big to finance by a single company,

segmented bifurcation of debt and e!uity helps to diversify the risks to many investors which

creates problem at managerial level, decision making and distribution of cash generated

among investors. (yndication of loan is one method which finances big project in which debt

Is led by one bank and syndicated by other banks . This helps to distribute the risk associated

with the project among the consortium of banks and helps in avoiding collision. #lso new

entity with no association with parent company will help to reduce the risk of contamination

which helps to protect the financial strength of investor/s main business. Thus, to mitigate the

risk associated with financing of project emphasis of new structures of financing are being

used such as new risk distribution models, credit protections and instruments of financial

market to widen the scope of financing.

0rossover structures of financing are being developed in which private players are involved

in development of project and operational activity and government handles the market related

risks. #lso derivatives such as forward and futures, insurance of economic risks, foreign

e$change fluctuations are being introduced to reduce risk. #lso securitisations of project


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debts are developing class of assets of investors. This market instrument would provide

greater li!uidity in financing of project.

The credit spread and the risk associated is driven by the level of leveraging a project is

utilising and value of asset of (P) at maturity. Project with long debt repayment period will

have higher risk as the future value of assets of the firm is not certain in nature. 1hen the

leveraging is high the risk is borne by the debt holders during maturity of shorter period. The

project which is non2recourse in nature is completely dependent on cash flows generated and

relies on the construction and pre operational phase after which return can be estimated.

The credit spreads have regression on various micro economic variables such as maturity

period, guarantees made by other parties, borrowers and macro2economic variables such as

foreign e$change fluctuations, growth of GDP, inflation, foreign e$change deficit, reserves

and world market interest rates. The political risk is calculated by 3corruption inde$

published by Transparency International4.

Finding

The findings by the article are that the credit spreads risk form an inverse parabola which

signifies the risk e$posure during the time period of the project. #lso political risks and

guarantees have a major impact on project finance loans and e$ert risk on the credit spread.

#lso project financing relies on many macro and micro economic variables. Development of

the capital market for financing of project will help in credit risk for new asset classes. Thus,

careful analysis of project and efficient deployment of resources and resources over various

classes of assets will help to decrease the credit risk.

Therefore, proactive role of banking sector, government sector and private sector towards

financing of project will facilitate economic development and growth in the developing

countries and growing economies.

References#5ature of 0redit -isk in Project "inance y 6arco (orge &1orld ankGroup International "inance 0orporation

3http788papers.ssrn.com8sol98papers.cfm:abstract;id?=?4

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The Nature of Credit Risk in Project Finance