109. Commercial banks have traditionally been the source of finance for PPPs, especially in Europe, but also in the MENA region. Increases in prudential requirements in the wake of the financial crisis, most notably BASEL III, have seen tighter capital and risk weighting requirements imposed on financial institutions. This has reduced the enthusiasm of banks to lend to infrastructure projects, especially in regions seen as risky, such as MENA, where such loans would attract a higher risk weighting and therefore require greater capital reserves. However, some banks will still be willing to lend to these projects, if for no other reason than to maintain their relationships with clients that may wish to participate. These banks will be very reluctant to lend past the construction phase, which, depending on project complexity, will typically take 2-3 years and mostly less than five years. Bank loans will need to be refinanced or "taken out" at end of the construction period. The need for refinancing or construction loan take-out is currently a significant barrier to private sector investment in MENA region infrastructure.
110. In OECD countries, PPP cash-flows are seen as well suited to long-term institutional investor needs, as they are long-term, matching the liabilities of insurance and pension plans, and are often direct obligations of a highly-rated government. Institutional investors that are required by regulatory oversight or their governing documents to make only high credit quality investments have increasingly participated in PPP infrastructure, as both equity and debt investors. Such investors will not be willing to invest, or will be prohibited from investing, in higher credit risk investments such as MENA region infrastructure.
111. The public counterparty in a PPP will typically desire to pay its obligations in local currency, since its revenue is most likely denominated in local currency and it ultimately controls the local currency. This can create a problem for foreign investors, as revenue from the project will be in local currency while debt service and other expenses will likely be incurred in foreign currency. In other words, the developer and/or investors will face foreign exchange (forex) risk12. Foreign exchange risk is usually hedged through a derivative contract, a swap, a future or a forward contract. These contracts are widely available in the over the counter market for frequently traded liquid currencies, but are much less likely to be available for MENA-region currencies. If such a product can be found, it may be prohibitively expensive, increasing financing costs and jeopardising value for money. Bespoke hedging options may be available, but again these will tend to be expensive.13 For a foreign developer or investor, it is far preferable that the government take foreign exchange risk.
112. Finally, regarding equity investors especially, the return demanded may be too high to justify procurement by PPP. For example, the return on equity received on PPPs in OECD member states is typically 11%-13%. In light of the increased risks, (real and perceived) of doing business in many MENA countries, equity investors will typically require a 20%-25% return, which may make value for money for the state questionable.14
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12. Note the foreign exchange risks considered herein are those arising from exchange rate volatility only. Risks related to controls over conversion of local currency or restrictions on the ability to transfer funds out of the jurisdiction can be mitigated through political risk insurance and are not considered above.
13. See the June 2013 ISMED Newsletter at: http://www.oecd.org/mena/investment/Issue1_June2013.pdf
14. Return on equity figures are based on ISMED Programme staff member experience and OECD consultations.