What Are Sovereign Guarantees?

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Introduction

Sovereign Guarantees or government guarantees or “wrap”-( aprotective layer around the original agreement) have become one of the major drivers of project finance in developing countries. A sovereign guarantee is a promise by the government to discharge the liability of a third party in case of the party’s default.

What Do Sovereign Guarantees Mean to the Government?

Sovereign guarantees are guarantees given by host governments to assure project lenders that the government will implement particular actions affecting the project. In line with project finance, the sovereign guarantee serves as a capital guarantee that enables the transfer of risk to the government in the event of default, usually as part of the public sector to private sector partnerships (PPP) following policies, initiatives, mandates, or particular goals of a particular country.

Sovereign guarantees are contingent liabilities of the governments that come in to assist in case an event covered by the sovereign guarantee occurs. In theory, the government is forced to accept risks including exchange rates and political risks because it’s in a better position to handle this by creating sound economic policies.

Governments will want to issue a sovereign guarantee for the full project’s value in case they are confident in the private sector developers and if the sovereign guarantees will trigger and accelerate investments in their country. In most cases, government agencies will also want to reap the benefits of the projects once they are operational. The projects can be in line with electric grid stability, energy, food and water security, affordable housing, and other infrastructure development projects.

Do developed countries issue sovereign guarantees?

Developed countries seldom issue sovereign guarantees in their countries because they needn’t do so. In more wealthycountries, private sector infrastructure projects easily accessfinancing at affordable rates (even though the private entities tend to move slowly or adjust terms suddenly). Therefore, the government doesn’t need to partner with the private sector to cover its liabilities.

However, most developed countries and emerging/frontier market host governments will choose to partner with private developers to simplify the procedure. A sovereign guarantee can greatly accelerate funding and it’s particularly useful regardless of the country’s economic situation for establishing new industries, creating jobs, and or boosting growth.

How to Obtain and Use Sovereign Guarantees?

In developing countries, either you need to use diplomatic ties or you’ll need to use new or existing ties to high-calibre government officials such as the President or the Vice President to gain proper attention from the country’s Minister of Finance.

Parties involved in a sovereign guarantee

The guaranteed entity. This is the government contracting authority, such as a line ministry, subnational government or a State-Owned Enterprise (SOE), which is the counterparty of the sovereign guarantee.

The guarantor. This is the sovereign guarantee provider such as the Ministry of Finance.

The beneficiaries. Mainly the project company (Special-purpose Vehicle/Entity) and private sector lenders or investors.

From a private sector perspective, the benefit of a sovereign guarantee is to elevate the creditworthiness of the government contracting agency. But, from a government’s perspective, there are several implications to the fiscal risks of the two entity types. In case the guaranteed entity is a government agency, the obligation being guaranteed is already an explicit government obligation, and therefore the guarantee doesn’t necessarily add to the overall fiscal risks.

In the case of a State-Owned Enterprise (SOE), the obligation is on the SOE’s balance sheet, which the government is then backstopping as an explicit obligation because the government is the controlling shareholder.

There are two types of sovereign guarantees namely;

• Financial or credit guarantees.

• Performance guarantees.

The above sovereign guarantees can be used to cover a wide variety of risks but with different implications for the issuing governments. Financial or credit guarantees effectively cause the government to take on the debt-service obligations of the borrower in the event of default, thus greatly impacting the government’s budget and the country’s borrowing limits.

Under a financial guarantee, the government is stepping into the underlying loan agreements to make debt-service payments on behalf of the borrower such as the subnational government or the SOE usually regardless of the cause of default. Financial guarantees are rarely offered by governments for public sector-private sector partner projects (PPP projects). Instead, financial guarantees are common in cases where the Ministry of Finance provides a guarantee to lenders for borrowing undertaken by subnational government units or SOEs for specific infrastructure projects.

Financial or credit guarantees are typically structured and demonstrated as unconditional, unrectifiable, and liquid (demanding timely payment), hence making their claim process straightforward.

