ABSTRACT
Policymakers and corporate leaders are seeking ways to direct financial flows to the developing economies of East-Central Europe and the former Soviet Union. From a geopolitical perspective, the stability of this region—both political and economic—depends on creating an economic web that connects the states of the former Soviet Union and East Central Europe with the more developed countries and with each other. From a business perspective, this region has great potential, with low labor and production costs and largely untapped markets. The economic development of this region can contribute to the growth of the world economy; and conversely, stagnation or economic instability in this region could lead to political imbalances that lead to further economic decay.
219Project finance structures have a significant role to play in addressing the financing needs of East-Central European and former Soviet countries over the next several decades. This paper explains the mechanics of project finance transactions, describing the elements that must be analyzed and the risks that are being taken. It then places this type of financing in the broader context of alternative forms of financing, and clarifies the unique role project finance has begun to play in the region. It explores why demand for project finance has grown and continues to grow. This background establishes the framework for understanding the relevance of limited recourse project finance for these countries, and for understanding further developments that will enable such deals to be carried out in this region.
Project finance transactions depend on the revenue streams of a project for repayment of borrowed funds. Because there is no pro forma structure that can be used each time a project finance deal is designed, transactions typically take at least a year for final approval and for disbursement of funds to begin. Analysts review the elements of a transaction to determine how best to compensate for the risks involved and construct a bankable structure. Six categories of risk examined include: political risk, uncertainties associated with the legal/regulatory environment, project risk, reliability of financial flows, cross border risk, and pricing risks.
Project finance combines several advantages that set it apart from other forms of financing. Lenders include multilateral organizations, bilateral agencies, and commercial institutions. However, when any one of these entities lends on its own, using traditional financing tools, it usually does not have the flexibility allowed by a project finance structure. Specifically, project finance allows a great deal of latitude in crafting an appropriate structure to adress the particularities of a country, an enterprise, or a specific project, thus better accommodating higher-risk environments such as those found in East-Central Europe and the former Soviet Union. Risk may be mitigated for each party by employing a combination of financial instruments (such as an escrow account, a syndicated credit facility, or hedging through use of derivatives), and by apportioning the risk among several participants.
Another advantage project finance has over traditional financing structures is that it facilitates the mobilization of large amounts of capital for a single project by enabling several institutions—public and private—to participate. The International Finance Corporation has estimated that countries in the East-Central European and former Soviet region are likely to spend roughly $28 billion a year during the 1990s to upgrade their infrastructure. The bulk of the capital for these projects may well come from project finance transactions. Project finance lends itself to such finance-intensive projects as those in the oil and gas sector in Russia, Kazakhstan, and Uzbekistan, for example, and large-scale highway projects in Poland, Hungary, and the Czech Republic. Renovating a port in one of the Baltic countries might be another project best structured as a project finance deal because of the large amount of capital necessary.
A word of warning: project finance should not be viewed as a panacea to the financing needs of this region for two significant 220reasons. First and foremost, the success of a project finance transaction is contingent upon a functioning and reasonably consistent legal and regulatory system; and legal systems in the majority of the countries of this region are incipient at best. A creative engineer of a project finance transaction should be able to overcome some of the inconsistencies in the legal system that are found in most developing countries. However, there is a limit to how much assurance one can receive from any transaction structure unless applicable laws and regulations are relatively predictable and transparent.
Second, while project finance is particularly suited to large-scale projects, smaller projects are best financed through other means. The greater the risks involved, the more complicated the structure maybe, thus consuming more staff time and extending the period from design to disbursement. The labor and time-intensive nature of this form of financing inclines most institutions to opt for larger-scale projects to justify the substantial investment of time required.
Development of the economies of East-Central Europe and the former Soviet Union requires huge capital inflows that necessitate the expansion of the modes of financing applied. As the countries in this region develop legal and regulatory structures that enable financing, project finance structures are expected to be utilized more frequently.
