For Educational Purposes Only
Sovereign guarantees are given by host governments to assure project lenders that the government will take certain actions or refrain from taking certain actions affecting the project. Although a blanket sovereign guarantee of all project risks is impossible to obtain in any project finance transaction, many of the legal and political risk categories typically encountered in an infrastructure project will be well within the host government’s ability to control and may therefore be fairly allocated to such host government.
In theory, the government is forced to accept risks such as exchange rate and political risk because it is better able to manage it through sound economic policies. In practice, however, the heavy debt burden under which many a developing country is labouring may be compounded when, during a period of economic difficulties in the host country, the beneficiaries of a guarantee ask the sovereign to make good on its promise. As the current financial crisis in Asia shows, very few emerging market nations are able to withstand the resulting stampede.
The value of a sovereign guarantee is further constrained by the sovereign debt ceiling. As a result, many lenders are taking a second look at, and in some cases finding ways to avoid, the need for such guarantees through, for example, other risk mitigation measures such as political risk insurance from multilateral, bilateral and export credit institutions as well as private insurance companies.
WHAT IS A SOVEREIGN GUARANTEE?
A guarantee by the government that all obligations will be satisfied when and if the primary obligor goes into default. It is the risk that a foreign central bank will alter its foreign-exchange regulations thereby significantly reducing or completely nulling the value of foreign-exchange contracts. The Sovereign Guarantee is just a “standard” financial guarantee but it is issued by a Government body not a private institution like banks or corporations.
WHY DO GOVERNMENTS USE SOVEREIGN GUARANTEES?
One of the most attractive features for project financing is that it allows the sponsors of a project to guarantee the obligations of a special purpose project company in lieu of incurring direct obligations. Being contingent obligations, guarantees need not be reflected on the guarantor’s balance sheet. However, guarantees are required to be disclosed in footnotes to financial statements in accordance with the prescriptions of the United States Financial Accounting Standards Board.
Indeed, rating agencies often take note of a sponsor’s contingent liabilities, particularly when such liabilities are substantial. Nonetheless, the impact of such guarantees on a sponsor’s credit profile is, by far, much less severe than an equivalent direct liability on its balance sheet. Sovereign Guarantees have therefore become one of the keystones of project finance. Countries that wish to issue such instruments need to be aware of the need to have the liability noted in their financial statements as a contingent liability.
WHAT IS THE PURPOSE OF SOVEREIGN GUARANTEES?
Governments at all levels can issue “financial guarantees” in order to financially promote projects that are deemed to be in the public interest. The guarantees are used as economic incentives for the capital market to finance the projects. In Sweden, for example, financial guarantees have in the past been used to promote agriculture, fishing, housing construction, shipbuilding and energy supply. From the beginning of the 90’s, they have primarily been used to alleviate the Swedish bank crisis and for promoting investment in the infrastructure. The Sovereign Guarantee is only as good as the Government issuing it.
WHO CAN ISSUE SOVEREIGN GUARANTEES?
Generally speaking a Sovereign Guarantee is issued for project financing and loans for government projects such as: Power Projects, Roads, Railways, Ports and Shipping Infrastructure, Telecommunication and other necessary large State Infrastructure projects. In the case of private projects, the Sovereign Guarantee poses a totally different set of problems. Depending on the Constitution (or Ruler) of a particular country the Civil Government Administration will evaluate projects looking to be underwritten by a Sovereign Guarantee and make a recommendation to the Parliament (or the Ruler of the Country) as to whether issuing a Sovereign Guarantee is prudent or allowable.
Usually if a Parliament term in office is approaching its end, “no sovereign guarantee were issued to the private sector, but they will to the government sector. In all cases based on the Constitution of a particular country it comes down to the judgement of the President, Prime Minister or Ruler to issue or not issue sovereign guarantee on the private sector.
He/she can do it (issue) provided that the project is classified as sort of to solve an impending crisis, for example power crisis, water supply crisis, etc. Now, in the world many newly elected government may issue Sovereign Guarantees to power projects which need utmost attention to solve power crisis that is foreseen to happen in the immediate future. In general Sovereign Guarantees will be issued by the Ministry of Finance and ratified by Parliament.
DO SOVEREIGN GUARANTEES ALWAYS INVOLVE RISK?
Yes any situation where one group is guaranteeing to underwrite losses of the other party creates inherent risk. In the case of a Sovereign Guarantee there are many situations where the country could default of the commitment. A Sovereign Guarantee is described as an undertaking by the guarantor (Government) to pay, after the occurrence of certain events which have led to a substantial deterioration of the creditworthiness of the institution promoted by the guarantee (the ”Beneficiary”), one or more amounts to the Beneficiary or directly to its creditor(s).
In the case of these Sovereign Guarantees, the undertaking is directly linked to an underlying loan and involves an undertaking from the guarantor (Government) to honour the payment obligations of the borrower (the Beneficiary) under the terms of the loan agreement in the event of his default. In this case one can say that the creditor holds a put option on the guarantor (Government) since the creditor has, in effect, an option to sell the guaranteed debt to the guarantor (Government) at an agreed upon price, i.e. the face value of the debt.
Courtesy: Russell Duke is Chairman & Managing Principal at National Standard Finance, LLC. Mr. Duke can be reached at RDuke@NatStandard.com. www.NatStandard.com