Financial guarantees are rarely utilized in infrastructure PPP projects because they may facilitate unbalanced risk allocations, which place all risk with the government, and they aren’t linked to any performance indicators for the private sector. As a result, the government can be liable for many risks including natural disasters and defaults by the private sector such as construction contractors.

Financial guarantees may provide the wrong incentives for the private sector because they relieve the debt-repayment pressure from the sponsors or contractors, especially if the project isn’t carefully planned and designed. Moreover, governments are usually left with no option to remediate the situation through internal coordination or renegotiations and are instead obligated to make immediate payments.

The good thing about financial guarantees is that they can be very powerful tools to build investor confidence, open new markets, or improve financing terms of the guaranteed counterparts such as sub nationals or SOEs under certain market conditions or specific policy considerations.

Sovereign guarantees for PPP projects (Project Guarantees)

Sovereign guarantees for PPP projects are nearly always structured as performance guarantees to reinforce particular government undertakings or cover the risk of a guaranteed government counterparty’s failure to perform targeted or specific risks or obligations linked to underlying PPP contracts or concessions.

With sovereign guarantees for PPP projects, the government commits to making the contractual obligor (for instance, the PPP contracting agency, subnational government, or SOE) fulfil its obligations under specific project agreements like concession agreements, supply agreements, or output purchase agreements. The central focus is on performance although it may include financial implications to eventually make the beneficiary complete.

The government’s obligations as the 3rd party performance guarantee provider will be discharged in case it can remedy the situation or find ways to deliver or fulfil the performance or service obligations according to the standards or indicators as stipulated in the underlying concession or PPP contracts. Thus, unlike financial guarantees, performance guarantees are conditional, and based on what’s being guaranteed can be broad or relatively narrow.

To call on the government’s guarantee for a PPP project, the beneficiaries normally need to first go after the primary obligor or guaranteed counterparty, which is usually the PPP contracting agency or counterparty of the PPP contracts following the dispute resolution mechanism of the project agreements.

Additionally, although performance guarantees provide ultimate recourse for the beneficiaries, they give the government more liberty and time to correct the problems (through cure periods) and to formulate a solution before it needs to make full payment. For instance, if the off-taker misses a payment under an output purchase contract, the government or the Ministry of Finance may ably apply pressure on the off-taker or find another arrangement to make the payment, before having to make the payment from its budget directly.

Why should government officials understand the differences between financial and performance guarantees?

Understanding the differences between financial and performance guarantees will enable government officials to make more nuanced decisions about when to issue guarantees, the types of guarantees to offer, and how to structure and negotiate them, instead of avoiding them altogether. From the government’s risk and financial management perspectives, a performance guarantee is more favourable than a financial guarantee because the risk exposure tends to be more manageable.

When assessing government guarantees, governments should carefully assess the specific risks, which are being guaranteed to calculate with greater accuracy, the profitability of a triggering event occurring, and the ultimate liability to the government.

What Are Payment Guarantees?

Such guarantees can be either finance or performance-related based on how they are structured. Payment guarantees are monetary engagements, which require the guarantor to execute a payment on behalf of the guaranteed entity, based on the terms defined in the original concession agreement, in the event of payment default by the primary obligor (either the PPP contracting agency in PPPs or the subnational or SOE borrower).

Payment guarantees can be conditional or unconditional. Unconditional payment guarantees are typically seen in public procurements. An unconditional payment guarantee is a financial guarantee utilized by sovereign entities to allow subnational governments or SOEs to gain access to, or get better terms for commercial financing to fund their public infrastructure investment programs.

Payment guarantees in PPPs, however, are mainly structured as performance guarantees because performance expectations may eventually be met indirectly via payment by the guarantee provider in case it fails to cure the performance issues or the payment default created by the primary obligor.

