Role of guarantees in infrastructure provision

Public sector guarantees are given to attract private sector financing for critical projects

NORTHAMPTON:

In recent years, countries around the world have faced the massive challenge of developing and maintaining critical infrastructure.

Constraints on public sector budgets and financing growing infrastructure needs make the role of private sector imperative. A spate of research has shown that private sector participation increases efficiency in investment, management and operation.

However, the private sector faces numerous obstacles that impede its participation in infrastructure projects. One primary reason is the longterm nature of infrastructure projects. This requires a strategy that effectively deals with risks and uncertainty over the entire lifecycle of the project.

Such uncertainty and risks inevitably result in the inability and unwillingness of private sector participation.

A key incentive to attract private sector participation is in the form of offering concession contracts by governments to private operators and developers.

Concession contracts are broadly defined as a legal arrangement in which a firm obtains a right to provide the service from the government.

Concession contracts are crucial in ensuring private sector participation in the provision of critical public goods. These are used for the provision of a variety of infrastructure such as that in transport, telecommunication and energy.

Various forms and structures of concession contracts are used where governments or multilateral organisations such as the World Bank enter a risk sharing agreement.

This is predominantly in the form of debt repayment in the event of insolvency and compensation to private parties in the case of demand falling short of forecasts.

Public sector guarantees

A key element of concession contracts is public sector guarantees given by the government to attract private sector financing and overall participation in infrastructure projects.

Public-private partnerships (PPP) are crucial means of infrastructure provision in many developing countries including Pakistan.

According to the World Bank Public Private Partnership Lab, since 1990 the country has been involved in 116 PPP projects worth $32 billion.

Governments may be able to help encourage private participation in PPP projects through supporting instruments such as guarantees.

Public guarantees are defined as a promise by the guarantor to a beneficiary that in the event of a specified default by an obligor, the guarantor will pay the beneficiary the specified amount.

Key elements of guarantee contracts include the extent of loss coverage, the types of risks covered and the financial instruments to be used.

Typically, guarantees cover lenders or bond investors against default on payments by a borrower. Latest figures on the Ministry of Finance website show that the guarantees offered by the government from July 2020 to March 2021 constituted 0.2% of gross domestic product (GDP).

Guarantees can mobilise and leverage private sector financing by mitigating or protecting it from the regulatory, political or foreign exchange risk.

Public guarantees can aim to spur lending to priority sectors such as small and medium enterprises (SMEs), low-income households or ‘green’ investments.

Some pros and cons

Offering guarantees come with huge benefits, but also significant risks. Although guarantees can facilitate government access to commercial funding for crucial infrastructure provision, guarantees represent a contingent liability to the issuer, with a significant potential negative impact on its financial viability and credit rating.

This undermines debt sustainability in emerging and developing economies and makes them vulnerable to external shocks.

Another key risk involved in offering guarantees is the information problem that is associated with offering such instruments.

By protecting the private sector against losses, guarantees can encourage them to take on more risks, leading to higher default rates.

Such cases, known as ‘moral hazard’, can be reduced by ensuring that the project has adequate collateral to incentivize all stakeholders to perform.

Guarantee schemes have historically been a target of corruption and financial mismanagement. To conclude, the structure and design of guarantees is crucial for their success. Measures should be put in place to ensure the transparency and independence of such funds.

Mismanagement of guarantees can result in long-lasting repercussions for a country’s balance sheet, reducing its political and fiscal space for development.

THE WRITER IS A DOCTORAL CANDIDATE AT THE BARTLETT, UCL