How Blended Finance can support the development of local capital markets in lower income countries

GuarantCo, a Private Infrastructure Development Group (PIDG) company, was established in 2005 to help mobilise local currency financing into domestic infrastructure in lower income countries across Africa and Asia. We promote the development of local capital markets in order to support the alleviation of poverty.

Unfortunately, in reality, creating affordable infrastructure financed by local capital markets in lower income countries can be very challenging. The high double-digit interest rates, short tenors (typically three years), limited understanding of project financing, uncommercial collateral/security requirements and risk averse financial market regulators are all common barriers that developers of infrastructure encounter. Nevertheless, as pension and insurance markets in lower income countries develop and consequently the pools of capital requiring long-term investment opportunities are also growing, local capital markets have an increasingly important role to play in addressing the infrastructure financing gap.

Typically, investors in lower income countries are restricted to investing in government securities or short-term deposits with the largest banks, thus creating significant concentration risks, which are neither desirable nor wise. This raises the question as to why they are reluctant to diversify and invest in infrastructure projects which in developed economies is viewed as a safe asset class. The answer lies in the local capital markets’ capacity to assess the credit (repayment) risk of an infrastructure project and therefore how to price the credit risk of infrastructure projects appropriately.

GuarantCo uses blended finance in three ways to help address this capacity gap and to mobilise local capital markets to provide long-term local currency financing into infrastructure projects.

1. Leveraging public sector donor capital to provide guarantees to local investors

GuarantCo was designed to be a blended finance vehicle, receiving first loss (equity) capital from public sector donors (shareholders) against which it is able to write guarantees of up to three times the value of its shareholder equity. These guarantees in turn can, on average, mobilise up to a further four times private sector investment into infrastructure projects. Consequently, through GuarantCo, every USD 1 of public sector donor capital can mobilise up to USD 12 of private sector investment into an infrastructure project in the markets on which PIDG focuses.

GuarantCo has high international credit ratings from Fitch (AA-) and Moody’s (A1) which are underpinned by the equity commitments of its government shareholders and its 15-year track record of providing guarantees without incurring any significant loss. The credit ratings provided by Fitch and Moody’s translate GuarantCo’s credit risk to being equivalent to that of sovereign credit risk in lower income countries. In other words, GuarantCo risk is as good as government risk as far as the local capital market is concerned. Thus, by GuarantCo providing a guarantee the local capital market is able to substitute the credit risk of the infrastructure project with a credit risk that is as good as government risk and by implication, to price the risk of the infrastructure project against established government benchmarks.

GuarantCo is also able to use its guarantees to extend the tenor of a financing beyond established local capital market norms. In 2019, GuarantCo provided a guarantee to a bank in Bangladesh to provide a 13-year local currency loan to the first utility scale solar project in the country. GuarantCo was able to mobilise the bank to provide the financing with an initial 50 percent guarantee. Although the bank already had experience in financing the established power sector in Bangladesh, it needed to mitigate the “first mover” risk attached to the solar project, despite the technology being proven and well established elsewhere, and to extend a tenor which was significantly longer than the market norm of five years. To help the bank overcome these challenges, GuarantCo’s guarantee steps up from covering 50 percent of the loan after the first five years to gradually covering 100 percent in the later years.

2. Using PIDG Technical Assistance to provide grants to support capacity building workshops for local investors.

In addition to providing guarantees, GuarantCo also regularly complements its transactions with PIDG Technical Assistance, the grant-providing arm of PIDG which is also donor funded, to finance “free-to-attend” capacity building workshops in local markets. These are designed to help train and educate investors about how to assess the credit risk of infrastructure projects.

For example, in 2014, GuarantCo organised a one week training workshop, funded by a grant from PIDG Technical Assistance, for a group of Nepalese banks to learn about project financing which resulted in these banks providing a 16 year local currency financing with a 90 percent guarantee having originally sought a 100 percent guarantee from GuarantCo. The 10 percent residual risk taken by the Nepalese banks was equivalent to 14 times the value of the grant provided by PIDG Technical Assistance to finance the training workshop thereby demonstrating another way how blended finance can help develop local capital markets.

3. Developing local currency guarantors to support the development of local capital markets

In 2016, PIDG partnered, through GuarantCo and PIDG Technical Assistance, with the Nigerian Sovereign Investment Authority to set up and operationalise InfraCredit Nigeria, a local currency guarantor dedicated to mobilising long-term local currency financing into infrastructure in Nigeria. Through its guarantees, rated AAA locally, InfraCredit Nigeria has enabled Nigerian pension funds to invest in long-dated infrastructure transactions for the first time, thereby opening up a pool of local currency liquidity equivalent to USD 2 billion which previously had been unavailable to the infrastructure sector.

As can be seen from the graphic below, GuarantCo provides contingent capital, a form of guarantee, to InfraCredit Nigeria which is leveraged through InfraCredit Nigeria to enable every USD 1 of public sector donor capital in GuarantCo to mobilise USD 81 of private sector investment in Nigeria. Blended finance on this scale can be transformational for local capital markets as InfraCredit Nigeria is proving. Going forwards, it is the intention of PIDG to build further versions of InfraCredit Nigeria in other lower income countries across Africa and Asia.

In summary

Specialised blending facilities, such as GuarantCo, support the reduction of local currency risks for infrastructure projects, help to crowd in private sector investors and develop local capital markets which ultimately create a significant developmental impact on people’s lives.

Since GuarantCo was established in 2005, the company has closed 55 transactions in 22 countries, provided 43 million people with improved access to infrastructure, created 235,000 jobs and enabled USD 5.6 billion of investments (source: PIDG Annual Report 2019).