Payment guarantees in PPP transactions are usually conditional and linked to underlying authorizations or PPP contracts, with performance fundamentals for both parties. For instance, the central government may agree to provide a payment guarantee for subnational governments or SOEs to backstop their payment obligations, either for ongoing payments (such as availability of payments for roads, and capacity and energy payments for power projects), or termination payments.

But, such payment guarantees are often dependent on several conditions. In the case of power projects, when the government provides payment guarantees on the payment obligations of the state-owned utility under the power purchase agreement (PPA), the private sector must deliver electricity following the pre-agreed volume and quality standards in the PPA. In case there is a dispute, the payment obligation is established by the dispute resolution mechanism, which has been agreed upon by both parties.

What Are the Benefits of Sovereign Guarantees?

To enable financing of a project, which wouldn’t ably receive funding in the absence of a guarantee. Sometimes projects having several positive economic and social benefits have perceived risks that the private sector won’t accept to take on without a guarantee. For instance, the supply of electricity in rural areas of countries in emerging markets is so risky for the private sector to undertake without a guarantee.

A sovereign guarantee is one way to allow thegovernment to capture the benefits of such projects, which may not otherwise be implemented.

Sovereign guarantees can help build confidence in a PPP market. Sovereign guarantees can help build confidence in a PPP market and demonstrate government commitment to a PPP project, especially in countries where PPPs are relatively new and the market or sector is not tested for private participation.

Sovereign guarantees can be beneficial in case policies are difficult to adjust due to political reasons. Where certain political or regulatory factors may have held up negotiations, a sovereign guarantee can be a crucial workaround in case the policies are hard to change for political justifications such as raising tariffs in the short run, allowing projects to go ahead when the regulatory environment is still uncertain or unfavourable, or if sectoral reforms are still underway, and speeding up the whole project preparation time by covering risks, which are likely to delay project implementation. In such cases, sovereign guarantees can be utilized as interim or transitional measures to mobilize the private sector for infrastructure financing and delivery in the short run.

They improve the terms of financing. Sovereign guarantees improve the terms of financing by either reducing the cost of financing, increasing the amount of financing available to the project, or lengthening the tenor of the project’s financing, thereby reducing the annual cost of debt service passed through to the users of the project’s services. For instance, by providing a project company with a guarantee concerning the payment obligations of a state-owned electric power distribution company, the payment risks are transferred from the utility to the government guarantor, which usually has a better credit profile.

This risk reduction enables private sectors to be satisfied with lower returns in line with the risks, and hence lower the cost of funding. For similar reasons, sovereign guarantees when added to a well-structured project can increase the number of firms that bid to implement the project. This added competition can lower the cost of the project.

What Are the Risks Associated With Sovereign Guarantees?

Moral hazards

Certain guarantees which are so broad such as financial guarantees could reduce the overall benefit to the government by requiring payouts when the risks covered by the guarantee should be private-sector risks. Broad or extreme guarantees may also create a moral threatscenario whereby the incentive for private investors to be efficient in performing their obligations is lowered because they no longer have as much at stake as the government does.

Fiscal risks

Fiscal risks are potential adverse impacts on the financial position of the public body as a result of factors, which affect the performance of a PPP project.

As noted by the International Monetary Fund, guarantees are a form of government intervention and thus are likely to alter the incentives faced by the private sector and other public sector entities due to market failures.

Because of the difficulty of predicting when sovereign guarantees are called and the size of the payout, sovereign guarantees aren’t usually subject to the same degree of scrutiny through the budget process as regular spending. This makes it hard to verify that a sovereign guarantee is the best fiscal policy instrument to meet a certain objective.

When sovereign guarantees are called, usually there isn’t ready funding for them in the current budget. These challenges are magnified when the government gives sovereign guarantees to multiple projects and an economic crisis triggers the payment provision for all the sovereign guarantees simultaneously when the national budget is already strained.

Conclusion

Sovereign guarantees are among the major drivers of project finance in Africa’s emerging markets even though they are associated with different risks.